Sunday, January 4, 2015

Bright Horizons: Overvalued Stocks Can Be A Good Thing

Bright Horizons Family Solutions, Inc (BFAM) runs day care center sponsored by employers. The company has a long history and Bain was the sponsor of the recent IPO. Famous Bain alum Mitt Romney even mentioned it in his presidential campaign.

On the surface, valuation has always looked stretched and it just continues to get worse over the past 2 years. At $45.4 per share, BFAM trades at 26x 2015E earnings and 16.5x LTM EBITDA.

When Rich Valuations Can Help the Long Thesis

I decided not to short this for a variety of reasons. The more counterintuitive one (at last to me) is that in BFAM’s case, over-priced stock can actually be a good thing. BFAM is a serial acquirer and they’ve been able to acquire at 5-9x EBITDA (recent acquisitions include kidsunlimited, Childrens Choice…etc). If you can raise money at >16x EBITDA and acquire at 8x EBITDA, you can do this all day and add to shareholder value in the process.

Everyone knows that companies should do buybacks if stock is undervalued. The flip side of that is if your stock is over-valued, you should issue shares and buy something of value with it.

This seems borderline ridiculous. After all, if over-priced stocks could be part of a long-thesis, then when is anything ever too expensive? Clearly there has to be caveats with the “use over-valued stock as cheap currency for accretive acquisitions” argument. There are a couple requirements I can think of, both of which BFAM was able to meet.

  1. Large potential for growth through acquisition, and acquisitions make sense because you can’t simply take business from competitors
  2. Price arbitrage between acquirer and target. 

I think the criteria above should filter out most high P/E stocks. Typical high priced internet companies cannot buy each another cheaply. For disruptive companies, acquisition might not even make sense if you can simply take business away from competitors. For example, TrueCar (a car lead-generation company) can take business from competitor AutoBytel. It would not make sense for TrueCar to buy AutoBytel.

Bright Horizons, on the other hand, meets these criteria. Its market is vast and highly fragmented, with over 100,000 licensed U.S. day care centers (BFAM currently has <900 centers). The day care center business is location dependent, so you have to either build or acquire, instead of simply taking business away from competitors. Finally, the ability to raise money at 16x EBITDA then acquire at 5-9x certainly qualifies as price arbitrage.

Other Reasons AGAINST Shorting BFAM

These are more mundane and should be part of any standard long-thesis for this name. I will just list them out below.

  • This name deserves premium multiple 
    • EPS growth in the high teens or even 20%+
    • Stability of cash flows and track record = lower required returns from investors
    • The company is a bit of a glamour stock and commands glamour valuation. Normal, day to day people actually have heard of Bright Horizons, and would like to brag that they own their kids’ day care center.
  • EBITDA is understated because they're adding new facilities and those have not fully ramped up yet. As children age each year, Bright Horizons’ pricing naturally falls due to lower operating cost. This allowing them to raise prices without customers noticing.

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