G8 Education Ltd (ASX: GEM), recently announced that it has contracts in place that give it the right to acquire eight premium childcare and education centres from a number of different vendors. The acquisitions are expected to settle before the end of September 2015. The total purchase price for the eight centres is around $12 million, excluding transaction costs. This transaction will increase the number of places by 855 and takes the total number of places in the Australian portfolio to 35,125 per day.
While these acquisitions may sound positive, here is why G8 Education's ongoing growth-through-acquisition strategy makes it a sell for this investor.
First, let's look at the positives.
Positive federal budget changes
G8 Education will certainly be one of the biggest beneficiaries from changes to the childcare sector announced in this year's federal budget.
The government will provide $3.5 billion to the childcare industry over the next four years, with the majority of the increase to be available from July 2017. The system will also be simplified with a new single means-tested childcare subsidy, to be paid directly to operators.
The new system will see an increase in funding, particularly for lower income families earning up to $65,000, who will receive funding support for 85% of the childcare cost per child, or a designated benchmark price, whichever is the lowest. This will fall to 50% for families with incomes of $170,000 and above.
Positive sales and profit growth
Sales and profit margins look very healthy. Since 2007, G8 Education has grown sales by 103% per year from $3.3 million to $479 million in 2014. Its operating profit margins have grown to 24% in 2014, and its net profit margins have grown to around 10% in 2014.
On the surface, this all looks positive for G8 Education, but let's now have a look at the negatives.
The $688 million funding gap
Basic fundamental analysis of G8 Education's financials reveals that since 2007 it has been left with a growing funding gap of $668 million.
This $668 million consists of negative cash flows after investing of $572 million, dividend payouts of $68 million, $27 million in other financing cash flows, and $0.17 million in foreign exchange effects. This leaves G8 Education with a funding gap of $668 million. To offset this gap, G8 Education has had to increase its borrowings by $385 million and raise equity of $400 million to cover the shortfall.
Further, G8 Education's return on equity (ROE) has consistently averaged a very poor 4.59% since 2007. In 2014, the company generated a ROE of around 13%. The only problem is that its growth-through-acquisition strategy has increased debt by 66% per year from $10 million to $352 million. Its debt-to-equity ratio is now at 42.83% in 2014.
No competitive advantage
G8 Education does not have any competitive advantage. The childcare industry is highly fragmented with lots of vendors. The majority of providers manage only one centre. While this does give G8 Education a great opportunity to make well-priced acquisitions and consolidate the industry during the next decade, as with all acquisitions, management expects the combined entities to generate synergies through increasing sales or lowering costs or a combination of both. There is always a risk that G8 Education will be unable to achieve these benefits.
Poor share price performance
In the past 12 months, G8 Education's share price has dropped by around 21%, a massive underperformance when you compare it to the S&P/ASX 200 (Index: ^AXJO)(ASX: XJO), which is up around 4% during the same time. The share price, which is currently around $3.50 is a long way from its high of around $5.60 back in September 2014.
At its current price of around $3.50 and a P/E of around 20, I think G8 Education's shares are still overvalued, even at these levels.
