After hitting an all-time high of $5.63 in September 2014, shares of early childcare provider G8 Education Ltd (ASX: GEM) have sunk to $3.40, which is just above their 52-week low of $3.21. This selloff is likely caused from waning confidence in G8's acquisition strategy and its future funding capability.
G8 acquires childcare centres for a target price of 4x earnings before interest and tax (EBIT) and then rolls them under their management system.
Future acquisition growth and funding
The capacity of G8 to fund future acquisitions and pay dividends is a major issue for investors. The business acquired almost $500m of childcare centres in 2014 which was funded through a capital raising and several debt issuance programs. After announcing another $45m of acquisitions in 2015 and paying for dividends the company will have minimal cash left in the bank, estimated at $30m.
This concern is validated when free cash flow to equity (FCFE) is compared to the dividend payments. Basically, FCFE is the cash flow available after all operating expenses, interest and principal payments have been paid and investments in working and fixed capital have been made. In short, this is the cash flow available to pay dividends to shareholders or to be retained and used to fund acquisitions.
The increase in free cash flow has been consumed by an equal increase in dividends which would normally result in no earnings being retained by the company. The third column, paid in shares, is the amount of the dividend that was paid by issuing shares through the company dividend reinvestment program (DRP).
By issuing shares instead of paying cash this amount is available for reinvestment back into the company and amounted to $23m in 2014. With only $20-30m free cash flow per year after paying for dividends, it is likely that any future acquisitions will require further equity or debt.
There is a sneaky method that G8 could use to avoid raising additional equity or issuing debt. In December 2014, G8 issued the quarterly dividend using a fully underwritten DRP in which UBS was the underwriter.
What is a fully underwritten DRP?
A fully underwritten DRP is effectively a small capital raising. It allows the company to issue shares for the entire dividend, paying out zero net cash in the process. Those who elect to receive a cash dividend will have their shares sold to the bank underwriting the plan. In this respect, a shareholder requesting cash is not receiving a payment from company earnings but rather selling down a stake in the company. This method allows a company to declare a dividend without actually paying for one. For this reason they are misleading and are not shareholder friendly as those who do not elect to receive shares will have their holding diluted.
Gripes aside, using a fully underwritten DRP over the next 12 months would provide G8 with around $100m of additional free cash to acquire approximately 50 new centres. To sustain its high growth rate it is likely G8 will aim to acquire more than 50 centres per year, indicating that a capital raising or additional debt may still be required even if they use this method.
Is it sustainable?
G8 Education has increased its dividend roughly inline with free cash flow. Personally, I would prefer to see the company retaining a greater portion of its earnings to internally fund acquisitions rather than continually tapping investors and debt markets whilst simultaneously increasing its dividend. At this point in time the combination of dividends and acquisitions appears to be unsustainable without additional funds in FY15/16, depending on acquisition volume.
With large numbers of quality childcare centres still available issuing additional equity for acquisitions will allow G8 to continue growing at a rapid rate. This will ultimately benefit shareholders if the quality of acquisitions is maintained. This will be important to watch as competitors including newly listed Affinity Education Group Ltd (ASX: AFJ) may increase the cost of future acquisitions.
With a little control from management G8 should be able to fund a large proportion of its acquisitions from free cash flow in the near future and will be able to increase its dividend at a sustainable rate.
With shares trading around $3.40 and offering investors a grossed up yield of 10%, I think current fears of the business model and future funding capacity are overblown and the shares provide good value.
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