There has been a lot of negative commentary lately about companies that use the 'roll-up' strategy to drive earnings growth. Companies like G8 Education Ltd (ASX: GEM), 1300 Smiles Limited (ASX: ONT) and Greencross Limited (ASX: GXL) have proven the strategy can be successful but some investors are getting nervous if the growth is sustainable.
So what exactly does this strategy involve and why has the market suddenly changed sentiment to companies that employ it?
Here is a quick guide for investors to help them understand what all the fuss is about.
A 'roll-up' strategy basically means one company acquires many smaller businesses to achieve earnings growth. For example, G8 Education purchases multiple childcare centres and gains that revenue immediately. The strategy usually involves companies within the same sector and in theory should reduce costs through economies of scale and synergies.
There is one major pre-requisite that must be met if the strategy is to be successful and that is the industry in question needs to be highly fragmented. This means the industry is not dominated by one or two players and instead there are many small operators. Unlike supermarkets or petrol stations, industries like childcare centres, vets, dentists and law firms have traditionally been operated by local businesses that can be consolidated by larger companies.
'Roll-ups' tend to be successful when equity markets are rising and the share price of the company in question is also rising. This is because many of the acquisitions are funded through capital raisings. Shareholders are usually more willing to invest more capital when the dilutionary effect of capital raisings is minimised and this is the case when the share price is high.
Another important factor for shareholders is the acquisition price. The strategy is most successful when the multiple paid for the acquisition stays within a set target. In most cases, listed companies earn an earnings uplift by purchasing private companies at a multiple of four or less. This essentially makes the listed company comparatively more attractive and is known as the public to private price-to-earnings arbitrage.
Finally, investors need to be aware of the mix of debt and equity to fund potential acquisitions. As previously mentioned, equity raisings are usually well received when the share price is rising. When the share price is falling, it is harder for public companies to raise equity and they have to rely on debt to fund further acquisitions.
The well-known case of ABC Learning has been a lesson to many investors about the risk of taking on too much debt and companies have been less inclined to utilise large amounts of debt to make acquisitions. Without more capital however, the company cannot make further acquisitions and instead needs to rely on organic growth and reduced costs to maintain earnings growth.
Foolish takeaway
Only time will tell if the 'roll-up' strategy will be successful but investors should be cautious when companies rely solely on acquisitions to create earnings growth.
