G8 Education Limited’s (ASX: GEM) share price has climbed 89% in the last six months rising from 41 cents to currently trade around 94.5 cents. However, the child care centre operator appears to be following a strategy similar to that of ABC Learning, which crashed and burned in 2007 after taking on too much debt. Broker analysts appear to be falling for the same trap now as they did with ABC, with 2 analysts having a strong buy rating on the stock, and only one with a hold rating.

As one broker notes “investors can look forward to a period of acquisition newsflow, lifting our EPS forecast and supporting the ongoing re-rating”.

For the year to December 2011, G8 reported a 396% increase in net profit, from $3.5m to $17.3m, and earnings per share jumped from 3.2 cents to 9.3 cents per share.

Acquisitions

Over the past 20 months, G8 has acquired five separate child care groups and now owns 135 child care centres, while it has recently expanded into Singapore with 20 owned/operated child care centres and 51 franchised centres.

To fund the acquisitions, borrowings have increased from around $15m in 2010 to $36.4m in 2011. The company has also raised more equity with 12m shares issued in February 2012, on top of share raisings in 2011 of $19m and $18m in 2010.

This is very similar to ABC Learning. ABC had to raise debt and more and more equity to pay for its acquisitions. Intangible assets now total $142m – more than its net assets of $115m.

(In 2004, ABC Learning had $152m of net assets, but $236.8m of intangibles).

The net debt to equity ratio as at the end of December 2011 was 32 per cent, but will fall thanks to the February issue of 12m shares for the Kindy Patch acquisition.

G8 has also announced that it has an acquisition pipeline of over 70 centres that it’s considering.

The Foolish bottom line

While it would be harsh to suggest that G8 is an ABC Learning clone, so far there are many similarities between the two businesses.

So how do you tell if G8 is an ABC Learning clone? The key things to watch are return on equity, net profit margins, free cash flow (operating cash flow less capital expenditure) and net debt levels.

Any time you see any of those indicators deteriorate significantly over two or more periods, its time to head for the exit, if you haven’t already.

The ASX is already on the move in 2012, and Goldman Sachs experts recently said they reckon S&P/ASX 200 could top 5,000 next year. Read This Before The Coming Market Rally is a must-read for investors who don’t want to miss out on the party. Click here now to request your free copy, before it’s too late

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Motley Fool contributor Mike King doesn’t own shares in G8. Take Stock is The Motley Fool Australia’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691).

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