Childcare centre owner Affinity Education Group Ltd (ASX: AFJ) is increasing the size of its business by around 66%, after announcing that it will acquire 51 centres in an $80 million deal.
In a sector that is dominated by independent operators, Affinity and its larger competitor G8 Education Limited (ASX: GEM) are expanding their market share rapidly.
G8 Education recently acquired Sterling Early Education for $228 million, which includes 91 premium childcare and education centres, including 76 long day centres and 15 centres for outside school hours care. That was in late March, and followed an announcement in February that it was acquiring 63 centres. G8 now has 388 centres, while Affinity's total centres will rise to 119 post the latest acquisition.
What will be a concern for investors is that both Affinity and G8 had previously said they aimed to buy centres at around four times earnings before interest and tax (EBIT). Affinity's latest acquisition is priced at 5.2 times EBIT, while G8's purchase of Sterling was priced at 5.8 times EBIT.
Either independent operators have wised up to the moves by the two largest listed companies and are demanding higher prices, or G8 and Affinity are more willing to pay higher prices to build scale.
Either way, the rapid expansion of both companies will bring back memories of ABC Learning, which crashed after taking on too much debt, while trying to expand rapidly both here and overseas.
G8 for its part says that it will return to paying lower prices in future, but Affinity says it is changing its strategy and will describe deals on the basis of whether or not they would add to future profit. That raises a red flag in my books, as ABC Learning also reported massive rises in profits, but its free cash flow was negative for six years, and shares on issue and total debt soared before it collapsed.
Foolish takeaway
With one obvious red flag, Foolish investors may want to steer clear of Affinity for now. As a newly-listed company, there is not much financial history on which to judge the childcare operator's performance. Further acquisitions at multiples above four times EBIT would raise more red flags, not just for Affinity but also G8 Education.
