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Is there trouble brewing for these education stocks?

Australia’s two largest listed childcare groups Affinity Education Group Ltd (ASX: AFJ) and G8 Education Ltd (ASX: GEM) have delivered above-average returns for investors over the past 12 months. Affinity is up 29%, while G8 is up just under 50% after a period of rapid growth.

The primary business model of the two companies is identical; buy as many childcare centres as possible, at reasonable prices, in order to reduce overheads per centre and achieve ‘efficiency of scale’ benefits. This story may seem familiar for investors in ABC Learning during the 2000s, however these companies have (mostly) vowed to learn from lessons of the past.

But first, some history

ABC Learning was formed in 1988 and quickly grew in Australia and overseas by purchasing the majority of competitors at what turned out to be inflated prices. Such was the company’s appetite for growth, debt steadily grew to $1.8 billion and in 2007 the company revealed it was unable to afford repayments. This triggered the share price to spiral downward and the company was eventually placed in receivership, with a large proportion of centres sold to a charitable consortium now known as Goodstart Early Learning.

A different approach…

G8 Education has a stated aim to purchase centres for four times forward earnings before interest and tax (EBIT). This has allowed the purchases to be immediately earnings per share accretive, while minimising the company’s debt load relative to assets. G8 has performed well, and investors have piled in as the sustainable growth story has gained traction.

Affinity has taken an extremely similar approach, however appears to be less concentrated on a defined price limit. The terms of the last purchase of two centres were not disclosed, while the previous purchase of seven centres was for 4.3 times forward EBIT.

A potential game changer!

In the last month, the two companies have made major acquisitions to rapidly boost daily childcare places. G8 announced the purchase of 91 centres to increase daily places by 28% to 27,995, while Affinity this week announced the purchase of 51 centres to boost daily places by 83% to 8,290. Importantly however, these purchases were made for 5.79 times and 5.3 times forward EBIT.

G8 noted that the purchase was above its preferred purchase price, but the opportunity to add 30% more places was essentially too good to refuse. Affinity appears to have only noted that the purchase will be earnings per share accretive immediately and reflects its preferred purchases going forward.

Foolish takeaway

It’s far too early to say that the market has changed and childcare centre owners are starting to drive a hard bargain with G8 and Affinity, but I would like to see the next purchase being closer to four times EBIT, especially from G8. I believe G8 remains the best option of the two, based on its stance of paying a reasonable price for centres. This should limit gearing, increase free cashflow over time and allow the company to continue paying strong dividends. For now, investors should keep an eye out for the next purchase and which way the purchase price moves.

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Motley Fool contributor Andrew Mudie does not own shares in any companies mentioned. You can find Andrew on Twitter @andrewmudie

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