G8 Education Ltd (ASX: GEM) is one of the largest operators of childcare centres across Australia and Singapore. The stock has been a top performer over recent years, but would it make a good investment today? Here are the pros and cons of the company.
Pros
- Management has achieved 52% earnings per share (EPS) growth annually between 2010 and 2013 through a series of astute acquisitions. 2014 accounts will be released this month to reveal another stellar year.
- Childcare is a growing industry because women are increasingly returning to work after having children and parents are attributing more importance to early education.
- The childcare industry is fragmented. Despite being a market leader, G8 Education has only 5% market share in Australia with lots of room to expand.
Cons
- Future growth will be slower because each year more acquisitions are required to maintain current growth rates.
- Growth by acquisition is risky because sellers always have more information than buyers, so the odds are stacked in their favour. This risk is somewhat mitigated by management's track record.
- Regulatory risk because revenues are dependent on government rebates.
- Management pays dividends whilst issuing new shares, effectively giving to shareholders with one hand and taking with the other.
Overall G8 Education is a strong and growing business, albeit subject to moderate risks.
What is a good business worth?
Interest rates are low and you would be lucky to find a term deposit paying much more than 4%. Term deposits are risk-free and therefore preferable to any stock with a comparable earnings yield. Vocation Ltd (ASX: VET), another education provider, highlights the risks inherent in stocks. Once trading at over $3, it now trades at just 25 cents after the Victorian government cut funding.
When interest rates inevitably rise, a stock with an earnings yield of 5% is going to look expensive. I would not buy any stock with an earnings yield of less than 6%, and even then I would only buy the best companies. A good company such as G8 Education should provide an earnings yield of 8% to cover the extra risk.
Does G8 Education fit the bill?
Management advised the market on 4 December that earnings before interest and tax (EBIT) will be less than 5% over $101 million for 2014. Adjusting for interest and tax, I estimate that net profit after tax (NPAT) will be around $65 million. The market capitalisation of G8 Education is $1.5 billion, giving a current earnings yield of 4.3%.
Foolish takeaway
Admittedly, the above figures are a little conservative because they do not include the full-year impact of acquisitions made in 2014, but the company is so far away from my 8% benchmark that this is irrelevant.
It is difficult to predict the future so I prefer to rely on a margin of safety when making investment decisions. Although G8 Education is a quality dividend paying company, there is no margin of safety as its earnings yield is too low. Therefore I would not consider buying at current prices.
