Childcare centre owner and operator, Affinity Education Group Ltd (ASX: AFJ) fell as much as 11.9% in early trade today, following the removal of a trading halt.
Last week, Affinity shares entered the trading halt pending the announcement of an acquisition and $75 million capital raising.
Following the successful completion of the $52 million institutional offer component earlier in the week, retail investors on the share registry at 7pm tonight (Sydney time) will have the right to participate in the upcoming $23 million retail component.
The money from the capital raising will be used to fund the acquisition of nine premium childcare centres – one in Brisbane and eight in New South Wales.
Having listed on the ASX in late 2013, Affinity has been aggressive in buying new centres. Following the completion of the latest acquisition, it'll have 161 centres.
Like G8 Education Ltd (ASX: GEM), Affinity essentially undertakes a very simple price arbitrage – it raises debt cheaply or issues shares (to raise money) at a high price, which is then used to fund buying new centres at much lower multiples.
So long as Affinity's management can buy new centres for a low profit multiple, such as four times annual earnings before interest and taxes (EBIT), earnings per share will increase.
Whilst it sounds simple, there are a lot of variables at play and investors need to be alert.
With the collapse of ABC Learning still fresh in the memory of many investors, it's important to focus on occupancy rates (keeping centre occupancy rates above 80% is a must, in my opinion) and interest cover.
Interest cover is easy to calculate, it's EBIT (earnings before interest and tax) divided by interest expenses. At 31 December 2014, G8 Education's interest cover was 8.9 times (which is very good).
Following Affinity's capital raising, debt is expected to be $34.9 million, which is lower than the $71.8 million it would've been had it not issued shares. I think this is acceptable. However, in the long term, occupancy is the overriding factor to the company's profitability.
Should you take part in Affinity's offer?
Investors will have the opportunity to buy new shares at $1.18 per share under the retail offer. Before midday today existing shares were trading at $1.19. New shares won't be tradable for around a month (15 April 2015). If shares trade lower than $1.18 today and your brokerage costs aren't too high, you could always just buy your new shares on the market and save yourself the hassle of going through the offer (but that's unlikely to happen).
However, I'd probably take up the offer if I already held shares (I don't) and believed in Affinity's investment thesis over the next three to five years, this would avoid the effects of dilution.
So long as investors – and management – buy centres which have good occupancy rates and debt is kept to an acceptable level, the growth strategy being pursued could be worthwhile. However, I think it's important to understand that this type of rollup strategy isn't risk-free arbitrage and it's not likely to be a viable growth strategy over the ultra-long-term (10 years of more).
