Can G8's growth-by-acquisition strategy sustain its attractive dividend?

2015 may have been a shocker of a year for G8 Education (ASX: GEM) following its failed acquisition of rival Affinity Education Group (ASX: AFJ), earnings and revenue falling short of expectations, and market concerns that it's paid too much for recent acquisitions.

But the childcare centre owner and operator's fortunes appear to have stabilised since the China-fuelled sell-down earlier this year, with the share price up around 8% since mid-January following revelations it's paid down SGD155 million of bank debt earlier than expected.

This early pay down of debt is encouraging, especially given some concerns over G8's ability to repay its entire corporate note of $486 million in mixed AUD/SGD debt within the next five years.

A new debt package, plus a new Chair (Mark Graham Johnson), and the pending appointment of former Suncorp CEO David Foster to its board, all bode well for Brisbane-based group in 2016.

The company deserves a lot of kudos for the way it's aggressively grown its business through a growth-by-acquisition strategy – costing it around $1 billion – which have taken its child care centre numbers to around 455 across both Australia and Singapore.

In simple terms, the stock's value creation thus far has come from what's called a 'multiples arbitrage'. In other words, G8 buys childcare centres privately at a multiple of four to five times EBIT, and then raises equity as a public company at an average of about nine times.

However, what you need to keep an eye on is its heavy reliance on finance and share issues to grow sales. The company typically picks off clusters of individual businesses from private owners using funds raised from public markets (i.e. shareholders) at much higher rates or debt. 

Given the growing pressure that these acquisitions have placed on its balance sheet, you should look for greater disclosure on the occupancy rates of its child care centres, the purchase price and location of new centres, plus a better understanding of its total operating cash flow.

Unsurprisingly, net-debt to equity – now at 50% – has grown significantly within recent years, and its total funding gap has grown to $668 million. Given the meteoric growth-by-acquisition strategy adopted failed rival ABC Learning, you need to watch G8's cash flow and the future manageability of its gearing levels carefully.

Admittedly, at 1.41, G8's cash flow ratio appears pretty good. However, when compared with a cash flow ratio of 2.11 back in 2010, it's clear that recent acquisitions are starting to stretch the balance sheet.

What's equally concerning for investors is the longer-term impact of its growth-by-acquisition strategy on its highly attractive (quarterly paid) dividend yield of 6.5%, which once franking credits are added grosses up to around 11%.

While quarterly dividends – which are currently around 50% of total cash flow – appear sustainable at current levels, this may not remain the case if G8 continues to rely on additional debt which can and does dilute shareholder value.

It's likely that taking on additional finance could see the company pay substantially higher rates, subject to interest rates and investor appetite for debt at the time.

Despite G8's long-term funding gap, long-term cash flow relative to reported profits is strong, and the stock is expected to continue delivering the exceptional earnings per share (EPS) growth that shareholders have enjoyed over the last five years; with EPS of $0.25% (F) in 2015, jumping to $0.28 and $0.32 in 2016 and 2017 respectively.

However, the profitability of G8's acquisitions appears to be deteriorating, and much of the increase in equity can be attributable to equity raisings. Equally revealing, new share capital of $510 million eclipses the $31 million of retained earnings.

At face value, G8 is becoming a riskier investment, and with only around 7% share of long-term care centres in Australia, more acquisitions appear inevitable. There's growing concern that with quality acquisitions become scarcer and competition for acquisitions threatening to erode the multiple arbitrage G8 has achieved in the past, growth could become less bankable.

Based on some 12 month targets of around $4.30, the current share price looks like a reasonably attractive entry point, especially for those taking a long-term view on the stock.

Get underneath G8's headline numbers next reporting season, and pay particular attention to increased debt levels, cash flow, and return on assets. Also pay close attention to any underlying commentary on the likely funding of future debt to perpetuate its growth-by-acquisition strategy.