G8 Education And The Notion Of Arbitrage

On tonight's edition of Your Money Your Call Shares, a great investment analyst was on the show who talked about one of the companies i own. He proposed a situation which was very interesting. He mentioned how G8 education (ASX: GEM) is arbitraging the private sector's cheap side and bringing it to the public.

I'm not entirely sure if i understood him correctly or if I'm veering off on a different tangent but essentially, he hinted towards the business being able to buy private businesses (the childcare centres) which are cheaper and bringing them public in one form or another (which tend to be more expensive). For example, G8 education is paying approximately 4x forward EBIT for the centers. However, to buy one stock of G8, it is far more expensive than 4x EBIT on the market. This way, Chris Scott has used his entrepreneurial skill to raise his own personal wealth in an intellectually sound manner (which isn't a foreign strategy for Mr Scott). The pullback in G8 Educations price is triggering potential buys. Contrastingly, it's interesting to see that Citi Group has recommended a sell on the stock.

A common theme i hear about the company is that as they have used economies of scale to drive margins and the like, which in this case is a limited strategy as there is a quota on the ratio of children to teachers. Continuing with this logic, it makes sense to assume growth in margins driven by this method isn't sustainable. However, this doesn't stop them from buying more centres and to continue their roll-ups. Another problem here is that the deteriorating balance sheet as a result of this, which is incrementally increasing the risk of the business. Pricing potential is also an issue. It's important to note that, if you bought the stock when the company's EPS was about 11c and five years later the EPS has grown by a factor of five, the problem of questionable growth at a premium is reduced. For example, lets assume that in five years from now the company has EPS of $0.55 and is trading at 18x. If you bought in now, the downside is reduced (leaving aside the interim period).  Another potential problem is that the business has a restricted organic growth business model which may be a cause for concern in the future. All aside, i still believe the company is good and to say the least, it's been a good learning experience.

I'd highly recommend watching the show if you're interested in stocks because it provides some good insight to various different analysts and their different ways of thinking about the market, but more importantly, about specific companies.