Description

Thesis

Afya Ltd (AFYA) is a well managed growth company whose valuation has de-rated to an attractive level. The company is the leader in the for profit medical education business in Brazil, a fragmented, underserved industry with attractive  economics and  high barriers to entry.  The Company’s nascent effort to develop a digital ecosystem to address the needs of the healthcare industry provides significant optionality while the core education business provides upside and limits the downside. 

Why (I believe) the opportunity exists 

Brazilian Equities De-rating

The opportunity exists because Brazilian stocks have  been in a bear market for the past decade and suffered an even steeper de-rating  in 2021 due to aggressive monetary tightening. The Selic Rate (Fed Funds equivalent), having  declined from 14% to 2% from 2016 to 2020, increased abruptly from 2% to 9.25% in 2021. The tightening reversed a  multi year asset allocation shift from fixed income to equities. Newly listed companies which had attracted international growth investors were especially impacted. For example, Stone (STNE), the payments company which became well known because of its prominent shareholder roster (Berkshire Hathaway, D1, Lone Pine) is  down 80% from its peak and has suffered a significant multiple derating on the back of earnings disappointments. 

Downward Earnings Revisions 

The opportunity exists because Afya has gone through an earnings downgrade cycle over the past year. Afya has delivered attractive growth and profitability since its IPO: 34% revenue cagr, 36% EBITDA cagr, 47% EBITDA margin, 75% of EBITDA convereted to free cash flow. However, in 2020 and 2021 the company faced Covid related headwinds. The company experienced a deterioration in its cash conversion cycle as receivables increased from 70 to 95 days of sales.  The expansion of new capacity was delayed, resulting in a reduction in  revenue growth estimates. And, the expansion into Digital Services, which is an entirely new business, resulted in greater than expected dillution to margins.  As a result, the  consensus 2022 EPS estimate declined from $1.43 at the beginning of 2021 to $0.95 currently. 

Company Description and History

Afya is the leading medical education institution in Brazil and a leading contender in the embryonic market for digital services targeting the healthcare ecosystem in Brazil. As of the last quarter, undergraduate tuition, the vast majority of which comes  from medical courses, comprised 86% of revenues. Continuing education comprised 4% of revenue. Digital services to the healthcare ecosystem in Brazil accounted for the remaining 10% of revenues. Revenues are estimated to be $300 million in 2021 and $390 million in 2022. 

The Company was founded by current board Chairman,  Nicolau Carvalho Esteves MD in 1999. After having served as CEO of several companies (IPTAN, IESVAP) which now form part of Afya, Mr Carvaholo Esteves launched ITPAC Araguaina in the state of Tocantins with initial capacity for 480 students.   The company has expanded via acquisitions throughout its history.

In 2016, the company created a holding company called NRE Educational in partnership with Bozano Investimentos (aka Crescera)  in order to accelerate the industry consolidation process.  In March 2019, Afya Educacional was created from the merger of NRE and MedCel, a brand of preparatory courses for residency programs. 

In July 2019, Afya Educational listed its shares  in the NYSE at $19/share. In April 2021, Softbank Latin America invested R$ 822 million (US$150 million) via a convertible note bearing an attractive 6.5% rate, convertible into 5.9 million Class A shares at $25.35/share. The proceeds were intended to fund Afya’s Digital Services strategy. Additionally,  Softbank acquired 2.2 million shares from the controlling shareholders for an undisclosed sum and took a board seat. In August 2021 Bertelsmann Ventures acquired the entirety of Bozano Educacional’s (aka Crescera) shares for an undisclosed sum. Bertelsmann had held an indirect stake in Afya through its investment in Bozano Educacional since 2016.  

As of 3Q21 Afya had 93.1 million common shares outstanding (94.2 fully diluted), comprised of  47.9 million Class A shares and 45.8 million Class B shares. The company has a dual class structure with class A shares entitled to 1 vote and class B shares entitled to 10 votes.  The table below is a dated but provides a rough breakdown of the shareholder structure. Bozano Educacional has been replaced by Bertelsmann Ventures and Softbank Latin America now owns the convertible and roughly a 2% stake in common shares which it acquired from the founders.  

Management

Since the IPO, management has done an impressive job of executing the Company’s  aggressive expansion strategy. It has successfully integrated multiple acquisitions, on average doubling the EBITDA margin of acquired schools. Reference checks with competitors and former employees indicate that management is experienced and capable. Importantly, the management team is deep for a company its size  and possesses a  broad range of complementary skills. This is particularly  important given the ambitious Digital Services  strategy the Company is pursuing alongside the rapid expansion of the core business.  

The Undergraduate Medical Education Industry in Brazil
With 16 thousand students, 24 campuses and 6% market share, Afya Ltd  is the leading provider of undergraduate medical education in Brazil. It derives the vast majority of its revenues from undergraduate medical school tuition.  Medical schools in Brazil are heavily regulated by the Ministry of Education and Ministry of Health. Twenty five percent of the schools are state owned. Seventy five percent are privately owned. In order to get a license to operate or expand capacity, private school operators go through a lengthy and onerous vetting process.

Between 1980 and 2010, medical school capacity  did not keep up with population growth, resulting in an acute shortage of doctors. In order to address the shortage, in  2013 the Federal Government  launched a program of public tenders for “medical school seats” called Mais Medicos. Although the annual number of graduates has increased from 15,000 when the program was introduced to 25,000 currently, the shortage persists today. As of today, Brazil has  2.4 physicians per 1,000 inhabitants compared to the OECD average of 3.5.

Being a doctor in Brazil is an  attractive career choice.  Physicians earn on average 1.6 x more than engineering graduates and  1.7x more than lawyers. Additionally, they enjoy a high level of employability (97%). The average payback period of a medical school education is five years. Having a doctor in the family is still important in Brazil as evidenced by the fact that 80% of medical tuition is funded by the students’ families. Despite the increase in medical graduates from 15,000 annually in 2012 to 25,000 a year today, the premium pay versus other professions has persisted, especially in the smaller towns in the interior of the country where Afya is mostly present. 

Being a scale operator of medical schools in Brazil is an attractive business. The onerous regulatory environment heavily weighs factors such as reputation, track record , and financial stability, favoring the incumbent and imposing barriers to new entrants  and subscale or undercapitalized operators.  This is reflected in the allocation of new “seats.”  Since the introduction of the Mais Medicos program,  Afya has won a disproportionately high 24% of available new capacity. 

The fragmented nature of the market provides an attractive consolidation opportunity for a well managed, well capitalized market leader like Afya. Since its IPO in 2019, Afya has acquired six medical schools at an average multiple of 5x EBITDA post synergies. Collectively, Afya has been able to expand the EBITDA margin of acquired companies by 22% (from 18% to 40%). Even after these acquisitions Afya operates in only 10 out of 24 Brazilian states and is far from breaching levels of concentration that would raise regulatory concerns. Afya’s goal is to reach 15% market share (versus 6% today) by the mid to late 2020’s. 

Afya has unusually high  visibility into revenue growth for the next six years due to the number of already awarded, pre-operational slots.  It takes six years for a new “seat”  to reach full capacity in terms of number of students. Furthermore  new “seats” are awarded with a predetermined tuition rate and annual price escalators.  Given the number of awarded, pre-operational “seats,” management has guided to 14% student volume growth from 2020 to 2026. Inflation passthrough for existing students plus price escalators on new “seats,” would add 4-5% to the volume growth. If the company continues to operate at 100% capacity, which is likely given the unmet demand for space at medical schools, undergraduate medical tuition revenues are likely to grow at a 19%  cagr from 2020 to 2026. This is before considering additional awards or acquisitions. 

Other Undergraduate Programs and Medical Specialization 

Undergraduate science and undergraduate “other” account for 20% of undergraduate tuition revenue These are undifferentiated programs that were part of some the acquired businesses. Afya’s objective is to gradually phase out these programs because they dampen the growth and profitability of the company. 

Thirty nine percent of Brazilian physicians have a specialization. This number is growing and Afya is introducing new offerings to meet the demand. Currently specialization courses account for 5% of total revenues, but this category is growing at a 15% rate. 

The entire education segment, including the non-medical undergraduate programs and specialization programs, represents 90% of total revenues. These revenues  should grow at 15% cagr pre acquisitions based on management guidance. 

Digital Services

The transformative opportunity for Afya is within  the  nascent Digital Services strategy. Management’s objective is to expand beyond education and create the leading digital apps in Brazil to fulfill the needs of physicians beyond their educational journey. It is a very ambitious strategy modelled after M3 Inc  (2413 JP). The vision is based on six market opportunities: content and technology for medical education, clinical decision software, practice management tools/electronic medical records, telemedicine, digital prescription and physician/patient relationship management.

In the past two years, Afya has acquired and integrated eight technology companies which fit into its vision of a digital ecosystem. The entrepreneurs who started these companies were sold on the idea that, by leveraging Afya’s reach and reputation within the medical community and each other’s network of customers, their businesses can scale and achieve dominance in their respective areas. Many of these entrepreneurs now form part of Afya’s management team. In 2021 Afya enlisted the support of Softbank Latin America specifically to pursue this strategy. Softbank invested $125 million  via a convertible note struck at $25/share and placed a senior executive on the  board. 

Afya has acquired leading companies within each vertical,  but these are still small businesses operating in large, unmapped white spaces.  Afya claims that 200,000 physicians and medical students or 32% of the addressable market is already part of its ecosystem through their use of at least one service. White Book Clinical Decision, the largest of the digital companies with revenues of $30 million in the past twelve months,  is the #1 medical decision making app in Brazil. It has 160,000 monthly active users, and an 84 NPS. It is ranked #10 across all apps in Brazil by App Annie. 

Afya believes  the total addressable market for Digital Services is larger than the undergraduate education opportunity. Currently Digital Services represent 10% of revenues.  Management has set a target of achieving, within five years, Digital Services revenues in line with undergraduate tuition revenues. This is an ambitious target. It  is definitely not factored into the stock price today at all.

Summary Financials 

Valuation 

Since the IPO, Afya’s trailing EV/EBITDA multiple has declined from 33x to 13x. The company now trades at a PE of 14x 2022E. Based on the contracted expansion of “seats,”  the top line is likely  to grow in the 15-20% range between 2021 and 2021. The company’s EBITDA margins remain healthy around 40%, and the business is  free cash flow generative..

Below I attempt to frame the upside/downside by estimating Afya’s potential value at the end of 2025. 

Valuation of Education Business 

The education business comprises 90% of revenues.This includes secondary education and the residency preparatory business. 

The undergraduate medical tuition business is contracted to grow at a compounded 19% rate through 2026 based on already awarded seats and already negotiated price escalators. The non-medical undergraduate business is basically in run-off and the secondary education business is growing 14%.  Together, the education segment generated roughly $260 million of revenue in 2021. Assuming revenue growth of 15% through 2026  as per management guidance,  the education business revenues should double to $520. This assumes no acquisitions which will continue to be an important part of Afya’s strategy to reach its goal of 15% market share versus 6% today. 

EBITDA margins for the education segment have been in the 45% range and 75% of education  EBITDA has converted to free cash flow. Arguably, the education segment’s EBITDA margins are depressed because acquisitions initially dilute margins. Mature campuses at 100% capacity operate at 60% EBITDA margins. Assuming a 45% EBITDA margin and 75% free cash flow conversion,  Afya will generate $234 million of EBITDA and $175 million of equity  FCF in 2026. Bear in mind that cash conversion is high because, under the PROUNI program, private universities are exempt from federal sales and income taxes in exchange for offering scholarships to low-income students.  

Under the above base case scenario, in 2026 Afya will be a highly cash flow generative company in a stable but more mature business. Applying  a 15x multiple to 2026 estimated FCF of $175 million, the stock will trade at $28  per share. This would equate to a 19% cagr in the share price. I believe that these estimates are conservative because they exclude growth via acquisitions, dividends and buybacks (the company will be highly cash flow generative) and  because they assign no value to the Digital Services business. 

Valuation of Digital Services 

Digital Services will generate approximately $30 million of revenue in 2021. At the 2021 analyst day, management stated that over the medium term (5 years) their goal is for  Digital Services to be  equal in size to the Education segment in terms of sales and to generate EBITDA margins of 30%. This would imply $500 million in revenues and $150 million in EBITDA in 2026.  Management is modeling this business based on M3 Inc. (2413 JP). M3 Inc generates USD 1.8 billion of revenues and has been growing revenues consistently in the high teens. It has 30% EBITDA margins, 20% net margins, and it trades at a forward PE of 50x, EV/Revenue of 15x, and EV/EBITDA of 31x. 

Let us assume  that Afya, by using the cash flows from the education business to fund growth,  is able to meet half its target by 2026. Under that scenario,  Digital Services would generate $250 million of revenue with 15% EBITDA margins resulting in  $40 million of EBITDA. Valuing Digital Services at 15x EBITDA, half of M3 Inc S multiple, Afya’s Digital Services division would be worth $600 million or $6/share. This would increase the expected return on Afya shares from 19% to 25% cagr (2021-2025). 

It is impossible for me to value the  Digital Services business.  It could be worth nothing or it could be worth $4.5 billion if management delivers on its ambitious goals. Under the success scenario,  Digital Services would generate $500 million of revenue in 2026  with  30% EBITDA margins. If the market were to value it in line with M3 Inc’s  current 30x EBITDA multiple, Digital Services alone would be worth $4.5 billion. More importantly, I think that the market is currenlty assigning zero value or negative value to this option.

Conclusion

I think AFYA is an attractive stock at current levels. Management and the board are very capable. The company is well capitalized. The core business, which is dominant, stable, and growing, amply justifies the current stock price. Based on my estimates, Afya trades at a 6% free cash flow yield if we were to strip out Digital Services. Based on contracted growth, this cash flow will grow at 15% over the next five years.  Digital Services is a long shot, but it could be worth close to 4x the current market capitalization if management executes.

Risks 

FX Risk

Afya earns in Reais. I think that the Real is quite undervalued, having depreciated significantly in real terms over the past ten years. I am comfortable with that risk because I believe, over time, it is a wash. 

Competition Risk 

Afya is  operating in a very attractive, capacity constrained niche within the for profit education space. Large diversified players have and will try to enter the market. I believe the smaller markets in the interior of the county where Afya is strong are relatively immune to competition. These are markets that generally cannot support more than a single player profitably. 

Saturation Risk 

Currently Afya operates at 100% capacity. I would worry if at some point supply begins to exceed demand.  I will continue to monitor this, but I think that this is not a risk within the next five years. 

Execution Risk 

If management does not execute, the stock will languish or even sell off further. 

Regulatory Risk

I do not see a big risk here. There are always regulatory changes which can have a positive or negative impact. For profit education has a bad name in the United States. The situations are not comparable.

Catalyst

Execution of business plan.