Description

TL;DR

•  Buy a vertical market software business (~80% gross margins, with 35%+ EBITDA margins, and historically 20%+ FCF margins) that is founder owned / run (CEO owns just shy of 50% of the stock) was extremely impacted during COVID (declining enrollments + no pricing increase which management chose to turn into a heavy investment year)

• The original “venture” backer General Atlantic just re-bought into the story purchasing $50M of equity in November along with $50M in convertible notes – Dragoneer also participated in the convertible notes buying $100M for itself.  The $150M convertible notes mature in November 2028 and convert at $29 per share (stock currently is at ~$21).  The notes yield 8% fixed interest rate payable in Brazilian Reais (pretty sweet considering the SELIC rate is at 10.75% presently). 

• You can buy this business for ~9x fwd EBITDA despite the fact it will grow by high double digits (potentially 20%+) for many years to come

• ARCE has an A+ management team with additional optionality (international expansion and capital allocation)

• Brazil is one of the few countries on earth that may be easing rates next year which could be a large macro taiwlind and the current high commodity environment doesn't hurt Brazil's main exports so we should see per capita income rise going forward
• COVID has altered the path of education globally - everything is going from analog to digital and ARCE will benefit from that

About the Company:

ARCE is a K12 education company (read a different way – a vertical software company) that is trading at a massive discount to its intrinsic value due to a myriad of temporary factors (1) COVID which unfortunately had a horrible impact on students globally, (2) Macro Issues in Brazil, and (3) NASDAQ listing (no Brazil listing) with lower float.  ARCE can be a multi-year 20%+ IRR return as it continues to drive superior outcomes, fixes its COVID / M&A induced working capital issues, and benefits from supplemental attach rates. As we have seen the K12 sectors in the US rebound (HMHC, LRN, etc.) we will start to see with Brazil (summer break is December through January in Brazil). 

As previously mentioned, ARCE is a K12 education company in Brazil that provides learning management systems (LMS) to private schools.  They do no business with the government so no need to worry about government changing financing or any of the “ick” that comes along with for-profit secondary education.  ARCE provides curriculum, materials, and training to teachers to help drive superior outcomes for students.  ARCE does this via a B2B2C sales model – they utilize this model to lower CAC and churn – the schools make a small mark-up on reselling the LMS to students.   Their revenue algorithm is simply:

Enrolled students x Price Per Student = Core ACV => Core Revenue

There is a separate algorithm for supplemental products which we will touch on later.  ARCE is a vertical market software company trading at ~13x current year EBITDA that is part of an oligopoly that will benefit from secular tailwinds.  They will be able to grow at 20%+ for the next 5 years and you can quickly bridge to this trading for <15x TEV/FCF which seems silly even accommodating the Brazilian discount.

ARCE originally IPO’d in 2018 at $17.50/share. In 2020 ARCE peaked at $60/share. Since IPO ARCE has traded at an average fwd EV/EBITDA of 21x (lower std deviation of 13.6x and upper std deviation of 28.6x) and presently ARCE trades at 10x fwd EBITDA. ARCE’s main competitor VSTA IPO’d in July 2020 at $19/share (it has traded straight down since IPO due to COVID pressures). VSTA has traded at an average fwd EV/EBITDA of 10x (lower std deviation of 6.7x and upper std deviation of 12.9x) and presently VSTA trades at 7.8x. VSTA is a messier story owned by a parent company that may not have shareholders best interests at heart and has structurally lower margins due to the fact they actually sell physical textbooks. 

Secular Tailwinds:

There are two main secular tailwinds for ARCE: (1) public to private and (2) textbook to LMS.

Brazil has 40k+ private K12 schools with on average 200 students per school charging R$9k/month.  Brazil has 43M pupils enrolled in K12 schools of which ~18% (7.6M) go to private schools.  The chart below shows how this transition has fared over the last 10+ years:

As can be seen private enrollments have broadly ticked up both in number and as a percentage of overall enrollments.  Brazil has essentially been in a recession for the last ~6 years so this explains why it has peaked out and we can also see the ding from COVID in 2020 and more seriously in 2021.   From 2010-2021 private school enrollments increased by 0.5% annually in Brazil (it was 1.4% CAGR from 2010-2020).  According to the 2018 PISA test results Brazil public vs private K12 schools had one of the widest gaps globally reinforcing parents desire to send their kids to private K12 schools.  ARCE will benefit from increase per capita income in Brazil that allows more parents to send their kids to private schools – this obviously has a ceiling (i.e. wont be 100%) but its not crazy to see private school enrollments go to 20%-25% which is meaningfully above the current penetration rate.  Private education remains a top three priority for Brazilian households with 79% of parents ranking education as the #1 importance spend category.  ARCE has a NPS of 84 which is up from 71 in 2019.  ARCE is in an enviable spot with their superior as can be seen the chart below:

In addition to the public to private transition ARCE also benefits from the textbook to LMS transition.  This is simply schools switching from solely analog textbooks to hybrid digital LMS solutions. As can be seen from the chart below textbooks still represent ~42% of the private market in Brazil.  LMS market share has grown from 27% in 20201 to 55% in 2021 and this likely tops out around 80%-90% sometime over the next 5-10 years.  Within the digital solutions the two largest share players are Arco Platforms (ARCE) and Vasta Learning Systems (VSTA).  Within the other category are players like Objetivo, Pliedro, Bernoulli, and SPD (affiliated with Catholic Church).

VSTA is larger than ARCE based on pupils but ARCE is 1.4x larger than VSTA based on core ACV and is 3.5x larger in supplemental ACV. This shows that ARCE is the premium priced provider – this is mainly due to superior outcomes (mentioned above) meriting a higher price point.  It is also worth flagging that ARCE has gone from almost no share to a meaningful share in a fairly short time.  This was done by developing a very good platform and acquiring businesses that they then found ways to improve they outcomes and economics of.  ARCE acquired Positivo and was able to improve EBITDA margins by 900bps with a +800bps gross student retention improvement in the 2nd year following its acquisition.  On average acquired brands see a +13 point improvement in NPS scores one year after ARCE acquired them and ARCE is able to improve EBITDA margins.

ARCE guides to a R$20.6B TAM (R$5.2B TAM in core solutions and R$15.4B in supplemental) and VSTA guides to R$24.4B ($6.0B in core solutions and R$18.4B in supplemental). From a top down perspective there are 43M students in Brazilian K12 in 2021 (US is 50.7M K12 students) and 7.6M of these (~18% of K12 population) are enrolled in private schools. Total tuition spent on private K12 in Brazil is R$67B-R$70B/year and one month of tuition would be R$5.6B-R$5.8B which supports the core market sizing.  The core market is normally priced at inflation+ which in Brazil is no small number.  At present ARCE earns about 16% of its potential current market if it went 100% LMS (it wont).  ARCE’s share should grow and its pricing per people overtime will be some small inflationary amount as this calms in Brazil.

Core vs Supplemental:

ARCE’s business by revenue is currently 76% core and 24% supplemental.  Core represents the main subjects that occupy 8-3 (or whatever the school hours are) learning.  Supplemental is additional classes outside of the main school that students may take – this can include English as a second language, socioeconomic classes, STEAM classes, etc.  The supplemental TAM is R$15B-$18B which is 3x-4x the size of the core market. 78% of schools mention they want supplemental options and the majority of parents when polled expressed interest. Presently supplemental only represents 24% of ARCE revenue and in FY21 only 11% of ARCE students used a supplemental product (in 2022 this will be 14%-15%), ultimately ARCE hopes to grow supplemental to near 30% of revenue up from low 20s now.  Supplemental is a win-win-win.  Parents like it since they can consolidate spend (often at a discount to third party providers) and they no longer have to worry about logistics of moving kids after school to their next activity.  Schools like it since they get to utilized idle assets (aka classrooms) and make additional income.  LMS providers like it since obviously its an additional revenue stream for them.

This chart from ARCE’s most recent earnings does a great job walking through the potential cross sell opportunity and how meaningful it could be:

As can be seen above supplemental provides an interesting call options to further accelerate the strong growth ARCE will see out of its core business.  Supplemental does have a pricing cap as there is only so much parents can / are willing to pay.  But this can easily be increased dramatically from its current state and the LMS providers are in a cat bird position to benefit from this spend consolidation.

Overall Growth Algorithm:

Core: Core ACV should contribute to overall revenue growth around 10%-16% over the next 5 years (driven by 3%-5% pricing (inflation+) + 3%-5% textbook transition + 2%-3% pupil growth + 2%-3% share capture.

Supplemental: Supplemental ACV should contribute to overall revenue growth around 8%-12% over the next five years (driven by increase adoption / cross sell and overall moving as we move from 1 in 10 pupils using one program to something like 3 or 4 in 10). 

This drives an overall growth algorithm of 18%-28% over the next five years.  ARCE reported last week and already guided to +46% YoY ACV growth (+32% YoY organic ACV) which is thesis confirming and they confirmed that ACV would = revenue.  2021 was one of only years it didn’t match up due to COVID issues.

Margin Improvement:

EBITDA and FCF will compound quicker as margins have been dinged by COVID and ARCE’s choice to heavily reinvest in the business during a down year (i.e. showing management’s capacity to suffer for greater long-term results).  FCF has historically been lumpy due to large M&A and significant technology investments (ARCE capitalizes software development and intangibles).  Management has guided that CapEx would trend down to 8%-9% of sales from 17% in 2021 and what is guided to be 11% in 2022 (ARCE is spending a lot to unify their tech stack at present).  COVID was a big impact due to declining enrollments which drove higher receivables and bad debt (schools couldn’t pay) and ARCE relaxed payment terms to help clients in a horrible time.  This slide walks through some of the impacts COVID played with their FCF:

Overtime this is a business that will do 40%+ EBITDA margins with 20%+ FCF margins (esp as CapEx normalizes in the 8%-10% range).  ARCE was able to do 20%+ FCF margins prior to COVID with 30%+ EBITDA margins so there is no reason to believe as they work through this investment period and COVID it won’t normalize at those levels.  Some of the more mature brands actually have 50%+ EBITDA margins which shows the potential ceiling for this business.

Overall Returns:

Using the broad constructs above its not hard to see a business with $600M+ in revenue in FY25 with 40%+ EBITDA margins and 20% FCF margins which would make it trade at <10x TEV/FCF and ~5x EBITDA.  This is just far too cheap for a solid grower with an A+ management team (didn’t talk on this much but in all channel checks even competitors heap praise on this management team) that is winning its market overtime through superior outcomes.  I think there is a high possibility ARCE will be a multi-bagger as the equity re-rates and people get more comfortable with Brazil (if it ever leaves its current “recession”).  But until then I am fine holding the current multiple flat and underwriting ~20% IRRs.

Comparable US LMS companies (INST, PWSC, DTOL CN, all trade at 7x+ sales and 20x+ EBITDA.  ARCE is growing faster, has higher margins, and yet trades at a dramatically lower multiple (Brazil obviously explains some of this).  

Catalyst

Risks:

1. Brazil macro goes deeper into recession causing parents to pull kids from school
2. Investors just never care about the growth and profitability and multiple continues to compress - seems unlikely but in emerging markets anythign is possible 
3. Competition comes up displacing ARCE (ARCE has historically been the displacer)
4. TAM is smaller than anyone thinks despite top down / bottoms up / and logical survey work