Description

Estacio Participacoes (ESTC3.BZ - R$12)

Generating more than a 30% return on capital with EBITDA growth of  >20% per year, Estacio appears extremely mispriced at 8x 2009 unlevered earnings with >20% of its market value in net cash.  Estacio is the largest private Brazilian post-secondary education company.  The Company is led by an incentivized and proven management team from highly reputed operational restructuring focused private equity firm called GP Investments.  Strong double-digit EBITDA growth over the next five years, driven by clearly defined operational restructuring initiatives, highly-accretive tuck-in acquisitions and a strong secular tailwind, will reveal a significant valuation dislocation and a conservative 280% upside over the next 3 years.  Unlike US post-secondary peers, less than 2% of Estacio's students depend on credit financing to pay for the education (the balance use their own cash).  Since 2005, the company has been undergoing a transition that began with its conversion into a for-profit organization.   In May 2008, the controlling family sold a portion of its ownership to GP Investments.  GP brought in a new management team in February and expects to improve EBITDA margins by at least 1,100 basis points through a) removing excessive general and administrative costs left in place by the founding family, b) reaching below-inflation salary increase agreements with the teachers, and c) reducing the dropout rate (currently at 45%).  After spending a significant amount of time with new management and visiting six campuses in Brazil, we are confident that the cost reduction initiatives are achievable.  We expect minimal organic enrolment growth given the state of the global economy, but the Brazilian government has become increasingly focused on raising the penetration rate of post-secondary education, which may provide some support.  In fact, the Government's stated target is for 30% enrollment of young adults between 18-24 of age by 2010 versus just over 12% penetration at the end of 2008 (no chance of this happening).  After layering in operational improvements currently underway, Estacio will be able to earn well north of R$3/share once GP Investment's restructuring plan is complete (comparable margins to peer Anhanguera).  Given Estacio's strong long-term growth and return profile, we believe that Estacio should command at least an 8% yield on restructured unlevered earnings (2011/2012) yielding a R$34 fair value per share or 280% upside from current levels. 

Investment Merits

• Market leading defensive businesses with strong backdrop: Estacio is a very good business: +30% ROIC, major scale and brand advantages, high regulatory barriers to entry and a defensive end market. Estacio is the only for-profit academic institution with University status, permitting the company to offer new courses without Ministry of Education (MEC) authorization (a 2-3 year process for peers). This should permit Estacio to achieve higher organic growth than peers. The Company is expected to also grow through acquisitions, folding other schools onto its platform while management continues to pay out half of net income in dividends. The Company should also grow share as many smaller, distressed peers are currently filing for bankruptcy or looking for buyers. Enrollments should show respectable growth for the first semester of 2009 and pricing remains firm (+4-5%).
• New best-in-class management: In May 2008, GP acquired 20% of the company's total capital directly from family owners at R$16.50/share. GP Investments, a top Latin American PE firm focused on turnaround opportunities, has brought in a strong management cadre with incentives of up to 5% ownership in Estacio if 5 year targets are met. GP's investing track record is outstanding and includes successful investments such as Gafisa (10 yr investment with 24% IRR), Logistica (11 yr investment with 17% IRR) and Equatorial Energia (3 year investment with 1,403% IRR). New CEO Eduardo Alcalay has one of the highest return track records of all professionals at GP Investments. The management option plan (5% equity dilutive) will incentivize over 300 employees by directly linking annual payouts to aggressive annual performance targets.
• Significant scope for margin improvement: New management believes they can improve EBITDA margins from 11% to 20%+ within 4 years. Other Brazilian education companies have mid-20s margins due to more efficient cost structures. Management has already reached deals with teachers' unions across most of their territories that ensure over 200 bps of margin improvement over the next 4 years. Estacio is also implementing a new shared service center (SSC) with SAP, which will enable the company to reduce G&A employees from 280 to 70. Additionally, the Company expects to take total headcount from over 5,000 operational employees to 3,000. This can be achieved given that at the end of 2009, 78 campuses possessed their own back office with full staff (management, legal, payroll, IT, etc). The result would be savings of significantly more than R$40 million/year, increasing EBITDA margins by 820bps. Estacio's new curriculum design should enable the average number of students per class to rise from 30 to 37, improving utilization and boosting margins by an additional 200 bps. By increasing distance learning programs and through the growing wealth effects in Brazil, mgmt believes that the dropout rate can decrease by at least 5% from 45% to 40%. This could also boost margins by 100-200 bps through utilization improvement. While an improvement in the dropout rate and increased distance learning would substantially benefit the company, we do not include these potential benefits in our forecasts. Increased INSS taxes will eat into margins by about 1% per year until 2011. This is the cost of going from a non-profit to for-profit entity.
• Attractive valuation with clear market dislocation: With EBITDA growth north of 20%, >30% ROIC and peers that trade at a significant premium, Estacio is worth a multiple of its current share price (EBITDA margins of 20%, comparable to peers). The valuation dislocation exists for three reasons: 1) the Company is largely unknown following its IPO in September 2007, 2) off-balance sheet tax-related liability could represent nearly 20% of current market cap (almost 0% chance following a recent government announcement) and 3) Estacio is a show me story - new management with aggressive cost-cutting and acquisition targets against a family-run/owned backdrop with a short track record of missing targets (pre-GP).
• Brazilian education has a strong secular tailwind: The post-secondary education penetration rate in Brazil for students between 18-24 years old is just over 12% versus 50%+ for neighboring countries such as Argentina and Chile. The Brazilian government recently stated it intends to increase the penetration rate to 30% by 2010 through offering more student loans and providing tax incentives (such as access to retirement accounts for education purposes). IBGE data shows that post-secondary education in Brazil has grown at a compound annual rate of 11% from 1997 to 2005, with approximately 6mm enrolled students. Market share of private institutions has grown at a CAGR of 13.5% from 1997 to 2005, while public institutions' share grew at an annual rate of 5.8% in the same period (private sector market share increased from 61% to 73% from 97 to 05). In fact, post-secondary enrollments have grown every year in Brazil since I can find data (1997-2008), including the year of Brazil's latest currency crisis in 1999.

Model

Investment Risks

• Unemployment rate in Brazil: If unemployment increases significantly in Brazil, both the drop-out and rate and new admissions will be adversely impacted. Company management believes that organic enrollment growth for the industry will be roughly in-line with GDP absent major involvement from the Government. Estacio recently hired the head of marketing for Anhanguera who led his team to industry leading growth and retention rates. The Company also believes they will gain share from failing schools without cutting tuition.
• Execution risk: Turnaround could prove difficult if new curriculum is boycotted by faculty or if employees resist the new reporting structure. 70% of the faculty (100% of certain unions/geographies) have agreed to the new compensation scheme proposed by Estacio.
• Brazil/LatAm/Liquidity/Technical risks

Catalyst

• Step change in earnings: we believe that Estacio will generate materially higher earnings than current expectations. Through industry channel checks and discussions with management, we developed the view that overly bearish expectations are priced into immediate and longer-term forecasts.
• Government announcements regarding new programs to stimulate greater education participation
• Acquisitions of other schools at distressed prices to fold into the Estacio system (cheap way to acquire new students)