ARCE - Arco Platform: Sell If Price Crosses $14 Before The Go-Private Deal

2023-10-17 08:50:50 ET

Summary

• Arco Platform, a Brazilian education company, is going private, offering $14 per share, which doesn't align with my DCF model's fair value estimate.
• The company's history of aggressive mergers and acquisitions has led to a significant debt load, and the pandemic further challenged its financial health.
• Investors should consider selling their shares in the open market if the price exceeds $14 before the go-private transaction to secure profits and reduce uncertainties.

Arco Platform Limited ( ARCE ) is a Brazilian education platform that provides a pedagogical system with technology-enabled features to deliver educational content to private schools in Brazil. The company has been facing issues dating back to its IPO on Nasdaq about five years ago when it positioned itself as part of a rapidly growing and high-valuation ed-tech segment.

Arco's stock, which peaked at $59.15 in February 2020, steadily declined to a low of $7.99 in November last year. The pandemic posed a challenge for the education company, leading to a deterioration in its financial health during that period.

The presented thesis to investors was that Arco could make low-cost investments in companies that would be added to their ecosystem to grow through technology.

However, over this period, Arco made multiple acquisitions of start-ups and struggled to acquire established companies, leading to lower efficiency gains.

As the company heads towards going private, which is expected in the last quarter of this year, Arco has agreed to sell all of its shares for $14, even though my valuation analysis assigns a fair value of $9, suggesting overvaluation.

A Questionable Business Model

Arco had a strong appetite for mergers and acquisitions (M&A) and successfully navigated this path. However, the COVID-19 lockdown had a significant impact on the company. It was in an overextended position, waiting for higher revenue that never materialized.

Since its initial public offering ((IPO)) on Nasdaq, Arco has acquired 15 companies, investing R$3 billion. In February of last year, it acquired PGS and Mentes do Amanhã, both assets of Pearson Education in Brazil. Before these acquisitions, they were part of the Edupass group, an educational benefits platform. Arco also acquired Eduqo, an educational technology (ed-tech) company, Me Salva!, a provider of preparatory courses for college entrance exams, and the educational systems COC and Dom Bosco.

The most considerable sums were allocated to Positivo Educação (R$1.65 billion), Escola da Inteligência (approximately R$480 million), and the COC and Dom Bosco groups (R$920 million).

This aggressive approach to inorganic growth significantly impacted the company's debt, which reached R$3.3 billion in 2022. This debt equals 78.6% of the company's market capitalization during 2022.

Nonetheless, Arco could not generate a positive cash flow as recently as it reported a negative cash flow of R$100 million in its fiscal year 2022. In the previous years, the amounts were positive at R$92 million and R$24 million, respectively.

As a result, I have reservations about how Arco will effectively meet its obligations, given that it accumulated R$1.2 billion in debt to offset its negative cash flow from operations.

Arco is Going Private

Arco Platform has announced a definitive agreement with General Atlantic and Dragoneer to sell all outstanding Class A shares currently traded on Nasdaq for $14 per share and to take the company private.

The price represents a modest premium of 1.4% over the closing price as of October 10. This price is also higher than the $11 per share initially offered by the asset managers in late 2022 when shares were trading below $8 per share.

The asset managers will pay approximately $400 million for these shares, which account for 51% of Arco Educação's equity. This transaction values the company at roughly $1.5 billion.

The Sá Cavalcante family, the owners of educational systems such as SAS, COC, and Positivo, will retain their Class A shares and maintain control of 88% of the company's voting power after the transaction.

The operation is expected to be completed between the fourth quarter of this year and the first quarter of next year, subject to approval from Arco's shareholders and regulatory entities.

Undergoing a Deleveraging Process

Arco Platform filed with the Securities and Exchange Commission (SEC) in late July to issue a R$550 million non-convertible debenture. This debenture carries an interest rate tied to CDI (a common Brazilian interbank rate) plus 2.6% per annum and is set to mature in July 2028.

In the previous year, Arco had already conducted a debenture issuance totaling R$1.22 billion with an interest rate of CDI + 2.3% per annum. The strong demand for Arco's debt issuance was surprising, especially considering the company's high leverage, which stood at three times the cash flow generation before this issuance. The company has been utilizing the proceeds to reduce its short-term debt, bringing it down to 1.5x when considering the net debt/adjusted EBITDA multiple over the last 12 months.

Arco had also experienced a deterioration in its liquidity. Its ability to meet short-term obligations, which was once at 17.1x in 2018, has now fallen to 1.2x. Nevertheless, this strategy is a part of the company's balance sheet management. In practice, they are increasing their debt by over half a billion reais.

Extending payment terms is a part of Arco's plan during the process of taking the company private. However, there isn't a specific date for convening the shareholders' meeting and presenting the proposal for delisting from Nasdaq.

Is This a Good Time to Go Private?

Amid Arco's decision to go private, the timing is a contention.

This move by the company comes at a moment when there's a growing perception that Arco is poised to unlock its value in the coming years by consolidating acquisitions, synergy gains from all operations, and streamlined processes. However, the company seems to limit the number of participants at the table.

With the deleveraging process this year, this move theoretically has the potential to be a turning point, with positive prospects for the next three years. Nevertheless, the delisting is a source of frustration for shareholders who entered during the challenging times and cannot participate in the company operationally.

Earlier this year, Arco informed shareholders that it expects an EBITDA margin for this year to be between 36.5% and 38.5% for pedagogical solutions and -10% for financial management solutions (with a projection of breakeven in 2024 and long-term performance between 30% and 40%). In the first quarter, the company's consolidated EBITDA margin was 20.7%; in the second quarter, it was 17.7%.

In the second quarter of 2023 alone, Arco recorded revenue of R$471 million, a 14% increase compared to the previous year's period, and an adjusted net profit of R$78 million. Arco reported a net loss of R$74 million in the second quarter, about 5.5 times the loss reported in the same period last year.

Valuation

Examining the current multiples at which Arco Platform is trading and assuming a 207% increase in EPS for 2023, the company is currently trading at a forward P/E ratio of 27.9x. This valuation is 96% higher than the industry average but still 40% below its historical average.

In my discounted free cash flow model, however, it appears that the shares of Arco Platform may be overvalued, assuming conservative assumptions.

When constructing my model, I relied on revenue growth estimates provided by Seeking Alpha for the Arco Platform, projecting a growth rate of 34.5% in 2023, 28.9% in 2024, and 18.3% in 2025. Additionally, I assumed a stable gross margin of 76.6%, based on the company's five-year historical average, and an effective tax rate of 34%, also in line with the company's historical average.

In my model, I incorporated a cost of equity of 16.7%, derived from Brazil's long-term interest rate curve (TJLP), currently at 6.55% per year. I also included a cost of debt of 10%, as provided by the company's data. I utilized a leveraged beta of 1.06 for the Education sector and factored in Brazil's equity risk premium of 9.6%. As a result, this calculation led me to a weighted average cost of capital ((WACC)) of 15.8%.

I calculated the present value of discounted free cash flows from 2023 to 2025 based on Seeking Alpha's estimates for revenue growth. My assumptions for SG&A expenses were based on 10% of revenues, following the company's five-year average. I also considered D&A in line with the five-year historical averages. For CapEx, I assumed the company's guidance of maintaining 10% of the revenues. Assuming that changes in NWC would remain the same for the next two years, considering the last twelve trailing months, this led to an unleveraged FCF scenario of $63.3 million for 2023, $113 million for 2024, and $143.6 million for 2025.

Consequently, by considering a terminal value of $1,059.4 million and discounting it to the present value using a WACC of 15.8%, we calculate the present value of the terminal value to be $696.9 million. When we add this present value of the terminal value to the present value of cash flows for the forecasted period, we reach a total Enterprise Value of $928.2 million. Adding Arco's cash position and subtracting its debt, we reached an equity value of $602.9 million. This value was divided by Arco's 66.45 million outstanding shares, resulting in an implied value of $9. This suggests a potential downside of 34.3% compared to the share price of $13.81 on October 12th.

The Bottom Line

As Arco Platform proceeds with its go-private process, investors who held the company during its downturn may be disappointed, given the $14 per share offer. Considering the company's projected revenue growth and improved leverage, this offer might be underwhelming. However, according to my DCF model, the fair value appears to be $9 per share, suggesting that the offer is more than reasonably priced.

It's essential to note that shareholder approval is a requisite for Arco's go-private transaction. Arco Platform has accepted $14 per share as the closing price, and with the current share price at $13.81, investing in Arco Platform shares appears to carry some unnecessary risk.

For those currently holding profitable positions in Arco, this seems to be an opportune moment to consider selling the stock on the open market before the takeover's closing date, particularly if the price surpasses $14. This strategy would enable you to secure your profits and avoid potential fluctuations or uncertainties tied to the closing process.

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