2023-12-05 13:27:48 ET
Summary
- Afya is a Brazilian company that owns and manages universities specializing in educating doctors.
- The company continues to trade at fair value and may present opportunities if it ever returns to prices below $15 per ADR.
- Afya's business has advantages such as resilience, aspirational product, pricing power, and regulated supply, but growth is limited due to the nature of the industry.
Afya ( AFYA ) is a Brazilian company that owns and manages universities specializing in educating doctors.
In December 2021, I wrote an article on the company . I then rated AFYA with a hold, commenting that it was close to fair value. I liked many of the company's positive qualities but warned against being too aggressive with growth projections.
Today, I revisit the company and find that most of the claims back then are still valid. Trading at a 30% higher price than in December 2021, the company continues to trade at fair value and may present opportunities if it ever returns to prices below $15 per ADR.
A great, resilient business with growth limits
In this section, I will summarize the positive and negative aspects of Afya's business, as expressed in a more detailed fashion in my December 2021 article.
Afya's primary asset is 3,163 authorized seats to offer medical doctor education in Brazil, divided across several private universities throughout the country, especially in backland regions like the Amazon.
This business has a plethora of advantages: it is resilient to short and mid-term economic cycles, it sells an aspirational product (becoming a doctor), it has pricing power, it has no substitute products, supply is regulated, the state foments its expansion, and it pays no income taxes in Brazil. Finally, the market is still demanding, given that Brazil has between 50% and 75% of the doctors per 1000 inhabitants that developed countries have.
Not only this, Afya was acquiring these fantastic businesses (private universities specialized in MD education) at P/E multiples close to 6x, or EBITDA multiples below 5x.
On the contrary, Afya's main challenge was that it could not grow at growth-investor rates for long. Universities are limited, other groups in Brazil also acquire them, and the government expands seats slowly.
Against this challenge, the company was doing acquisitions in more aggressive terms (P/E of 10x or EV above 6x), plus what I believe was diworsification (diversification for the worst as Peter Lynch called it) by acquiring digital businesses that had different economics.
The situation has not changed much
Today, the main ideas behind my thesis are still valid.
On the not so positive, the company has continued acquiring universities at a slower pace and with higher valuations. The last five university acquisitions have valued each medical seat at BRL 2.3 million, which I approximate to a P/E of 10x.
It has also continued acquiring digital businesses that do not provide much value. By 3Q23, Afya had spent more than BRL 230 million in acquiring digital businesses. These businesses are only a small portion of Afya, generating less than 10% of the company's sales at undisclosed EBITDA margins and growing less than 4% YoY, excluding acquisitions. I do not believe the company should use managerial focus and capital in this area that is not part of its core competencies.
On the positive side of things, the main business is very resilient, and continues expanding organically. Afya is currently at top capacity, with 21,556 students for 3,163 approved seats, or 6.8 students per seat.
Mais Medicos 3
Additionally, a new avenue for growth has been opened by the Brazilian government's program Mais Medicos, which hopes to create 10,000 medical school seats nationally. Of those 10,000 seats, Afya disclosed, 5,700 will be distributed through the program to new schools and 2,000 to existing private schools.
The program makes a special focus on opening seats in areas that are currently underserved. Afya has experience in this area, with most of its campuses in areas outside of the Brazilian core in the SouthEast of the country. Afya disclosed on its 3Q23 earnings call that it plans to propose 36 new campuses, each for 60 seats and 2,160 seats. I believe that is aggressive (it would represent almost half of the program), but that the company can probably get at least 10% of the new campus seats (570 seats) and 10% of the expansions allocated to existing private universities (200 seats). I believe this is relatively conservative, given that the company already offers 10% of the country's private seats, which include previous editions of the Mais Medicos program.
Seat expansion, or university creation rather than acquisition, is a much cheaper way to gain seats. On the same call, Afya's management commented that although each seat acquired has cost closer to BRL 2 million, if those seats are "built" (either expanding a campus or building a new one), the cost comes down to just BRL 500 thousand, which is much more attractive from a capital allocation perspective.
According to the company's schedule, preliminary results from the Mais Medicos proposals should be available as soon as July 2024.
Back-of-the-envelope maturity business
Afya seems like an easy-to-model business.
Starting with undergraduate medical education, the company currently has 3,163 seats, and I expect it will get at least 770 new seats from Mais Medicos. These latter seats will take several years to build and fill with students, but we can in the meantime, work with a terminal value assumption.
At maturation, the company expects 6 students per seat. However, their financials show 7 students per seat (for example in 3Q23 21,556 average students per 3,113 operating seats). If we use 7, that means 27,500 students at maturity. Each student's average net ticket (considering sales taxes and scholarships) is BRL 8,556 per month or BRL 102,672 per year. This implies around BRL 2.8 billion of revenue at maturity.
On top of that, we have other students. Undergraduates in non-MD courses number 46 thousand today and generate an average of BRL 15,000 per year. Graduate medical courses have 4,791 students, each generating about BRL 30,000 per year in revenue. I do not expect the graduate students to grow as they require a hospital to do residency in, which is not under Afya's control. These students add another BRL 840 million in revenues.
The next question is which margin to apply to the business at maturity. I believe the company can get closer in FCF generation to its EBITDA margin after interest than to its operating margin after interest. The reason is that the CAPEX of building a university is mostly non-recurring (the building is built once). The company's CAPEX currently represents 10% of revenue, but I expect this to decrease to 5% of revenues or less as it reaches the maturity stage. The company's operating margin is 30%, whereas its EBITDA margins are closer to 38%. I believe a midpoint of 34% is closer to operating cash flow generation after the final stage of CAPEX. This would imply, at maturity, operating profits of BRL 1.2 billion per year.
Conclusion
At this juncture, we have the question of debt. Currently, AFYA has BRL 2.4 billion in debts, which, added to lease costs, generate about BRL 400 million in net interest expenses yearly. However, at maturity, the company could use cash flows to repurchase some of that debt, considering that Brazil has a history of high real interest rates.
Therefore, I prefer to value the business on an EV basis. This leaves room for repurchasing the debt or refinancing at lower rates, maybe in foreign markets. Currently, AFYA has an EV of $2 billion or BRL 10 billion.
This implies an EV/EBIT multiple of 8x or an earnings yield of 12.5% on maturity earnings. I believe this is fair because of a few considerations.
On the positive side, the 12.5% earnings yield has built-in inflation adjustments, making it much closer to a 12.5% real yield. The business has other quality characteristics, including low cyclicality, brand-building capacity, and favorable taxation.
On the negative, it will take time to reach maturity because those 770 new seats have to be built and then filled. Plus, they are not certain; 770 seats is my speculation of how much they could get from Mais Medicos. On top of that, Afya will probably reach a limit to how much it can expand after at some point, Brazil reaches parity in terms of doctors per 1,000 inhabitants with the OECD average. Finally, Brazil's businesses tend to be inflexible to variations in the foreign exchange rate, and if the Brazilian real devalues, the earnings power of the company in dollars would devalue as well.
Therefore, my conclusion is that AFYA is fairly valued and, therefore, an opportunity below these prices, but not at the current prices. Buying on the perspective of future appreciation would be speculation, and I am not considering the investment from that perspective.
For further details see:
Afya Is Trading At Fair Value