Afya: Poised For Growth, But Likely Fairly Valued (NASDAQ:AFYA)

Afya Limited (NASDAQ:AFYA) stands as Brazil’s leading medical education group, offering a comprehensive physician-centered ecosystem that empowers students on a lifelong journey of medical learning. This journey begins when they enter medical school and extends throughout their preparation for residency, undergraduate programs, and continuous medical education activities.

Afya’s innovative methodology integrates content, interactive learning, and an adaptive experience, catering to individuals dedicated to lifelong medical education.

The investment thesis for Afya centers on growth, driven by the company’s proactive acquisition strategy to expand its undergraduate, continuing education, and digital health services segments. Consequently, the substantial cash flow generated by the company has been primarily channeled into these expansion efforts to increase its revenues over the next five years significantly.

Most notably, Afya successfully rebounded in 2022, recovering the student demand and revenue impacted by the pandemic throughout 2021. In 2023, the company continues to display strong revenue growth and robust cash generation. Despite a few concerns, the company has maintained consistent profitability, indicating a potential continuation of this trend.

However, as the company’s current valuation multiples appear stretched considering its growth prospects, there is reason for caution. Even though these multiples are below historical averages, taking into account macroeconomic risks in Brazil, a cautious stance on Afya seems prudent for the time being.

What is the current state of Afya’s business, and what is its future direction?

Afya’s business can be divided into two main segments. The first segment focuses on integrating undergraduate education support, preparatory courses, graduate programs, and specialization in medicine, with a current Total Addressable Market [TAM] of R$22.1 billion. The second segment pertains to digital health services, encompassing everything from clinical decision support to content and technology for medical education, with a current TAM of R$28.4 billion.

Afya holds 3,163 approved seats in the undergraduate domain as of H1 2023, representing nearly 10% of all private school seats in Brazil. In Brazil, pursuing a medical career typically involves around six years to become a general practitioner, 8 to 10 years to become a specialist doctor, and 10 to 12 years to become a sub-specialist doctor. Afya’s platform is well-equipped to accommodate students at all these stages, offering entry points and support throughout their educational journey.

The pandemic notably affected Afya’s continuing education students, primarily because practical classes stopped in 2021. However, by 2022, demand had already rebounded to pre-pandemic levels. In the first half of 2023, there was a further 31% increase in demand compared to the first half of 2022. In tandem with this demand growth, revenues surged by an impressive 48% during the same period.

Regarding Afya’s digital services, the company operates various branches, including Afya iClinic and Afya Whitebook. These branches offer digital prescription services and clinical decision-making software. Currently, digital services hold a 34% market share in Brazil, and its B2B monetization strategy, primarily focused on the healthcare industry, stands out with a TAM of R$24.4 billion.

The company’s growth is primarily driven by robust cash generation and conversion. Over the last five years, Afya has successfully increased its cash flow from operating activities at a Compound Annual Growth Rate [CAGR] of 42%. Moreover, thanks to solid profit margins, the net profit has also exhibited steady growth over the same period, with a CAGR of 29%.

However, Afya aspires for more. In its guidance for 2023, the company aims to achieve total revenues of R$2.85 billion, maintaining a CAGR of 33% over the last three years. Simultaneously, it targets an adjusted EBITDA of R$1.2 billion, with a CAGR of 29% over the same period. As a result, Afya’s focus within its undergraduate business involves organic and inorganic growth strategies to double its net revenue to R$2.03 billion by 2028. In the continuing education business, they aim for significant scaling, anticipating net revenue to grow four times to R$109 million by 2028. The digital services business is also expected to expand its net revenue by 6.3 times to reach R$190 million by 2028.

In summary, Afya anticipates a remarkable 6.3-fold increase in its revenues by 2028.

Latest financial results

In its most recent quarter, Q2, Afya reported a frustrating net income of R$87.5 million, marking a 17.5% decrease compared to the same period in 2022. The adjusted net income totaled R$131.9 million, representing a year-over-year decline of 17.8%. The drop was due to higher financial expenses, mainly related to the increase in leverage due to UNIT Alagoas and FITS Jaboatao business combination and higher interest rates in Brazil (12.25%).

Between April and June, the net revenue reached R$712.6 million, reflecting a 19.1% increase year-over-year. Excluding acquisitions, revenue amounted to R$598.1 million, a 9.4% rise compared to the same period in the previous year. Notably, the most significant growth was observed in the Continuing Education segment, driven by a robust intake process and course maturation, resulting in a quarter-over-quarter expansion of 50%.

The Digital Health Services segment showed a 28% increase in net revenue compared to the same quarter in 2022. This performance underscores the potential in the Digital Services sector and can be attributed to the growing B2B engagements, including new contracts with pharmaceutical industry companies.

Excluding the impact of acquisitions, the adjusted EBITDA reached R$241.8 million, marking a 10% increase compared to the previous year. However, the adjusted EBITDA margin saw a 50 basis point reduction year-over-year, falling to 37.7%. This margin decline is attributed to the revenue mix, with a higher contribution from the Digital and Continuing Education segments, as well as the consolidation of four new Mais Médicos campuses (operation started in 3Q22), UNIT Alagoas, and FITS Jaboatão dos Guararapes. While these new additions perform well, they have lower margins than the integrated companies.

In the first six months ending June 30, 2023, CAPEX decreased from R$161.2 million to R$102.2 million, reflecting a 36.6% decrease compared to the previous year.

For 2023, the company maintains its adjusted revenue projection, ranging between R$2.75 billion and R$2.85 billion, with an adjusted EBITDA projection between R$1.1 billion and R$1.2 billion.

In the last quarter, the company reaffirmed its previously issued guidance for FY23, which already accounted for the impact of the increase in FG-FIES. Afya successfully concluded the acceptance of new medical students for the second semester, ensuring full occupancy in all of its medical schools.

Looking ahead to Q3, where the company is scheduled to report its results on November 13, the estimate is a 13% year-over-year growth in earnings per share [EPS], with revenues expected to reach around $143.67 million, marking an approximately 31% increase compared to the same period last year.

Valuation: fairly priced

Afya, as a growth-stage company, is currently trading at a higher forward price-to-earnings multiple, specifically at 14.2x. This valuation aligns well with the education services industry norms but is also approximately 40% lower than its historical average over the past five years.

Compared to its main domestic peers, such as Grupo Ser Educacional, traded on the Brazilian stock exchange under the ticker BVFM: SEER3, Afya’s valuation stands out. Afya trades at an EV/EBITDA multiple of 4.3x, which is notably more favorable. In contrast, Grupo Cruzeiro do Sul, also listed on the Brazilian stock exchange under the ticker BVMF: CSED3, trades at a stretched price-to-earnings multiple of 28.9x and an EV/EBITDA of 3.3x, making Afya’s multiples appear much more discounted.

In my discounted cash flow [DCF] model, crafted based on the S&P Global Intelligence consensus among four analysts regarding revenue growth, EBIT, and free cash flow, I find the stock well-priced, even with conservative assumptions. Calculating a Weighted Average Cost of Capital (WACC) of 14.15%, taking into account Brazil’s long-term interest rate (TJLP), an equity premium risk of 9.6% for the country, and an average cost of debt of 11.9%, as disclosed by the company in its filings.

After calculating the unlevered free cash flow for the next three years, I derive a terminal value of $2,280.83 million, which, when brought to present value considering a 2% perpetuity growth rate, amounts to $1,343.22 million. Adding the present value of the terminal value to the present value of the FCF, I arrive at an Enterprise Value of $1,958.73 for Afya. Considering its cash position and subtracting total debt, I calculate an equity value of $1,522.13, which, when divided by its 89.75 million shares, results in an implied share price of $16.96. This is approximately 1% below the current share price as of November 7th, which is $17.10.

The Bottom Line

Afya is a company that has been rebounding in terms of revenue and cash generation after experiencing the negative impacts of the pandemic. It remains well-positioned to execute its ambitious growth plans. However, some concerns in the investment thesis should not be overlooked.

For instance, the company’s stock-based compensation has consistently been around 10% of its net income over the last four years. In 2021, this percentage exceeded that threshold, which may raise some concerns. Additionally, Afya’s capital expenditures [CAPEX] have consistently exceeded 25% of its net income over the past years. This aligns with Afya’s acquisitive nature but could pose a risk, especially in the face of headwinds from the Brazilian economy, which is marked by high political and fiscal risks.

However, a Cash Flow to CapEx ratio of 3.32 signifies that for every dollar the company allocates to capital investments, it generates $3.34 in cash flow from its operations. This ratio is a positive indicator, reflecting the company’s strong ability to generate sufficient cash to cover its capital expenditures and potentially have surplus cash available for other purposes.

Furthermore, Afya appears to trade at a premium compared to its main domestic peers listed on the Brazilian stock exchange when considering the EV/EBITDA ratio. According to my discounted cash flow (DCF) model, factoring in the S&P Global Intelligence consensus on revenue growth and free cash flow until 2025, the fair value of the company, applying a discount rate of 14.15%, appears to align closely with the current share price.

Consequently, while the company’s robust growth plans for 2028 may bring surprises, from a more cautious perspective, Afya’s shares appear to be reasonably priced. As a result, I would adopt a neutral stance at this time.