Education. abc. Education team

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1 team Luciano Campos* Analyst HSBC Bank Brasil SA Caio Moscardini* Analyst HSBC Bank Brasil SA *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 1

2 2 Sector structure K-12 Listed companies Abril Educação Post-Secondary Listed companies Anhanguera Latin America Equity Research Kroton Educacional 194,937 non-listed companies Kroton Educacional Estácio 2,375 non-listed companies Source: HSBC, MEC

3 Sector price history Mar-07 9-Jun-07 9-Sep-07 9-Dec-07 9-Mar-08 9-Jun-08 9-Sep-08 9-Dec-08 9-Jun-12 9-Mar-09 9-Jun-09 9-Sep-09 9-Dec-09 9-Mar-10 9-Jun-10 9-Mar-12 9-Sep-10 9-Dec-11 9-Dec-10 9-Sep-11 9-Mar-11 9-Jun-11 Source: Economatica, HSBC AEDU3 ESTC KROT11 3

4 4 EBIT margin asset turnover chart (2011) ESTC3 Latin America Equity Research KROT11 AEDU3 ABRE % 5.0% 10.0% 15.0% 20.0% 25.0% Source: Company data, Bloomberg, HSBC

5 Sector description Brazil s education sector consists of basic education (k-12) and post-secondary segments. In recent years, some large publicly-traded companies have emerged, such as Anhanguera, Estácio and Kroton, reflecting the growth potential of some parts of the education system. Most of the education providers are still small, private companies, however, with tens of thousands of such providers operating. The industry consists of the basic education segment, for students through 17 years of age (grades K-12), and the post-secondary segment, for students that have already attained a high school degree or equivalent and are eligible to pursue an undergraduate degree. Luciano Campos* Analyst HSBC Bank Brasil SA luciano.t.campos@hsbc.com.br *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations The K-12 segment had c50.9m students in Around 84.5% of students are enrolled in public schools, most of which are managed by municipalities. Although there is limited growth potential in total enrollment, there is low usage in smaller schools of learning systems which combine book sales with consulting services and which represent an important source of revenues for companies like Abril Educacional and Kroton. The post-secondary segment had 5.45m students in Of these, just over 73% were enrolled in private schools. Partial de-regulation in 1996 allowed for-profit entities to offer post-secondary degrees under more flexible terms, including evening classes for working adults and shorter programs. The government created the PROUNI program in 2005, which offers tax incentives to private schools to create more capacity. As a result, undergraduate enrollment in private schools grew at CAGR of 9.6% from , reflecting the introduction of new campuses, additional programs on existing campuses and/or new delivery methods such as distance learning. The industry response resulted in over-capacity, however, which has driven M&A activity over the last five years. More recently, growth of post-secondary enrollment fell to 0.7% in 2009 and 6.5% in This trend might make it more difficult for the government to achieve its policy aim of increasing enrollment to 12m by 2020, or 33% of the 18- to 24-year-old population. The government has tried to boost enrollment with initiatives such increasing the availability of lower-interest student loans (FIES in 2010). The growth increase in 2010 relative to 2009 can be partially explained by the FIES program, which allowed many students to continue to finance their studies. companies listed on Bovespa are for-profit organizations that provide educational services direct to students and/or products and services for public and private schools. Basic education (K-12 companies) such as Abril Educacional and Kroton provide learning systems for public and private schools. Some own a few private schools that serve as laboratories to develop and demonstrate their learning systems. Post-secondary education companies such as Anhanguera, Estacio and Kroton offer traditional (on campus) and distance learning undergraduate and graduate programs, as well as some vocational training such as language courses and exam prep for tests required for technical careers in the public (government) sector. 5

6 Key themes Industry excess capacity and M&A activity We estimate that capacity in the private post-secondary sector exceeded demand by 51% in M&A has been a common strategy pursued by Brazilian education companies to reduce capacity. There were 31 deals between November 2006 and May 2012, and that is just including acquisitions involving postsecondary institutions and the listed companies Anhanguera, Estacio, or Kroton. Those transactions involved cbrl3.9bn in total enterprise value (EV) and more than 557,000 enrollments, including 266,630 in distance learning programs. In terms of EV per enrollment, those transactions averaged BRL6,412, and ranged from BRL1,900-11,200. M&A activity involving listed companies has followed funding rounds. The first one was in , following IPOs. The second started in 2011 and seemed to have ended by mid We believe other cycles may come in the future since we believe small players are losing their ability to attract new students and may be forced into M&A and/or closing their doors. However, at least for now, there is limited evidence that total capacity has been reduced. Market share gains as the main source of organic growth As discussed above, the growth of enrollments in the post-secondary segment has been decelerating over the last few years. Freshman enrollments in private schools which grew at CAGR of 4.5% between to reach 1.52m in It fell by -5.2% in 2010 to 1.37m. The listed companies have been able to sustain organic growth of enrollments by increasing their market share of private new freshman admissions through higher and more effective marketing spending and faster introduction of new programs. The combined market share of Anhanguera, Estacio and Kroton of freshmen enrollments in the traditional (on-campus) segment increased from 13.4% in 2009 to 15.3% in If we assume that the total new freshmen enrollments remained stable at 1.37m in 2011 and 2012, the implied market share of the same players would have increased to 18.7% in 2011 and 23.8% in We believe this trend can continue for a few more years, as bigger entities with marketing budgets continue to attract students from smaller private entities. The expected impact of FIES The Brazilian government re-launched the FIES (student loan) program in 2010 with offers of a 3.4% nominal annual interest rate, 18 months grace period on repayments, and a repayment period of 12 months plus three times as long as the time to complete the studies. We believe that the FIES can help reduce attrition rates in the industry. However, we still have not seen enough evidence to prove that FIES can help the number of new freshmen enrollments to start increasing again. Distance learning and other segments with high growth potential While enrollment in the basic education segment and traditional post-secondary segments are either stable or growing very modestly, enrollment in distance learning programs grew more than 15.5 times from c60,000 in 2004 to c930,200 in Furthermore, the distance learning segment offers more convenience and lower prices. Graduate programs are another important source of growth, and will likely become even more important over time, we believe, as the number of Brazilians with undergraduate degrees increases because it enhances a person s competitive advantage in the labor market. 6

7 Late payment of tuition bills The post-secondary segment suffers from a chronic problem of high levels of accounts receivables. According to the law, a student that pays at least one monthly tuition in a given six-month term cannot be prevented from concluding that term, even if they make no more payments. All that the school can do is to not allow the student to enroll in the next term. This law creates an incentive for students to pay other obligations before they pay their tuition. Moreover, schools that want to grow fast, may also have an incentive to be lenient with students for a few terms, renegotiating the past due tuitions and allowing the students to enroll in the next term. The increased availability of student loans, especially the FIES, may help break this cycle. However, in the early stages of implementation of the FIES, the program had a very long cash cycle the time it takes for the company to receive the payment from the government of up to 250 days in some cases, which resulted in an increase in the unpaid bills, or accounts receivable, of many companies. Anhanguera, Estacio and Kroton reported accounts receivable on the level of days of receivables in 2010 and days in However, if FIES turns to a more normal cash cycle below 80 days, the listed companies may benefit from lower time and lower risk associated to collection of receivables. Sector drivers Given the still low penetration of student loans, the education sector in Brazil tends to show more cyclicality than in other countries, making GDP growth, consumer confidence, unemployment rates and delinquency rates of consumer loans important drivers, especially for the post-secondary segment. In fact, a significant part of students currently enrolled in post-secondary programs are working adults that pay out-of-pocket for their education. When the economy decelerates and cause unemployment to rise, education companies tend to observe an increase in delinquency rates of tuition fees, sometimes followed by an increase in the drop out rates and by a slowdown in the number of new freshmen admissions. We believe that the increasing penetration of student loans, especially with very attractive terms from FIES, can reduce this cyclicality. As explained above, public policy is also a key driver. The best examples of those are the PROUNI and the FIES, which exert long-lasting effects over the industry. Finally, the education industry is rent and labor intensive, therefore, inflation of those inputs are important drivers for the industry. More specifically, teachers are unionized in Brazil and have collective annual salary increases linked to a basket of inflation indexes, with rents also linked to inflation. Key segments Textbook publishing includes textbooks used by public and private schools in all educational segments, from kindergarten to graduate schools. Private schools choose their list of recommended textbooks every year and students buy them in bookstores or online. Public school textbooks for grades K-12 are free through the National Textbook Program (PNLD in Portuguese), which spent BRL1.3bn on books in 2011, as part of funds secured by law targeted all K-12 students enrolled in public schools. Abril Educação is a major player in the publishing segment with the brands Editora Ática and Editora Scipione. Learning systems are a combination of textbooks and consulting services offered to public and private middle and high schools as an alternative to traditional textbooks. Instead of allowing teachers to select textbooks and define their teaching plan for the year, schools that purchase learning systems receive 7

8 textbooks and teaching plans for the year and, depending on the contract, training for the teachers. Learning systems are associated with improved academic results, although there is limited data available to back this up. In the case of public schools, learning systems compete directly with the PNLD, with the first financed by the local municipality government and the latter financed by the federal government, ie, at no cost to the municipality. Abril Educação and Kroton are major players in this segment. Traditional post-secondary consists of on-campus undergraduate and graduate programs. In the first quarter of 2012, this segment represented c86%, c91.5% and c59.3% of the revenues of Anhanguera, Estacio and Kroton, which are major players in this segment. Between them, the three companies account for 181 campuses and c653,880 enrollments. Distance learning post-secondary is a fast-growing segment in undergrad and graduate programs which allows students to receive class material and other content remotely without having to go to the school campus as often. Exams and laboratory work must still be done in the traditional method; therefore, the schools have distance learning centers, which are facilities with some classrooms, a library and computers. Some schools offer distance learning through online methods in which students access content through the web and go to the distance learning centers to take exams, once every 1-2 months. Other schools offer methods that require 1-2 weekly visits to the learning centers, where the students take classes transmitted through satellite or through another method. In general, there is big variety of distance learning offerings, including different combinations of technology and frequency of visits to the distance learning center, and there is still limited visibility on which models will prevail. After the acquisition of Unopar in December 2011 and Uniasselvi in May 2012, Kroton became the largest distance learning player in Brazil, with 447 distance learning centers and c276,014 enrollments as of 1Q12. Anhaguera is the next, with c200 distance learning centers and c142,500 enrollments, including vocational programs. Estacio has 52 distance learning centers and c50,200 enrollments in this segment. Valuation Given the short tenure of the listed Brazilian education sector, with IPOs starting in 2007, and the several organic and inorganic forces driving important transformations of growth, margins and returns in the sector, we believe that DCF is still the most appropriate valuation method for the education sector. We Brazil education e Providers Growth Sales 50.1% 18.4% 16.5% 17.2% 33.3% EBITDA 39.1% 13.5% 12.2% 48.9% 63.2% EBIT -0.2% 6.2% 9.8% 74.8% 69.7% Net profits -50.8% 210.9% 36.6% -14.4% 188.2% Providers Margins EBITDA 13.3% 12.8% 12.3% 15.6% 19.1% EBIT 7.5% 6.7% 6.4% 9.5% 12.1% Net profit 2.2% 5.7% 6.7% 4.9% 10.5% Providers Productivity Capex/sales 23.8% 9.7% 25.7% 24.3% 6.4% Asset turnover (x) Net debt/eq ROE 3.1% 7.0% 7.5% 4.4% 10.6% Note: based on all HSBC coverage of Brazil Source: HSBC estimates 8

9 believe that the next most used metric would be forward-looking EV/EBITDA ratios, followed by PE ratios. companies have traded at an average one-year forward EV/EBITDA of 9.3x ( x), and forward PE of 14x ( x) over the last two years. Overall, the companies have experienced strong growth, with a CAGR of 17.4% in the period and an expected 33.3% growth for 2012, from a combination of M&A and gains of market share in the admissions of new students. ROE are also on the rise, from 3.1% in 2008 to reach 10.6% in 2012 as companies extract more value from previous acquisitions. 9

10 Sector snapshot Key sector stats Consumer Discretionary 4.39% of MSCI EM Latam Trading data ADTV (5 Year) (USD mn) Free float market cap (USD bn) Performance since inception* Absolute % Relative to MSCI EM Latam % 3 largest stocks TV.N, FALABELLA, LREN3.SA Correlations (5-year) with MSCI EM Latam 0.88 *IPO 2007 to 2009, performance includes dividends Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Top 10 stocks Stock rank Stocks Index weight 1 TELEVISA CPO 1.47% 2 FALABELLA 0.60% 3 LOJAS RENNER ON 0.46% 4 LOJAS AMERIC PN 0.36% 5 CIA HERING ON 0.36% 6 CYRELA REALT ON 0.30% 7 PDG REALT 0.26% 8 ANHANGUERA ON 0.21% 9 MRV ON 0.21% 10 LIVEPOL 'C-1' 0.20% Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Country breakdown Country Weights (%) Mexico 7.51% Chile 6.73% Brazil 3.58% Colombia 0.00% Peru 0.00% Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Core industry driver: Brazilian post-secondary market dynamics 10,000 8,000 6,000 4,000 2, ,000-4,000 26% Conversion rate of high school grads into undergrad freshmen Enrolls lost by graduation or drop outs Source: Ministry of (MEC), HSBC PE band chart Sep-11 Nov-11 Source: Economatica, HSBC Jan-12 High School grads 78% 6,379 Total Enrolls New undergrad freshmen Mar-12 May-12 AEDU ESTC KROT PB vs. ROE AEDU, ESTC and KROT average % 80% 60% 40% 20% 0% -20% -40% 35% 30% 25% 20% 15% 10% 5% 0% 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 PB ROE Source: Economatica, HSBC 10