Arco Platform Limited (NASDAQ:ARCE) Q1 2023 Earnings Call Transcript May 25, 2023

Arco Platform Limited beats earnings expectations. Reported EPS is $1.38, expectations were $-0.47.

Operator: Good afternoon, everyone. Thank you for standing by, and welcome to Arco Platform First Quarter 2023 Earnings Call. This event is being recorded. . This event is also being broadcast live via webcast and may be accessed through Arco’s website at www.investor.arcoplatform.com, where the presentation is also available. Now I’ll turn the conference over to Robert Otero, Arco’s CFO. Otero, you may begin your presentation.

Robert Otero: Thank you. I’m pleased to welcome you to Arco’s First Quarter 2023 Conference Call. With me on the call today, we have Arco’s CEO, Ari de Sa Cavalcante Neto. During today’s presentation, we will make forward-looking statements. Forward-looking statements generally relate to future events or future financial or operating performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those contemplated by these forward-looking statements. Forward-looking statements in this presentation include, but are not limited to, statements related to our business and financial performance, our expectations and guidance for future periods, our expectations regarding strategic product initiatives and their related benefits and our expectations regarding the market.

These risks include those not set forth in the documents that we issued earlier today as well as those more fully described in our filings with the Securities and Exchange Commission. The forward-looking statements in this presentation are based on the information available to us as of the date hereof. You should not rely on them as predictions of future events, and we disclaim any obligation to update any forward-looking statements except as required by law. In addition, management may reference non-IFRS financial measures on this call. The non-IFRS financial measures are not intended to be considered in isolation or as a substitute for results prepared in accordance with IFRS. We have provided a reconciliation of these non-IFRS financial measures to the most directly comparable IFRS financial measure in our press release.

Please note that except for revenue, gross margin, selling expense, G&A and cash flow from operations, all other financial measures we discuss here are non-IFRS, and growth rates are compared to the prior year comparable period unless otherwise stated. We also note that year-over-year comparisons are affected by acquisitions that were not included in our 2022 financials. Let me now turn the call over to Ari, Arco’s CEO.

Ari de Sa Cavalcante Neto: Thank you, Otero, and thank you, everyone, for joining today’s conference call. I would like to start with the highlights of the quarter on Slide 3. On Arco’s Pedagogical business, which includes our core supplemental brands, we delivered a 28% top line and EBITDA growth in the 2023 cycle so far with adjusted EBITDA margin at 41.5% despite an already anticipated pressure on costs to print our content. Since 2022, the industry has suffered from a material increase in printing costs, resulting from higher paper prices globally, which has been impacting our gross margins since last year. We expect this pressure to slow down in the second half of the year with a significantly lower impact on our gross margin in 2023, and we are working to mitigate such circumstantial effects as we discuss further in the presentation.

We remain confident, we will deliver our EBITDA margin guidance for the fiscal year between 36.5% and 38.5%. Our Pedagogical business has posted material and structural improvements. Adjusted EBITDA minus CapEx metric cycle to date expanded 10 percentage points year-over-year. And we posted significant improvement in cash flow generation in the first quarter of the 2023 cycle, allowing Arco to generate cash, reflecting improvements across working capital, CapEx and taxes, which Otero will discuss in more detail soon. The quarter, we also launched a new segment resulting from the acquisition of ISAAC. The Financial & Management Solutions segment debuts in Arco P&L, adding growth with a 133% increase in net revenue year-over-year. With ISAAC, that enables Arco to further strengthen its dominant position in Brazil’s education ecosystem by diversifying the scope of its portfolio of products, making us a true one-stop shop platform for our partner schools while establishing closer relationship with families.

I wanted to remind that we have been implementing several initiatives to drive a more efficient, agile and scalable operation, which is shown by matrix whose performance is under our control, such as capital deployment, SG&A management and working capital. The printing cost pressure is circumstantial, and those initiatives that we are taking are already unlocking margin gains in 2023 and will significantly improve our cash generation. On top of our efforts to improve internal operation, we must always keep our partner schools at the center of all our decisions. This commitment requires continuous investment in our products and solutions, full dedication while serving our customers and our result to always evolve as a company. I will now turn the call to Otero who will continue the presentation.

Otero, please go ahead.

Robert Otero: Thank you, Ari, and good evening, everyone. We will begin by presenting the results of our Pedagogical business initiating on Slide 6. Given the difference in revenue recognition this quarter, when compared to the first quarter of 2022, we strongly recommend investors to analyze our business performance on a cycle-to-date basis, starting in Q4 2022 up to Q1 2023. Net revenue in the 2023 cycle grew 28% year-over-year, reaching BRL 1.136 billion, with Core Solutions up 26% year-over-year and Supplemental Solutions driving a robust 38% year-over-year growth cycle to date. In the first quarter, revenues for the Pedagogical business were up 10% year-over-year, reflecting the lower revenue recognition versus last year.

We maintain our guidance for BRL 1.9 billion of ACV in 2023 with 20% — 24% growth versus 2022. Moving to Slide 7, we discuss the Pedagogical business adjusted EBITDA margin. Despite the cost pressures, we managed to keep our adjusted EBITDA margin in line year-over-year in the 2023 cycle at 41.5%. While the content providing costs consumed 5.5 percentage points of margin, our SG&A efforts managed to generate the same positive impact on our profitability for a flat performance versus the 2022 cycle. On the next slide, we discuss in more detail the leverage behind our EBITDA margin guidance achievement this year. Moving to Slide 8, we expect an important improvement on gross margin behavior in the second half of the year reflecting a few initiatives, including printing prices renegotiation due to volume reallocation and integrated supply management strategy, direct paper negotiation and acquisition from producers and more intense technology usage will allow for more scalable content production and delivery setups.

All in, we expect the Pedagogical business cash gross margin to be down at approximately 2.5 percentage points in 2023. At this point, we have already signed contracts for the 2024 cycle printing process, which starts next August. Thus, we have a very high visibility on our content production cost for the second half of the year. On SG&A, we will continue to unlock scale gains and grow our expenses at a much slower pace when compared to our top line growth. We have posted significant results over the last 3 years and expect this trend to continue in the future. On Slide 9, we disclosed the main metrics behind the significant improvement in the Pedagogical business cash generation in the quarter. Improvements in days of sales outstanding, delinquency and days of inventory were key to revamp our working capital dynamics this quarter.

Moving to Slide 10. We disclosed the effect of a more optimized capital allocation strategy that continues to reflect our focus on product evolution, but also it starts to show the higher cooperation and investment coordination among our brands. These efforts resulted in Pedagogical CapEx in the 2023 cycle at 6.4% of net revenue from 16.3% in 2022. This enabled us to expand almost 10 percentage points the adjusted EBITDA minus CapEx metric in 2023 cycle to 35% from 25.2% in 2022. As a result, in Slides 11 and 12, we show the improvement in every line of our operating cash flow, leading our Pedagogical business to our free cash flow to form of BRL 187.6 million in the first quarter that represents almost 40% of net revenues in the quarter and BRL 174.5 million expansion when compared to the first quarter 2022 figures.

When looking at the 2023 cycle, we delivered BRL 96.8 million free cash flow generation at BRL 321.1 million expansion versus the negative BRL 224 million free cash flow registered in the 2022 cycle to date. Now moving to Slide 14. We officially debuted our Financial and Management segment with a brief recap on ISAAC’s business model and trajectory. ISAAC was founded in August 2020 to address K-12 schools overarching needs with software and financial solutions as an all-in-one platform. ISAAC has already reached BRL 266 million in annual recurring revenue as of March 31 and currently transact almost BRL 3 billion in yearly total payment value or TPV. ISAAC’s first product, the Revenue Guarantee aids Brazilian’s school’s financial struggles once help them surpassing first, limited managerial skills; second, pen and paper or in legacy ERP systems that made billing mostly offline through paper invoices; collecting unstructured and laborious leading to friction with parents; eliminates financial volatility schools once ISAAC becomes responsible for all tuition collection, incorporating the delinquency risk that is priced in the applied take rates and guarantees a monthly fixed streamline to schools.

Such product provides recurring and monthly revenue once schools are paid in monthly installments during a 12-year long education cycle and a reduced working capital as most parents often delay a few days. And delinquency at the end of cycle is structurally low as delinquent students cannot reenroll for next school year as stated by law. On Slide 15, we go through the business model fundamentals of ISAAC that enables such powerful and complementary early drivers. First, intense growth based in take rate model, mandatory for all students provide significant scale. Second, such rapidly growth strengthened the relationship with schools that already use our Core and Supplemental Solutions by offering complementary Financial and Managerial Solutions and additionally provides an intake sales motion that adds new schools into our cost portfolio and pave the way for monetizing a pipeline of products going forward.

Third, on top of that, ISAAC’s state-of-the-art technology team and structure is a main pillar of enhancing pricing and collection processes and reducing our cost to serve while gaining scale. ISAAC’s trajectory as March ’23 is on track to its historical robust growth profile, as we can see in Slide 16. ARR growth year-over-year surpassed the 80% mark and is combined with a powerful increase of efficiency. When analyzing a school over total headcount metric in a single year, ISAAC was able to almost double such ratio demonstrating the power and scalability of its tech-enabled model. Moving to Slide 17, we show the first earnings result of our cost financial and management segment. Net revenue in the first quarter were BRL 62.5 million and 133% growth versus a pro forma net revenue of the first quarter 2022 prior to the acquisition.

Adjusted EBITDA margin was minus 23.6%, an expressive 74 percentage points year-over-year expansion versus a pro forma adjusted EBITDA of the first quarter. EBITDA improvement correlates directly to scale gains resulting from its growth and type profile. Due to its rapid growth pace, it’s expected that margins will gradually increase quarter-over-quarter, ramping up on revenue growth and scale gains. We are confident in reaching our net revenue guidance of between BRL 300 million and BRL 350 million for the 2023 fiscal year and hovering our minus 10% adjusted EBITDA margin guidance for the F&M segment in this fiscal year. On Slide 19, we provide a snapshot of our consolidated first quarter ’23 results that combines both Pedagogical and F&M results.

First quarter consolidated figures delivered a net revenue of BRL 534.9 million and adjusted EBITDA of BRL 110.7 million with 20.7% adjusted EBITDA margin. Consolidated adjusted net income was minus BRL 42 million, representing a minus 7.9% adjusted net income margin. Consolidated free cash flow to firm reached BRL 207.6 million, representing 38.8% of net revenue in the period. Moving to Slide 20, we present the evolution of our free cash flow to firm since 2018, in order to highlight the significant performance of this beginning of the year, definitely a milestone once we deliver the highest rate over revenues in such period. On Slide 21, we highlight Arco’s free cash flow generation after our financial expenses, reaching BRL 94.4 million or 17.7% of net revenues in the first quarter, initiating a year of robust cash collection as disclosed on Slide 22.

From the BRL 937 million of accounts receivables that are not past due in March 31, we expect to collect approximately BRL 460 million up until the end of June. Such result collaborates to Arco continuous deleveraging process as disclosed in Slide 23. In the first quarter, we further reduced our net debt over adjusted EBITDA last 12 months to 3x, calculating according to our covenant specifications. While analyzing our current obligations, we continue to deploy our liability management strategy in order to meet our obligations for short and long term. As mentioned in previous calls, we are confident in our cash generation capacity. And on top of that, we are currently at final stages of issuing an additional credit line to strengthen our balance sheet to make for the future capital disbursements.

With that, we conclude the representation. Operator, we can now open for questions. Thank you.

Q&A Session

Operator: . Our first question comes from Lucca Marquezini with Itau BBA.

Lucca Marquezini: We’ve got two questions from our side. First, Otero, you mentioned that — during the call that Arco has already initiated the billing contracts for next year’s commercial cycle. So can you please provide more color on the terms negotiated and also how they compare to this year’s costs? And then secondly, regarding cash flow generation, we saw a significant improvement that was mainly caused by better working capital. So can you please comment on the recurrence of these effects that led to improvement in working capital?

Robert Otero: Thanks for the question. So starting with the first one. As you said, yes, we already have signed contracts of 41st batch of 2024 content. We’ll start the screening process by the end of July, beginning of August. So at this point, those negotiations are pretty much well advanced and some contracts are signed, as I said. For those, we are seeing prices per page down in nominal terms, okay? I would say, a mid- to high single-digit decline in prices per page for the initial deliveries, which, as I said, we started printing in August, and we start delivering to schools by mid to the end of the fourth quarter, okay? On the second point on cash flow generation, you’re right, I think that’s the most important highlight of the quarter.

It is 100% recurring, okay? There’s no one-off effect in this cash flow generation. Actually, this goes back to, I mean, the business fundamentals, right? So this business generates a lot of cash. The key reason why our cash flow performance deteriorated in the last 2 years, has much more to do with circumstantial events such as and the incorporation of the acquisitions. So assuming a normalized environment, which is the one we are operating at right now, the business generates cash naturally. I don’t want to minimize the impact or the influence of internal initiatives and the work the team is doing to improve, of course, and accelerate the return to this very healthy cash flow profile. So we’ve been putting a lot of focus on that through internal processes through incentives to the management.

This has become the key metric through which we measure success in the company. And now this is reflecting in concrete results, okay? So again, this is recurring. There’s no one-off effect, and you should see this behavior throughout the year. Okay.

Operator: Our next question comes from Lucas Nagano with Morgan Stanley.

Lucas Nagano: We have two questions. First one is related to costs. I understand that for the 2024 cycle, the printing costs should reduce. But what are your expectations on the margins for the rest of the 2023 cycle, given that the materials must have been already printed? And second question is related to the next — the 2024 sales process. So could you give us some color on your perception on the competitive environment? And which level of ACV growth you’re targeting for Core and Supplemental? And do you see ISAAC helping to accelerate the growth in the Pedagogical segment as well?

Robert Otero: This is Otero speaking. So starting with the first question on cost and the expectation for this year. So as I said during the opening remarks, we expect the gross margin this year — in the fiscal year, okay, to be down around 2 to 3 percentage points max. So this means an improving curve in the upcoming quarters. And this reflects negotiations that are already affecting the 2023 the cycle. So we were mostly exposed to higher prices for the first batches of the 2023 cycle. Along the process, we managed to relocate volume in other suppliers and other printing companies and managed to reduce prices for the current cycle. But for the 2024 cycle, which we started printing in August, this affects the Q4 directly and helps ourselves minimize the impact in the entire year.

But again, at the 2023, as I said, I mean, we saw pressure, especially for the beginning of the printing process, but we managed to relocate capacity and will be fully exposed to those higher prices for the entire cycle. And again, we expect the gross margin to be down this year at a much lower pace than what we showed in the first quarter. On the second point, for the 2024 sales process, it is early to say, as you know — I mean the curve accelerates a lot in the second half of the year traditionally. But what we can share at this point is that when we compare to the 2023 ACV builder process, we are ahead of the curve in pretty much every metric that we look at. So in terms of price increase, in terms of cross-selling, upselling and new school addition, we are performing ahead of the curve and light ahead of our expectations.

But again, important to emphasize that it’s early. So let’s keep expectations bearing in mind that we are still beginning the process. But the data we have at this point shows encouraging expectations for the completion of the sales cycle. With regards to ISAAC, I would say that at this point, we are focusing more on the cross-sell to sell ISAAC. So I would say it’s early to focus on what we would call a reverse cross-sell, which we do for supplemental products. And I think we will end up doing with ISAAC. ISAAC already has more than 1,200 schools as clients. So it is a relevant based of potential clients to Arco’s Pedagogical business. It is important. But for a matter of focus and priority, we are, at this point, focusing more on the cross-sell of the Pedagogical sales force helping create leads and sell ISAAC to our current Pedagogical clients.

I think it’s much more a matter of prioritization and focus. And probably, we’re going to start the reverse cross-sell more likely towards the end of this year or in 2024. Yes, I think this answer the questions. I think you got…

Operator: Our next question comes from with JPMorgan.

Unidentified Analyst: I have two. So first, on ISAAC, do you continue to expect breakeven by the end of opportunities in the public sector.

Robert Otero: Jessica. Otero here. I’m sorry, but could you repeat the first and second question. I’m not sure if it’s our connection here, but I lost ask you. If you could repeat, I would appreciate.

Unidentified Analyst: Yes, sure. My second question is regarding the public sector. Do you see any opportunities here going forward?

Robert Otero: Great. Thank you. Thanks for repeating the question. So on the first one, yes, this continues to be the base case. As you saw in the first quarter, they posted a minus 26% EBITDA margin differently from Arco. The ISAAC business builds up revenue along the year, right? So — sorry, minus 23.6% EBITDA margin. And differently from Arco’s business, ISAAC compounds revenue along the year, right Jessica. So the scale gains and the operating leverage happens along the year, right? So you should expect this minus 23.6% to converge to our guidance for the full year. So everything is on track. I think the business is performing in line with expectations. So there’s nothing at this point that would lead us to believe that the breakeven will take longer to happen than what we initially planned.

So far so good. The business is performing in line with the expectations. With regards to the public sector, I think it’s a good question, but obviously, we think the opportunity in the private sector is so big, and we think we can explore this opportunity in the private sector in so many ways, that at this point, for a matter of focus, we will continue to focus in the private sector. We are just scratching the surface in many segments in which we operate. Now we have had ISAAC, I mean even more straight to the platform. So for a matter of focus and for a matter of belief that this is the best place to focus. And we will continue to, I mean, focus on the private sector.

Operator: Our next question comes from Pedro Caravina with Credit Suisse.

Pedro Caravina: So I would like to do a follow-up on cash generation. So you improved a lot the cash generation for the 2023 cycle. If I may ask, what are behind the better working capital dynamics? Following my colleague’s question. And what should we expect for the following 2 quarters of the cycle? Is there a concentration of cash generation in the first 2 quarters? Or is — I don’t know, better terms and improvements at all. And also, I noticed that there was a reduction in CapEx expanding. So were the levels higher in 2022? And what should be a recurring level going forward for CapEx maybe as a percentage of revenues?

Robert Otero: Pedro, Otero here. Thanks for the question. So in terms of the cash flow improvement, I think it’s much more a normalization of the working capital behavior. I think we are leaving behind events or impact from events that really changed and affected the behavior of the company’s working capital. I think the impacts on receivables, inventories to a lesser extent, payables as well. So we’re seeing a normalization across the board. So if you look at delinquency for example, we’re now performing — our performance on the delinquency right now is better than a pre-COVID levels. So I would say that the business is going back to a normal profile. And internally, we are putting much more focus on that as well, right? So I think this adds more fuel to this recovery or accelerates this recovery, okay, Pedro?

So internally we’re putting a lot of effort. This applies to contracts with schools, this applies to . This applies to all those renegotiations going on with the printing suppliers. So it’s a very ample effort that is translating into this improvement in working capital because this has become a key focus. And the internal incentives are all towards this goal. In terms of the expectation for the next quarters, the second quarter is usually a very strong quarter as well for collection, okay? So you should not expect anything different. And the Q4 is usually the quarter at which we see a highest consumption, right, in terms of cash and working capital consumption. So we should expect a similar trend to that. So Q1, Q2, very strong in terms of collections and inflow of cash.

And Q4, usually the weakest one for cash flow generation. In terms of the CapEx expanding, we have not changed the mindset towards, I mean, being the dominant and the best player in terms of quality and product quality and technology evolution. So this has not changed at all. And this is not the reason why CapEx is actually losing relevance as a percentage of revenues. I think it has much more to do with the way we’ve been operating the company and the level of coordination among the brands and reduced redundancy across the brands. So all those things that — some of them we even discussed at Arco Day in terms of centralizing technology development, for example, all of that translates into a more efficient capital deployment process and now is reflecting into the CapEx losing relevance as a percentage of revenues.

We maintain the guidance of CapEx as a percentage of revenues of 8% to 10%. But at this point, I would say that there’s a sign that CapEx will trend below or slightly below or at the low end of this guidance.

Operator: . At this time, we have no further questions in the queue. That concludes Arco’s First Quarter 2023 Earnings Call. Thank you very much for your participation, and have a good night. You may now disconnect.