Investors who bought Arcos Dorados (Nasdaq:ARCO) thinking they were getting McDonald's-like (NYSE:MCD) consistency with a Latin American growth kicker have been badly surprised over the past year, as Arcos Dorados' performance has lagged its franchiser's performance by roughly 25%. A lot of what has hurt the company is arguably out of management's control, as weakening consumer conditions across much of Latin America (including Brazil and Mexico) and persistent inflation make operations much more challenging. Although these shares do appear undervalued relative to their long-term potential, management has a lot of work to do to realize that potential.
Earnings Highlight The Good, Bad, And Ugly
When Arcos Dorados reported earnings about two weeks ago, it was another example of just how challenging it is to run a consumer-oriented business in Latin America right now. While inflation is encouraging spending (why save money if the value erodes day by day?), it is also doing a number on the company's operating costs and product positioning.
Revenue rose 9% as reported or nearly 17% in constant currency, more or less hitting the sell-side target. Sales were strong (up 14%) in the SLAD region (which includes Argentina and Venezuela) and solid (up more than 9%) in Brazil, but softer (up 7%) in NLAD (which includes Mexico) and in the Caribbean (up 5%). 
Same-store sales were likewise mixed. Brazil saw same-store growth of 10%, but 70% of that growth came from pricing (food inflation is running about 13% in Brazil). SLAD comps shot up 21% on inflation-fueled consumer spending in Argentina, while NOLAD comps declined more than 4% as consumer spending weakens in Mexico.

SEE: How To Analyze Restaurant Stocks
Margins were likewise very mixed. Operating profits declined 7% as restaurant expenses rose 10%, though the company's operating margin was actually a bit (20bp) higher than expected. Profits were up strongly in SLAD and up some in Brazil, but NOLAD reversed to a loss and profits in the Caribbean declined 3%. Although the company's overall operating margin is just 4% (against more than 30% for McDonald's), Brazil and SLAD continue to lead the way with operating margins over 8% despite ongoing wage, food, and input (paper, etc.) inflation.
Slowing Expansion Is Good, Improving The Image Would Be Better
As I said, Arcos Dorados' experience in Latin America is not unusual at present. AB InBev (NYSE:BUD) has seen volumes weaken in the Latin American beer markets, Wal-Mart (NYSE:WMT) has seen Mexican same-store sales turn negative (and Brazil's are not exactly strong), and many other consumer companies have reported that business is getting considerably more challenging.
Against that backdrop, I'm glad that management is apparently receptive to slowing its store expansion plans. There's certainly room for more McDonald's stores across Latin America, and companies like Starbucks (Nasdaq:SBUX) and Burger King (NYSE:BKW) are looking to grow their footprints too, but racking up a lot of debt to expand in a tougher market may not be the wisest move today.
If management isn't going to be opening new stores, they should take the opportunity to tighten up operations. McDonald's still has an image problem in Mexico due a decision years ago (after a major devaluation) to cut service and quality levels to maintain margins. That sounds like a very un-McDonald's-like thing to write, but the fact is that management has to address this more aggressive or risk losing the Mexican market to other fast food vendors.
In Brazil, far and away the company's largest market, a Big Mac costs about $8 against a minimum wage range of $1.59 to $2.33 per hour (by way of comparison, a Big Mac averages about $4.56 in the U.S. with a federal minimum wage of $7.25/hr). While the cost of living in Brazil is higher than a lot of Americans realize, there is still the risk that McDonald's is pricing itself out of this growing market – and as the unending jokes about Whole Foods/”Whole Paycheck” may indicate, reputations can last for quite some time and alienate potential customers. Arcos Dorados has started changing up equipment and operating processes to reduce costs, but this is still a big item on the “to do” list.
The Bottom Line
I continue to believe that Arcos Dorados can achieve a long-term revenue growth rate in the high single digits (8% to 9%), with significant margin and free cash flow generation improvements. Unfortunately, as those improvements slide more into the out years, the discounted value of those cash flows decrease and so too does the fair value on these shares.
While I'm bullish on the long-term prospects for growth and consumer spending in the company's key markets, the near-term risks from inflation and consumer spending are meaningful and investors should realize that they're leaning into the wind with these shares today.
Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.


Related Articles
  1. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  2. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  5. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  6. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!