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.

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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.
Tickers in this Article: ARCO, MCD, BKW,

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