Arcos Dorados - Rare Or Overcooked?

By Stephen D. Simpson, CFA | December 18, 2011 AAA

What happens when emerging markets start seeing better incomes and higher standards of living? In the earliest days, it means cell phones, televisions and motorbikes. Later, it can mean adding more protein to the diet. Still later, it often means spending on luxuries like dining out, and American quick-service restaurants often represent affordable luxury in many parts of the world.

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To that end, Arcos Dorados (NYSE:ARCO) is not only a play on improving economic conditions in Latin America, but a way to play one of the faster-growing markets for the proven and globally-successful restaurant chain McDonald's (NYSE:MCD). While it's one of the very few direct investment plays available to American investors within this trend, it's not exactly the cheapest stock by many standards.

What Arcos Dorados Is
Arcos Dorados is basically a giant franchiser of McDonald's restaurants south of the U.S. border. With about 1,750 restaurants, the company has broad geographic distribution, but about half of the company's revenue (and 70% of its EBITDA) comes from Brazil. Other countries in southern Latin America like Argentina, Venezuela and Colombia account for about another quarter of the business, while the remainder is split between the northern Latin American countries and the Caribbean. (For more on EBITDA, see EBITDA: Challenging The Calculation.)

Apart from its operating areas, this is basically a straightforward business. Arcos Dorados builds and operates McDonald's restaurants, and it does so basically in line with McDonald's standards and requirements.

The Bull Opportunity
Compared to the developed world, residents in Arcos Dorados' operating areas do not go out to eat all that often, and certainly not at American-branded chains like McDonald's, Burger King, Subway, Yum Brands (NYSE:YUM) (KFC, mostly), Domino's (NYSE:DPZ) and so on. As economic conditions improve, more and more people are going to these restaurants, and that is fueling impressive growth for Arcos Dorados.

To wit, same-store sales growth has been trending in the mid-teens, with overall revenue growth at or above 20%. EBITDA and operating income is also growing, but not at the same rate as sales. As time goes on, the idea is that Arcos Dorados can capture more and more of a growing wallet - both from attending to local tastes and expanding offerings like the McCafe concept.

The Bear Risks
Arcos Dorados is not free money for investors taking a long position. For starters, the company has been experiencing some meaningful margin erosion, mostly due to wage inflation but also somewhat due to commodity inputs. When Adecoagro (NYSE:AGRO) and Cresud (Nasdaq:CRESY) see higher beef and dairy prices, that is not great news for Arcos Dorados.

It's also problematic in that Arcos Dorados competes with the likes of Panera (Nasdaq:PNRA) and Chipotle (NYSE:CMG) for growth investors' dollars, and Arcos needs to offer better margins to be an equally compelling long-term story.

Arcos Doradoes also has some structural issues. The master franchise agreement with McDonald's requires minimum capital and ad spending, creates a dual-class structure, and could lead (in some circumstances) to a scenario where McDonald's can buy control of the company with minimal tag-along rights for shareholders. Also note that the company's sizable position in Brazil, Argentina and other Latin American countries means that currency is a significant factor, and more than a few grizzled investors will have second thoughts about trusting a story that revolves around the Brazilian real or Mexican or Argentine peso.

The Bottom Line
If Arcos Dorados can maintain double-digit revenue growth and start producing mid-single digit free cash flow margins by 2015 (and then continue to post solid growth on both lines), the stock is definitely undervalued today. Given the under-penetration of McDonald's in these markets relative to more developed markets, that's absolutely possible.

It's a risky bet, though, as the company has a long way to go to get to a mid-single digit free cash flow margin. Consequently, some growth investors may be more inclined to stick with Panera or Chipotle, and other investors may opt for a China play like Country Style Cooking (NYSE:CCSC) instead. Still, by the standards of emerging market stocks, Arcos Dorados has a better chance than most of living up to optimistic investor expectations. (Emerging markets provide new investment opportunities, but they include risks. For more, see What Is An Emerging Market Economy?)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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