Arcos Dorados Feels The Squeeze

By Stephen D. Simpson, CFA | March 06, 2012 AAA

After a big bounce early in 2012, investors are taking a step back and realizing that conditions in the emerging markets may not be as bad as feared, but they're not as good as hoped. As a direct play on consumer spending in Latin America and Brazil, Arcos Dorados (Nasdaq:ARCO) shows a lot of that push-pull dynamic. Although underlying growth is OK and growth potential is significant, investors have gotten spooked by slower sales growth and greater cost impacts than originally feared.

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Squeezed at the End of the Year
Arcos Dorados had a challenging fourth quarter that came in a little short of initial expectations. Revenue rose more than 10% as reported (about 16% in constant currency), on a better than 11% same-store sales growth number.

Unfortunately, growth was weakest in the most important market. Same-store sales were up just about 6% in Brazil this quarter, and while it seems that this is a country-wide phenomenon that has impacted companies like Yum Brands (NYSE:YUM) and Starbucks (Nasdaq:SBUX) as well, it is still a cause for concern.

Profits were a mixed bag. Reported operating margin improved, but adjusted operating income was up only about 6% on a reported basis and about 10% on a constant currency basis. Product cost inflation and wage growth are both pressuring margins for this huge McDonald's (NYSE:MCD) operator.

Mexico and Puerto Rico Are Long Term Opportunities and Risks
Although Brazil makes up about one-third of the company's store base, this country still contributes a disproportionate share of Arcos Dorados' EBTIDA. On a long term basis, getting operations in the Caribbean (especially Puerto Rico) and NOLAD (Mexico) up to snuff is a major opportunity and should be a strong priority. (For related reading, see What Is An Emerging Market Economy?)

Of course, not doing so also represents a major risk to the company. Part of the problem here is that McDonald's used to run its Mexican units to maximize profits and not share. Consequently, Burger King was able to establish a more competitive market share and the perception is that McDonald's is expensive. There's no structural reason that the Mexican operations of Arcos Dorados can't be more profitable than they are, but this market is going to take a lot of focused attention to improve.

Plenty of Growth to Be Had
While the nutritional merits of McDonald's may be lacking, the fact remains that McDonald's stores are still something of an aspirational destination in most of Arcos Dorados' markets. That sets up the company as a good play on ongoing growth and economic improvement.

Moreover, if these markets follow trends seen in other countries, there's going to be ongoing pressure against street vendors and small hole-in-the-wall restaurants (usually in the name of "public health" and sanitation) that could push more traffic to QSR restaurants.

At the same time, Arcos Dorados still has the opportunity to roll out more McCafes, more stores in general and more menu items, to capture more of those pesos, reals and bolivars.

The Bottom Line
Arcos Dorados got a little too expensive amidst the renewed optimism on emerging markets and the stock has softened up since then. The overall growth potential of this company is still strong, though, and investors may want to keep a closer eye on this stock from here. While the risk-reward trade-off does not make it a slam-dunk buy today, the stock is getting quite a bit more interesting, even if core markets like Brazil may not be as strong as investors hoped.

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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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