McDonald's (NYSE:MCD) may be the leading dining concept in Brazil and much of Latin America, but that doesn't promise smooth sailing for its large franchisee/operator Arcos Dorados (NYSE:ARCO). Not only are operating expenses pressuring margins, but overall economic conditions and rising competition in Brazil are squeezing numbers from the other side as well. Although these shares do not look too expensive today, investors need to appreciate the above-average volatility if they choose to nibble on these shares.
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Tough Numbers in a Tough Environment
The quality of Arcos Dorados' second quarter really depends on which numbers you focus on and the context in which you view them. Comp growth and margins weren't great, but the Street had been bracing for even worse.
While revenue was up about 15% in local currencies, it grew only 2% in U.S. dollar terms. Revenue in Brazil was actually down 9%, while NOLAD (largely Mexico) was up 6% and SLAD (largely Argentina and Venezuela) was up 19%. Comps were up over 10%, but Brazil comps were up less than 6% versus over 10% growth last year. NOLAD comps were up 9% and SLAD comps looked impressive at 19% until you appreciate the significant impact of inflation in that number.
Margins are likewise under pressure. Operating income was up a reported 14%, but the company-owned restaurant margin fell almost two points and adjusted EBITDA dropped 1%, with a significant 26% decline in Brazil. Simply put, higher wage costs, operating expenses and food costs are definitely taking a toll.
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Is Growth Just a Brazilian Economic Issue?
There are some questions now about the quality of the Arcos Dorados growth story. Even as McDonald's is the largest chain in Brazil by a wide margin, there still looks to be plenty of store expansion potential. Against that, though, are high costs and rising competition.
Quick service restaurants like McDonald's are thought of as cheap dining options in the U.S., but the food served by Arcos Dorados is some of the most expensive McDonald's food in the world. It probably won't surprise readers to read that Norway, Sweden and Switzerland are up there in terms of Big Mac prices, but Brazil and Venezuela are also in the top five worldwide, and that's an increasingly relevant issue in a country where economic conditions have been weaker as of late.
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Competition is also potentially becoming more problematic. In addition to local/regional operators like Habib's and International Meal Company, Arcos Dorados is seeing a stronger push from competitors like Burger King (NYSE:BKW), CKE and Subway in Brazil. Given the relatively greater success of companies like Yum! Brands (NYSE:YUM) in markets like China, I don't think investors can afford to just assume that McDonald's will always be the top choice in these markets. At a minimum, it puts more pressure on the company to stay competitive with price and menu offerings, and that costs money.
The Bottom Line
Luckily for Arcos Dorados, most of its competitors are trying to compete on a global basis, taking on Yum! and McDonald's across multiple markets around the world. That ought to give the company some incremental advantage with its narrow focus on Latin America and Brazil. Likewise, Brazil's tougher times won't last forever and store comps have held up alright by the standards of past slowdowns.
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Near its 52-week low, Arcos Dorados definitely looks more reasonably priced than at other times over the past year or so. Expectations still call for robust cash flow growth, and a lot of that growth is back-end-loaded toward the end of the next ten-year period. Consequently, there's quite a bit of risk to this name. Nevertheless, I would think that operating performance and sentiment would rebound as Brazil does, and while this is a risky and volatile name, it could prove to be a good emerging market growth story for years to come.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.