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Arcos Dorados: Happy Meals in Latin America

November 28, 2012 | About:
Mark Lin

Mark Lin

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Arcos Dorados (ARCO) is the world’s largest McDonald’s franchisee in terms of system-wide sales and number of restaurants, operating the largest quick service restaurant chain in Latin America and the Caribbean. It has the exclusive right to own, operate a McDonald’s restaurants in 20 Latin American and Caribbean countries and territories. It operates or franchises 1,840 McDonald’s branded restaurants with over 90,000 employees serving approximately 4.3 million customers a day, as of December 2011.

Valuation

ARCO is currently trading at a trailing 12 months P/E of 21.57 and a trailing 12 months EV/EBITDA of 9.09. ARCO delivered a ROE of 17.2% over the past 12 months.

Financial and Business Risks

ARCO is highly geared with a gross debt-to-equity ratio of 94% and a more manageable net gearing of 59%. This is not helped by an interest coverage ratio of 2.2 and current ratio of 1.1. If we use trailing debt-to-EBITDA instead, ARCO is at a more conservative coverage ratio of 1.1x. Debt refinancing risks are low for ARCO, as the bulk of the debt will mature in 2016 and 2019. The balance sheet debt does not include $925 million of operating lease commitments.

Of ARCO's outstanding long-term debt, 58.5% was denominated in U.S. dollars as of Dec. 31, 2011. ARCO is managing the impact of foreign exchange rates through the restructuring of the denomination of its debt to more closely match denomination of cash flows and implementing hedges where possible.

ARCO's rights to operate and franchise McDonald’s-branded restaurants derive exclusively from the rights granted to us by McDonald’s in the Master Franchise Agreements through 2027. Pursuant to the MFAs, McDonald’s will determine whether to grant ARCO the option to renew between August 2020 and August 2024. McDonald’s also has the right to acquire ARCO's non-public shares upon the occurrence of certain events, including the death or permanent incapacity of its controlling shareholder or a material breach of the Master Franchise Agreements.

ARCO's growth is largely dependent on new restaurant openings, and consequently growth in comparable store sales. Its restaurant locations has increased from 1,569 at the date of the acquisition to more than 1800 restaurants. There are many challenges that ARCO faces in opening new restaurants, including determining the availability of desirable locations, securing reliable suppliers, hiring and training new personnel and negotiating acceptable lease terms. If ARCO fails to meet changing consumer preferences or economic growth in Latin America falters, ARCO will be badly hit.

ARCO sources its supplies from many approved suppliers in Latin America and the Caribbean, with 25 of its largest suppliers accounting for approximately 80% of purchases. Although ARCO is not dependent on any single supplier, the informal nature of the majority of its relationships with suppliers, where oral agreements are made in place of written contracts, increases the risk of suppliers defaulting on their obligations.

Twenty-seven percent of ARCO's restaurants are sub-franchised. If franchisees do not meet their financial obligations, this will affect ARCO's profitability.

Business Quality and Capital Allocation

ARCO is the dominant QSR brand in the region with superior brand recognition and leadership position. McDonald's has a 9.9% market share in Latin America with 1,880 restaurants, 1,852 dessert centers and 319 McCafes. In contrast, the next two largest competitors, Burger King and Subway, have market shares of 3.1% and 2.5% respectively. For the first nine months of 2012, ARCO has achieved a organic revenue growth of 14.4% and comparable sales growth of 9.4%. In the last 12 months, there were net additions of 103 restaurants.

ARCO is also the world's largest McDonald's franchisee based on system-wide sales and number of restaurants, with its sales representing 5.5% of McDonald’s 2011 global sales, and its restaurants representing 6.8% and of McDonald’s 2011 total franchised restaurants. Forty-six percent of ARCO's total restaurants units are freestanding, allowing ARCO to differentiate the brand with the full McDonald’s experience in terms of McCafe’s, dessert centers, 24-hour operations and home delivery, etc.

ARCO is a proxy for Latin America economic growth and the surging middle class who prefer convenience and away-from-home eating. Latin America is the fastest-growing foodservice market in the world with a projected 5% CAGR between 2011 and 2016. The key Latin America nations such as Brazil, Argentina, Mexico and Colombia have young and growing populations with more than 30% of the population between the ages of 15 to 34. Brazil, Argentina and Colombia achieved GDP per capita CAGR of more than 5% from 2006 through 2011.

ARCO sports a dividend yield of 2% with a dividend payout ratio of 32%.

Conclusion

Buying ARCO is akin to investing in emerging markets ETFs with a Latin America focus. I am not an expert on emerging markets or Latin America, and Latin American economic growth forecasts are beyond me.



Disclosure


The author does not have a position in any of the stocks mentioned.

About the author:

Mark Lin
Working hard to be a better investor

Rating: 3.0/5 (4 votes)

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