Description

Thesis:

Arcos Dorados is an ideal investment for a long-term oriented investor seeking a high quality durable business, with a strong moat, a great management team, a healthy balance sheet and plenty of tailwinds supporting significant growth potential.  Arcos Dorados (ARCO) - Spanish for Golden Arches - is McDonalds master franchisee in Latin America, headquartered in Argentina.  It is the largest McDonalds franchisee both in terms of number of units and revenues - with 1,960 restaurants and ~$4,000 MM in sales expected for FY 2012. 

While the stock doesn't look cheap using trailing metrics, proven and accelerating high-return investments, including reimaging’s, brand extensions, and an aggressive unit expansion plan across markets with attractive secular demographic and economic dynamics, combined with continued strength in SSS growth and expanding operating margins over the long run, make the stock a bargain relative to what it will be earning in the next few years. 

For those willing to ignore some recent weakness in comps (…and the stock) and a temporary dip in margins – which we consider “noise” given the investment mode the company is operating in and the inherent inflationary volatility of the region – this is a great time to pick up shares of a growth business at a reasonably attractive valuation (mid-teen forward multiple with ~15-20% CAGR in EBITDA for the next 5+ years, without saturation and plenty or room for additional growth, able to sustain a premium multiple for many years to come). 

While some recent concerns about labor and COGS inflation, and elasticity of demand to price increases, are valid, we believe investors should be looking out 3+ years and appreciate the visibility of the unit development growth and the fact that it only scratches the surface of the ultimate long-term potential in LatAm.  We think restaurant units could approximate 2,500 by 2015, representing ~$650 MM in EBIT – with some minor cash build a 5x 2015 multiple on the EV.  Interestingly, we expect capacity will continue to exceed supply by at least 50% (using modest assumptions of capacity significantly below mature markets like the US).  This will allow expansion plans to continue for a very long time allowing for profitable growth despite intensifying competition from the likes of Burger King, Subway and KFC.

Brief history of the “new” Arcos Dorados:

ARCO's current relationship with MCD was structured as a Master Franchise Agreement in 2007 by Chairman and CEO, Woods Staton, who has been with MCD for 26 years, acquiring 1,590 restaurants across 20 countries for $700 MM, as part of MCD world-wide refranchising program.  Staton owns ~40% economic interest and non-listed B-shares giving him >75% voting control - which MCD can buyback in the event of a material breach of contract.  The MFA is valid until 2027 with a 10-yr renewal option and a controlling interest buyback option in 2037 by MCD at fair market value. 

ARCO was IPO'd in April of 2011 at $17 / share.  The transaction was primarily a secondary with three sellers, Gavea Investimentos, Capital International and DLJ South America selling $1.09 billion, while the company raised $152 MM used for growth capex.

Background and discussion:

It goes without saying that McDonalds is a dominant brand with global appeal - consistently among the top ten most recognized / admired brands throughout the world.  As an aside, it is worth noting that McDonalds (MCD), the franchisor parent of Arcos Dorados, is a wonderfully run, high-quality business that we also believe to be a great long-term investment; albeit with a distinct risk / reward profile.  VIC has some interesting write-ups and discussions on MCD that I recommend people read.

While MCD is mainly a franchisor, ARCO is primarily an operator owning ~80% of its units.  This changes the risk profile of ARCO from the predictable royalty stream seen in the McDonalds parent business model, to a hands-on operator model that assumes higher product and execution risk.  This, however, is an attractive attribute about the ARCO story since LatAm has been a structurally undermanaged and underinvested region for many years under MCD ownership - leading to slow unit development / growth despite visible strength across regional economies (unit CAGR from 2000 to 2010 was 2.2% in Latin America; translating to ~4 units per million people compared to 45 in US).

Since ARCO took over the operation from MCD buying the business in 2007, underperforming stores have been closed, money losing operations have been turned around making them profitable, new brand extensions have emerged, and marketing spending has revitalized the brand across underperforming regions.  By steadily increasing penetration and striking a balance among restaurant types (free-standing, in-store, mall, and food-court) management has carefully preserved extraordinary economics demonstrating incredible skill as capital allocators.  

Investments in margin expanding concepts like McCafe’s and Dessert Centers, along with the development of local product / menus, are growth formulas that have proven profitable across regions.  In regions where ARCO cannot achieve scale, sub-franchises that pass royalties thru to MCD have been used, while generating a return on investment through an expanded marketing budget and property management / leasing & sub-leasing business, often with franchisees covering rent and capital investments (depending on type of situation).

However, what makes the ARCO story exciting and unique beyond its capable management, is the attractive characteristics of its addressable market - i.e. LatAm's dynamic consumer market.  

As mentioned above, in contrast to Asia, Europe and most other regional markets, Latin America is significantly underpenetrated with significant unit growth opportunities across virtually all countries in which ARCO operates.

In terms of brand image, our research indicates that, in LatAm, McDonalds is seen more as an aspirational brand and has been successfully positioned as a "fast casual dinning" experience, as opposed to a quick service restaurant (QSR), attracting a wider income bracket than in more developed countries (while avoiding the negative "junk food" connotation and image).  This provides ARCO with a structural advantage in terms of pricing and market potential.

The thesis is simple: primarily a unit growth / reimage story where management is plowing back all FCF to invest in profitable investment opportunities along its multiple formats.  We view pricing power as primarily used to offset local cost inflation for food, labor, occupancy and utilities - but it is worth noting that efficiencies in supplier relationships, transaction growth, and unit penetration should still support comps and margins for many years.  We expect the top line to steadily grow as ARCO adds ~125 - 175 units per year with accelerating trends.   

Growth strategy / capacity, by the numbers:

Plenty of positive upside opportunities exist in better than expected brand-extension penetration per restaurant across all regions.

A few things to keep in mind when considering the brand extensions below: There are studies that show sugar consumption grows exponentially as a function of per-capita GDP.  This is a significant driver for ARCO with estimates that Dessert Centers could increase by over 2.0x - representing more than 1,500 additional units by 2015.

Also, latent demand for specialty coffee shops – which has driven Alsea’s Starbucks success story in Mexico with ~350 units – has also shed light on an market that is in its infancy in LatAm.  Interestingly McCafe’s have been positions to a target the high-end affluent market through standalone units in high-traffic areas because Starbucks has been slow to penetrate South America.  The strategy is proving successful, but what makes this interesting in our opinion, is the fact that this is a fast rising tide that will lift all boats in this market.  This adds plenty of optionality to the ARCO story.

• Representing almost >50% of restaurant openings, freestanding units with drive-thru's, playgrounds, and McCafe's are a primary focus.  On average these require a $1.4 MM investment with three-year average ROI of 27%.  This is where the most capital can be put to work.

• McCafe's and Desert Centers represent a very attractive growth opportunity as units could triple from current levels by 2015.  A McCafe investment requires a $70 K investment and generates an average ROI of 46%.  Meanwhile the average ROI on a Desert Centers is a whopping 170% on a $43 K investment.

• Reimaging’s have also been a growth driver with good economics.  In general a reimaging requires a $350 K investment.  Overall reimaging’s have created significant value, but returns have been mixed across regions.  ROI for new openings are ~30% while reimaging’ s are ~17%.  However, the returns have been hurt in recent years due to aggressive reinvestment in turning Mexico around – following a capex / low price strategy to regain market share (instead of maximizing returns).  We believe there has been a significant lag in Mexico’s results that should be show strength in upcoming years.

As a result of the broad growth strategy, ARCO’s uses of cash will exceed operating cashflow as management exploits all opportunities.

In terms of market capacity, GDP per restaurant, adjusted for purchasing price parity (PPP), for example in France, is $1,795 MM and its ratio of inhabitants per restaurant is 54,655.

Using the above metrics for comparable markets lead to a blended capacity potential of 3,700 units by 2015.  The countries with the highest penetration potential are Peru (9x), Columbia (5.4x), and Brazil (2.6x).  Mexico is the most mature with a 2.4x potential. 

Assuming a modest system-wide unit CAGR of 6 - 7% for the next 5 years, combined with high single digit / low teen comps through pricing and transaction growth, top-line growth should be sustained in the mid to high teens.  We believe EBITDA in 2015 will exceed $750 MM with FCF of ~$300 MM.   

Investment heavily weighted towards Brazil:

When looking at ARCO on a regional basis, Brazil has been the major success story driving ARCO’s results with ~40% of restaurant units representing over 50% of system-wide sales and close to 70% of EBITDA. 

While investors worry that the low-hanging fruit has been captured here – driven by a very efficient operation with high transactions per store, strong pricing, and great margins – there is still clearly plenty of opportunity for further penetration in terms of number of units. 

GDP & population per restaurant metrics adjusted for PPP show that market penetration in Brazil is still about 1/3 to 1/2 that of other mature markets.  And while there has been some headline risk and hair to the Brazil “economic wonder” theme, we still firmly believe this is a very strong emerging consumer society that can drive consistent growth for brands like McDonalds. 

Revenue in Brazil will continue its upward CAGR - driven by SSS keeping with inflation (which has been low recently) combined with healthy unit expansion.  Brazil EBITDA should break the $500 MM mark in the next couple of years assuming margins expand slightly above 17% benefiting from G&A leverage there. 

In contrast, over the years, the North Latin America Division (NOLAD) has been dragged down by underperformance in Mexico – which represents ~20% of restaurant units and ~5% of system wide sales & ~4% of EBITDA.  Five separate JV partners and many franchisees led to perennial poor management and underinvestment – which led to a deterioration of quality / maintenance. 

Problems led to market share losses, brand erosion, and very low transactions per restaurant (1/3 of those seen in Brazil and Argentina).  By acquiring franchisees and aggressively investing in reimaging’s plus quality control programs, management has been focused in turning Mexico around since 2009.  Some progress has been made driving transactions and ticket sizes up.  However, we expect the benefits of this strategy to continue playing out in upcoming years driving NOLADS EBITDA margins up to~13% with a steady 10% CAGR on the top-line – potentially leading to 2015 NOLADS EBITDA of ~$75 MM or higher. 

Argentina & Venezuela (SLAD) – along with Chile, Columbia and Peru – represent ~30% of restaurants, 28% of revenues and ~20% of EBITDA.  These countries although healthy fundamentally in terms of their operations, have been challenging due to macroeconomic / inflation factors.  Over a full market cycle, however, the expectation is that profitability, while bumpy, will be stable especially as countries like Columbia and Chile gain importance in terms of the mix. 

Stock selling below IPO levels

The most recent Q results disappointed investors and analysts, especially performance in Brazil where comps showed clear weakness. 

We believe the market has overreacted selling off the stock from its high of $29.43 to a low of $12.03.  The current $14.90 is still below its IPO price and we believe is cheap given that the long-term thesis supported by the increasing purchasing power of  ~600 million consumers, outstanding demographic trends, and accelerating consumption patterns, remains largely intact.  

Furthermore, two favorable catalysts are the upcoming World Cup and Summer Olympics, events being sponsored by MCDs, in 2014 and 2016 respectively. This should support ARCO’s brand growth locally and put to rest exaggerated concerns about the health of Brazil's consumer economy - as well as provide a technical / thematic boost to the stock.

Concerns and Risks:

The primary risk for ARCO’s thesis has to do with broad macro factors.  ARCO is a LatAm operator and thus is exposed to local currency risk while the company reports its results in USD, with long-term financing in dollars (which it actively hedges).  But FX volatility clearly impacts the P&L from quarter to quarter.  The company's primary inputs are food & paper - which it imports - and labor inflation is also an important line item that management keeps an eye on.  The good news is that structurally high inflation in countries like Argentina, Brazil and Venezuela has never prevented the company from executing its business model.  In the short term, all these factors create plenty of noise given their lumpy and volatile nature, but in the long run cost inflation has successfully been passed on to the consumer supporting healthy margins and returns on capital.

It is worth mentioning that in recent years, the company has also been quite aggressive in making its supply chain more efficient and diversifying among its providers to achieve savings offsetting some cost increases.  Furthermore, the use of long-term contracts to reduce commodity cost inflation volatility (~35% of sales) has also helped.  

These combined initiatives have translated into higher operating visibility and helped management pursue aggressive growth without concern for an impact on quality or operational inefficiencies.  

Other risks to keep an eye on are:

- Macroeconomic Trends

- Food and labor inflation

- FX volatility

- Staton 75% voting power

- Competition

Catalyst