There’s More Than One Way to Profit Off McDonald’s

by Will Ashworth | December 5, 2011 8:38 am

McDonalds golden arches 630 flickr 300x225 There's More Than One Way to Profit Off McDonald'sCan you name the top-performing stock in the S&P 500 year-to-date? As of Dec. 2, it was Cabot Oil & Gas (NYSE:COG[1]) at 132.7%. How about the top-performing restaurant stock in the S&P 500? Chipotle Mexican Grill (NYSE:CMG[2]), up 51.9% YTD. The former McDonald’s (NYSE:MCD[3]) spinoff has had a fine year. So too has its former parent, which has gained 28.2%.

Normally, when I recommend the sale of one stock and the purchase of another, it’s usually because one company is either much cheaper or much better. In this situation, I’m recommending investors sell McDonald’s and buy stock in its largest franchisee, Arcos Dorados Holdings (NYSE:ARCO[4]) because the opportunities that exist in Latin America are too great to ignore. However, I wouldn’t hold it against you if you decided to own both.

IPO

Arcos Dorados went public in April 2011, selling 84.5 million class A shares at $17 each. The company itself sold slightly more than 9.5 million shares for net proceeds of $152.3 million, while existing shareholders sold the remaining 75 million shares. Arcos Dorados is using its share of the proceeds for the opening and re-imaging of its restaurants. It then did a secondary offering at the end of October, with existing shareholders selling an additional 44.5 million shares at $22 each.

Since the secondary offering, ARCO stock basically has flatlined but still is up 32.1% through Dec. 2. As the world’s largest McDonald’s franchisee with 1,767 locations in Latin America, its future appears bright.

The Business

Arcos Dorados has the exclusive right to own, operate and grant franchises of McDonald’s restaurants in 20 countries, including Brazil, Chile, Mexico and Venezuela. Brazil is by far ARCO’s most important country, generating 52% of its overall revenue for the first six months of 2011 and 69% of adjusted EBITDA. Arcos Dorados accounts for 5.1% of McDonald’s global sales and is the largest fast food chain in Latin America. The company itself paid $141 million in royalties to McDonald’s in 2010, and that doesn’t include what the franchisees themselves paid to the Golden Arches.

Arcos Dorados CEO Woods Staton, along with a consortium of investors, acquired McDonald’s Latin American operations for $700 million in August 2007. Staton brought McDonald’s restaurants to Argentina more than 20 years ago and since 2004 also was in charge of McDonald’s South American restaurants. At the time of the acquisition, McDonald’s faced the wrath of activist investor Bill Ackman, who was demanding it increase the rate of dividends and share repurchases. The Latin American operations were a casualty of its restructuring. The move worked, as MCD stock has more than doubled since then compared to a 19% loss for the S&P 500. This is a reminder that acquisitions sometimes can be win-win situations.

The Opportunity

Staton has a lot riding on the success of Arcos Dorados. Personally and through a holding company, he is the beneficial owner of 39.7% of the total economic interests of the company and controls 76.1% of the votes. If ARCO’s third-quarter results are any indication, Staton has little to worry about.

Systemwide comparable sales grew 15.7%, and overall revenues on a constant currency basis were up 19.8%. All four of Arcos Dorados’ operating segments experienced revenue increases in the quarter, including 24.4% YOY growth from its most important market in Brazil. Its biggest success on a same-store sales basis was its Southern Latin American division, which saw a 31.7% increase, while the biggest disappointment was its Caribbean operations, declining by 1.9% because of a difficult economic climate in the region.

However, the Caribbean accounts for less than 10% of overall revenues and 2.6% of adjusted EBITDA, so it’s not a big deal. Brazil, on the other hand, managed to increase adjusted EBITDA in the first three quarters by $45 million, or 27.4% YOY. Brazil is now and will continue to be its driver of growth.

Bottom Line

Arcos Dorados expects 2011 full-year earnings of $125 million, or $0.58 a share. Analysts expect ARCO to grow earnings 21% each year for the next five. If so, the company’s earnings by the end of 2016 would be $1.50 per share. That’s a forward P/E of 14.9 times with a growth rate that’s 50% higher.

Something’s got to give, and I believe it’s the share price. If everything unfolds as planned, Arcos Dorado’s earnings will grow twice as fast as McDonald’s itself. That has to be worth more than $22 per share.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned stocks.

Endnotes:
  1. COG: http://studio-5.financialcontent.com/investplace/quote?Symbol=COG
  2. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  3. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  4. ARCO: http://studio-5.financialcontent.com/investplace/quote?Symbol=ARCO

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