Arcos Dorados: Feast On It

“The best-laid plans of mice and men.” That’s the best description I can muster as I’ve watched the stock price of McDonald’s (NYSE:MCD) Latin American franchisee Arcos Dorados (NYSE:ARCO) drop 45% from Dec. 5, 2011 — the day I gave it a hearty endorsement — to the close of business May 18, 2012. In less than six months, ARCO has lost half its value. Investors smell blood.

All the more reason to take a bite out of the world’s largest McDonald’s franchisee. It’s too appetizing to pass up. Here’s why:

In my article last December, I finished with these ominous words: “Something’s got to give, and I believe it’s the share price. If everything unfolds as planned, Arcos Dorados’ earnings will grow twice as fast as McDonald’s itself. That has to be worth more than $22 per share.”

I couldn’t have been more wrong if I tried. So what went awry? Actually, not much. Investors simply didn’t like the fact that first-quarter earnings dropped 20% year-over-year to 12 cents per share despite revenues increasing 11.5% to $921.6 million and systemwide comparable sales increasing 11.6%.

The big culprit for the drop in operating income is increased spending on restaurant openings. As part of its master franchise agreement with McDonald’s, it is required to invest at least $60 million annually over a three-year period between 2011-13, opening at least 250 restaurants. Since Dec. 31, 2011, it has opened 88 restaurants, which is approximately 18 per quarter. To meet the 250 required in their agreement, Arcos will have to open 23 per quarter over the next 20 months. Therefore, investors can expect a drag on operating income until at least the end of 2013 as it doubles capital expenditures. That’s not a bad thing when you consider that its comps are growing at a double-digit pace and its adjusted EBITDA continues to grow by 8%-12% each quarter year-over-year.

I tend to be a glass-half-full person and, as such, I’m always looking for the good in potential investments. In the Arcos Dorados situation, it’s helpful that its two biggest regions by revenues also are its most profitable. The biggest is Brazil, followed by the Southern Latin America division (SLAD), which consists of Argentina, Chile, Ecuador, Peru, Uruguay and Venezuela. Together, the two divisions generated 83% of the revenue in the first quarter and 96% of its adjusted EBITDA.

While Brazil’s operating margins still are higher, SLAD is coming on strong. Its EBITDA margin increased 250 basis points in Q1 to 10.3% as its comparable sales grew 27.9% year-over-year versus 5.5% for the Brazil region. It will be interesting to see what happens in the next few quarters. Brazil is going to have to pull up its socks if it doesn’t want to be eclipsed.

The two weakest links in an otherwise solid business are its Caribbean and Northern Latin America divisions (NOLAD), which combined account for 34% of its total restaurants, 17% of revenue and just 4% of adjusted EBITDA. In the big picture, they aren’t a serious drain on the business and at some point will experience a rebirth from a profitability perspective. In the first quarter, the NOLAD division showed some life with a 6.8% increase in comps and a 3% increase in adjusted EBITDA. CEO Woods Staton, who holds 76% of the votes and has a 38.2% economic interest in the business, surely will reach into his treasure chest of business experience to turn both regions around. You can count on it.

Take advantage of Arcos Dorados’ 45% swoon over the last five months and buy its stock for a song. With Q1 comps that were 60% higher than McDonald’s, ARCO’s future is bright indeed.

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

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