Arcos Dorados: Qué es un Desastre!

This past week, shares of Arcos Dorados (NYSE:ARCO) were absolutely hammered on an unexpected drop in earnings when the company reported first-quarter numbers.

Before we get into the net income shortfall, let’s at least acknowledge the good news (as per the company’s earnings release:

  • Revenues increased by 11.5% year-over-year, or by 16.6% on a constant currency basis, to $921.6 million, with continued strong contribution from company-operated and franchised locations across the region.
  • Systemwide comparable sales increased by 11.6% year-over-year.
  • 86 net additions of restaurants during the past 12 months, with an accelerated year-over-year pace in openings.
  • Adjusted EBITDA increased by 8% year-over-year, or by 12.2% on a constant currency basis, to $78.1 million.

Now all of that is well and good, but what killed the stock on the heels of this report is the 28% drop in net income to $25.4 million — down from $35 million. No es bueno.

When you buy into a company like Arocs Dorados — which was trading at a premium multiple owing to the massive growth opportunity it has throughout Latin America — you do so expecting that the company will be able to grow earnings at a rate exceeding its peers. Unfortunately, ARCO has been unable to do so — it blamed foreign exchange (currency fluctuation) and higher-than-expected taxes for the shortfall. Which is fine, we understand, but the company has been public for a very short time and hasn’t yet earned any benefit of the doubt with its shareholder base yet.

And when you consider the fact that Arcos also disappointed the Street with its Q3 report last fall, you can understand why the selling was so heavy and seemed to be laced with contempt. That’s what happens to untested companies are perceived to be serial underperformers.

When I picked the stock for InvestorPlace‘s 10 Best Stocks for 2012 contest, it had a closing price of $19.77 (Dec. 19, 2011). As of Friday, my pick has lost a gruesome 27%, with more than two-thirds of this drop having occurred on the heels of last week’s disappointing earnings report. The restaurant industry as a whole is up 7.5% year-to-date and the total U.S. market has returned 9.6% — making this pick look even worse on a relative basis than it is on an absolute basis.

What now?

I still am long the stock in accounts I manage as part of a higher-risk basket of stocks, and I wish I were not. Earnings gap-downs are unfortunate; you watch helplessly as your position opens substantially lower before you can do any kind of risk mitigation, and even a stop-loss or a sell stop limit won’t help you. But they are part of the game when you own individual equities. What separates a professional from an amateur is what the next move is.

My next move is to look for a selling opportunity once the smoke has cleared. The four pillars of my original bullish thesis are largely intact:

  1. Expanding consumer spending in Latin America
  2. The ferocity of McDonald’s (NYSE:MCD) as a global brand
  3. Growth within a defensive sector
  4. The comeback potential for emerging-market equities in 2012

But several other factors have changed since I’ve recommended the stock that have me looking for a chance to get out, as opposed to a chance to buy more and lower my cost. These new considerations include a recognition that the management team is unable to communicate with the Street to avoid disappointment and an inability to control expectations. In addition, the political situation in some of the countries ARCO operates in has grown shakier, as has the currency stability (which meaningfully impacted its Q1 results).

In addition, on a macro basis, emerging-market stocks are now rolling over after their relatively strong performance at the start of the year — this action is eerily reminiscent of 2011 and 2010, and as we are de-risking across all our portfolios in general, ARCO offers us a great excuse to take it off the playing field.

The plan going forward for me on ARCO is to watch for any bounce at all and then to take my loss. I will continue to follow the stock, especially during its Q2 earnings report. I’ll be looking for signs that management has gotten a better handle on the vicissitudes of its business and the public market’s expectations.

On paper, I’m stuck with ARCO through December 2012 for the purposes of the InvestorPlace contest. But I don’t live “on paper” — I live in the real world, and in the real world I believe there will be better uses for the capital I’ve got allocated to this stock in the near future.

Josh Brown is a financial adviser at Fusion Analytics, managing portfolios for both institutional and individual investors. He also hosts “The Reformed Broker,” a blog about markets, politics, economics, media, culture and finance. Email him here or follow Josh on Twitter at @ReformedBroker.

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