Arcos Dorados ("Golden Arches" in Spanish) is the world's largest McDonald's franchisee in terms of the number of restaurants and system-wide sales. The company has a broad footprint across Latin America and the Caribbean, with a particularly strong position in Brazil. Although the region in which it operates is volatile, and many markets are facing stiff headwinds, we believe the long-term prospects are tasty.
The company holds appeal in our view, on valuation and because of an attractive long-term addressable market opportunity by leveraging one of the world's strongest brands with a local flavour. There is also scope for an improvement in margins, capital returns and the debt profile.
Arcos Dorados does come with a large side order of risks, and the shares have a volatile history. Key here is the political and economic upheaval that is often present in the company's markets. The inflation in these economies and the resulting depreciation of their respective currencies versus the reporting currency (US dollars) was a major factor in the sell-off in Arcos' shares in the three years to 2016. The political environment in Brazil this year and the currency have also been challenging, to say the least.
We view this risk as being somewhat mitigated by the diversification across markets, an undemanding valuation and the still rather dire state of affairs in many of its key markets (on balance there is much more scope for improvement than a worsening backdrop). Arcos shares trade at an undemanding valuation of less than 0.6 times historical sales and a multiple of nine times 2017 forecast earnings. The forward price to earnings multiple is pinned at approximately 26 times.
Up to 50 new restaurants
Second quarter consolidated revenues increased 16.2 per cent year-on-year to $799 million, driven by strong revenue growth, partially offset by the negative impact from currency translation. The adverse currency translation impact mainly reflected the depreciation of the Argentine peso and Venezuelan bolivar, partially offset by the appreciation of the Brazilian real. On a constant currency basis revenues were up 18.3 per cent, or 13 per cent, excluding operations in Venezuela. The troubled Venezuela economy is suffering from hyperinflation.
The company added 25 net new restaurants from the second quarter of 2016 to the second quarter of 2017, taking the total to 2160. The bulk (around 95 per cent) of sales are from company-operated restaurants, with the remainder from franchised restaurants.
Adjusted earnings increased 38.4 per cent year-on-year to $57 million, driven by constant currency revenue growth and margin expansion. All four reported geographic regions posted higher adjusted earnings, with Brazil (over 40 per cent of revenues) the key contributor.
The adjusted EBITDA margin expanded 1.2 percentage points year-on-year to 7.1 per cent. The company highlighted efficiencies in food and paper, occupancy and other operating expenses as the key areas that saw improvement.
Arcos Dorados is planning to open between 45 and 50 new restaurants in 2017 and has a capital expenditure budget of $US150-180 million. The company is accelerating the modernisation of its existing stores which should help margins. The company has an agreement with McDonald's to open 180 new restaurants (with a focus on Brazil) over the next three years, and reinvest $292 million in existing restaurants.
Overall the valuation for Arcos is low in our view for a company of this ilk. Arcos has a long-term "golden" opportunity to leverage one of the strongest brands in the fast food industry, with McDonald's site penetration in Latin America and the Caribbean being a small fraction of that in "developed" markets. Brazil, which is the single most important market for the company, is showing glimmers of improvement economically.
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