Description

The rundown

Arcos Dorados (ARCO) is the largest McDonald’s franchisee in the world with 2223 restaurants in Latin America. The company has a 2-3x growth runaway ahead of it, has maintained 5% unit growth in its largest, most profitable market despite a severe recession there and is capable of earning, as it once was, 20% returns on new restaurants. Yet the company trades at .6x EV/sales, putting it in the cheapest 10% of the market.

ARCO shares are worth at least $13, 80% more than its current price. They will eventually be worth even more when the Latin American economies move from the “acute explosion” phase of the abuse cycle to the “reconciliation” phase.

The situation 

On the surface, ARCO is a casualty of Brazil’s recession, 50% inflation in Argentina and economic collapse in Venezuela. Subsequent currency devaluations took a growing business and made it look like a basket case. USD revenue shrank 25% from 2013 to 2015, and the stock is down 60% from its IPO 8 years ago.

The problem is two-fold. (1) ARCO operates in volatile markets. (2) It earns its money in local currencies but reports financials in US dollars, resulting in volatility on top of the initial volatility. Imagine for a moment if the woman from Seinfeld with the “man hands” was the same woman as the one with the “two face.” Imagine how Jerry’s delicate nervous system would react to this sensory overload. Well, US investors have reacted the same way. And now a business that could double in size in seven years trades at the same valuation multiple as Kohl’s or Rent-A-Center, companies that might not even exist in seven years.

ARCO’s USD-reported numbers obscure the truth. When you look at ARCO’s numbers in local currency and adjust them for inflation, you see a picture the opposite of what the reported figures show.

Take Brazil, which is by far ARCO’s most important market with 45% of revenue and 70% of EBIT. As Brazil goes, so goes ARCO, which is why this writeup will focus on that country. In USD, Brazilian revenue has fallen a whopping 28% since 2013. However, when you look in the local currency, in Brazilian real, you see that revenue has actually grown 25% cumulative or 4% annually since 2013. And that’s in real terms, net of inflation.

ARCO can grow in two ways: unit growth and same-store sales growth. Since the recession, all of ARCO’s growth in Brazil has come from unit growth. Meanwhile SSS, which were growing 12% a year in real terms, completely flatlined.  

But let’s put that in perspective. Brazil went through one of the worst recessions in its history. GDP per capita contracted almost 10%. Nonetheless, (A) ARCO was able to continue unit growth unabated and (B) SSS held strong despite both the unit growth and the recession. That means, when push came to shove, ARCO’s customers were willing to spend a greater percentage of their income to continue eating there.  That tells us that ARCO is what Buffett used to call an “inevitable”—i.e. one of those businesses that are “virtually certain” to grow in value over time. It’s rare to find such businesses in the cheapest 10% of the market.

Meanwhile Brazil has officially exited its recession and is putting up some tepid growth numbers. Once a fuller recovery gets underway, ARCO’s SSS growth will rebound, likely back to the 12% real, 16% nominal SSS growth it was enjoying before the recession. And since ARCO has done the hard part and has continued growing restaurant count, this rebound would be occurring off a substantially bigger base. Compounding this effect is the fact that Brazil isn’t just ARCO’s biggest market—and the one that represents the bulk of ARCO’s growth runway—it’s also ARCO’s most profitable market. In Brazil, ARCO’s adj. EBITDA margins are usually 13%, which is above those of the rest of the company. This is in part due the popularity of McCafes and, in particular, Dessert Centers there. Both are more profitable than typical restaurants and, pre-recession, were offering ROI’s of 40% (on the McCafes) and 160% (on the Dessert Centers).

ARCO’s expanded restaurant base is like a new wing under construction in a museum. ARCO’s gotten virtually no credit for it because its potential isn’t visible yet. It’s still in darkness, just waiting for someone to pull down the sheets and turn on the lights. 

Another important factor here is that once ARCO gets back on its growth trajectory, it can sustain that growth for a long, long time. Not just in Brazil but throughout LatAm. McDonald’s core market is young people and young families. Latin America has 600 million people versus 300 million for the US, and people in Latin America are younger. There’s more than double the number of potential customers there versus here. Meanwhile the market is underpenetrated, even after adjusting for GDP per restaurant. Brazilians and Argentines don’t all need to suddenly start eating like South Dakotans in order for ARCO to increase the number of its locations 2-3x.

To bring it all together, there are two things that would have large effects on ARCO’s shares.

(1) A return to growth in SSS.

(2) The Brazilian real stops depreciating so rapidly. It doesn’t even need to recover against the dollar, though if that happens, it would rapidly boost both ARCO’s margins and its reported numbers.

Competitive advantage

McDonald’s is the one of the most enduring brands in the world. What’s compelling here is the low risk and the high certainty that brand offers. How many stocks in the market today can you say with “virtual certainty” will exist in 10 years? Now of those, how many can you say will have substantially grown intrinsic value in a decade, once again with “virtual certainty”?

What’s also compelling is that you can see with your own eyes how dominant McDonald’s is and how it factors into the lives of almost everyone. When my family goes on road trips, we all gorge at McDonald’s. We don’t even eat it in the restaurant. We eat in the car or loiter in the parking lot like gypsies. And it feels wonderful shedding my inhibitions and longevity goals and eating exactly what I goddamn please. I don’t know many people who don’t, on some level, genuinely like McDonald’s food. My kid sister lives in Manhattan, ground-zero of anti-McDonald’s bias, and is one of those annoying Millennials who are uber-healthy and uber-European-seeming. Even she will call after a night out to inform me that she just crushed three McChickens. Then we share a laugh and catch up by talking about how much we dislike everything. That’s the power of McDonald’s. Its golden arches shine in the hearts of even the most spiritually diminished among us.

No other fast-food brand has entered the public consciousness like McDonald’s has. Also, at its price point, few other nationwide brands appeal to women as much as McDonald’s. The reasons I’ve been given for this are: (1) McDonald’s makes a point of keeping its bathrooms clean. (2) McDonald’s doesn’t sell things like “The Baconator^TM” or the “Bacon ranch monster taco^TM.” In other words, McDonald’s avoids placing items on its menu that are likely to be found on the floor of a van you’ve just been kidnapped in.

Ultimately McDonald’s has been so successful because they’ve created something that appeals to the most people. It’s interesting that that appeal has carried over, largely intact, to Latin America. Even there, customers prefer McDonald’s to everything else in the category. McDonald’s enjoys the highest sales per unit of any QSR in the region. It also has 12% market share, 3x the market share of Burger King, its closest competitor, giving it scale advantages. ARCO currently has 10% EBITDA margins. As management likes to point out, the business is set up for margin expansion when topline grows. Moreover this growth is poised to happen in Brazil, where EBITDA margins have historically been 13%. Going forward, 10-11% EBITDA margins are realistic, which translates into 4-5% FCF margins using maintenance Capex.

Another huge advantage comes from scale in marketing. Per its agreement with McDonald’s, ARCO must spend 5% of sales on marketing and advertising, and while there isn’t data on this, its ad dollars likely go much farther than the competition’s. This is a crucial advantage because it’s one that will grow over time rather than erode. An HBS case study on Coke impressed this on me a long time ago. Using the numbers in the back, you could calculate how much Coke spent on advertising per customer versus Pepsi. As I recall, Coke spent half of what Pepsi did, which is incredible when you think about it. Coke’s scale and mindshare meant that Pepsi had to work twice as hard just to stay in place as Coke did.

McDonald’s enjoys the same advantage in LatAm. And ARCO has a monopoly on McDonald’s restaurants in the region, so only they can capitalize on it. As a result, ARCO doesn’t need a lot of things to go right in order to work out. It only needs one thing: for its home economies to continue stabilizing.

The situation in Brazil

Shamefully I had a moment where I wanted to do some cursory research on Brazil and Argentina and then present it as if I could possibly have my finger on the pulse of Latin America. All I can say is that Brazil ended its recession last year and has been growing 1-2%. Beyond that, I can honestly say that I don’t have a finger on the pulse of a single macro issue facing the world today. The macro realm stopped making sense to me years ago. But it doesn’t need to make sense to me.

ARCO is a classic, old-school value situation where to invest in a security’s long-term value, investors must buy into uncertainty and an unfavorable short-term outlook. There is no "right" time to buy with stocks like this.

Valuation

ARCO is currently reimaging its restaurants as part of McDonald’s Experience of the Future initiative. Once we strip away the spending on EOTF and the growth Capex, we have a business yielding 8% in FCF. Meanwhile ARCO is poised to grow at 10-15% for a long period of time. Even if it stopped building new restaurants, it could grow SSS in double digits, most notably in Brazil, where 70% of the total profits come from.

8% yield + 12% growth (the midpoint) = 20% annualized total return. I believe that’s what investors could earn over the next 5+ years. And that return assumes that other investors never come in and “save” us by rewarding ARCO with higher multiple.

In terms of intrinsic value, ARCO trades at .6x EV/sales. It’s worth at least 1.1x sales, or $13 per share, which is 80% upside. At that valuation, investors could still earn a decent absolute return on this. ARCO once traded at 20x EV/EBIT on a growth story that fizzled not because it was wrong but because of randomness. Randomness only obscures things for so long, and when the pendulum swings, it won't take much for investors to become excited about this company again.

 DISCLAIMER: This writeup is based on the author's opinions, predictions and estimates. Please do your own research.

Catalyst

Brazil's economy continuing to stablize or even return to its growth trajectory.