Take a great brand name, combine it with growing economies, and get subpar results? This feels like the story of Archos Dorados. The company literally is the McDonalds of the Latin American marketplace. Archos Dorados has the rights to franchise McDonald’s Corporation (NYSE:MCD) business to countries like Brazil, Mexico, Panama, Costa Rica, and more. On the surface it seems like this is a can’t-lose proposition, but something is being lost in translation.
What Makes The Original Great
The thing that makes McDonald’s so great is the company’s consistent operations and huge cash flow. McDonald’s food is served fast and at a value price no matter what location you walk into. Many competitors to McDonald’s like Yum! Brands Inc. (NYSE:YUM) and Burger King Worldwide Inc (NYSE:BKW) offer similar setups. Each of these companies has a stronghold in the United States, and is expanding internationally to find growth.
One of the things that makes McDonald’s Corporation (NYSE:MCD) so different from the competition is that the company’s margins are first class because of their reliance on franchisees to do the heavy lifting. In the current quarter, McDonald’s operating margin was 31.61%, compared to 27.66% at Burger King Worldwide Inc (NYSE:BKW) and just 12.16% at Yum! Brands. Archos Dorados should have strong margins because of being able to copy the McDonald’s model, right? Unfortunately that hasn’t been the case, and in the last three months, the company’s operating margin was just 7.93%.
One Of These Things Is Not Like The Other
One of the primary reasons that Archos Dorados’ operating margin is so much lower than their peers is they don’t utilize franchisees in the way the others do. Burger King and McDonald’s should give classes in how to generate returns from franchisees. Burger King generated almost 40% of their total revenues from franchise income, and McDonald’s generated 32.52%.
Yum! Brands not surprisingly has a lower operating margin as we saw before, because they also get much less of their revenue from franchisees. In the last three months, Yum! Brands received 13.2% of their revenue from franchise income. By comparison, Archos Dorados only generated 4.41% of their total revenue from franchisees. There is a clear lesson here: more franchise income equals better margins. Archos Dorados needs to take a page out of the McDonald’s Corporation (NYSE:MCD) playbook and utilize franchisees more.
The Bottom Line (Or Lack Thereof)
If you hear Archos Dorados has lower margins and lower franchise revenue, what do you think happens to their cash flow? The answer is obvious: the company has cash flow issues as well. While some would gloss over the company’s negative free cash flow as a non-issue because they are expanding, this idea doesn’t hold water.
Archos Dorados makes the decision of how many stores to open each year, and it appears they may be expanding too fast. While the company’s debt-to-equity ratio at 0.88 is in line with McDonald’s at 0.89, this is a much smaller company. The company carries significant debt primarily because they choose to open company owned restaurants. If they leaned on franchisees more, they would have better margins and better cash flow to avoid this debt.
While Yum! Brands‘ debt-to-equity ratio of 1.36 is higher, the company’s significant free cash flow makes this less of an issue. Investors who own Burger King Worldwide Inc (NYSE:BKW) know that the company’s relatively high debt-to-equity ratio of 2.55 comes more from prior mis-management than anything fundamentally wrong with the concept.
Is The Stock Undervalued Anyway?
It might sound strange to suggest that Archos Dorados could be undervalued even with all of these concerns, but it seems like that’s the case. The company shows very strong comparable store sales, and if not for currency fluctuations, revenue would have increased 13.8% in the current quarter. Analysts expect EPS growth in the next few years of 15.7%, and the company paid a trailing yield of 1.76%.
While Archos Dorados doesn’t match the yield of 3.12% at McDonald’s Corporation (NYSE:MCD) or 1.95% at Yum! Brands, the company is expected to grow significantly faster. Of their peers, only Burger King is actually expected to outpace Archos Dorados in EPS growth over the next five years.
However, each of Archos Dorados‘ peers is being valued more highly based on the PEG ratio. Burger King Worldwide Inc (NYSE:BKW), for instance, has a PEG of 1.35, McDonald’s Corporation (NYSE:MCD) PEG is 1.84, and Yum! Brands PEG is 1.9. By comparison, Archos Dorados PEG of 1.31 looks reasonable. The company can certainly improve its operations by leveraging franchisees more, but Archos Dorados‘ value seems to be lost in translation in this market.
The article Something Is Being Lost In Translation originally appeared on Fool.com and is written by Chad Henage.
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