Arcos Dorados (NYSE: ARCO) recently reported a lackluster fourth quarter causing the stock to drop approximately 8% the day of earnings. Now that the stock is trading close to the April 2011 IPO price of $17.00/share, should you start building a position in McDonalds’ (NYSE:MCD) largest franchisee in the Latin America region? Hedge fund managers Roberto Mignone (see Roberto Mignone’s new stock picks) and James Crichton and Adam Weiss have large positions (see Scout Capital Reported Stake in ARCO) in the company. Let’s take a closer look at the stock.
The combination of Q4 2011 results were mixed and 2012 guidance was nothing out of the ordinary – which have led to downward revisions in consensus estimates. There is little doubt that the long-term story exists, particularly at the macroeconomic level, with significant potential in the Latin American quick-service restaurant sector coupled with proper positioning. ARCO’s market share across the region clocks in at 12.4%, which is nearly 3x that of nearest competitor Burger King, which was taken private by 3G Capital in late 2010 (see Jorge Lemann is the King of Burger King), and 5x that of Subway. Over 500 million consumers are undergoing meaningful income class migration in the region and underpenetration is undeniable—in Brazil there are 3.1 units per million people compared to 45.2 un/mm in the US and 17-18 un/mm in Europe. However, investors will need to get comfortable with short-term fluctuations in the face of compressed operating margins from wage inflation, foreign exchange headwinds, and lumpy same store sales (SSS) growth in different regions.
The Company reported 63 net openings in Q4 2011 along with 10.5% (16.1% on a constant currency basis) revenue growth to $958.5 million. For the twelve months ended December 31, the ARCO’s revenues grew by 21.2% (17.7% on a constant currency basis) to $3.7 billion. For the FY 2011, there was net addition of 85 restaurants.
In Brazil, SSS decreased y-o-y from 10.4% (nine months ended 09/30/2011) to 6.3%, driven by slightly negative customer traffic and positive average ticket, which is worth noting given that Brazil is ARCO’s most important market contributing over 50% of revenue. NOLAD’s (Mexico, Panama and Costa Rica) revenues increased 7.2% y-o-y with SSS increasing 8.4%. Good news is that the turnaround story in Mexico is progressing according to plan. SLAD’s (Argentina, Venezuela, Colombia, Chile, Perú, Ecuador, and Uruguay) revenues grew by 25.2% y-o-y, driven by a strong 27.8% increase in SSS. The Caribbean (Puerto Rico, Martinique, Guadeloupe, Aruba, Curaçao, F. Guiana, Trinidad & Tobago, US Virgin Islands of St. Thomas and St. Croix) continued to struggle with a weak economic backdrop in Puerto Rico. It reported revenue growth of 1% and a decline in SSS of 2.2%.
ARCO reported cash and cash equivalents $176.3 million at December 31, 2011. The Company’s total financial debt (including derivative instruments) was US$ 532.3 million, which included the 2019 USD Notes and R$400 million related to the BRL 2016 Notes issued in July, 2011. Net debt (calculated as total financial debt less cash and cash equivalents) stood at $356 million and bringing the leverage ratio to 1.0x. Total capital expenditures for the FY 2011 totaled $319.9 million. Debt covenants are at 2.5x, which ensures a limit on Company leverage.
At these price levels, weak results are likely priced in. ARCO is trading at 10.1x 2013E EV/EBITDA, which is at a discount to Chipotle’s (NYSE: CMG) 18.1x, partially due to the difference in franchisee business model. ARCO trades only slightly higher than MCD at 9.9x and YUM! Brands (NYSE: YUM) at 9.3x in spite of target markets that are growing at a much faster clip. YUM’s strongest brand in Latin America and the Caribbean is KFC. 2012 guidance was net revenue growth of 15%-17%, adjusted EBITDA growth of 10%-12%, effective tax rate of 31%-33%, and capex of $340-$350 million plus the opening of 130 planned new units. These parameters seem achievable and indicate execution of the Company’s growth strategy.
As of Q4 2011 ARCO was in the portfolios of 24 hedge funds (see Top 8 Restaurant Stocks Most Loved by Hedge Funds). Given the weaker performance last quarter, ARCO will need to report solid quarters in the coming year that meet guidance and indicate robust fundamentals to keep investors onboard. It will be key for management to avoid any additional shortcomings like its Q4 2011 SSS guidance of 15% versus the reported 11.5%. We recommend avoiding the stock for the moment.
