Arcos Dorados (NYSE:ARCO) isn't getting much love these days. Despite a decent earnings report in the face of severe economic challenges in two major markets, the world's largest McDonald's (NYSE:MCD) franchisee turned in constant currency revenue growth of 3.6% for Q4 and 6.2% for FY 2013. More impressively, EBITDA margin grew 20 basis points quarter on quarter, from 11.1% to 11.3%. Brazil, it's largest market, is hosting the World Cup this year and the Olympics in 2016, which should provide a short-term boost to earnings. Management has a strong track record of performing in the Latin American markets, and has maintained a good track record of operational performance. Guidance for 2014 revenues and EBITDA growth are in the mid- to high teens.
Given all these positives, I set out to build a discounted cash flow model for ARCO, fully convinced that the sound operational metrics and forecasts would lead to an undervalued stock. Surprisingly, that's not what I found.
ARCO has approximately 210M shares outstanding at the end of 2013. At the current price of $9.37, that implies a market cap just shy of $2B. Based on 2013 sales of $4B, ARCO trades at a price/sales ratio of 0.5. That appears pretty cheap and is less than one-sixth the P/S ratio of McDonald's (3.43).
To value ARCO, I used management's 2014 assumptions of revenue and store growth (13% and 90 stores, respectively). Beyond 2014, I projected store growth of 90 in 2015 as well, and around 70 thereafter. From 2013-20, my store growth CAGR is 3%. I also assumed a per-store sales growth CAGR of 3%, leading to a revenue CAGR of 7%. Given the exchange rate fluctuations and political uncertainty, achieving 7% CAGR in USD would be a pretty formidable achievement.
I assumed operating margins flat to 2014. I believe the company does have some options in this area, but there are political pressures in several geographies that put upward pressure on labor costs. Also, I am assuming interest costs to be fairly stable through 2020. However, and this is an important assumption to the upside, I'm not assuming any foreign currency losses as these are inherently unpredictable. These have been a major drag on ARCO's earnings in the past couple of years.
With these assumptions, ARCO's net income jumps from $54M in 2014 to an estimated $201M by 2020. However, with a discount rate of 12% (appropriate for a company that operates in such a high-risk environment) and a terminal growth rate of 3%, I get a value of $1.75B for Arco, for a 13% downside to current market cap with pretty optimistic assumptions. The valuation model is shown below:
There is a lot to like about ARCO as a company. It is well-managed, in a growing space, and the operational variables are relatively easy to understand and control. However, there are also reasons for concern. The environment in which it operates is at best uncertain, and at worst downright hostile to business (think Venezuela). Though ARCO's share price has dropped in the past few weeks, the valuation -- even with pretty optimistic assumptions -- it appears to be somewhat overvalued. Throw in some foreign exchange and political risk, and the overvaluation becomes substantial. There are better places for your money. I am currently long ARCO, but intend to sell soon now that I've taken a closer look at the challenges it faces.
Disclosure: I am long ARCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.