Don't Let Morgan Stanley Downgrade Scare You Away From Arcos Dorados

Feb. 9.12 | About: Arcos Dorados (ARCO)

This past week, Morgan Stanley (NYSE:MS) downgraded shares of Arcos Dorados (NYSE:ARCO) due to slower top line growth. Shares of the largest McDonald's (NYSE:MCD) franchisor are trading down around 11% from when Morgan Stanley cut shares.

Business

Arcos Dorados is the leading quick service restaurant company in Latin America. In 2010, the company accounted for 5.1% of McDonald's' entire global sales. McDonald's had a 10.4% market share in Latin America, compared to 3.3% and 2.3% for Burger King and Subway respectively. McDonald's' market share eclipsed the 9.7% held by the next five restaurant companies.

The countries in which Arco Dorados operates in enjoy growing populations and a growing young middle class demographic. During the Morgan Stanley Consumer Conference in November, Arcos Dorados made a presentation to highlight the growth possibilities.

In the United States, the percent of population in the 15-34 age demographic is 27.4%. In Arcos operating regions, the percent become much higher including:

  • Brazil 33.6%
  • Argentina 31.8%
  • Mexico 34.5%
  • Colombia 33.7%

As the middle class grows and more people eat out, Arcos Dorados becomes a great company positioned for that growth. With Brazil representing the largest country represented, sales set up well for the World Cup in 2014 and Summer Olympics in 2016.

Locations

Arcos Dorados is the largest McDonald's franchisor in the world. In August of 2007, Arcos Dorados acquired the Latin America and Caribbean McDonald's exclusive franchise rights. The terms of the deal were for 20 years, and also offer a 10 year renewal option. Since the 2007 agreement, Arcos has opened 195 company owned locations and an additional 68 franchised restaurants. The company has 1770 total McDonald's restaurants under its ownership. Of the 1770, 1300 operate dessert centers inside of them, and 267 have McCafe locations located inside. Arcos has also focused on updating and making improvements to existing restaurants. Over 530 McDonald's locations have seen significant upgrades since Arcos ownership.

In September, the first McDonald's was opened in Trinidad & Tobago. The location, located at West Mall, is McDonald's return to the country which had stores from 1997-2003. The locations were closed due to low sales. Arcos has opened five additional stores in the island nation since September, and fully believes it can take advantage of its 20th country with McDonald's locations.

Countries

Arcos Dorados is the exclusive holder of the franchise rights to 20 countries and territories broken into four regional categories:

  • Brazil (Brazil) 627 Locations
  • NOLAD (Mexico, Panama, Costa Rica) 473 Locations
  • SLAD (Argentina, Venezuela, Colombia, Chile, Peru, Ecuador, Uruguay) 533 Locations
  • Caribbean (Puerto Rico, Martinique, Guadeloupe, Aruba, Curacao, French Guinea, Trinidad & Tobago, St. Thomas, St. Croix) 144 Locations

Third Quarter Results

The third quarter earnings saw revenue up 24.7% from the previous year. Comparable restaurant sales rose 15.7%. Revenue was reported at $984 million for the quarter. Net income was reported at $19.6 million, which was a decrease from 2010's $29.1 million. The decrease was due in large part to a one time charge of $13.9 million in relation to debt restructuring on senior notes. Earnings per share for the third quarter were $0.09, a decrease from 2010's $0.12.

By Geographic Location:

  • Brazil - Revenue up 24.4%
  • NOLAD - Revenue up 17.4%
  • SLAD - Revenue up 33.9%
  • Caribbean - Revenue up 2.6%

The South American region experienced the largest increase in revenue. This was due in large part from an increase of 31.7% in comparable restaurant sales. The Caribbean region saw slower revenue growth and actually experienced a decrease in comparable sales of 1.9%.

Also in the third quarter, Arcos announced that fiscal 2011 has seen the addition of 64 restaurants to its ownership portfolio, including the six locations opened in Trinidad & Tobago. Improvements in financials were seen in food and paper costs, but were offset by higher payroll costs, debt restructuring fees, and foreign currency exchange rates.

Nine Month Results

With the first nine months of the fiscal year reported, Arcos has seen revenue increase 25.5% from the previous year. The company has recognized $2.7 billion in revenue through the third quarter. Net income has increased 6.8% to $69.3 million.

Fourth Quarter

March 5th becomes the important day to watch for the company. Fourth quarter and full year financial results will be made available. During the third quarter earnings release, the company said it expected an "important number of restaurant openings during fourth quarter of 2011".

With nine months in the books, Arcos has earned $0.32 per share. Going into the fourth quarter in 2010, Arcos had only $0.27 in earnings per share. Analysts will be looking for $0.26 in earnings per share for the fourth quarter. Analysts are expecting $0.58 earnings per share for fiscal 2011. The five analysts predict a range of $0.54-$0.67. In 2012, six analysts have forecasted earnings per share of $0.90.

Shares

Shares of Arcos Dorados have traded at a range of $17.62 to $29.43 over the last fifty two weeks. The company held its initial price offering in April of 2011 at a public price of $17 per share and shares quickly rallied on the first trading day.

In October, the company sold an additional 40.4 million shares in a secondary offering at a price of $22.00 per share. Shares now trade at $20.50, which is a range below the company's first day on the open market and the recent secondary offering.

Dividends

Arcos has paid out three quarterly dividends to date. Since its IPO, the months of July, October, and December saw shareholders receive $0.059 per share owned in dividends. This represents $0.236 annually. The current yield on shares (trading at $20.50) is 1.2%. This is a generous dividend considering the company is in its growth stage and could be using its profit to open new restaurants.

Institutional Holdings

The company is represented in the FTSE Argentina 20 Exchange Traded Fund (NYSEARCA:ARGT) as the third largest holding with a 9% weighting. Shares are also a top ten holding of WCM BNY Mellon Focused Growth Exchange Traded Fund (NYSEARCA:AADR). Fidelity owns over 15% of outstanding shares through various mutual funds.

Recommendation

After failing to pull the trigger on other emerging market stocks I recommended like PriceSmart (NASDAQ:PSMT) and Mercado Libre (NASDAQ:MELI), I finally bought shares of a great Latin American company. I followed Arcos Dorados close to the time of its IPO and bought shares in May of 2011. I have since added to my position and the company is one of my top four holdings. In July I disclosed my portfolio holdings in an article on Seeking Alpha. On March 5th, Arcos Dorados will report fourth quarter and full year earnings. I expect an earnings beat and think we will likely see shares rally after earnings.

Disclosure: I am long ARCO.