Arcos Dorados: Besides Macroeconomic Uncertainty, The Improvement Continues

| About: Arcos Dorados (ARCO)

Summary

Macroeconomic outlook for Latin America is still difficult, but Arcos continues to deliver like a good restructuring play.

The business continues to make steady progress on operational and financial fronts.

The improving balance sheet and possibility of economic stability should remove major overhangs on the story, helping the investor sentiment.

Since my previous note on Arcos Dorados (ARCO), one of the biggest master franchisees of McDonald's (NYSE:MCD) in the world, the fundamentals of the business have shown a steady progress and the stock has followed the movement, though at a slower pace. Over the past few weeks, the stock has come under pressure, but a closer look at the fundamentals suggests the pace of progress is consistent and some of the recent doubts may ebb over the coming weeks and months.

The core thesis remains valid

The Long thesis largely rests on the stock closing the gap with McDonald's, as the business restructures on the back of operational efficiencies, improving cost structure and debt reduction. Markets have by and large given up on the name, as reflected by the more than 70% decline in the stock over past five years and poor credit rating, even though most of the problems have been caused by macroeconomic factors, be it weak currencies or weak GDP growth in Latin America.

But the current pessimism seems to be ignoring the company's extremely strong market position in geographies that have the perfect demographics, as well as market trends, to support long-term growth of the fast food restaurant segment, while the company's deep and mutually beneficial relationship with McDonald's removes any threat to the master franchisee agreement. With extremely low expectations, any sign of economic stability in the related geographies should improve the sentiment around the stock.

Progress consistent and a lot to look forward to

It may be hard to ignore the inflation driven growth of corporate expenses in Argentina or the impact of currency on the topline, but the good quality of execution is visible in the numbers and worth appreciating. Ignoring currency that is beyond the management's control, there is visible and consistent progress at both operational and financial levels, be it the cost reductions at the restaurant level, cuts in general & admin expenses or debt reductions. More importantly, the cost cuts and debt repayments are not coming at the expense of investments in technology upgradation, restaurant improvements or menu changes.

The company has opened 31 new restaurants and added 138 dessert centers over the last year, besides reaching re-franchising agreements for almost 40 restaurants, half of which have already been transferred to the franchisees. Even though the broader demand will continue to be driven by the economic trends, stable to improving market share does position the business to monetize the economic improvement, as and when it arrives.

Reorganization and cost-cutting plans have led to consolidated general & admin expenses declining by almost 1%, as a percentage of revenue, and operating margins should benefit further as technology upgrades and the resulting restaurant efficiencies take hold. Even though overshadowed by currency movements, EBITDA margins have shown improvement of almost 50 bps at the consolidated level, benefiting from decent leverage in the model.

As for debt, asset monetization, refinancing efforts and temporary cuts in capital expenditures have yielded results, as reflected in the net debt/adjusted EBITDA ratio of 2.3 times, within the company's target range and down from 2.5 times at the end of the first quarter. The leverage ratio is not too far from the requirements of the master franchise agreement with McDonald's. Not to forget that doubts over Brazilian and Argentinean economies have also ebbed, with expectations of economic growth by next year.

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