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McDonald's (MCD) is known as the "king of defensive of stocks" because of its proven ability to grow sales and revenue in even the harshest of economic environments. However, Arcos Dorados (ARCO), McDonald's independent Latin American master franchisee, has proven to be anything but. Its IPO was touted as one of the hottest of 2011 with its combination of McDonald's proven business model and strong brand operating in a highly populated region with some of the world's fastest growing economies.

But since then it has only delivered disappointment for investors with its share price being gutted by the market to be almost 50% down from its post-IPO high of around $29. This has seen numerous analysts and market pundits talk up the company's prospects. However, I believe they are wide of the mark and have taken an overly optimistic view of the company and the growth potential that Latin America represents for the discretionary consumer sector.

Weak financial performance

A key reason for Arcos Dorados' poor share performance has been its disappointing financial results. The company missed the consensus forecast earnings per share for the first quarter 2012 by 33%, reporting earnings-per-share of 12 cents. It also reported that revenue was down by 4% to $922 million and net income was down by 45% to $25 million.

This is in stark contrast to McDonald's, which reported an 8% rise in consolidated revenue to $6.6 billion and a 7% increase in earnings-per-share to $1.23, despite the difficult economic environment. For the same period Arcos Dorados also reported a weaker balance sheet with cash and cash equivalents dropping by 18% to $144 million, although long-term debt remained steady at $532 million.

Weak debt profile

Arcos Dorados has total debt of $540 million and after subtracting assets net debt of $396 million. This gives the company a solid debt to equity ratio of 73.4%, which I would normally find to be quite appealing. Particularly when it is considered that it is almost half of the industry average of 134% and lower than key industry peers including McDonald's, YUM Brands (YUM) and Burger King World Wide (BKW).


(Click to enlarge)

Source data: Yahoo Finance, Bloomberg, Arcos Dorados, McDonald's, YUM Brands, Burger King World Wide Q1 Financial Results, Yahoo Finance and Fidelity.com.

However, when other aspects of the company's debt profile are considered its level of debt becomes less appealing. These include firstly the relatively low amount of cash totaling $144 million in comparison to the level of debt.

Secondly, the company's cash flow to debt ratio of 47% is particularly low and is significantly lower than its peers as the chart shows. With such a low cash flow to debt ratio it is likely that Arcos Dorados will have to finance its current liabilities from sources other than its operating cash flow or slow the rate at which it is spending cash. This also leads to some concern about whether the company will be able to continue operating without raising additional funds, because the existing cash balance cannot last forever.

In addition, for reasons discussed later I expect Arco Dorados' cash flow to decline as the operating environment becomes more difficult. If the company were to slow the rate at which it is spending cash then it will be obliged to curtail its aggressive store expansion program triggering a fall in future revenue growth.

Finally, a considerable portion of Arcos Dorados' long-term debt totaling $306.5 million is denominated in U.S dollars. This leaves the company exposed to currency movements and therefore increased interest costs. So far this year both the Brazilian real and Argentine peso have significantly depreciated in value against the dollar with the real is down by 7% and the peso's official rate down by 5%.

Higher than expected operating costs

For the first quarter 2012 the company reported that cost of goods sold (COGS) had remained steady from the previous quarter at $787 million. This is of some concern because revenues were down by 4% during the same period.

Furthermore, total COGS as a portion of revenue is 85% making Arcos Dorados one of the higher cost budget restaurant chains in the industry as the chart below shows.


(Click to enlarge)

Source data: Arcos Dorados, McDonald's, YUM! Brands and Burger King World Wide Q1 2012 Financial Results.

When Arcos Dorados peers are considered, the standout performer from a cost perspective is McDonald's with a COGS to revenue ratio of 62%, which is the lowest of the four companies compared. This also helps to explain McDonald's superior profit margin, which at 19% is higher than Yum Brands 17% and more than six times Arcos Dorados particularly thin profit margin of 3%.

Arcos Dorados' thin profit margins and higher operating costs in proportion to sales can be attributed to a number of factors. Firstly, unlike McDonald's, Yum Brands or Burger King, the company is obligated to make regular royalty payments. These payments are made for the use of the McDonald's brand and operating model and increase as gross product sales increase. This means that as the company expands its restaurant footprint in order to grow sales and revenue these royalty payments increase.

Since 2009 this cost has steadily increased, having grown from around 4.5% of total revenues to now be 4.77%. This means that for every dollar of revenue earned Arcos Dorados loses almost 5 cents as a royalty to McDonald's before other operational costs and expenses are allowed for.

Valuation is still too high

Despite Arcos Dorados share price being down by 32% over the last year, I believe that it is still over-valued in comparison to its peers. The company at the time of writing is trading with a trailing price to earnings ratio of 30 and a one year forward price-to-earnings ratio of 24, which indicate that the company is more expensive than either McDonald's or Yum Brands as the chart illustrates.

Source: Fidelity.com

With economic growth in the region expected to be subdued for some time it is likely that consumption will remain subdued and Arcos Dorados' earnings will not grow as forecast. This indicates that the company's IPO price and subsequent share price were over inflated by an unrealistically optimistic view of economic growth and development in Latin America.

Growth catalysts

Arcos Dorados has the exclusive rights to own, operate and franchise McDonald's restaurants in 20 Latin American and Caribbean countries until 2027. This gives the company exclusive access to one of the fastest growing regions in the world, with Latin America averaging an annual GDP growth rate of 4% over the last decade. The region also has a rapidly growing middle-class, which is the key socio-economic segment that the McDonald's brand appeals to. It is expected that by 2030 Latin America's middle-class will have grown by around 75% or 313 million in size.

Brazil as the region's largest economy and most populous country is Arcos Dorados' key growth market in the region. Over the last decade Brazil has also experienced phenomenal economic growth, which saw it overtake the U.K. in 2011 to become the world's sixth largest economy. This strong economic growth has also contributed to a sizable demographic shift in the country, leading to significant growth in the country's middle-class and a considerable increase in discretionary consumption.

As a result Arcos Dorados have focused on growing market share in Brazil, which has seen just over one third of the company's restaurants located there and the remainder distributed throughout South America, the Caribbean, Mexico and Central America.


(Click to enlarge)

Source: Arcos Dorados Credit Suisse LATAM & EMEA Conference Presentation

The company has also embarked on an ambitious expansion program since listing, in order to expand its geographic footprint and take advantage of the regions large population and growing affluence. This has seen the opening of 86 new restaurants across Latin America over the last 12 months.

On face value all of these factors should bode well for Arcos Dorados' future growth and profitability. However, I believe that this outlook is somewhat simplistic and has not correctly accounted for the economic, political, social and demographic challenges that exist in the region.

Macro environment and outlook

Latin America's economic fortunes are closely dependent upon the economic health of China and the member countries of the European Union, because these are the region's main export markets. It was China's insatiable appetite for raw materials that created a commodity boom in many parts of Latin America, which was the catalyst for the phenomenal rates of economic growth. It is also this boom that financed the growth of the region's middle-class and domestic consumption.

However, China's economic growth has slowed substantially over the last year, causing a significant fall in demand for Latin America's commodities. Like China, European demand for commodities and other goods has fallen significantly. This has been caused by the European financial crisis and the fiscal austerity measures that have been implemented to manage it. All of which has caused a number of European economies to slip into deep recessions reducing demand for many of Latin America's exports.

This has manifested itself as a significant slump in economic growth in Brazil and curtailed economic growth across the region. Since reporting a GDP growth rate of 7.5% for 2010, Brazil's economic growth has plunged sharply, with a full year GDP growth rate of 2.75% in 2011 and now 1.89% for the first quarter 2012.

When combined with the Brazilian government's heavy handed use of monetary policy over the last two years to curb inflation, domestic consumption has stalled. In April this year retail sales were down by 16% from the end of 2011. Unemployment has also risen by around 1.3% over the same period, with the official unemployment rate now at 6%. Brazilian economic growth is expected to remain subdued for some time, with the country's forecast 2012 GDP growth rate dropping to around 2% on the back of falling industrial and agricultural output. As a result I believe that discretionary consumption will continue to fall over the short to medium-term, which will also slow the growth of Brazil's middle-class.

There are more optimistic expectations for 2013 onwards, with the GDP growth rate expected to be at around 4% plus annually. But these forecast rates are still significantly lower than those seen at the height of Brazil's recent economic boom. For Brazil to see a return to strong economic growth there will need to be a significant uplift in Chinese economic activity and an end to the European financial crisis.

These factors combined with the significant structural economic, political and social issues in the region will prevent Arcos Dorados from fully benefiting from the region's recent strong economic growth.

Pricing doesn't fit regional demographics

The region's significant disparity in wealth, high levels of poverty and low average income, especially in comparison to the U.S., places a significant limit on the spending power of consumers in the region.

The chart below sets out the average monthly salaries, adjusted for purchasing power, for five of Arcos Dorados markets in the region comparing them to the U.S. From the chart it clear that consumers in Latin America lack the spending power of their U.S counterparts with average salaries a third or more lower than the U.S. In Brazil the average monthly salary is only one-quarter of the U.S and it is even lower in Colombia and Mexico.

Source data: International Labor Organization

Despite the disparity in income levels in the region and the significantly lower average salaries in comparison to the U.S, Arcos Dorados charges similar prices for their meals and food products. The average price for a Big Mac in Latin America is around $4.41 per unit and this is higher than the $4.20 charged in the U.S.

Source data: The Economist

Both Brazil and Colombia have the most expensive prices for a Big Mac, yet they are among those countries with the greatest income disparity and lowest average incomes in the region. When comparing the price of a Big Mac as a percentage of average monthly income the disparity becomes even clearer.

Source data: The Economist, International Labor Organization

For these reasons it is clear that Arcos Dorados is unable to operate in the traditional McDonald's segment of a high quality value for money budget restaurant. As a result, it loses the broad-based appeal normally associated with McDonald's in more developed economies by placing Arcos Dorados firmly in the mid-priced restaurant segment.

Asa result the company loses the defensive attributes typically associated with the McDonald's operating model. These by virtue of a strong brand and budget pricing have traditionally allowed McDonald's to perform strongly even in the most difficult operating environments.

Bottom line

Despite Arcos Dorados' exclusive rights to the McDonald's brand in Latin America and the optimistic outlook for the region's economic growth, it is difficult to see the company being able to deliver the predicted value for investors. This can be attributed to a combination of operating issues relating to its pricing structure, debt profile and operating expenses. In addition, the company has failed to adjust its operating model to the regions demographic and economic characteristics.

For all of these reasons I believe the company's outlook and projected growth is overly optimistic and it won't be delivering strong financial results for investors for some time. This I believe readily demonstrates that the company's IPO price was over inflated and that even allowing for the current fall in value, the company is still over-valued in comparison to its peers. Clearly Arcos Dorados is not a low risk defensive investment like McDonald's, but rather a high risk leveraged play on the ongoing growth of emerging markets in a region well known for its political and economic volatility.

Source: Arcos Dorados: A Not So Golden Investment Opportunity