Arcos Dorados Stronger Than Its Stock

| About: Arcos Dorados (ARCO)
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It's cold comfort for shareholders, but it seems like Arcos Dorados (NYSE:ARCO) has gotten sucked into the same "anti-polar" vortex as many other consumer-oriented Latin American stocks. With the USD/BRL exchange rate moving from 2.03 to 2.37 over the past year and the USD / MXN rate moving from 12.67 to 13.08, worries about consumer spending trends in markets like Brazil and Mexico and the economies of Argentina and Venezuela are almost secondary.

The good news is that, as an operating company, Arcos Dorados is still doing pretty well. Sluggish comp growth in Brazil is a worry, but comps have generally been picking up and margins seem to have stabilized. I'm looking for strong comp growth and unit expansion to drive revenue growth, and I believe the shares are meaningfully undervalued today. All of that said, investors are going to have to be able to deal patiently with the ups and downs of currency movements or take a more aggressive view towards entering, exiting, and re-entering the shares.

Comps Mixed, But Improving Overall

Arcos Dorados delivered comp growth of more than 12.6% for the company's third quarter, a significant improvement from the 6.5% growth in the prior year and the 11.6% figure in the second quarter. Comp growth was spurred by the economic issues in Argentina and Venezuela, as the company's SLAD division saw comp growth of 25% and the Caribbean unit (including Venezuela) saw comps rise almost 23%.

Elsewhere the story was more mixed. NOLAD comps were up 6.6%, and while that may not sound very impressive, that is actually pretty solid given what companies like FEMSA (NYSE:FMX) and Walmex (OTCQX:WMMVY) have been saying about the Mexican consumer. Alsea (OTCPK:ALSSF) did do better with nearly 9% comp growth, but Burger King (BKW) only managed about 2% comp growth for the same period.

Brazil, too, was something of a disappointment. After 10% comp growth in the second quarter, growth of 5.6% in the third quarter disappointed. Conditions for consumers in Brazil are getting better, but it bears repeating again that McDonald's (NYSE:MCD)/Arcos Dorados is actually pretty expensive for the Brazilian consumer. Arcos Dorados is trying to work on this with more promotional efforts and cost reduction initiatives, but it's a long-term work in progress.

Will New Policies In Mexico Crimp The Chains?

While McDonald's isn't as expensive on a relative basis in Mexico as it is in Brazil, it still isn't priced as an everyday destination as a Big Mac costs about 55% of the daily earnings of a worker making minimum wage in Mexico. The bad news is that it's going to get even more expensive.

Among the various tax and business reforms that the Mexican government passed last year, a new junk food tax will add 8% to the cost of McDonald's food. Granted, Alsea and Burger King (Burger King is among Alsea's many partners) will face the same tax and FEMSA is also getting hit by a 10% soft drink tax, but it's just one more headwind for the company to face. After all, whether you want to debate whether sin taxes are targeting at reducing consumption or merely exploiting it, the fact is that higher taxes almost always lead to lower consumption.

I expect Arcos Dorados to attempt to innovate around this. McDonald's is still relatively popular in Mexico, and I don't expect this tax to change that, but the company will have to figure out how to cut corners on other costs if they want to fully offset this new tax.

Will Global Sporting Events Boost Brazil?

Between the World Cup in 2014 and the Olympics in 2016, Brazil is going to be a busy place for the next two and a half years or so. McDonald's is a big corporate sponsor for both events, and I expect Arcos Dorados to benefit from the global sponsorship efforts of McDonald's. I am not suggesting that Brazilians are suddenly going to think "there's Olympic basketball today, I think I'll eat a Big Mac", but free promotional activities won't do them any harm.

At the same time, the company continues to work on extended product development efforts. Arcos Dorados is really trying to improve their breakfast and post-midnight offerings, and any meaningful developments here would likely be very good for incremental margins (the stores are open and staffed anyway).

A Good Runway For Long-Term Growth

Certainly there is, and will continue to be, significant competition for Arcos Dorados. Companies like Yum! Brands (NYSE:YUM) and Subway are aware of the potential of Latin American markets just as much as Burger King or Arcos Dorados. Likewise, Alsea offers a more diversified platform across the four countries in which it operates - Alsea operates over 1,400 stores through partnerships with Domino's Pizza (NYSE:DPZ), Burger King, Starbucks (NASDAQ:SBUX), Brinker's (NYSE:EAT) Chili's, and California Pizza Kitchen among others.

I am looking for Arcos Dorados to combine strong comp growth and unit growth to generate around 10% annual revenue growth across the next decade. That unit growth will compromise free cash flow yields in the short run, but I still believe that mid-single digit margins are possible down the line. With that, free cash flow could grow at an annual rate over 20%, albeit likely in a lumpy fashion.

The Bottom Line

Even with an elevated discount rate, I estimate Arcos Dorados' free cash flow as being worth about $13.75 per share today on a discounted basis. I'm not making any explicit exchange rate forecasts in this process, and I fully acknowledge that exchange rate movements (let alone devaluations like those in Venezuela) will have a big impact on the year-to-year performance of the shares.

Currency moves are just part of the background risk of investing in overseas companies, and I'm not selling FEMSA just because currency issues (among others) have hit the stock. Likewise, I wouldn't avoid Arcos Dorados just because currency has punished the stock and margins. Arcos Dorados is definitely on the higher end of the risk spectrum, but I think there is at least reasonable return here for that risk and I think Arcos Dorados could be a good LatAm rebound stock for 2014.

Disclosure: I am long FMX, . 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.