It's tough to grow a business when two large markets are convulsing under the weight of horrible macroeconomic mismanagement, but Arcos Dorados (NYSE:ARCO) isn't going to get a free pass just because the problems in Argentina and Venezuela are not its fault. Inflation, affordability, and competition remain challenges across the company's operations and I don't fault investors who want nothing to do with another Latin American consumer stock groaning under the weight of macroeconomic issues.
The shares of Arcos Dorados are down about 10% from when I last wrote, and the story remains frustratingly similar. There is significant growth potential in the business, as it could double the number of McDonald's (NYSE:MCD) stores it operates over the next decade, but potential isn't worth much if the actual results don't get better.
Some Good, Some Bad For The Fourth Quarter
There is still a lot of "yeah, but" to Arcos Dorados. For instance, constant currency revenue growth of 16% and same-store sales growth of almost 11% both sound great for a growing restaurant operator. Unfortunately, overall system volume was down 3% and much of that "growth" came from the punishing inflation in Argentina and Venezuela. Exclude those countries and same store sales was only 2% on a 2% decline in volume. The good news is that margins held up well, with reported EBITDA up 6% (and up 20% adjusted) and operating income up 13%.
Operations in the key market of Brazil were definitely mixed. Revenue fell 1% as reported in U.S. dollars, while rising more than 9% in BRL, with same store sales up about 2%. EBITDA declined slightly, while operating income rose almost 2%. All in all, Brazil disappointed on the revenue side, but the company did a better than expected job of controlling costs.
NOLAD (which is largely Mexico) was disappointing, with reported revenue growth of 1% (and local growth was similar) and a greater than 2% decline in same store sales. Profitability was a little better, though, as EBITDA rose 6% and the operating loss shrank.
SLAD and Caribbean results were greatly impacted by the economic chaos in Argentina and Venezuela. Reported revenue rose almost 5% in SLAD, with same store sales up more than 21%. In the Caribbean segment (which includes Venezuela), revenue was up 14% with greater than 27% same store sales growth. Margins held up; EBITDA was up almost 13% in SLAD and about flat in the Caribbean, while operating income rose 22% and was basically flat, respectively.
Comps A Cause For Some Concern
Arcos Dorados isn't the first, or only, company with heavy exposure to Latin American consumers (particularly in Brazil) to report shaky results. What concerns me a little more now is the comparable performance.
Burger King (BKW) announced almost 2% same store growth in the fourth quarter, which I suppose is slightly reassuring. Less reassuring was the nearly 10% comp growth for Alsea SAB, a large, diversified Mexico-based restaurant operator with partnerships with Domino's Pizza, Starbucks, and Burger King. Seeing as how 85% of Alsea's stores are in Mexico, it seems like a stretch to blame anything particularly macro-specific for Arcos Dorados' performance. What I can say is that the problems with McDonald's in Mexico go back a long time and before Arcos Dorados, including clashes with government policies and often tone-deaf advertising campaigns. Likewise, because Alsea does not break out results in detail, it is difficult to say if the growth is coming from pizza, coffee, or sit-down casual dining chains.
What Can Management Do To Make Things Better?
I have seen readers state that Arcos Dorados should bail out of Argentina and/or Venezuela. I think that would be a mistake. Argentina and Venezuela are two of the largest restaurant markets in Latin America and McDonald's has good brand value in both countries. What's more, bailing out of long-term opportunities just to avoid short-term troubles seems ill-advised, particularly when the SLAD and Caribbean segments are still profitable for the company.
It's also worth noting that the company isn't exactly expanding its operations there with any particular speed. Over 70% of the stores added in 2013 were added in Brazil and even there the company is tapping the brakes on expansion until same store sales growth picks up again.
Management also continues to work on menu and pricing refinements for the Brazilian market. BRF Brasil Foods (NYSE:BRFS) has mentioned working closely with Arcos Dorados to develop new food concepts and the company could definitely benefit from adding more affordable items to the menu (and/or maximizing other concepts like McCafe and "dessert centers". On a related note, management has also been moving forward with changes to its in-store equipment line up to reduce labor inputs and wastage.
The Bottom Line
Not much changed about the Arcos Dorados story in the fourth quarter, and so not a lot changes in my long-term model or outlook. I'm looking for long-term revenue growth of around 10%, with unit growth alone likely contributing around 6% to 7% of that. Accordingly, I don't think 3% to 4% same store sales growth for markets like Brazil, Argentina, and Venezuela is too onerous. I am also expecting the company to ultimately slow its store expansion and show greater FCF leverage as capital spending declines as a percentage of sales. With that, I believe FCF growth can exceed 20% over the next decade on a CAGR basis.
Discounting that back, I still see a fair value of around $13 for Arcos Dorados. I already have plenty of exposure to Latin America and Brazil, which is the primary reason why I don't own Arcos Dorados today. This company has made it easy to dislike the stock (the shares have been in a near-steady decline since the 2011 IPO, largely tracking the iShares Brazil ETF (NYSEARCA:EWZ)), but the company is still growing and valuations are not that demanding relative to the sector.
Disclosure: I am long BRFS. 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.