ARCOS DORADOS | Inflation | Economic Growth

Rec: Arcos Dorados Holdings Inc.

Position: Buy

(ARCO: $18.09)

March 29, 2012 Target: $36.79

Shares Out: 209.5M

Market Cap: $ 3,789.55

FYE: Dec

Concept: 1. Differentiated growth opportunity combining a dominant brand, growth industry, and an economically emerging region 2. Privileged business model with underappreciated pricing power and accelerating unit growth 3. Significant increase in store base will add meaningfully to earnings 4. Attractive return characteristics in core Brazilian market and potential turnaround in Mexico can lead to improving capital returns. Summary: Arcos Dorados Holdings Inc. (“ARCO” or “the Company”) represents an attractive investment with near-term catalysts. ARCO is McDonald‟s (“MCD”) largest franchisee and the market leader in the Latin American Quick Service Restaurant (“QSR”) sector. Since October 2011 through March 30, 2011, ARCO has traded down 18% (vs. S&P up 28%) driven by fears of deteriorating macroeconomic conditions in Brazil (including a depreciation of the Brazilian real vs. the US dollar) and increased concerns over beef-driven COGS and wage inflation. The current price of $18/share provides a compelling entry point to investors. Aided by an underappreciated pricing power and demographic tailwinds, I believe ARCO has the ability to double its store base while maintaining a strong balance sheet and improving on its current ROIC of 18%. Guided by near term macro-economic fears, the market expects ARCO to deliver an unreasonably pessimistic same store sales (“SSS”) growth rate of 3.5% on a constant currency basis. I believe the fair market value for ARCO today is $37/share. Company Background: Arcos Dorados Holdings Inc. has the exclusive right to own, operate and franchise McDonald‟s (MCD) stores in 19 Latin American and Caribbean countries. It is the largest QSR chain in Latin America with ~1800 units (~75% company-operated) and MCD‟s largest franchisee worldwide. ARCO went public on 4/14/11 and is using $152M in net proceeds to open 100+ units per year and reimage existing stores. The company reports in four segments: Brazil (35% of units), SLAD (30% of units) consisting of Argentina, Chile, Colombia, Ecuador, Peru, Uruguay and Venezuela, NOLAD (27% of units) consisting of Costa Rica, Mexico and Panama, and the Caribbean (35% of units) consisting of Aruba, Curaçao, French Guiana, Guadeloupe, Martinique, Puerto Rico, Trinidad and Tobago and the U.S. Virgin Islands of St. Croix and St. Thomas. Investment Thesis: 1. Ability to expand store base in the medium to long term. ARCO operates in 19 countries/territories representing a market of approximately 575 million people (larger than the US, UK, France, Germany, and Italy combined) in which the QSR sub-segment offers opportunity for significant growth. In many of the Territories, including Argentina, Brazil, Chile, Colombia, Ecuador,

Mexico and Peru. I estimate that the current store base can almost triple (2. According to Euromonitor. I assume ARCO will increase store count by 900 stores or ~23% of the potential increase in store base shown in Figure 1. Further. Yang Gui. Over the 2000-2006 period.  Demographics. . buy side analysts had a 27% forecast error in the short term (0-3 months) and 2 a 68% mean forecast error in the long term (18 months and beyond) . In 2010. Figure 1. Craig Chapman. average 24-month forecast error for US sell-side analysts at the individual stock level 1 was 93%. the fast food segment in Latin America is expected to grow by 73% in Argentina. the average 12-month forecast error was 47% . and younger age profile vs. March 2007 3 Report of the regional intergovernmental conference on ageing: towards a strategy for the implementation in Latin America and the Caribbean of the Madrid International Plan of Action on Ageing. In most markets. I assume ARCO will build no more than the 260 new stores it has committed to add between 2011 and 2013. I believe ARCO can increase store traffic by at least 3% annually. Based on data from the United Nations Economic Commission for Latin America and the Caribbean. I expect wage rate growth to mitigate cyclical pressures from fragile economies in developed markets. To ensure that my forecasts do not suffer from optimism bias. a. 41% in Mexico. Forecasting growth rates is fraught with danger. Wage rate growth. Reverse engineering the current price using a discounted cash flow model shows that the market expects ARCO to grow at a SSS rate of 3. I assume the number is revised downwards by 10% in each subsequent 3-year period.5 times greater than in the United States. In a study conducted by Groysberg et al.6x) from current levels since the ratio of QSRs per 1M people in Latin America is far less than the ratio in the US. Company reports Reality Check: Guarding against optimism bias. September 9. The Société Générale Group Boris Groysberg. All in all. of which approximately 28% are under 14 years old and 46% are under 25 years old. 60% in Brazil. Paul Healy. 11% in Puerto Rico and 177% in Venezuela. ARCO can leverage its #1 market share to increase traffic by 3% annually.9 million 3 people in 2010. Devin Shanthikumar. the ratio of GDP PPP per McDonald‟s-branded restaurant is at least 2. Brand halo. Adjusted for GDP per capita vs. United Nations Economic Commission. In Latin America and the Caribbean the MCD brand benefits from an aspirational cachet as a “destination”   1 2 James Montier. 2008. more developed markets. 2. the US. 31% in Chile. between 2012 and 2022. The Dangers of DCF. my model uses the rate of store growth ARCO has committed to in its Master Franchising Agreement (MFA) with MCD. As a business focused on young adults in the 14 to 35 age range and families with children. ARCO‟s territories represented a market of approximately 575. Millward Brown Optimor‟s annual survey of global brand strength ranked MCD brand as the sixth most valuable brand in the world and the most recognized brand in Brazil.5% until 2022. Store Potential Analysis Source: CIA World Factbook. Do Buy-side Analysts Outperform the Sell-side? .5% on a constant currency basis. federally mandated wage rate growth is typically above inflation. this implies a 1314% wage rate growth in CY2012. 47% in Colombia. in Brazil the formula is sum of the GDP growth from 2 years ago and last year‟s inflation. I believe ARCO can easily exceed this hurdle when analyzed both in terms of ticket and traffic. traffic will continue to benefit from the territories‟ population size. Buy-side analysts have fared no better. November 2011. Current price implies an unreasonably low same store sales (“SSS”) growth rate of 3. Mind Matters. from 2011 to 2015. Underscored by MCD‟s brand halo and favorable demographics.

Francine Lafontaine. Mini-formats in the form of McCafés and Dessert Centers account for 35% of transactions. a franchisee in the US would have earned 8. I model a 6% increase in average ticket. slightly below the blended inflation rate for the territories.  Inflation. 1992. .4x -1.  Figure 2. A key aspect of my thesis is ARCO‟s ability to increase transactions per month in Mexico from 18000 to 25000. Costs of Control: The Sources of Economic Rent for McDonald’s Franchisees. Due to the low price of the products sold by these formats. MCD enjoys a #1 market share in Latam of 12. nearly 3. through which the company offers a rotating selection of existing products at reduced prices. Kaufman.5x that of its closest competitor Burger King. Return on investment on McCafés and Dessert Centers in FY2010 was 54% and 190% respectively. 4 Patrick J.9% for an ounce of gold4. it is rare for companies to sustain the ability to raise prices indefinitely. Transactions driven by McCafés and Dessert Centers lend to pricing power.0% annually from 1964-1988 vs 5.4%. Assuming food and paper costs increased in line with inflation. Average ticket can grow by 6% annually because of ARCO’s underappreciated pricing power and menu innovation. Historically the company has been able to increase prices at 1.6% trough in FY2009) driven by the “Big Pleasures. As a result. mitigating the impact of food price inflation (Figure 2). increasing prices by only the minimum coin overcomes the effects of inflation without reducing traffic.  Value.restaurant with a reputation for safe. Looking forward. University of Michigan Press. in line with those in Brazil. However. comps and margins have rebounded in 1H11 (store margins stand at ~10% vs. Small Prices” value menu program. the 5. other territories. b. NOLAD margins have been poor vs. However.5x inflation. fresh and good-tasting food in an attractive setting.

RBD has grown sales at a CAGR of ~7% and EBIT at a CAGR of ~12% between 2006-2011.00% 2. my estimate of 9% SSS growth rate for ARCO appears reasonable given its favorable demographics and greater pricing power (0.4% from 2008-2011. On a per store basis.nz Average SSS growth 6. Franchise agreements enforce stringent standards for performance and minimum benchmarks for store reimaging and openings. I model a growth in average ticket of 6% vs.com Reality Check: Testing ticket and traffic growth assumptions against empirical evidence (RBD case study) Restaurant Brands (RBD) provides an illustrative example of the potential growth that can be expected from a QSR franchisee in tough economic conditions and demographic headwinds.Figure 3.00% 0. RBD historical comparative store sales and EBITDA 250 200 150 100 50 0 2007 2008 Sales Source: www.00% 4. Relationship with MCD – impact on ARCO’s bottom line.4x inflation for ARCO). Given the elevated prices in Brazil and Argentina. QSR Market Share in Latin America Source: Company reports. Besides the widely understood advantages of scale such as purchasing leverage with suppliers. and operational systems all in various phases of integration across the company‟s markets.4% 10. In light of such evidence.00% 8.co. 1.restaurantbrands. .00% 6. forecast CY2012 inflation in the high single digits. Additionally. Euromonitor Figure 4. Source: Numbeo. owing to a refurbishment program started in 2005. ARCO‟s relationship with MCD adds value in terms of operations and governance. despite an economic slowdown SSS growth has averaged 6.00% 2009 EBITDA 2010 2011 Same store sales growth 3. remodels. RBD is a listed company in New Zealand and is currently a franchisee of 89 KFC stores.8x inflation for RBD vs. ARCO is following MCD‟s globally proven “Plan to Win” with high/low pricing.

Francine Lafontaine. Made-For-You (MFY). 5 6 John F.08% (with no credit for a potential turnaround in Mexico). University of Michigan Press. Kaufman. reducing payroll costs by ~40 bps.21%  Equity risk-premium: 6%  Terminal growth rate: 2% (well below mid-to-high single digit 20-year average food inflation)  20% probability of recovery for NOLs associated with NOLAD operations  Mid-year convention The current price implies unreasonably pessimistic SSS growth rates. paid for out of global marketing spend but yielding considerable in-country attention and benefits.3% annually .23%  Beta: 0. Love. Brazil. MFY reduces the number of transactions per crew hour by 15% and allows for more customization of orders. Mexico. Implemented in the US in early „00s. failure rates in the MCD system as a whole 6 have averaged 0.000 in 1973 ). Costs of Control: The Sources of Economic Rent for McDonald’s Franchisees. the current stock price implies an SSS growth rate of only 3. Globally sponsored events.  Valuation I value ARCO using a DCF methodology. Data going back to the 1970s shows MCD‟s centrally led marketing campaigns have a history of success (the very first central marketing campaign 5 in the US resulted in a doubling of per store volumes in five years to $621.5%  Risk free rate: 2. Bantam Books. Investment Risks/Considerations
 Store returns could erode as ARCO pushes into newer markets: Mitigant – MCD sets out strict guidelines in terms of store performance in its MFA. My rollout. Even if ARCO grows to 2754 units (below the new store openings specified in the MFA) and refurbishes 120 stores annually 
 while keeping gross margins constant at 19. My key DCF inputs were as follows:  WACC: 7. and Argentina – representing 80% of profits – should all have MFY system wide by the end of FY2012. These are globally sponsored events by MCD. ARCO benefits from MCDs continuing advancements in attacking operating margin “leaks” through operational innovation. McDonald’s: Behind the Arches. with in-country promotions bolstered by in-game branding and restaurants in athlete villages. refurbishment.5%. and SSS forecasts are outlined below. 1986 Patrick J. to obtain a value of $37/share. 1992. Historically.88  Gearing (D/D+E): 20%  Cost of Debt: 10. . I model 9% SSS growth rate (3% traffic growth and 6% ticket growth) and assume total stores grow to 2754 units with a 50bp improvement in per store margins. I believe that the 2014 World Cup and 2016 Olympics are important events for ARCO. as I believe it best captures the cyclicality inherent in retail company earnings.

brand superiority.
 Macro risks – 1) dollar-based security with substantial currency exposure 2) substantially exposure to mall based store infrastructure makes the business vulnerable to retail slowdown 3) Venezuela accounts for ~5% of EBITDA. visible growth profile. Financial Models .I expect lumpy returns due to forex volatility but given demographic strengths. long-term business fundamentals will remain strong. Mitigant .

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