MCD and 600 Million

By Callum Turcan - August 22, 2012 | Tickers: ARCO, BKW, MCD, YUM | 0 Comments

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Population Growth and Comparisons

As of July 2011, the United States had a population of 311,591,917 (according to the US Census Bureau), with McDonald's Corp (NYSE: MCD) having about 14,100 of its restaurants in the United States. By 2020, the US Census Bureau estimates that the US population will grow to 341,387,000. More mouths to feed means more burgers will be sold to keep up with America's hunger. Simple enough, as the population gets bigger, fast food companies benefit from more demand.

Taking that concept, let's apply it to Acros Dorados Holding Co (NYSE: ARCO). Arcos Dorados operates in Latin America and the Caribbean, which according to the World Bank, had a population of 582,554,334 in 2010. Assuming this was to grow by roughly 7 million a year (in 2009 it was 576,048,448), their population is now probably around 600 million. This trend will continue, which means Latin America will have many hungry mouths to feed as well. But, McDonalds has 14,098 restaurants in the US, with Arcos only having 1,858 (at the end of June). This could mean that Arcos Dorados has a lot of room to run.

Acros

Arcos Dorados is a holding company which has the sole right of licensing out McDonald's franchise or building its own restaurants in all of Latin America. It has a sweet gig going, as does McDonald's, which takes 5% of what Arcos Dorados makes. McDonald's has an amazing brand that everyone loves. When Acros builds a restaurant, everyone knows what products it is selling, and they seem to like them.

Comp Sales

In the second quarter, Brazilian sales were up 11.5% in terms of the real (Brazil's currency). In the NOLAND region (Northern Latin America Division), sales were up 15.4% in local currencies. In SLAD (Southern Latin America Division), sales were up 24.7% in local currencies. This is all very promising news. One thing that you must keep in mind though is that in reported terms, sales in Brazil fell 9.1%, were up 6.2% in NOLAND and 18.9% in SLAD. In Brazil that was due to immense weakness in the real, which fell 23% versus the US dollar. You shouldn't worry though, because a lot of Arcos' debt is in the real, so it isn't a problem. The same thing happened in the other segments of Arcos. Overall, same store sales increased 10.4% (year over year), and mind you last year in 2011 Q2 same store sales were up 14.8%.

Consumers in Latin America are taking a strong liking to McDonald's. One thing Acros does that is different than McDonalds up in America is they offer a big dessert menu because of how hot and humid it is up there. These dessert centers are very popular and are installed in 1,694 of its stores, or 91% of its restaurants. It is good to see management shake things up with these dessert centers, this enables the company to have better comp sales as the product offerings reflect the culture and region it is being sold in, which is very hot and humid, so things that are cold like ice cream sell very well, which increases profits and thus the company's stock price.

Perks from the McDonald's Family

Several advantages Arcos has over its peers is that it is a well-known brand; if tourists (which is a big part of these economies) from the US or Europe come over they are more likely to go to a fast food joint they know and love. McDonald's has an amazing brand and huge brand recognition, and many Latin Americans seem to be taking to the fast food concept. Also, Arcos Dorados' footprint is much bigger than the next competitor in Latin America. Yum! Brands Inc (NYSE: YUM), which has a very strong international presence and would be a major competitor, but has been putting most of its cards down on China, India, and Indonesia, which has led it to having only a small presence in Latin America. Yum! Brands (which owns Taco Bell, Pizza Hut, and KFC) hasn’t made serious inroads in Latin America for the time being, giving Arcos a very nice advantage. No one comes close to having as many stores up and operating that Arcos in Latin America. Arcos is planning on opening 130 restaurants this year, but so far has only opened 18. Management has said they still plan on opening all those stores, and historically speaking this also happened last year, as the bulk of new store openings happened in the second half of the year. Hopefully for Arcos, history will repeat itself.

Growth Runway

One reason why growth in Latin America is so strong is because in the US there are about 58 fast food restaurants per 1 million people, compared to 2 per 1 million people in emerging markets. For McDonald's, there is 1 restaurant per ~323 thousand people in Latin America, but in the United States, there is 1 restaurant per ~22,100 people. This shows just how big the runway for Arcos Dorados is. In the United States, even with all those restaurants and lots of competition, its same store sales were up 4.4% in May. This is very promising for Arcos, because if it can turn the success McDonald's had in America, then this stock will fly upwards.

Analysts expect long term EPS growth to come in at 24.3%, with a 33.9% bump coming in next year. This is supported by Arcos' management saying that it expects Brazil’s economy to turn around in Q3 and to post stronger GDP growth in 2013, at around 4%. Chile's economy, which has been more able than others to cope with the Eurozone problems (the Eurozone contracted -0.2% last quarter), is expected to grow by 4.5% this year and 5% next year, according to the OECD. After Milton Friedman advised Pinochet to open up Chile's economy, to stop printing money to fund government spending, and to privatize its social security (this led to the Miracle of Chile), Chile's economy has been very robust over the years and is a great source of stable growth in Latin America. Plus, being that Latin American countries are large commodities producers, if the US does QE 3, then all of these countries will benefit from a weak US dollar (as will Arcos Dorados).

Quantitative easing last time caused the US dollar to fall by 20% on the FOREX markets. Mexico's economy is also helping out Arcos Dorados, and if the newly elected president does privatize part of PEMEX, Mexico's state run oil company, and allows for foreign drilling and competition in Mexico, then Mexico's oil production (which is currently at 3.6 million bpd) could take off. This would result in an economic boom for Mexico, which is good news for Arcos. Argentina, as forecasted by Oxford Economics, is expected to see its economy grow by 4% for 2012. The point is, all over Latin America there is strong growth, which leads to higher levels of disposable income and for many they get to have disposable income for the first time. Very good news for a fast food joint like McDonald's.

Competition

Arcos Dorados is by far the biggest player in Latin America. Yum! Brands has only a small presence in Latin America, with 84 restaurants in Brazil and a small smattering elsewhere. Burger King Worldwide Inc (NYSE: BKW) is who Arcos should keep an eye on, because Burger King has 1,200 stores in Latin America, or 10% of its total store count. Personally, I think McDonald's beats out Burger King, because it has a better brand and advertising (Burger King's King didn't work out too well) and is more well known.

Problems

The biggest problems facing Arcos Dorados right now are largely out of their control. Rising commodity costs (as the price of corn and other crops spike due to the US drought, which makes meat more expensive as well) force Arcos to pass on price increases to consumers and hurts Arcos' margins. Another big pain for Arcos are weak local currencies versus the US dollar. This forces it to report earnings that are lower in US dollars, and it makes importing goods from the US much more expensive. As I stated before, Arcos did very well in Brazil when you are looking at it in terms of the real as same store sales increased by 11.5%, but in terms of the US dollar fell by 9.1%. That is quite a big difference, one is amazing and the other is horrible. Arcos is banking on Brazil's real to bottom out and to climb back upwards a bit. As far as commodity prices go, Arcos can hedge against the rising costs using futures and they can convert the real (and the other local currencies) into the US dollar as soon as they can, but this only solves part of the problem. Input costs will still be higher which hurts margins, and the local currencies will still be worth less than when Arcos sold their products to the consumer (assuming they fall against the US dollar) which means imports will cost more and same store sales will seem a lot worse than they really are.

Final Thoughts

Arcos Dorados has a long runway ahead, with plenty of growth potential. Hopefully it will be able to get all 130 of those stores up and running by the end of 2012, and will continue to see strong same store sales. McDonald's also stands to benefit from Arcos, as it makes a 5% royalty off of Arcos Dorados. I think in the long run Arcos is a good company to keep an eye on and should be an interesting growth story in the years to come. I'm bullish on fast food in Latin America.

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