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Is Arcos Dorados a Better Pick Than McDonald's?

Tom is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite its relatively simple and frequently copied formula for success, McDonald’s (NYSE: MCD) still remains one of the most dynamic entities within the quick serve and sit-down restaurant spaces.  The corporation, through the continuous launch of new menu items and the revamping of a large majority of its worldwide outlets, has acted to blur the definition of the greasy burger-flipping fast food joint of the past, and has become the model toward which competitors including Wendy’s (NASDAQ: WEN) and Burger King (NYSE: BKW) strive to copy.  The almost universal appeal of McDonald’s offerings and the rising middle classes in many of the corporation’s emerging markets will undoubtedly make the stock an easy investment for the investor with the long-term horizon.

Is there a better opportunity to capitalize on the swift growth McDonald’s will continue to experience as it expands further into BRIC nations and continues to revamp its existing United States and European outlets?  Arcos Dorados (NYSE: ARCO), more familiarly the McDonald’s of Latin America, may present a smaller, less followed, and potentially faster growing subset of McDonald’s proven formula. 

As the largest franchisee of McDonald’s restaurants in the world, Arcos purchased McDonald’s Latin American and Caribbean operations in 2007.  Likewise, the corporation was granted exclusive rights to own, operate, and sub-franchise McDonald’s restaurants in 20 countries and territories in a renewable 20-year agreement. 

Arcos currently operates 1,840 restaurants in four primary geographic areas –

  • Brazil: 662 restaurants
  • SLAD (Argentina, Chile, Colombia, Ecuador, Peru, Uruguay, Venezuela): 547 restaurants
  • NOLAD (Mexico, Costa Rica, Panama): 484 restaurants
  • Caribbean (various small islands): 147 restaurants

As one would expect, increasing populations in these areas, significantly improved discretionary incomes among the middle class citizens, and growing tourism industries have all contributed to extremely robust growth rates in each of the corporation’s markets.  Revenues have grown at a 12% CAGR between 2008 and 2011, and with expected 15-17% top line growth in 2012, Arcos is on track to hit between $4.2 and $4.3 billion in annual revenue.  The top line growth should be sustainable for the foreseeable future, as McDonald’s overall presence in these emerging economies is still rather limited:

  • McDonald’s USA: 14,098 restaurants = 1 restaurant per 22,200 citizens
  • NOLAD: 1 restaurant per 254,000 citizens
  • Brazil: 1 restaurant per 310,700 citizens
  • SLAD: 1 restaurant per 317,400 citizens

Arcos management understands and is taking full advantage of the growth opportunity, and has plans to construct an additional 130 restaurants in 2012 (7.1% of its existing store base).  Likewise, there is a huge opportunity to gain additional top line growth in existing restaurants by updating interiors/exteriors and adding McCafe and dessert centers within the locations.  Currently, only 40% of Arcos restaurants have the updated store image, and updated stores have historically shown an additional 5% in revenue as compared to the traditional-styled restaurants.  More aesthetically pleasing both inside and out, the updated McDonald’s locations tend to attract more drive by traffic and have a greater ability to keep patrons in the stores for longer periods of time – leading to additional purchases. 

McCafe and dessert centers have around 16% and 75% penetration rates, respectively, in Arco McDonald’s system-wide restaurants. 

At a fraction of the price of the total McDonald’s worldwide system – Arco enterprise value is under $5 billion vs. McDonald’s enterprise value at $110.9 billion – an investment in Arco sounds like a no-brainer, right?  The likely answer is surprisingly “no.”

Why Limit Yourself?

The same growth dynamics for Arco exist in several of McDonald’s other key markets.  An investment in Arco may very well grant an investor access to one of its most attractive future markets, by why isolate yourself to one particular segment?  

China, for instance, is likely to be McDonald’s largest growth market for the foreseeable future.  Even with a goal of hitting the 2,000 restaurant mark by the end of 2013, the corporation’s overall presence within the nation will be extremely minimal – around 1 restaurant per 672,000 citizens, or about half as sparse as Arco’s footprint in the SLAD or Brazil regions.  McDonald’s does not only have an amazing future opportunity in growing its China footprint, but it can also drastically increase the profitability of its existing stores through improved brand awareness. 

Yum! Brands (NYSE: YUM) has long been the American fast food leader in China, and has established an extremely strong base of around 4,500 restaurants (primarily KFCs and Pizza Huts) by entering the country early and quickly evolving with the local customs.  The success of Yum! in the nation shows the population’s love for the quick serve restaurant concept, and an increased McDonald’s presence in the market as compared to the established competition will lead to significant organic growth at least over the next decade. 

The growth is not isolated to emerging markets, however.  McDonald’s has huge capital investment plans going forward with the reimaging of its existing stores – of the 2,400 reimagings that will take place in 2012, 800 and 900 will be in the mature U.S. and European markets, respectively.  For the reasons stated previously, additional revenue per store should be expected from these updated and more attractive locations.  Likewise, with the corporation’s newer menu items (McCafe brewed drinks, fruit smoothies, breakfast items, etc.), the 24-hour operation roll-out in many locations, and the introduction of new customer time-saving technology (point of sale systems, hand-held order takers), the customer experience will continue to improve even in the corporation’s oldest markets.  As the same store sales dynamics show, there is still ample opportunity within the U.S. and European markets:

<img height="275" src="/media/images/user_112/mcdonaldssss_large.png" width="446" />

Again, why limit yourself to one of McDonald’s attractive markets?

Cost Control?

There is no doubt that Arco management has big spending plans to grow the Latin America and Caribbean McDonald’s footprint, yet management’s cost controlling abilities have been rather lackluster over the past several years. 

Company-owned restaurant revenue grew (year-over-year) 2.2% in 2009, 14.1% in 2010, and 21.1% in 2011, yet individual restaurant costs are growing at a faster rate:

  • 2009: Food/Paper costs grow 3%, Payroll/Benefits grow 6.4%, Occupancy costs grow 3.1%
  • 2010: Payroll/Benefits grow 15.9%, Occupancy grows 14.7%
  • 2011: Payroll/Benefits grow 23.2% (other costs less than or in line with sales growth)

The occupancy costs on the franchise side of the business have also been growing faster than revenues from the franchised restaurants.  Operating margins have, as a result, contracted from 8.5% in 2008 to 6.8% and 6.9% in 2010 and 2011, respectively.  Likewise, investors should naturally expect company revenues to increase as discretionary incomes in these emerging markets continue to grow, but they should also expect a similarly meaningful increase in the minimum wages that Arco must pay its hourly restaurant employees.  As an example, the Brazilian government did issue a minimum wage forecast for 2012 of 622.73 reais per month, up more than 14% from the late-2011 monthly rate.  It becomes increasingly difficult to scale operations when commodity costs (food/paper), real estate values, and minimum wages are all increasing at a similar rate as revenues.

Likewise, with an additional $340-$350 million in expected capital expenditures in 2012, the corporation is unlikely to be cash flow positive for the year.  Through the corporation's extremely rigorous new store growth since 2008, it has generated only around $0.66 per share in free cash flow, a cumulative level that is bound to reduce this year. 

Cheap Enough?

An investor is likely to find their best McDonald’s investment opportunity in simply purchasing the parent corporation’s operations.  The restaurant system will still receive a residual benefit from the growth in the Latin American operations, and will grant an investor access to the dynamic China market and the inevitable improvement in the existing United States and European locations.

Likewise, selling for an estimated 12.7x EBITDA (fiscal year 2012) – McDonald’s sells at 9.2x next year’s EBITDA at current market valuations – an Arco investment is not inexpensive enough to make up for the lack of exposure to McDonald’s growth elsewhere.

gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Arcos Dorados and McDonald's. Motley Fool newsletter services recommend Arcos Dorados, Burger King Worldwide, McDonald's, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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