A Golden Opportunity for Latin American Growth

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

I’ve written previously about my desire to add a bit more Latin American (LatAm) flavor to my portfolio.  One stock that I am looking at is offering a golden growth opportunity to profit on feeding the rapidly expanding middle class south of the border.  When I think about the food of Latin America, a McDonald’s (NYSE: MCD) hamburger is not the first thing that comes to my mind.  I’m not even sure a burrito from Chipotle would be considered true Latin cuisine.  Yet, when looking for one of the best ways to play the growth, investors need to look no further than the Golden Arches of LatAm, Arcos Dorados (NYSE: ARCO).

Arcos is the largest franchisee of McDonald’s restaurants in Latin America, thanks to their 2007 purchase of McDonald’s former LatAm business.  They paid just under $700 million dollars for the business and were granted an exclusive 20-year agreement to be the operator and franchisor of McDonalds in 19 countries in LatAm.  This exclusive agreement is renewable in ten year increments and includes the rights to Brazil and Mexico among the nineteen countries and territories.  In addition to the $700 million paid upfront to McDonalds, Arcos also pays them annual royalties ranging from 5% to 7% of sales and 50% of the initial fee earned from each new franchisee.     

The opportunity for Arcos is immense.  With less than 2,000 restaurants they have the potential to grow that more than tenfold.  If you look at the demographics, the current population of the US is about 309 million people and McDonalds has just over 14,000 restaurants.  In Arcos’ regions of operations there are 576 million people and while those regions will likely never reach the same levels of restaurant saturation, they still have a lot of room to run.  I mentioned earlier that Arcos was a play on the rapidly expanding middle class in LatAm, in one such example, according to the Brazilian Ministry of Finance they added 29 million to their middle class between 2003 and 2009 while cutting those living in poverty almost in half. Arcos generated 53% of their revenue from Brazil and they are just at the tip of the iceberg reaching this burgeoning demographic.   While they are the exclusive purveyor of McDonalds in LatAm, they are not without competition in the fast food industry.  YUM! Brands (NYSE: YUM) KFC unit continues to translate well overseas, including LatAm and there are also other local players such as Bob’s in Brazil.  None have the proven global brand of McDonalds that gives Arcos such a golden opportunity. 

Arcos reported 2011 fiscal results which included sales of $3.66 billion and net income of $115.5 million for a net margin of just 3%, well under the 20% margins enjoyed by McDonalds.  Part of the reason for their lower margins is due to their outright ownership of 74% of their stores while McDonalds owns just 20% of their stores.  According to their agreement with McDonalds, Arcos has the ability to franchise up to 50% of their restaurants leaving plenty of opportunities for margin expansion.  As Arcos grows its restaurant count it should lead to greater economies of scale and higher net margins.  One other item of note, Arcos pays a nice and juicy 1.25% dividend that has the potential to become supersized over time as Arcos continues to grow.   

I like Arcos a lot, but want to wait until they report their next quarter’s earnings before deciding whether or not to add them to my portfolio.  At around 35 times earnings Arcos looks expensive at first glance but when you consider the opportunity that lie before them and their projected earnings growth of 49% in 2012 and 24% in 2013, they trade at just 19 times their projected 2013 earnings.  I will be looking for continued double digit growth in same store sales as well as any mention of a slowdown in any of their core markets, but I think that Arcos could be a golden opportunity to capture some LatAm growth.  My hope is that Arcos’ earnings are again not well received by the short sighted Wall Street crowd allowing me to pick up the shares on the extra value side of the menu. 

Motley Fool newsletter services recommend Chipotle Mexican Grill, McDonald's, and Yum! Brands. The Motley Fool owns shares of Chipotle Mexican Grill. latimerburned owns shares of Chipotle Mexican Grill. 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.

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