Why I’m Buying This Golden Emerging Market Opportunity

By Matthew DiLallo - July 18, 2012 | Tickers: ARCO, BKW, EBAY, MCD, MELI | 0 Comments

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International investing is fraught with risks that can catch the average investor by complete surprise.  Currency fluctuations, political risk and overall instability can all take a perfectly good thesis and render it worthless.  To profit outside our borders it is best to look for ways to hedge your risk whereever possible.  As part of an ongoing series of virtual trades in a portfolio I’m calling the “No Drip, No Mess” Portfolio we are going to look at two such hedges as we add a great young emerging market opportunity to the portfolio.

If you’ve followed the main thesis of the portfolio for any length of time you’ll know that it is all about using income from dividends and options to buy great growth stocks. Without risking any of our starting capital, we’re using the income generated by the portfolio to hedge out some of the risk involved in buying more volatile growth companies.  By doing so we’ll be ensuring that we don’t initially over allocate capital to a position that could mess up our returns. 

For the investment recommendation today, we’ll be hedging out some of the risks inherent with investing internationally in a proven brand concept and business model.  Brands or business models that work in the United States can often be translated locally to great success.  Take eBay (NASDAQ: EBAY) for example, their model of operating an online marketplace and combining it with a payment platform has delivered returns for shareholders for years.   Argentinean based MercadoLibre (NASDAQ: MELI) with its similar business model is known as the eBay of Latin America.  This proven business model has helped the company better navigate the ups and downs of the currencies they do business with.  That’s why we’ll be investing in another proven business model as we invest in the same markets served by MercadoLibre.  As the Golden Arches of Latin America, Arcos Dorados (NYSE: ARCO) has the brand and the model to capitalize on decades of future growth.

Why Arcos?

As the exclusive owner, operator and franchisor of McDonald’s (NYSE: MCD) in Latin America and the Caribbean, Arcos has the business model to succeed.  The company started as a division of McDonald’s but was purchased by its management team in 2007 for $698 million and was entered into a 20-year exclusive agreement which is renewable in 10-year increments.  The opportunity is enormous as their addressable market is about twice as McDonald’s domestic market.  To serve this market, the company has less than 2,000 restaurants against the over 14,000 that McDonald’s has domestically. 

With such a large market opportunity and a world renowned brand, it’s rather refreshing to see how inexpensive the shares are.  When you consider that they are expected to grow revenue by 25% per year in each of the next five years, at 28 times earnings the company will compliment that revenue growth by increasing their earnings by 21% this year and 30% the following year.  This puts the company at just 17 times 2014 earnings, which is downright cheap. 

The final reason that I like Arcos is the fact that they do pay a dividend.  Typically, growth stocks reinvest all of their income back into growth, but Arcos pays a decent 1.67% dividend.  That income stream won’t add much to our bottom line in the near term but what it will add is a bit of confidence that the management team will manage the company’s cash conservatively. 

Risks and Why We’d Sell

There are three specific risks that cannot be understated: Brazil, large capital expenses and the previously mentioned currency risk.   Brazil is a double edged sword for Arcos.  It is their largest market and a market whose middle class is growing as 29 million Brazilians joined their middle class from 2003 to 2009.  However, that economy is slowing down and its currency is under pressure even more so after their central bank cut rates to historic lows.  When you combine the slowdown in Brazil and the multi-currency exposure of the business with their capital expenditure investments that are fueling future growth there is a chance for slip-ups in the short term.

Speaking about Brazil, with its economy a near term risk for the company, Burger King’s (NYSE: BKW) interest in the country is a longer term risk.  The newly public company was taken there by a Brazilian based private equity group that bought the company from another private equity group.  Burger King has a master franchise agreement with Vinci Partners which is focused on growing the brand in Brazil.  If they are able to gain traction and gain market share, it could signal serious trouble for Arcos.  However, McDonald’s has done fine battling BK and other fast food companies here in the states, showing that there is room for more than one.

The Trade

Still, despite these risks, I believe the long term potential by far outweigh the near term risks.  To further hedge out our risk we’ll be investing capital that was generated by the portfolio, not what would have been hard earned savings.  So far the portfolio has generated $2,048.74 of option premiums and $1,000 of that is set aside for our written put on Rex Energy.  We’ll be taking another $1000 or so of that cash and investing it in a 1% allocation in Arcos Dorados.  That’ll add 70 shares of Arcos to the portfolio and represent the maximum allocation we’ll allow for Arcos. 

Finally, two things that investors need to keep in mind when making an investment in Arcos is the timing of their next dividend and earnings.  Their next dividend will be paid on July 20^th to shareholders of record July 18^th.  While the six cent a share dividend isn’t critical to our returns, over time dividends do provide a larger portion of a stock’s return.  Finally, the company reports earnings on August 7^th and there could be increased volatility surrounding the company if earnings are not well received.   We are not worried about messing around with either date as we’re investing for the long term.  If you are concerned about their next quarter earnings you can wait to buy, just remember this is a long term investment in a company that has decades of growth ahead of it.

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