Debt Is a Universal Language

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Take a great brand, combine it with a huge market opportunity, and you should have a terrific investment opportunity. This should be the story behind Arcos Dorados (NYSE: ARCO). Here is a company with the rights to open franchises in Latin America for McDonald’s (NYSE: MCD), which should be the opportunity of a lifetime. The company is reporting respectable growth, but there is one big problem standing in the way.

I Wish This Were the Whole Story
In the restaurant industry, one of the key measures of success is comparable sales growth. Arcos Dorados is an international growth machine that has consistently posted positive comparable sales growth. Compared to some of the company’s peers, their same-store sales growth is impressive. In the last quarter, Arcos Dorados posted comparable store sales growth of 9.9%.

Some of Arcos Dorados' peers are the aforementioned McDonald's, Yum! Brands (NYSE: YUM), and Starbucks (NASDAQ: SBUX). Each of these companies has strong international operations, and some even go head to head with Arcos Dorados for customers. Looking at McDonald’s same-store sales growth of about 1%, Yum! Brands' gain of about 2%, and Starbucks' same-store sales up about 6%, you can see just how well Arcos Dorados is doing. It would be one thing if Arcos Dorados posted these impressive numbers in just one quarter, but the company isn’t a flash in the pan.

The company’s strong comparable store sales growth has caught analysts’ attention as well. This is the second reason investors need to watch Arcos Dorados: the company has the strongest expected earnings growth over the next few years. The average analyst expects earnings growth of more than 27% from the company.

Considering that Starbucks is seen as a champion growth stock, and analysts expect the company to post EPS growth of more than 19.5%, certainly investors should take notice of Arcos Dorados. When you consider that McDonald’s and Yum! Brands are also well loved stocks, and they are expected to grow earnings by 8.4% and 11.1%, Arcos Dorados looks like a huge opportunity.

Clearly a Better Value
Another positive for Arcos Dorados investors is the company’s relative value compared to their peers. Since each of these companies pays a dividend, and has a different growth rate and P/E ratio, the best way to compare them directly is using the PEG+Y ratio. This ratio takes into account the company’s yield and growth rate total, and then compares this figure to the company’s projected P/E ratio. Since a higher yield and growth rate versus a lower P/E ratio is a better value, the higher the number the better.

Of these four companies, the one that is relatively least attractive by this ratio is Yum! Brands. The company has the second lowest yield at about 1.85%, and has the second lowest expected growth rate at 11.12%. Given that investors are paying over 23 times earnings for this combination of traits, the company’s PEG+Y ratio is 0.55. The second least attractive value is McDonald’s, with a 3% yield, an 8.46% growth rate, and a P/E ratio of just over 17. This gives McDonald’s a PEG+Y ratio of 0.65.

Between Starbucks and Arcos Dorados, Starbucks carries a growth rate of 19.58%, but pays the lowest yield at just 1.22%. The stock isn’t cheap either with a forward P/E ratio of over 31, which gives it a PEG+Y of 0.66. By comparison, Arcos Dorados is expected to grow by 27.1% and pays a yield of 2.05%. This gives investors an expected total return of 29.15%. Given that the company’s 2013 projected P/E ratio is 30.61, the stock’s PEG+Y is 0.95. Based on these numbers, clearly Arcos Dorados is a better value.

All the Potential in the World
Though everything looks great when it comes to Arcos Dorados' growth, the company is spending itself into trouble. One thing all investors need to understand is the company’s financials. When it comes to expanding restaurant concepts, one issue that can derail their growth is too much debt. Though everything else looks good with Arcos Dorados' stock, investors need to be careful of the company’s balance sheet.

One way to tell if a company might be carrying too much debt is by looking at their interest expense versus their operating income. The company with the least exposure in this way is Starbucks. Starbucks only spends about 1% of their operating income on interest, versus YUM Brands spends 6.37% and McDonald’s spends 6.57%. By comparison, Arcos Dorados spends 40.21% of their operating income on interest. When a company spends $0.40 of every $1 of operating income you know they won’t have a lot left over once you subtract capital expenditures too.

While the Arcos Dorados story sounds promising, the company’s relatively expensive debt load has me on the sidelines. If the McDonald's of Latin America wants to prosper, they need to address this issue and quickly. If the company continues with this type of debt burden, all the potential in the world won’t mean a thing.

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Chad Henage owns shares of McDonald's. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of Arcos Dorados, McDonald's, and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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