Problems and Opportunity With the McDonald's of Latin America

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

After climbing 30% for the year in mid-May (easily outperforming the S&P 500 by 10% at the time), shares of the Latin American restaurateur Arcos Dorados (NYSE: ARCO) are now trading in slightly-negative territory for 2013. Like last year and the year before it, we need to ask yourselves “What exactly is wrong with the McDonald’s (NYSE: MCD) of Latin America?”

Formed in 2007, Arcos Dorados is the result of former McDonald’s executives purchasing the company’s Latin American regional operations. The purchase gave Arcos Dorados the rights to franchise and operate McDonald’s restaurants in Mexico, Central America, South America and the Caribbean; a franchise region with a combined population 580 million people. Today Arcos Dorados operates 1,959 full-service McDonald’s restaurants, 339 McCafé restaurants and 1,997 kiosk-like Dessert Centers.

No-Brainer or no brains?

In theory, although certainly not in practice, Arcos Dorados seemed to be a no-brainer investment opportunity. You (1) take the McDonald’s concept made so popular in the United States, (2) bring it to Latin America with its half billion population and a young emerging middle-class, (3) operate about 2,000 McDonald’s restaurants with the potential thousands of additional restaurants worth of growth in the future and finally (4) roll around on a pile of various Latin American currencies. What can possibly go wrong?!

Well… a lot can, apparently.

Exchange rate nightmares

For multinational companies, currency fluctuations are a typical concern from time to time. For Arcos Dorados, a multinational company that operates entirely in Latin America and reports its earnings in U.S. dollars, currency fluctuations have been an absolute nightmare!

Countries across the region have seen their currencies weaken against the U.S. dollar; some more than others. Brazil is Arcos Dorados’ largest market, where 37% of its restaurants are located and about 47% of its revenues are derived from. Over the past two years, the Brazilian Real has fallen more than 31% against the dollar. Last quarter, Arcos Dorados’ Brazilian division grew organic revenues by 15.9%. But thanks to the exchange rate, the reported revenue growth was actually just 2.4%. Ouch. Venezuela, while not as meaningful a source of revenue for Arcos Dorados as Brazil, has been another area of concern. Early this year, that country’s leadership essentially devalued its currency by about 32% overnight. Ouch again.

Brazil protests everything

Another recent issue has been protests in Brazil. The protests initially began in early June as an organized effort against public transportation price increases, but quickly spread to encompass other issues such as infrastructure, healthcare, education, the higher cost of living, government spending and political corruption (or pretty much everything). These protests triggered a broad sell-off of Brazilian and other Latin American equities, which included Arcos Dorados’, producing its most recent share price decline.

The population opportunity

Although the absolutely poor performance of the stock might indicate otherwise, there is still much to like about Arcos Dorados. As mentioned previously, there are as of the last official count (Dec. 2012) 1,948 full-service McDonald’s restaurants that Arcos Dorados operates in a region of 580 million Latin Americans (or 1 restaurant for nearly ever 300,000 people).

Over in the United States there are about 14,000 U.S. McDonald’s locations with a population of 312 million people (or 1 restaurant for every 22,285 people). For Latin America to have the same restaurant-to-people ratio as the United States, Arcos Dorados would need to build and operate an additional 24,078 new restaurants. Of course a little over 26,000 total Latin American McDonald’s restaurants might be overly optimistic growth estimate. Even if Arcos Dorados were to build half of that or even just a forth, that could leave the possibility of 6,000-12,000 new restaurants worth of growth ahead for a company with only 2,000 restaurants as of today.

Sports catalysts

Another reason to like the company is the future catalysts that could be the impetus for a large share price move up. In June 2014 and August 2016, Brazil will play host to the FIFA World Cup and the Summer Olympics respectively. As with previous World Cup and Summer Olympics, both of the events will receive major sponsorship by McDonald’s. Complete with a massive TV, radio and internet advertising campaigns, local events, restaurant promotions and sporting event venue retail exclusivity, the McDonald’s brand will be plastered everywhere in Brazil and across the region.

Foolish bottom line

Although Arcos Dorados is far riskier than simply investing in McDonald's Corporation itself, that risk is justified given the possible rewards. With the potential for much greater returns over McDonald's and the stock down 45% since the 2011 IPO, today's prices present investors with an opportunity to buy the company's growth in Brazil and elsewhere at a substantial discount. It is for those reasons that I purchased a small position in Arcos early last week. And if Latin American currencies strengthen, protesters' grievances are addressed and we get closer to the World Cup and the Summer Olympics, that could be just that thing needed to alter the downward trajectory of this supposed ‘no-brainer’ investment opportunity.

Matthew Luke owns shares of Arcos Dorados. The Motley Fool recommends McDonald's. The Motley Fool owns shares of Arcos Dorados and McDonald's. 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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