How Arcos Dorados Can Succeed as a Franchisee

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

A few years ago, amid the pending IPO for McDonald’s (NYSE: MCD) franchisee Arcos Dorados (NYSE: ARCO), analysts began to question the franchisee system’s profitability. Some pointed to franchisor advantages, others to the underwhelming history of franchisees. What's more, those concerns have seemingly turned out to be true; shares of Arcos Dorados have struggled tremendously since the IPO. It’s fair to ask: were those criticisms warranted?

A history of Golden Arches
Arcos Dorados translates to “Golden Arches” in Spanish, a clever moniker used interchangeably with “McDonald’s” to refer to the popular franchise in parts of Latin America. The company operates or franchises more than 1,970 McDonald’s-branded restaurants throughout Latin and South America. Here is how the agreement works:

1. Arcos pays McDonald’s an “Initial” franchising fee. Every time Arcos opens a new restaurant, McDonald's receives a payment. This fee varies depending on the location and type of acquisition. However, McDonald’s typically requires a 40% down payment on new restaurants, and the two companies’ agreement requires significant re-investments from Arcos -- in 2012, the company's capital expenditure totaled $294.5 million.

2. The Master Franchise Agreement (MFA) demands Arcos spend at least 5% of yearly revenue on marketing.

3. Arcos pays a royalty on revenue, currently 5%, as a price for carrying the McDonald’s name. In the long run (ten years or more), that percentage will increase to 7% of revenue.

For those keeping track, that’s a lot of money Arcos can’t control. For 2012’s $3.8 billion in sales, $180.5 million went to McDonald’s because of royalty fees. Add in the required marketing and expansion costs, and Arcos had no say on spending around 15% of its revenue. The good news, of course, is that the majority of that spending benefits Arcos Dorados, not just McDonald’s.

What’s more, the current reinvestment agreement expires after 2013, at which point Arcos can regain some control over expansion activities. In the meantime, the growth spending makes sense. Where Arcos Dorados operates, each restaurant represents 300,000 people; in the United States, a McDonald's restaurant or franchise will serve only 22,285 people.

Burger King and Carrols
Thankfully, the franchisor/franchisee relationship has a public precursor: Burger King Worldwide (NYSE: BKW) and franchisee Carrols (NASDAQ: TAST).

Carrols has clearly kept pace with the parent company from a price standpoint. A spin-off in 2012 reduced its share price, but after adjusting for that shift, Carrols has grown steadily since going public in late 2006. Burger King also posted impressive numbers after going public (again) in 2012 -- in fact, the company has outperformed Carrols since that time -- but Carrols boasts longer, more sustained share price success (after accounting for the spin-off).

TAST data by YCharts

Although investors might worry about Carrols revenue loss from 2011 to 2012 (over 30%), the company actually grew restaurant sales during that period, 7.1% at existing restaurants and 55.3% after accounting for newly acquired franchises; Carrols acquired 278 stores from Burger King shortly after its spin-off. The spin-off, while a long-term strategic play, pummeled revenue in the short-run. On the flip side, Burger King posted 17% profit gains despite huge revenue losses; the company re-franchised a net of 59 companies, losing revenue -- and costs -- of running the individual units.

Carrols at least makes a strong case as the superior stock for the future. Burger King only grew sales 5.9% (system-wide) or 3.2% (same stores) in 2012, against Carrols' 7.1% same-store sales growth. No one doubts that earning royalties from franchised restaurants generates higher margins than, say, running the restaurants independently. But, Carrols demonstrates that the franchisee can still outgrow the parent company, so long as the franchisee represents an “elite” swath of franchises -- and so long as the franchises themselves are profitable.

The future for Arcos
Back to answering the underlying question: can a franchisee outperform the franchisor? On all accounts, the answer is a resounding “yes.” Two factors would seem to threaten the franchisee business model: upper management taking away profits, and a business model doomed by lagging growth.

As the Carrols/Burger King scenario demonstrates, the franchisee can outgrow the franchisor. A number of other factors, including lower margins on those same-store sales, could inhibit profit growth, but a franchisee can clearly buck the trend, especially when the parent company is struggling with spotty overall demand and the franchisee is located in a small, high-growth market.

That brings us back to Arcos Dorados. It looks like a stretch to say that McDonald’s red tape kills Arcos’ growth. Both companies agreed to expansion measures because they saw a potentially high-growth market, so that spending won’t exactly inhibit the company’s bottom line. As to the 5% marketing costs, McDonald’s shells out north of 7% of revenue on marketing; is a 5% requirement so much to ask?

Finally, Arcos Dorados churned out a 7.4% operating margin after paying out royalties to McDonald’s in 2012, so it still manages to earn money -- even right now. Once it can cut down R&D expenditures, part of which includes a debt from its IPO, that number should jump further, and all of this without any help from the main reason investors were so excited about Arcos Dorados in the first place: the high-growth potential of Latin America.

Whether Latin and South American economies ever grow at their expected rates might ultimately determine whether Arcos can generate higher returns than McDonald's. And, even as GDP growth slows -- Brazil's growth, for instance, slipped to 0.9% in 2012 -- many economists still predict a rebound. McDonald’s products are not exactly luxury goods, either, which should also enhance Arcos’ options. Plus, for all the criticism of Arcos’ growth opportunities, McDonald’s profit has barely managed 2% annualized growth during the last five years.

Arcos Dorados faces plenty of risks. For one thing, as the Brazilian real continues to increase against the dollar, even increasing profits means a weaker bottom line in U.S. dollars. But the company relies on highly potent markets, increasingly manageable costs, and one of the best global brands in existence -- one study found that 88% of global consumers recognize the Golden Arches. The future looks bright. And, if the ever-looming risk does stunt Arcos’ growth, it won’t be a franchisor/franchisee issue that does the deed.

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Will Chavey owns shares of Arcos Dorados. The Motley Fool recommends Burger King Worldwide and 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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