It's easy to find investing opportunities among banks, commodity-driven firms, and other capital-intensive businesses in emerging markets. It's much more difficult to find companies with substantial exposure to consumers in emerging markets, so when these companies go on sale it pays to take note.
With 1,840 restaurants in Latin America and a share price almost 50% below its high from last year, Arcos Dorados (NYS: ARCO) is one of those opportunities. I suspect the company has at least another tough quarter or two ahead, but the price is attractive enough for me to add it to the Orange Portfolio now.
Why I'm buying Arcos Dorados
There are approximately 500 million people living in the 20 Latin American countries where Arcos Dorados is the exclusive franchisee of McDonald's (NYS: MCD) restaurants. But the company has just 1,840 restaurants in the region.
Compare that to the U.S., where we have more than 14,000 McDonald's restaurants for just 313 million people, and you start to get a feel for the potential opportunity Arcos Dorados has as the exclusive McDonald's franchisee in Latin America.
If you're thinking that higher incomes in the U.S. allow us to spend far more on junk food than Latin American consumers can, you're right. But incomes in Brazil and other Latin American markets have been on the rise, and all it takes is one look at the $10 billion in sales at Latin American bottler Coca-Cola Femsa (NYS: KOF) to know that Arcos Dorados has a better-than-average chance at growing its $3.7 billion in sales.
With Brazil providing a little more than half of the company's sales, the country serves as Arcos Dorados' primary growth market. The Brazilian government has claimed that some 40 million Brazilians entered the middle class between 2003 and 2011, so it is little wonder that Arcos Dorados has seen such strong growth there. In the past two years its sales have grown by 57% in Brazil, and overall sales growth has averaged 13% over the last five years. With the country's young population, growing incomes, and an under-penetrated fast-food market, the growth potential for Arcos Dorados is impressive.
A value-menu price
The future looks bright, but there are challenges to growth in the short term. In the last year Brazil has battled rising inflation, a big drop-off in consumer lending, an increase in loan defaults, and slowing GDP growth as a red-hot lending market has rapidly come back to normal. Fortunately, inflation is starting to slow, but the soft Brazilian economy has led to slower-than-expected growth at Arcos Dorados, and not surprisingly, a steady share-price decline.
The decline has knocked the shares down below 12 times operating cash flow. That's an attractive price given the growth potential, and there are a couple of one-offs in last year's results from IPO-related fees and the refinancing of some debt. With 86 restaurants opened in the last 12 months, and most of them in the fourth quarter of last year, Arcos continues to invest for growth and is well positioned for when Brazil and other Latin American economies resume growth.
What could go wrong
Inflation is a constant challenge in Latin America. In an attempt to maintain margins, there is the risk that management gets the value proposition wrong and raises prices too much or hurts margins by being too slow to react. I expect we'll see occasional surprises from quarter to quarter on this front, but since most of the management team has more than a decade of experience, I think they'll get the pricing mix right for the most part.
Arcos Dorados doesn't have a single restaurant in China, but the Asian giant could pose problems for the company if it continues to stumble. China is a big buyer of iron ore, copper, oil, and other basic commodities, and Latin American countries are big suppliers, making Chinese demand important to the region's growth. Right now, China is still growing, just at a slower pace. If growth slows further, it likely means slower economic growth in Latin America, which could mean Arcos Dorados has gotten ahead of itself with store openings. If this situation develops, I'll adjust my valuation expectations accordingly.
Arcos Dorados offers an experienced management team, a powerful global brand in fast-growing emerging markets, and a reasonable valuation. The primary negatives are the current economic headwinds, and while they may drag on for a little bit longer, they won't slow Arcos Dorados down forever.
At the time thisarticle was published Nathan Parmelee is a co-advisor of Champion Shares Pro and Share Advisor in the U.K. You can follow his real-money Orange Portfoliohereand his Twitter feed at @GlobalFools. Nathan owns shares of Arcos Dorados.The Motley Fool owns shares of Arcos Dorados and McDonald's. Motley Fool newsletter services have recommended buying shares of McDonald's.The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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