Arcos Dorados Holdings Inc. (ARCO), incorporated on December 9, 2010, is a McDonald’s franchisee. As of December 31, 2010, the Company operated or franchised 1,755 McDonald’s-branded restaurants, which represented 6.7% of McDonald’s total franchised restaurants globally. It operates McDonald’s-branded restaurants under two different operating formats, Company-operated restaurants and franchised restaurants. As of December 31, 2010, of its 1,755 McDonald’s-branded restaurants in the territories, 1,292 (or 74%) were Company-operated restaurants and 463 (or 26%) were franchised restaurants. These restaurants are operated under 4 geographically based divisions: Brazil, Caribbean, North Latin America and South Latin America. ARCO stock trades on the NYSE and closed at $13.69/share as of May 25, 2012.
The Economics of the Master Franchisee
Arcos is a Master Franchisee with McDonald’s. Under the MFA (Master Franchise Agreement), Arcos is required to own or enter into long term lease for all the real estate and store that it operates either directly as a company owned restaurant or through its own franchisees. For the restaurants that it franchises to a franchisee, it charges rent for the real estate, either a fixed amount or a gross % of sales, whichever is greater. Arcos pays the franchise fees to McDonald’s for all the company owned restaurants from its gross receipts. For the restaurants that it franchises, Arcos collects the franchise fees and passes them on to McDonald’s. In the situation that the end franchisee is unable to pay the franchise fee, Arcos is still liable to pay it to McDonald’s.
Essentially, for 74% of its restaurants, it is a franchisee to McDonald’s and for the remaining 26% it is a landlord collecting rent.
Since the company was incorporated in Dec 2010, the historical financials are scant. However, the scale of the operations allow us to make certain judgments based on the financials that do exist.
Balance Sheet and Asset Based Ratios
The following table summarizes the Balance Sheet as of Mar 2012.
|Cash/Equiv||$ 144.30||Payables||$ 147.70|
|Inventories||$ –||Short Term Debt||$ 6.70|
|Current Assets||$ 549.10||Current Liab||$ 558.40|
|Fixed Assets||$ 1,069.90||LTD||$ 533.40|
|Goodwill/Intangibles||$ 58.70||Total Liabilities||$ 1,196.80|
|Total Assets||$ 1,890.20||Equity||$ 728.70|
|Ratios||Market Value||$ 2,868.06|
|P B Ratio||3.94||P/TBV||4.28|
First thing I notice is that the Price to Book is quite high at almost 4. This is common for businesses that are not asset intensive, but Arcos IS asset intensive company with vast amounts of real estate and property holdings, not to mention the equipment. Assets that are leased would bump up the P/B ratio. Out of the 1755 restaurants, the company owns the land for 510 of them, or 29%. It owns the buildings for almost all of the restaurants except 12. So perhaps if all the leases were converted to ownership interest, the P/B ratio will fall to about half or about 2. This is still a bit high in my opinion.
And how well is the company utilizing its assets? Its Return on Assets is 5.6%. Being a franchisee is a low margin business.
My further concerns include a current ratio below 1. In a crunch, the company does not have enough current assets to pay off its short term liabilities. The company seems to be addressing this gap by issuing more bonds. At this time, I am not worried about its debt load.
Overall from the Asset quality and valuation basis, I am neutral on the stock.
Income and Growth
The other source of value is of course from the growth the company is generating. From 2010 to 2011, the company grew its revenues by 21% while the net income growth lagged behind at 9%. In Q1 2012, the company grew its revenues by 11% while the net income fell 28%. The company blamed lower operating results (duh), higher tax charges, and higher foreign exchange losses. Going forward, the company has guided 2012 revenues to grow in 15-17% range and adjusted EBITDA growth of around 10-12%.
For me, the company needs to bring up its current ratio to about 2. This means additional Long Term Debt of around $550 m. Using the latest debt issuance as a guidance for the cost of debt at 10.25%, this will imply and additional interest payment of about $56.4 m or about 25.5% of last years EBIT. With the projected 10-12% EBITDA growth, if the company does choose to bring its current ratio up to a comfortably liquid position, it might actually see an EBITDA decline (trade off being better liquidity on the balance sheet). I assume the company will choose a middle path so these numbers are just illustrative.
(They can also issue more equity, but that would be dilutive and is clearly a worse case for investors)
To put all this in context of the current stock price, the trailing P/E ratio today is 27.38 and the company pays a dividend of $0.06/share per quarter or 1.7% yield. It is not an undervalued stock from earnings multiple perspective.
From the income and growth perspective, I am not comfortable that the company can keep up the growth with the balance sheet it has currently and it will need to slow down.
Operating in Latin America has certain political risks. There are also foreign exchange risks, which were a factor in raising expenses for the company. Some of these risks are unpredictable so it is important to demand a discount for safety. I am not sufficiently familiar with the business environment in Latin America to put a number to this discount, but at the current prices it does not matter.
The company has a short history in the market. While it is growing its revenues at a good clip, it has come at the expense of its balance sheet quality. I anticipate the growth to slow in the coming year as its balance sheet becomes more strained. The stock price today offers a more optimistic view then is supported by its financial condition.