Today, we bring a thesis of a company that operates in a region of the world that we find very interesting for the coming years, but that we have talked about very little until now, Latin America. The company, Arcos Dorados ($ARCO), is the biggest franchisee of McDonald’s globally, and operates in 20 Latin American countries.
What is Arcos Dorados? $ARCO
Arcos Dorados represents McDonald’s brand in Latino America and the Caribbean, being the largest franchisee in terms of revenues (4% of the total) and number of restaurants (6% of worldwide restaurants). It has an exclusive partnership to own, operate and sub-franchise McDonald’s in 20 countries in South America and the Caribbean (in all the most populated countries: Mexico, Brazil, Argentina, Colombia, Peru etc.) where the company already operates 2,313 restaurants at the end of the first quarter. 29% of its restaurants are sub-franchises, although the share of revenues from them is only 4.5% (this number has been quite stable during the last five years).
As you may already know, the franchising business is of much better quality, with higher margins but lower revenues. We want to make clear that Arcos Dorados is not comparable to McDonald’s. While McDonald’s main income stream is the rental income that the franchisees pay, $ARCO is the one paying the royalty fee to McDonald’s. Arcos Dorados main revenue source is the operations of the restaurants.
Arcos businesses is much more similar to a normal restaurant chain. They make an initial investment to buy or lease the land, the equipment and the building to later either operate it or sub-franchise it. If the revenue source was the royalty fee from the sub-franchises, we would be talking about a different kind of business.
The royalty fee expected to be paid to McDonald’s is around 6% of total revenues in 2023 and 2024. We think it will probably rise slightly onwards. This is why McDonald’s EBITDA margin is an extraordinary c.50%, and Arcos stays around 10%. The royalty fee from sub-franchised restaurants to Arcos is 5%.
The company divides their geographic revenues in three different regions: Brasil, NOLAD (North Latin America – main countries are Mexico, Costa Rica and Panama) and SLAD ( South Latin America – main countries are Argentina, Chile and Colombia). In 2022, the revenues evolution per region during the since Covid has been as follows:
The operating margins are much higher in Brazil (13.1%) vs 6.7% and 8.5% in NOLAD and SLAD, respectively. This is mainly due to the higher percentage of sub-franchised restaurants in Brasil. When analyzing the margins in future results it is important to understand the mix between regions. For 2023, we expect the Brazil division to perform very well with also significant growth for the other two regions.
2) Why do we believe that an opportunity exists?
We were initially attracted to Arcos mainly for two reasons:
a) The opportunity to gain exposure to South America with a defensive approach. This is, having a clear view on what is the dynamics affecting the company (trends on food and labor inflation, customer demand, etc.), and limiting the country risk that would have investing in only one country of Latin America or the Caribbean.
b) The strength of McDonald’s brand and the disparity in valuations with other public restaurant chains.
As we continued deepening into it, we liked the cared strategy of growth for the coming years backed with excellent operations from recent history. All the sector was deeply affected by Covid and Arcos as one of the main players in the industry has strengthen their competitive and financial position. Now, the strategy is clear, open more restaurants of the most profitable kind the company operates in strategic locations and implementing digital solutions that drive the ARPU up.
Let’s analyse the feasibility of their strategy, examine their financials, and compare them with their peers to get a better idea of the investment opportunity’s magnitude. Additionally, we will provide our perspective and conclusions.