I'd keep Arcos Dorados (ARCO) on my watch list for just a little longer even after Friday's big tumble

05/07/2012 3:51 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

When I put Arcos Dorados (ARCO), the largest McDonald’s (MCD) franchisee in the world and the largest restaurant operator in Latin America, on my watch list back on August 16, 2011 http://jubakpicks.com/2011/08/16/faster-growth-than-mcdonalds-but-arcos-dorados-faces-some-unusual-risk-too/#symbol-ARCO  I said I loved the stock, but would sure like to buy it a bit lower.

Well, it’s down 45% from that August price—having tumbled17% on Friday, May 4, when its first quarter earnings missed estimates by 6 cents a share. The company reported earnings of 12 cents a share when analysts were expecting 18 cents. Earnings for the first quarter of 2011 were 15 cents a share.

Is it time to bite into a Latin American Big Mac? (The stock is down 0.63% today, May 7, as of 3:40 p.m. New York time.)

The huge tumble on Friday is intimately related to the reason I decided not to buy in August 2011. The shares then traded at a 31 times trailing 12-month earnings. Turns out that the company’s earnings haven’t been keeping up with expectations, though. If you look at what the company has earned over the four quarters of 2011, instead of falling with earnings growth, the stock’s PE has climbed because earnings have repeatedly disappointed. Using actual 2011 earnings and the August 12, 2011 share price the price-to-earnings ratio climbed to 46.4.

Or rather that would have been the price-to-earnings ratio at the end of 2011 if the stock hadn’t been falling for most of the last part of 2011. From the September 8, 2011 high to May 3, 2012, the shares were down 63%.

The almost 17% drop on May 4 on the company’s earnings miss wasn’t so much an over-reaction as a sign of some investors finally giving up on the shares.

So do you want to buy here? I recommended the stock as one of my six stocks from elsewhere http://jubakpicks.com/2012/05/04/hey-there-are-stocks-beyond-the-headlines-from-china-europe-and-the-u-s-here-are-6-from-elswhere/ just before the company reported.

Of course, you never buy just because something you fancied is down in price. It could actually be down for a good reason. And might even be headed lower.

So what’s the story with Arco Dorados’ earnings miss?

Some of it is a result of the slowdown in Brazil’s economy. Comparable store sales climbed 11.6% for the company as a whole but just 5.5% for Brazil.

Some of it is a result of the drop in the value of Brazil’s currency. Last year in the first quarter the real traded at 1.63 to the dollar. In the first quarter of 2012 the exchange rate was 1.82 to the dollar. That 10.4% decline in the real meant that revenue and earnings that Arcos Dorados earned in Brazilian reais translated into 10.4% fewer dollar in 2012 than a year ago. (The company also took a $6.6 million foreign exchange loss in Venezuela.)

Those problems in Brazil are significant for a company that derived 49% of its revenue from that country in the first quarter. You can see the currency effects mirrored in measures like the company's adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). In local currencies adjusted EBITDA grew by 8% but in constant currency growth came to 12%.

In addition Arcos Dorados got hit on the cost side by a mandatory annual increase in wages in Brazil ($28 million in system-wide higher wages for the quarter) that exceeded the increase in the average check in Brazil, higher royalty expenses ($5 million higher in the quarter), higher inflation in Argentina (21.3% in the quarter), and spending to upgrade the company’s information systems. I wouldn’t argue that upgrading information systems is an unpredictable cost, but higher inflation in Argentina might be (although given Argentina’s history, I wonder) and mandated wage increases bigger than price increases seems to me a reflection of a soft economy in Brazil.

After Friday’s punishment the stock had dropped to a price-to-earnings ratio of 28.4 on trailing 12-month earnings per share. That’s still not exactly cheap. McDonald’s (MCD) itself trades at a trailing 12-month PE of just 17.9.

The premium for Arcos Dorados is predicated on earnings at the company growing faster than those of McDonald’s. Way back in August 2011 that was certainly the case. For 2011 Arco Dorados had told investors to expect net income to grow by 35% to 45%. Earnings per share at McDonald’s were projected to grow by 11.3%. So while the price to earnings ratio for Arcos Dorados was higher than for McDonald’s, the ratio of PE ratio to earnings growth to (PEG ratio) was just 0.89 for Arcos Dorados and 1.5 for McDonald’s.

And for 2012? In its conference call the company said that the problems in the first quarter were worst in January and that the quarter got better in February and March. But—and I think this is important—the company didn’t talk about a second quarter turnaround but consistently pointed analysts to the second half of 2012. In other words the quarter reported in June could still have a nasty surprise or two before the second quarter recovery arrives.

Here’s what I think you ought to do. Wait a bit. Analysts will be busy recalculating their models over the next week or two and coming out with new—and lower—earnings projections. That will, in all likelihood, keep some pressure on the stock. See if the company confirms its current optimism about April sales and then how May ends up trending. At that point you can decide if you want to buy before the June earnings report—because it is looking better than expected—or wait out the chance of another negative surprise.

In other words, despite the drop in price, I’m keeping this one on the watch list for just a while longer.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Arco Dorados as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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