Can Arcos Dorados Withstand the $7 Big Mac?

08/16/2011 2:01 pm EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

Just looking at growth rates, if you want to load up your portfolio with Big Macs, you should buy Arcos Dorados (ARCO) instead of McDonald’s (MCD).

On August 1, the largest McDonald’s franchiser in South America reported second-quarter earnings of 7 cents a share, four cents a share above analyst estimates. Revenue climbed by 28.7% from the second quarter of 2010. (The company only went public in April.)

For all of 2011, the company told investors to expect revenue growth of 22% to 24%—up from prior guidance for 15% to 17% growth—and net income growth of 35% to 45%.

Sure beats the 11.3% earnings growth that Wall Street analysts are projecting for McDonald’s in 2011.

No wonder McDonald’s is trading at 17 times projected 2011 earnings and Arcos Dorados trades at 31 times earnings. That’s a P/E to earnings growth ratio of 1.5 for McDonald’s and .89 for Arcos Dorados (using the lower end of the company’s 35% to 45% net income projected growth rate.)

Time to snap up some shares, right? Even though the stock has rebounded to nearly $25 today, near the top of its 52-week range, from $22.03 on August 8 and $19.98 on July 18.

Well, not unless you understand exactly how tough a battle Arcos Dorados faces battling inflation in Argentina and Brazil.

To my mind, the inflation risk is high enough that I’d like to pay no more than $22 a share for the stock. And I’d be much happier buying at $20 or less. And with volatility being what it is right now, I think you’ve got a shot at those lower prices before the summer is out.

Here’s the problem: According to The Economist’s July Big Mac Index, Brazilians pay the equivalent of $6.16 for a Big Mac, about 50% more than the sandwich costs in the United States, and Argentines pay about 20% more.

And with wage and ingredient costs pushing rapidly higher in those two economies, Arcos Dorados customers are facing even higher prices in the future.

So far, the company has been able to raise prices, increase restaurant productivity, and juggle wage increases to keep ahead of the inflationary push. But if the global economy is indeed slowing, threatening to take an already slowing Brazilian economy into an even lower gear, I’ve got to wonder when consumers in Brazil start to push back against higher prices by buying fewer Big Macs.

I don’t doubt the company’s long-term growth potential—I’d just like to pay less right now for the short-term risks.

Certainly, management at Arcos Dorados faces operational challenges that are a degree (or two or three) more difficult than those faced by McDonald’s. “We raise menu prices as fast as we can and then delay salary increases by a couple of months,” said Chief Operating Officer Sergio Alonso in the company’s second quarter conference call.

Playing that wage-delaying game is critical now in Argentina, where private economists put inflation at 20% or higher. I don’t know if it will work in Brazil, where the government is expected to raise the minimum wage by 13.5% to 14% in January 2012.

Brazil is the company’s biggest division, and reported 26.9% year-to-year revenue growth in the second quarter of 2011.

As of August 16, I’d adding Arcos Dorados to Jim’s Watch List.

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, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Arcos Dorados as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio here.

Related Articles on GLOBAL