Wait on a Latin American Big Mac

Arcos Dorados, the largest McDonald's franchisee in the world, has seen shares fall 45% from August 2011.

By Jim J. Jubak May 8, 2012 1:22PM
Image: McDonald’s restaurant © AFP/Getty ImagesWhen 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 Aug. 16, 2011, 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 tumbled 17% on 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 was down 1.3% Tuesday.)

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 price-to-earnings ratio has climbed because earnings have repeatedly disappointed. Using actual 2011 earnings and the Aug. 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 Sept. 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 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 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 (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.

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. 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 the most recent quarter, see the fund's portfolio here. 
May 8, 2012 2:20PM
Can't afford to eat there any more the prices went way up and the meat on the burgers shrunk, the big mac is hardly anything more then bread now, fries and soft drinks cost way to much over $5 for a burger now, might as well just go to Red Robin for the same price they give you endless fries and drinks there, gave up on Mcdonalds use to like them.
May 8, 2012 2:11PM
I think I'll do what you do. Just watch.
May 8, 2012 2:38PM
My crystal ball says that the market will recover at least half of its loses by closing.  You can set your watch by when the PPT comes to the rescue.
May 9, 2012 12:44AM
McD's needs to sell breakfast items 24/7 along with their other menu items.
May 8, 2012 9:20PM
I think I'll do what you do. Just watch.

You're right, never thought of it before but that's all this guy does.  He either ends with with "Keep an eye on it"  or "We'll have to wait and see" or now it's "We'll have to keep it on the watch list"  LOL! 

May 8, 2012 3:19PM
May 9, 2012 12:42AM
If McD's is going down, everyone better get ready for a crash.  The golden arches make gold even in the poorest economies.  
May 9, 2012 1:15AM

Unless your name is Warren Buffett and you have billions of other people's money to spend, why buy during a correction? 


I try not to spend too much time catching a falling knife. Messes with my golf swing.


Anyway, park it in cash or dividend plays and wait til we see what happens in November.


And get outside, enjoy the sunshine. Summers here.



May 9, 2012 7:25AM

When you eat that crap from McDonald's, can't you hear your body screaming out at you to "Stop it, for God's sakes!"?    Look at the fat hogs waddling in and out of the doors.  "Super size that!" they shout.


Look at the drive thru between 5-6 PM.  The working moms have picked up their children from day care, then take them to the drive thru lane.  There, they get a sack full of crap, then mommy can go home, relax, and enjoy her smoking dope with her boyfriend. 


On payday, the drive-thru is full of jalopies with $500 boom boxes.  There's Mr and Ms Welfare chain-smoking as they wait for their sack of trash.  Scratching off lottery tickets as they go.


OK, whiney hineys, time for you to go snivel.  Losers, you'll never learn!

May 8, 2012 2:30PM

Mr. Sorros - thanks you so much for the gold dump to finance your guy. As a little guy I need to buy when you do this. If your guy get's back in - I will make some big money.

P.S. don't go to Russia on vaca as I think the warrant is back in!Tongue out


I don't think he eats at the Mac store like we do...


No PPT today I think "Words of..." Money spent.


Wow - I see I'm in the wrong chat room. Just so I can get a few more thumbs up - how about this...


Ya - OK, well we just need more checkout cards - Can we get that one that makes sure we get 1/4 pounder with fries and it's inspected by the USDA to be 100% approved by the US government to be100% inspected by the guy who is next in line to be the guy who inspects the value meal. It's not too much to ask is it? and why then does it cost a half days pay to get one. I think the Government needs to take over burgers and fries so we all get the same amount. Sorry need to take a nap that shake made me sleepy.


PSS. Kris, when the goverment takes over the burger - you will need a 100x zoom to see the meat(Meat=what they say meat is). Wake up America!


Hey PPT guy, I'm sorry we are both right. I was wrong about Sorros, he did have enough $ to get the market 1/4 of the way back. I will bet it's better tomorrow with all the folks who have anything to invest. I hope it all works out - I've been out for 7 years...

May 8, 2012 9:15PM
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