Brajesh Mishra

Rec: Arcos Dorados Holdings Inc. Position: Buy (ARCO: $18.89) April 16, 2012 Target: $37.00

Shares Out: 209.5M

Market Cap: $ 3,953.80

FYE: Dec

Concept: 1. Differentiated growth opportunity combining a dominant brand, growth industry, and an economically emerging region 2. Privileged business model with underappreciated pricing power and accelerating unit growth 3. Significant increase in store base will add meaningfully to earnings 4. Attractive return characteristics in core Brazilian market and potential turnaround in Mexico can lead to improving capital returns. Summary: Arcos Dorados Holdings Inc. (ARCO or the Company) represents an attractive investment with near-term catalysts. ARCO is McDonalds (MCD) largest franchisee and the market leader in the Latin American Quick Service Restaurant (QSR) sector. Since October 2011 through March 30, 2011, ARCO has traded down 18% (vs. S&P up 28%) driven by fears of deteriorating macroeconomic conditions in Brazil (including a depreciation of the Brazilian real vs. the US dollar) and increased concerns over beef-driven COGS and wage inflation. The current price of $18/share provides a compelling entry point to investors. Aided by an underappreciated pricing power and demographic tailwinds, I believe ARCO has the ability to double its store base while maintaining a strong balance sheet and improving on its current ROIC of 18%. Guided by near term macro-economic fears, the market expects ARCO to deliver an unreasonably pessimistic same store sales (SSS) growth rate of 3.5% on a constant currency basis. I believe the fair market value for ARCO today is $37/share. Company Background: Arcos Dorados Holdings Inc. has the exclusive right to own, operate and franchise McDonalds (MCD) stores in 19 Latin American and Caribbean countries. It is the largest QSR chain in Latin America with ~1800 units (~75% company-operated) and MCDs largest franchisee worldwide. ARCO went public on 4/14/11 and is using $152M in net proceeds to open 100+ units per year and reimage existing stores. The company reports in four segments: Brazil (35% of units), SLAD (30% of units) consisting of Argentina, Chile, Colombia, Ecuador, Peru, Uruguay and Venezuela, NOLAD (27% of units) consisting of Costa Rica, Mexico and Panama, and the Caribbean (35% of units) consisting of Aruba, Curaao, French Guiana, Guadeloupe, Martinique, Puerto Rico, Trinidad and Tobago and the U.S. Virgin Islands of St. Croix and St. Thomas.

Investment Thesis: 1. Ability to expand store base in the medium to long term. ARCO operates in 19 countries/territories representing a market of approximately 575 million people (larger than the US, UK, France, Germany, and Italy combined) in which the QSR sub-segment offers opportunity for significant growth. In many of the Territories, including Argentina, Brazil, Chile, Colombia, Ecuador, Mexico and Peru, the ratio of GDP PPP per McDonalds-branded restaurant is at least 2.5 times greater than in the United States. According to Euromonitor, from 2011 to 2015, the fast food segment in Latin America is expected to grow by 73% in Argentina, 60% in Brazil, 31% in Chile, 47% in Colombia, 41% in Mexico, 11% in Puerto Rico and 177% in Venezuela. Adjusted for GDP per capita vs. the US, I estimate that the current store base can almost triple (2.6x) from current levels since the ratio of QSRs per 1M people in Latin America is far less than the ratio in the US.

Figure 1. Store Potential Analysis Source: CIA World Factbook, Company reports

Reality Check: Guarding against optimism bias. Forecasting growth rates is fraught with danger. Over the 2000-2006 period, average 24-month forecast error for US sell-side analysts at the individual stock level 1 was 93%; the average 12-month forecast error was 47% . Buy-side analysts have fared no better. In a study conducted by Groysberg et al, buy side analysts had a 27% forecast error in the short term (0-3 months) and 2 a 68% mean forecast error in the long term (18 months and beyond) . To ensure that my forecasts do not suffer from optimism bias, my model uses the rate of store growth ARCO has committed to in its Master Franchising Agreement (MFA) with MCD. I assume ARCO will build no more than the 260 new stores it has committed to add between 2011 and 2013. Further, I assume the number is revised downwards by 10% in each subsequent 3-year period. All in all, between 2012 and 2022, I assume ARCO will increase store count by 900 stores or ~23% of the potential increase in store base shown in Figure 1. 2. Current price implies an unreasonably low same store sales (SSS) growth rate of 3.5% on a constant currency basis. Reverse engineering the current price using a discounted cash flow model shows that the market expects ARCO to grow at a SSS rate of 3.5% until 2022. I believe ARCO can easily exceed this hurdle when analyzed both in terms of ticket and traffic. a. ARCO can leverage its #1 market share to increase traffic by 3% annually. Underscored by MCDs brand halo and favorable demographics, I believe ARCO can increase store traffic by at least 3% annually. Demographics. As a business focused on young adults in the 14 to 35 age range and families with children, traffic will continue to benefit from the territories population size, and younger age profile vs. more developed markets. Based on data from the United Nations Economic Commission for Latin America and the Caribbean, ARCOs territories represented a market of approximately 575.9 million 3 people in 2010, of which approximately 28% are under 14 years old and 46% are under 25 years old.

1 James Montier, The Dangers of DCF, Mind Matters, September 9, 2008. The Socit Gnrale Group 2 Boris Groysberg, Paul Healy, Craig Chapman, Devin Shanthikumar, Yang Gui, Do Buy-side Analysts
Outperform the Sell-side? , March 2007

3 Report of the regional intergovernmental conference on ageing: towards a strategy for the

implementation in Latin America and the Caribbean of the Madrid International Plan of Action on Ageing, United Nations Economic Commission, November 2011.

Wage rate growth. In most markets, federally mandated wage rate growth is typically above inflation; in Brazil the formula is sum of the GDP growth from 2 years ago and last years inflation; this implies a 1314% wage rate growth in CY2012. I expect wage rate growth to mitigate cyclical pressures from fragile economies in developed markets. Brand halo. In 2010, Millward Brown Optimors annual survey of global brand strength ranked MCD brand as the sixth most valuable brand in the world and the most recognized brand in Brazil. In Latin America and the Caribbean the MCD brand benefits from an aspirational cachet as a destination restaurant with a reputation for safe, fresh and good-tasting food in an attractive setting. As a result, MCD enjoys a #1 market share in Latam of 12.4%, nearly 3.5x that of its closest competitor Burger King. Value. A key aspect of my thesis is ARCOs ability to increase transactions per month in Mexico from 18000 to 25000, in line with those in Brazil. NOLAD margins have been poor vs. other territories. However, comps and margins have rebounded in 1H11 (store margins stand at ~10% vs. the 5.6% trough in FY2009) driven by the Big Pleasures, Small Prices value menu program, through which the company offers a rotating selection of existing products at reduced prices.

b. Average ticket can grow by 6% annually because of ARCOs underappreciated pricing power and menu innovation.

Inflation. Historically the company has been able to increase prices at 1.4x -1.5x inflation, mitigating the impact of food price inflation (Figure 2). However, it is rare for companies to sustain the ability to raise prices indefinitely. Looking forward, I model a 6% increase in average ticket, slightly below the blended inflation rate for the territories.

Transactions driven by McCafs and Dessert Centers lend to pricing power. Mini-formats in the form of McCafs and Dessert Centers account for 35% of transactions. Due to the low price of the products sold by these formats, increasing prices by only the minimum coin overcomes the effects of inflation without reducing traffic. Return on investment on McCafs and Dessert Centers in FY2010 was 54% and 190% respectively.

 Figure 2. Assuming food and paper costs increased in line with inflation, a franchisee
in the US would have earned 8.0% annually from 1964-1988 vs 5.9% for an ounce of gold4.

Figure 3. QSR Market Share in Latin America Source: Company reports, Euromonitor

Figure 4. Given the elevated prices in Brazil and Argentina, I model a growth in average ticket of 6% vs. forecast CY2012 inflation in the high single digits. Source: Numbeo.com

Reality Check: Testing ticket and traffic growth assumptions against empirical evidence (RBD case study) Restaurant Brands (RBD) provides an illustrative example of the potential growth that can be expected from a QSR franchisee in tough economic conditions and demographic headwinds. RBD is a listed company in New Zealand and is currently a franchisee of 89 KFC stores. On a per store basis, RBD has grown sales at a CAGR of ~7% and EBIT at a CAGR of ~12% between 2006-2011. Additionally, despite an economic slowdown SSS growth has averaged 6.4% from 2008-2011, owing to a refurbishment program started in

4 Patrick J. Kaufman, Francine Lafontaine, Costs of Control: The Sources of Economic Rent for McDonalds Franchisees, University of Michigan Press, 1992.

2005. In light of such evidence, my estimate of 9% SSS growth rate for ARCO appears reasonable given its favorable demographics and greater pricing power (0.8x inflation for RBD vs. 1.4x inflation for ARCO).

RBD historical comparative store sales and EBITDA

250 200 150 100 50 0 2007 2008 Sales
Source: www.restaurantbrands.co.nz
Average SSS growth 6.4%

10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2009 EBITDA 2010 2011 Same store sales growth

3. Relationship with MCD impact on ARCOs bottom line. Besides the widely understood advantages of scale such as purchasing leverage with suppliers, ARCOs relationship with MCD adds value in terms of operations and governance. Franchise agreements enforce stringent standards for performance and minimum benchmarks for store reimaging and openings. ARCO is following MCDs globally proven Plan to Win with high/low pricing, remodels, and operational systems all in various phases of integration across the companys markets. Globally sponsored events. I believe that the 2014 World Cup and 2016 Olympics are important events for ARCO. These are globally sponsored events by MCD, with in-country promotions bolstered by in-game branding and restaurants in athlete villages, paid for out of global marketing spend but yielding considerable in-country attention and benefits. Data going back to the 1970s shows MCDs centrally led marketing campaigns have a history of success (the very first central marketing campaign 5 in the US resulted in a doubling of per store volumes in five years to $621,000 in 1973 ). Made-For-You (MFY). ARCO benefits from MCDs continuing advancements in attacking operating margin leaks through operational innovation. Implemented in the US in early 00s, MFY reduces the number of transactions per crew hour by 15% and allows for more customization of orders. Brazil, Mexico, and Argentina representing 80% of profits should all have MFY system wide by the end of FY2012, reducing payroll costs by ~40 bps.

Valuation I value ARCO using a DCF methodology, as I believe it best captures the cyclicality inherent in retail company earnings. My key DCF inputs were as follows: WACC: 7.23% Beta: 0.88 Gearing (D/D+E): 20% Cost of Debt: 10.5% Risk free rate: 2.21% Equity risk-premium: 6%

5 John F. Love, McDonalds: Behind the Arches, Bantam Books, 1986

Terminal growth rate: 2% (well below mid-to-high single digit 20-year average food inflation) 20% probability of recovery for NOLs associated with NOLAD operations Mid-year convention

The current price implies unreasonably pessimistic SSS growth rates. Even if ARCO grows to 2754 units (below the new store openings specified in the MFA) and refurbishes 120 stores annually while keeping gross margins constant at 19.08% (with no credit for a potential turnaround in Mexico), the current stock price implies an SSS growth rate of only 3.5%. I model 9% SSS growth rate (3% traffic growth and 6% ticket growth) and assume total stores grow to 2754 units with a 50bp improvement in per store margins, to obtain a value of $37/share. My rollout, refurbishment, and SSS forecasts are outlined below.

Investment Risks/Considerations Store returns could erode as ARCO pushes into newer markets: Mitigant MCD sets out strict guidelines in terms of store performance in its MFA. Historically, failure rates in the MCD system as a whole 6 have averaged 0.3% annually . Macro risks 1) dollar-based security with substantial currency exposure 2) substantially exposure to mall based store infrastructure makes the business vulnerable to retail slowdown 3) Venezuela accounts for ~5% of EBITDA. Mitigant - I expect lumpy returns due to forex volatility but given demographic strengths, brand superiority, visible growth profile, long-term business fundamentals should remain strong.

6 Patrick J. Kaufman, Francine Lafontaine, Costs of Control: The Sources of Economic Rent for McDonalds Franchisees, University of Michigan Press, 1992.

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