Is Arcos Dorados a Buffett Stock?

As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.

We can't know for sure whether Buffett is about to buy Arcos Dorados (Nasdaq: ARCO  ) , the largest McDonald's (NYSE: MCD  ) franchisee in Latin America, but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us. In this series, we do just that.

Writing in a recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Although the company may be too small for Buffett to literally invest in, does Arcos Dorados meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine Arcos Dorados' earnings and free cash flow history:

Source: S&P Capital IQ.

Over its four-year public history after splitting from McDonald's, Arcos Dorados has maintained fairly consistent earnings. The free cash flow shortfalls over the past two years were due to capital investments in store expansion.

Growth opportunities are significant. There are just 1,777 McDonald's restaurants covering Latin America's 500 million people, compared to the 14,000 restaurants covering the U.S.' 313 million. So far, however, rising costs have kept pace with Arcos Dorados' significant revenue growth, which has kept net income more or less steady.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

In its most recent quarter, Arcos Dorados generated a moderately low return on equity -- 11.7% with a moderate debt-to-equity ratio of 84%. While they're not perfect comparisons, since McDonald's is a franchiser and has greater economies of scale, the fact that the Golden Arches generated a return on equity of 40% last quarter with comparable debt levels shows that Arcos Dorados should have plenty of room for improvement.

3. Management
Prior to running Arcos Dorados, CEO Woods Staton had helped establish and run McDonald's Latin American restaurants since 1985. Before that, he ran marketing for a Latin American Coca-Cola bottler for a few years.

4. Business
Fast-food restaurants like McDonald's franchises aren't particularly susceptible to technological disruption.

The Foolish conclusion
So is Arcos Dorados a Buffett stock? Perhaps. The company exhibits several of the quintessential characteristics of a Buffett investment: consistent earnings, tenured management, and a straightforward business. It doesn't yet produce a high return on equity, however. McDonald's high returns indicate that there's plenty of room for improvement in this area, so we'll have to see how well Arcos Dorados is able to capitalize on the opportunity. If you're looking for another intriguing stock idea, check out 3 American Companies Set to Dominate the World, which details how McDonald's and two other multinationals are profiting abroad. I invite you to download this special report for a limited time by clicking here – it's free.

Ilan Moscovitz doesn't own shares of any company mentioned. Motley Fool newsletter services have recommended buying shares of McDonald's and Arcos Dorados Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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