You Should Invest in This McDonald's Franchisee

Should you buy the franchiser or the franchisee? The financial numbers will you help you to decide between investing in McDonald's or its largest franchisee, Arcos Dorados.

Jul 2, 2014 at 7:00AM
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Source: Arcos Dorados.

Arcos Dorados (NYSE:ARCO) is the largest McDonald's (NYSE:MCD) franchisee globally, operating quick-service restaurant chains (QSRs) in Latin America and the Caribbean. Conventional wisdom will lead us to pick McDonald's as an investment over Arcos Dorados, since the franchiser typically generates steady, asset-light revenue streams vis-a-vis its franchisees. However, the financial results tell a different story.

From 2010 to 2013, Arcos Dorados has grown its top line by a three-year CAGR of 10.1%, compared with a 5.3% CAGR for McDonald's over the same period. Does this make Arcos Dorados a better investment than its franchiser, McDonald's?

Emerging market proxy
It's a no-brainer that the penetration rates for all things consumer have reached saturation point in most developed markets. One of the bright spots in emerging markets is Latin America. It is estimated that GDP per capita for Latin American countries such as Brazil, Argentina, Chile, and Colombia has grown in excess of a 4% CAGR between 2006 and 2013. For example, Brazil's middle class population has increased from 66 million in 2003 to 106 million in 2011.

In addition, these countries have a higher proportion (above 30%) of young people aged between 15 and 34 years old, who are the key consumers of fast food. The results speak for themselves, with fast food being the second fastest growing consumer foodservice category in 2012, boasting year-over-year growth of 12%.

Arcos Dorados is a better proxy for emerging market growth than McDonald's. According to its segment results in 2013, developed markets such as the U.S. and Europe represented 72% of McDonald's top line, with the remaining revenue contributed by its operations in emerging markets such as Asia Pacific, the Middle East, and Africa. As a result, the attractive growth prospects of McDonald's emerging markets businesses are offset by the mature, slow-growth outlook for its operations in developed markets.

In comparison, Arcos Dorados represents one of the purest proxies for Latin American QSR growth. Based on Euromonitor research in 2012, its 1,948-large store footprint made Arcos Dorados the largest QSR operator in Latin America with 11.2% market share compared with 3.1% market share for its next largest competitor. By the end of 2013, Arcos Dorados has further grown its store count to 2,062 units. 

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Source: Arcos Dorados.

Freestanding restaurants
Arcos Dorados' market leadership in Latin America is protected by the fact that more than 45% of its restaurants are based in freestanding locations. In contrast with mall-based stores, there are three key advantages to freestanding restaurants.

Firstly, Arcos Dorados enjoys greater control over its freestanding restaurants compared to those based in malls. Leases for those freestanding restaurants Arcos Dorados doesn't own tend to be longer than mall leases, giving Arcos Dorados greater certainty over its prized locations.

Secondly, Arcos Dorados has a bigger say in the appearance of freestanding restaurants and the flexibility of remodels without the need to consult mall operators.

Thirdly, Arcos Dorados' free-standing restaurants provide sufficient indoor seating spaces and also come with drive-thru areas and parking lots, unlike mall-based restaurants, which usually consist of a front counter and kitchen with no seating area. This suggests free-standing locations can draw higher footfalls and deliver greater customer satisfaction.

Cheap valuations 
Arcos Dorados trades at a significant discount to McDonald's. McDonald's is valued by the market at a forward EV/EBITDA of 10.4, while Arcos Dorados sports a forward EV/EBITDA of 8.8. With respect to asset-based valuation metrics, Arcos Dorados trades at 3.8 times P/B, compared with a P/B of 6.2 for McDonald's.

In addition, Arcos Dorados' valuation is backed by hard assets such as owned stores. As of the end of 2013, the accounting value of Acros Dorados' property and equipment represents approximately half of its currently market capitalization. Given that property and equipment are stated at cost net of accumulated depreciation on the balance sheet, the actual value could be potentially much higher.

In contrast, property and equipment only accounted for a quarter of McDonald's market capitalization, because of its highly franchised operations and a lower ratio of store ownership. Approximately 80% of McDonald's restaurants were franchised as of the end of 2013.

Foolish final thoughts
McDonald's may be the more recognizable name of the two, but Arcos Dorados is a more attractive investment candidate, in my opinion. Arcos Dorados is better positioned to benefit from Latin America's burgeoning growth than its larger peer McDonald's, given its geographical focus. In addition, Arcos Dorados is cheaper on a EV/EBITDA basis and has stronger asset downside protection from the value of its owned restaurants.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of Arcos Dorados. 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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