Is Arcos Dorados Holding Inc Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Arcos Dorados (NYSE: ARCO  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Arcos Dorados' story, and we'll be grading the quality of that story in several ways:

  • Growth: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Arcos Dorados' key statistics:

ARCO Total Return Price Chart

ARCO Total Return Price data by YCharts.

Passing Criteria

3-Year* Change 

Grade

Revenue growth > 30%

25.2%

Fail

Improving profit margin

(73.3%)

Fail

Free cash flow growth > Net income growth

(66.6%) vs. (234%)

Fail (no growth)

Improving EPS

(62.5%)

Fail

Stock growth (+ 15%) < EPS growth

(48.2%) vs. (62.5%)

Fail (no growth)

Source: YCharts. *Period begins at end of Q1 2011.

ARCO Return on Equity (TTM) Chart

ARCO Return on Equity (TTM) data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(70.4%)

Fail

Declining debt to equity

30.1%

Fail

Dividend growth > 25%

(0.2%)

Fail

Free cash flow payout ratio < 50%

Negative FCF

Fail

Source: YCharts. *Period begins at end of Q1 2011.

How we got here and where we're going
Arcos Dorados collapses in a heap at our feet, emoting with all the overwrought pain of a flopping footballer (that's "soccer player" to American investors). But this time, the pain is real -- Arcos has failed to earn even one passing grade on nine tests, as its metrics all fall short of the strength we'd like to see in a good growth stock. Despite these problems, there could still be hope for Arcos to turn itself around and become the stock many investors hoped it might be when it went public three years ago. Can Arcos Dorados become the true "McDonald's (NYSE: MCD  ) of South America," or is this franchise operator doomed to disappoint fast-food investors forever? Let's dig deeper to find out.

Arcos shares finally began to show some life last month after a major analyst upgrade from Bank of America offered investors hope for a potential 50% gain. However, the company's recent results have yet to show bottom-line progress -- its latest quarter saw a year-over-year decline in net income. Investors are beginning to look past the profitability problem as they realize that Arcos' multiyear slide might have more to do with currency-exchange issues and the typically high expenditures of a fast-growing franchise than they do with any underlying business issues. After all, McDonald's has consistently managed a profit margin near the 20% range, and even long-unprofitable Wendy's (NASDAQ: WEN  ) has managed to improve its margins above Arcos' by focusing on improving efficiencies as a mature franchise operator:

ARCO Profit Margin (TTM) Chart

ARCO Profit Margin (TTM) data by YCharts.

It's worth pointing out that, while we may call Arcos a "fast-growing" restaurant operator, its rate of openings during the past two years is not that far behind Wendy's, and is barely twice that of McDonald's. Among the major burger franchises, only Burger King Worldwide (NYSE: BKW  ) posted a significantly slower franchise opening rate from 2011 to 2013:

Franchise

2011 Locations

2013 Locations

Two-Year Growth Rate

McDonald's 

33,510

35,429

5.7%

Burger King 

12,512

13,667

9.2%

Wendy's

5,177 

5,374 

3.8%

Arcos Dorados

1,840 

2,062 

12.1%

Sources: Company annual reports.

It's also worth pointing out that these numbers might not tell the whole story at Arcos, which has to manage its locations directly, in contrast to the franchising models of McDonald's -- which is what allows Arcos to exist in the first place --  and Burger King and Wendy's, which both count far more franchisees than company-owned locations. Fool writer Mark Lin has recently pointed out that roughly half of Arcos' market cap is backed up by real estate and other hard assets, which is a much higher rate than seen at our three comparable burger franchises. Lin also notes that Arcos' other valuation metrics, including its EV/EBITDA and price-to-book ratios, are lower than that of its franchise parent despite the fact that it boasts stronger comparable-store sales growth than most of its peers north of the border. Arcos may have its fair share of problems, but it's not likely to collapse under the weight of the Golden Arches anytime soon.

Putting the pieces together
Today, Arcos Dorados has few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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