Now This Is a Hot IPO

When it comes to investing overseas, I generally avoid at least two categories of stocks:

1. Recent IPOs.
2. Companies that describe themselves as the [Insert name of wildly successful company] of [Insert name of fast-growing emerging market].

There are good reasons for these rules of thumb. First, companies that fit either of these descriptions tend to be overhyped and therefore overvalued. Second, there's a body of research that demonstrates just how profoundly recent IPOs underperform the market average. Third, given their significant resources and intent on growing abroad, the Wal-Mart (NYSE: WMT) and Coca-Cola (NYSE: KO) of China, Brazil, India, or wherever is most likely to be Wal-Mart and Coca-Cola. In fact, it's precisely because the companies have outsized yet underappreciated emerging market growth prospects that they are core international holdings in the Fool's Million Dollar Portfolio.

What we've gone out of our way to avoid, on the other hand, are the likes of Youku.com (NYSE: YOKU) and E-Commerce China Dangdang (NYSE: DANG) -- the "YouTube" and "Amazon.com" of China, respectively. Not only do these newly public companies carry better-than-billion-dollar valuations, but they are not and barely are profitable, respectively. When the fundamentals catch up with the stocks, the stocks will be going down.

That, however, is not the case with another recent hot emerging markets IPO -- quite legitimately the McDonald's (NYSE: MCD) of Latin America.

Not just optimistic IR
Arcos Dorados (NYSE: ARCO) -- Spanish majors will know the name means "Golden Arches" -- purchased all of McDonald's operations in Latin America in 2007 for a little less than $700 million. That price was $896 million less than the net book value of that business, a seeming bargain for the buyers in that they were acquiring a world-class restaurant brand covering markets with some 500 million people, including both Brazil and Mexico. Yet McDonald's was also happy to sell. The company had struggled to operate in volatile Latin American markets and was barely profitable there. Management was trying to refocus the larger company on core operations -- a strategy that also entailed the spin-off of Chipotle (NYSE: CMG) in 2006 and the sale of Boston Market in 2007. By punting while retaining royalty collection rights and requiring a certain level of growth in store count, McDonald's banked some cash, got rid of a market that was soaking up time and capital, and maintained exposure to a promising market.

Ultimately, the deal worked out for both sides. McDonald's stock has nearly doubled since 2007, and Arcos Dorados is now being valued by the market for more than $4 billion, a hefty return for the original consortium of investors. Furthermore, because McDonald's continues to receive franchise fees and sales royalties from Arcos Dorados, the parent company has also benefited from the improved performance.

The question at this point, however, is whether there's still return to be had in Arcos Dorados by investors today.

This is a stock worth watching
My initial analysis of the company suggests there is. Consider, for example, the current store base:

Now compare those numbers to the United States. Incredibly, our country supports one McDonald's for every 22,000 people. Of course, we're a wealthier country with better infrastructure and a predisposition to fast food, so other markets may never support the same store levels as this one, but cut store potential in Latin America by one-fifth and there's still potential for 5,000 restaurants. Add to that the fact that economic growth in these markets drove same-store-sales growth of 5.5% in 2009 (a bad year) and 14.9% in 2010 (a good year), and it's clear that Arcos Dorados should deliver 10% to 20% annual total sales growth for at least the next decade.

Where the valuation gets trickier, however, is with regards to profitability. Under McDonald's management in 2006, the region eked out a mere 3.3% operating margin. That number is better today -- 6.8% in 2010 -- but still below what you'd find a more efficient operators such as McDonald's itself (even after adjusting for its franchising business) or Chipotle. A key question is whether Arcos Dorados can continue to get better in this regard. Working for the company is the fact that it's getting bigger, realizing economies of scale and other efficiencies. Working against it are rising food prices and the fact that Latin America -- with onerous regulation, the potential for price controls, and a volatile economic record -- is a scary place to try to make money.

The global view
It's because of that profitability question that I suggest investors hold off on Arcos Dorados for now. The current price of more than $20 per share is pricing in 10% to 12% pre-tax profitability at company-operated stores. Not only could it take some time for the company to achieve that level, but it could, given the aforementioned issues associated with Latin America, be a rocky road getting there.

But this stock deserves a place high atop your watchlist. Should IPO euphoria subside and the stock start drifting back to its $17 IPO price, that would be the time to start buying shares. The company would still have to work to become slightly more profitable, but I suspect it will succeed at doing that and that the long-term growth opportunity will help it deliver market-beating returns.

Get Tim Hanson's top global stock picks by joining Motley Fool Global Gains. Tim's "Global View" column appears every Thursday on Fool.com.