Arcos Dorados (ARCO 0.43%) has crashed by a jaw-dropping 52% year to date, as investors seem to be clearly disappointed with the company's lower-than-expected financial performance and reduced growth guidance. The McDonald's (MCD -0.81%) franchisee in Latin America is facing massive economic headwinds, and the outlook will most likely remain uncertain in the medium term.
On the other hand, the company still has enormous room for growth in the coming years, and the business isn't doing badly at all when adjusting for foreign exchange fluctuations and other factors outside the company's control. All of this begs the question: is the dip in Arcos Dorados stock a buying opportunity for investors?
A tasty business
Arcos Dorados is the world's largest McDonald's franchisee in terms of systemwide sales and number of restaurants. The company operates or franchises 2,075 McDonald's-branded restaurants, with over 95,000 employees serving approximately 4.3 million customers a day. These numbers make Arcos Dorados the largest quick-service restaurant chain in Latin America and the Caribbean.
Arcos Dorados has the exclusive right to own, operate, and grant franchises for McDonald's restaurants in 20 Latin American and Caribbean countries and territories, including markets such as Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico, Panama, Peru, and Venezuela, among several others.
The size of the consumer base in Arcos Dorados' territories is approximately 520 million people, equivalent to the combined population of the U.S., Germany, the U.K., and Italy. Besides, population growth rates are typically higher in Latin America than in Europe or the U.S., and a younger population bodes well in terms of consumption growth.
Management estimates that Arcos Dorados has a market penetration level approximately one-third of what McDonald's has in the U.S., so the company offers enormous room for growth in the long term.
A bitter context
Arcos Dorados has been hurt by economic volatility in several key markets lately. During the second quarter of 2014, the company changed the exchange rate used for financial reporting in Venezuela, which forced Arcos Dorados to recognize a foreign currency exchange loss of $39 million and asset impairments of $45.2 million.
Currency depreciation also had a negative impact on revenues in Argentina and Brazil, where economic activity was also below expectations. In addition, customers decided to stay home and watch the games during the massively popular FIFA World Cup in the second quarter of 2014, which delivered another hit to both sales and earnings during the quarter.
In this clearly difficult context, Arcos Dorados reported a 7.2% decline in revenues for the last quarter to $917.9 million. Reported EBITDA fell 37.8% to $42 million, and bottom-line results turned from a net gain of $8.8 million in the second quarter of 2013 to a net loss of $99 million in the second quarter this year.
On the other hand, performance is not that dismal when adjusting for currency fluctuations and the negative impact from the economic crisis in Venezuela. On an organic basis excluding Venezuela, system revenues grew 9.6% during the quarter, while systemwide comparable sales increased 7.8% versus the same quarter in 2013.
This is important to note, since the company seems to be mostly suffering from macroeconomic weakness as opposed to fundamental industry changes. While McDonald's is being challenged by the trend toward healthier nutrition in developed markets such as the U.S. and Europe, consumers in Latin America seem to still like Big Macs and fries.
Arcos Dorados reduced its growth guidance for 2014 because of the challenging economic conditions in its primary markets. Revenues excluding Venezuela were previously expected to increase between 13% and 16%, while the current forecast is for a growth rate of 9% to 11%. The company also cut its store-opening plans for the full year, from 90 to 84 new openings.
Arcos Dorados has adjusted the debt covenants in its revolving credit facility with Bank of America and its master franchise agreement with McDonald's to reflect growing debt levels. While the net debt-to-adjusted EBITDA ratio is still within reasonable levels at 2.6 as of last quarter, growing debt levels in the context of a challenging scenario is a major risk factor for investors in Arcos Dorados stock.
The bottom line
Most of the weakness in Arcos Dorados stock seems to be related to economic conditions in Latin America. The business is still growing when adjusting for currency fluctuations, and long-term opportunities for growth are certainly quite promising.
However, it's hard to tell when the economic landscape will improve, and growing debt levels are a major risk that need to be watched. Chances are Arcos Dorados can deliver substantial gains for investors once conditions change for the better, but volatility will most likely remain nauseating in the coming months.
For those with a strong enough stomach to buy at current prices, gradually buying small partial positions could be a smart idea to keep risks under control.