One of My Favorite Latin American Stocks is Now a Bargain

Over the past few years, I’ve been imploring investors to boost their exposure to the more dynamic economies and regions of the world. Simply put, Latin America, Asia and even Africa are poised to grow at a stronger pace in the next few decades than the United States and Europe. This view stems from the steady expansion of a middle class in each of these regions. As people move up from the lower-income strata, they spend money on appliances, homes, vehicles, fast food and many other typical consumer items. This creates a virtuous cycle, whereby a range of industries sprout up to support this demand, and they in turn create many more middle-class jobs.

Of course, there’s a good time and a bad time to load up on stocks and funds for these dynamic markets. I’m a huge fan of countries like Brazil, Turkey, Colombia and Indonesia — just to name a few. But these countries’ economies and markets haven’t fully decoupled from the United States and Europe. It’s an ongoing process, and troubles here still affect these emerging markets from time to time.#-ad_banner-#

Instead of focusing on these markets, I’m spending more time looking at specific companies that directly benefit from rising consumer incomes in these regions. I recently focused on home builder Gafisa (NYSE: GFA), which continues to trade poorly but offers the potential for significant upside if the Brazilian housing market firms up.

Is a housing stock too risky for you? After all, you need to accept the busts with the booms that come with this kind of stock. How about a company that makes money every quarter, posts solid top-line gains and is becoming the go-to provider for middle-class consumers in Latin America seeking a fast food meal?

I’m taking about Arcos Dorados (Nasdaq: ARCO), which currently sits in the investor doghouse and now looks quite inexpensive in the context of long-term regional growth. (The name means “Golden Arches” in Spanish — Arcos Dorados is the leading franchiser of McDonald’s (NYSE: MCD) restaurants in Latin America.)

This stock wasn’t always in the doghouse. It had been one of the hottest IPOs of 2011, eventually approaching almost $30 this past fall. Now it trades for half of that peak.

Reality sets in
It’s a bit unclear, in hindsight, why this was one of the hottest IPOs of 2011 (for awhile at least). Investors clearly got carried away in their anticipation of super-strong growth in a fast-growing region. In reality, this is a company that expands its 1,800 stores base by 5% to 10% every year and generates modest same-store sales gains.
But these numbers are a bit deceiving, as growth had been aided by a rapid build-up in the store base in recent years. And as the table above shows, growth slowed to a crawl in 2009 when the global recession took hold. Even as sales growth resumed in 2010, operating income growth stalled as currency effects and other costs constrained results.

Fast-forward to the first quarter of 2012, and the same thing is happening again. A slump in the Brazilian real shaved several percentage points of growth, forcing Arcos Dorados to earn six cents less than the $0.18 a share consensus estimate.

Make no mistake, despite the near-term speed bumps, this remains a solid long-term growth story. Even as the Brazilian economy (currently Arcos Dorados’ largest market) is expected to post modest 3% gross domestic product growth this year, sales are still expected to rise 10% (to $4 billion), thanks in part to new store openings. The International Monetary Fund says Brazilian economic growth will likely move back up by 4% in 2013, which is why analysts say the country’s sales could grow roughly 15% to $4.6 billion.

This isn’t just a play on Big Macs and French fries. Management has developed a range of menu items in each country that cater to local taste, so families have a diversity of options. Analysts at Brazil’s Itau BBV have a $25 target price, noting that they “remain confident in management’s ability to leverage on the aspirational appeal of McDonald’s brand and develop local innovations for consumers for a wide range of income levels, benefiting from the structural growth in demand in its core markets.”

Risks to Consider:  Arcos Dorados is on the cusp of a strong expansion in Mexico, where McDonald’s had lacked focus and rival Burger King was able to take solid market share. Also, Brazilian inflation is high but falling, though any uptick in inflation as the economy rebounds could deter Brazilian consumer spending. And there is foreign exchange risk. As analysts at Citigroup note, “the aggressive monetary easing in Brazil, although accelerating economic growth, could translate to a weaker exchange rate, complicating ARCO’s US (dollar) results.”

Action to Take –>
This stock traded for more than 30 times next year’s earnings this past summer, which is a bit absurd. Now that the forward multiple has been cut by half, investors can now see this stock as a long-term growth platform with reasonable valuation. Shares also trade at less than nine times projected 2013 EBITDA, a fair price to pay for a company positioned for sustained long-term growth.