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Get 50% Upside In Latin America With This Iconic Stock

Friday, December 06, 2013 7:00 AM

For many folks in Latin America, 2011 seems like an awfully long time ago. Just two years ago, regional economies were booming, and growth in middle-class consumption was off the charts.

That proved to be a fortuitous time for Arcos Dorados (NYSE: ARCO) to go public.

At the time, the company operated more than 1,700 McDonald's (NYSE: MCD) franchises in 19 countries across Latin America and the Caribbean, and in many respects was firing on all cylinders. Sales, earnings and net income were all rising at an impressive clip, and analysts expected more of the same in the years to come.

And then the wheels fell off.

Many Latin American economies eventually hit an air pocket, most notably in Brazil, which accounts for more than half of this company's sales and EBITDA (earnings before interest, taxes, depreciation and amortization). And as these economies have slowed, analysts have repeatedly lowered their profit forecasts.

Shares, which surged after the April 2011 IPO, now remain in a deep funk.

How badly has the economic slump affected financial results?

Let's examine a pair of 2013 forecasts by Brazilian investment firm Itau: one made in June 2011, the other issued Aug. 23 of this year. Expected sales have dropped from $4.58 billion to $3.95 billion, EBITDA from $516 million to $312 million, net income from $257 million to just $58 million, and earnings per share (EPS) from $1.23 to $0.23. (The firm did not provide an updated earnings model in its third-quarter report last month.)

Not only has Arcos Dorados (whose name means "golden arches" in Spanish) failed to deliver the sales growth that many had expected, but profits in 2013 are likely to be far lower than had been assumed a couple of years ago.

Some of the factors behind the steadily worsening outlook:

-- A move by the Brazilian government to compel fast-food operators to provide full-time and not part-time employment to its workers, leading to a hike in benefit spending.
-- A 30% drop in the Brazilian real against the U.S. dollar since 2011, which has led to hefty foreign exchange losses.
-- Slowing economic growth in Brazil, which has zapped consumer confidence and led to a sudden 9% sequential slump in retail sales in October.
-- Venezuela and Argentina, two other major markets for Arcos Dorados, have also been beset by slowdowns and currency slumps.

In effect, anything that could go wrong for Arcos Dorados has gone wrong. Yet, a broader view reveals a company with still-considerable growth prospects, and the early signs of an upturn for this business should start to appear in coming quarters.

Manageable Growth
Despite the unimpressive financial results -- when converted back into dollars -- Arcos Dorados has still been able to generate solid growth metrics. For example, same-store sales grew 12.6% in the third quarter of 2013 (although that figure was boosted by inflation). Indeed, same-store sales trends are healthier than the lagging share price indicates.

Recent results have been boosted by the launch of McBites.


Source: Morgan Stanley (store base at the end of 2012)

Of course, a strong dollar, relative to Latin American currencies, has blunted those gains, but exchange rates appear to have stabilized in recent months. That should remove the currency headwind in future quarters.

Another positive metric: A 140-basis-point improvement in third-quarter EBITDA margins in the all-important Brazilian market, compared to a year ago, thanks to falling food and paper costs. In late October, J.P. Morgan upgraded ARCO to "buy," noting that "core business conditions look better than they have been in almost two years."

Equally important, management believes that the McDonald's brand is still broadly under-penetrated in Latin America. The current store base is expected to grow more than 10% this year, with similar plans for 2014 and 2015.

As a point of reference, there is one McDonald's in the U.S. for every 22,000 people. In Latin America, each store represents roughly 300,000 people. Simply doubling the store base would still leave that metric at 150,000 people per unit.

And a key catalyst looms for the all-important Brazilian market. The 2014 World Cup will be held in Brazil, and as a lead sponsor, McDonald's expects to provide massive marketing support to the brand, which should have spillover effects across Latin America. That's one of the benefits of Arcos Dorados having a well-heeled big brother. The 2016 Summer Olympics, also to be held in Brazil, will receive similar marketing attention from McDonald's.

At this point, this company only needs to prove that the era of steadily falling estimates has passed. It's a hopeful sign that third-quarter EPS topped the consensus estimate for the first time in a number of quarters.

Equally important, the company will be coming up against easier quarterly comparisons in 2014, setting the stage for steadily rising year-over-year EPS growth. For example, the consensus forecast for the quarter ending in March 2014 is for EPS of $0.08, which would be double the year-earlier take. And for all of 2014, analysts expect EPS to grow more than 65%, to around $0.53 a share.

Once ARCO's growth can shine through as currency fluctuations and other impacts stop acting as a drag, this will again be seen as a solid long-term proxy for rising Latin American domestic consumption. Look for shares to move up to $18, or around 15 times projected 2014 EBITDA, on an enterprise value basis. That's a reasonable multiple for a company with such bright long-term growth prospects and would represent a 50%-plus gain from current levels.

Action to Take -->
-- Buy ARCO up to $14
-- Set stop-loss at $10
-- Set initial price target at $18 for a potential 29% gain in six months

This article was originally published at ProfitableTrading.com:
This Low-Priced Stock Could Soar 50% in the Next 6 Months

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.