Arcos Dorados Holdings (ARCO) holds the exclusive rights to operate McDonald’s (MCD) franchises in Latin America and the Caribbean. It is also the world’s largest independent McDonald’s franchisee.
I’ve been a fan of the company for more than a decade. So it’s good to see its stock start getting noticed by investors. ARCO stock is up more than 10% early in 2023 and 54% over the past year.
However, looking at a long-term chart for ARCO, you’ll see that it hasn’t been a bed of roses for shareholders. Arcos Dorados went public in April 2011 at $17 a share, considerably higher than its pre-IPO pricing range of $13 to $15. By August 2011, ARCO was trading within pennies of $30.
For the most part, it’s been downhill ever since.
On Wednesday, ARCO exhibited unusual options activity. As a result, it might be time for options buyers to take a bite out of the May 19 $7.50 call contract. Here’s why.
Profits Continue to Rise
Arcos Dorados reported Q3 2022 results in November that exceeded analyst expectations.
On the top line, its revenues were $916.34 million, nearly 2% better than Zack’s consensus estimate and 26.7% higher than a year earlier. However, its bottom-line profits stood out, nearly doubling year-over-year to $0.23 a share, 10 cents higher than the consensus.
Other highlights from the third quarter include a 34.2% increase in system-wide comparable sales, its digital channels delivered 42% of its systemwide sales, its consolidated adjusted EBITDA, excluding currency, jumped 27.0% YOY, it opened 14 freestanding units in Q3 2022, and its net debt was just 1.0x adjusted EBITDA.
“By consistently delivering the best guest experience in our restaurants, every single day, we are now driving sustainable, long-term revenue growth. This generates opportunities to capture operational efficiencies and dilute fixed costs to enhance profitability,” CEO Marcelo Rabach said about the company’s third quarter and year-to-date.
“Prudent capital structure management and data-driven investment decisions complete the picture of profitable growth we are delivering, all the way down to the bottom line.”
In the trailing 12 months ended Sept. 30, 2022, Arcos Dorados’ operating income was $252 million, its highest level since going public in 2011. That’s an operating margin of 7.5%. By comparison, in 2013, when its sales were $4.0 billion, $652 million higher than today, its operating margin was 5.9%, 160 basis points less.
The company is firing on all cylinders, but it thinks it can do better.
The 3Ds Are Helping
The 3Ds, for those unfamiliar with the term, stand for digital, delivery, and drive-thru. The company’s implementation of this strategy is “driving the strongest operating and financial results in our history,” Rabach stated in the Q3 2022 conference call.
I alluded earlier to the fact that its digital sales accounted for 42% of Arcos Dorados’ revenue in the quarter. The CEO emphasized this in the conference call. During the conference call, Chief Operating Officer Luis Raganato discussed the company’s digital initiatives, reminding analysts and investors that its largest market (Brazil) generated 52% of its systemwide sales in the quarter from digital.
“To drive further digital adoption, we invested in a 360-degree campaign to promote the Mobile Order and Pay feature of the app,” Raganato stated during the conference call. “This omnichannel approach to the digital strategy is strengthening brand perception related to convenience and generating significant sales growth in this channel.”
These aren’t new concepts in the restaurant industry, but they lead to higher sales when applied consistently. As the company likes to say, this omnichannel approach to its business has led to five consecutive record quarters.
The CEO highlighted other success stories around its 3D strategy.
For example, delivery accounted for just 2% of its sales in 2018. That’s up to 15% today. Its digital sales were less than 10%, over 40% in 2022. In Q3 2022, its delivery sales grew 34% YOY, while drive-thru sales were up 11% from Q3 2021.
As I said, its business operates at a very high-efficiency level.
The Valuation
Arcos Dorados’ trailing 12-month free cash flow is $189 million. Based on a market cap of $1.79 billion, it has a free cash flow yield of 10.6%. I consider anything above 8% to be in value territory.
Another value metric: its enterprise value of $3.05 billion is 7.93x its EBITDA, 40% lower than its five-year average. The last time its multiple was this low was in 2018.
According to Barchart.com data, of the five analysts that cover ARCO, all five rate it a Strong Buy with a mean target price of $9.50.
ARCO once traded near $30. While it might not get there in the next 3-5 years, it could trade in the low to mid-teens in 2023.
The May 19 $7.50 call had a volume of 4,606 on Wednesday, 22.25x its open interest. With 127 days to expiration and a $1.70 ask price, its share price has to increase about 9% to break even. Given its delta is 0.73356, an increase in its share price of $2.32 (27%) would double your premium.
Under $10, Arcos Dorados remains a buy.
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On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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