Shares of the world's largest McDonald's (NYSE: MCD) franchisee, Arcos Dorados Holdings (NYSE: ARCO), are down 21% year to date, but they've bounced roughly 15% off year-long lows since the organization released a well-received third-quarter 2018 earnings report on Nov. 14. Let's zero in on three comments made by management during the company's recent earnings conference call to obtain insight into the performance of a stock that may find room to recover in 2019.
Stabilization in Arcos Dorados' biggest markets
During the third quarter, we saw the benefits of our work as our team and operating structure were tested by volatile environment in our two largest markets, Brazil and Argentina. In this context, comparable [sales] increased 7.4% on top of the 10.4% achieved last year.
-- CEO Sergio Alonso
"Colombian Lunch" advertisement. Image source: Arcos Dorados Holdings.
With the election of Jair Bolsonaro to the presidency of Brazil in late October 2018, both the Brazilian stock market and the country's currency, the real, have stabilized. Brazil is Arcos Dorados' largest single market, responsible for more than 45% of total company sales.
Political instability and flat GDP (gross domestic product) growth in Brazil, coupled with a highly inflationary economy in Argentina (another significant market), have crimped Arcos' results over the last several quarters. Yet management expressed confidence in improving macroeconomic conditions in the third-quarter earnings call. CEO Sergio Alonso observed that a relatively benign economic environment throughout Latin America helped the company achieve a healthy 3.4-percentage-point increase in EBITDA margin to 12.2% during the last three months versus the prior year, along with a double-digit increase in net income and positive cash generation.
Technology is helping to drive traffic
Not only were we recognized as the marketer of the year across all industries in Latin America, but we also won eight of the nine awards that McDonald's received in the global category, helping McDonald's take home honors as the global marketer of the year.
The awards that Arcos Dorados won at the global level include marketing within the mobile gaming environment, CRM, promotion and lead generation. The innovative marketing initiatives behind these awards are a big part of driving profit to our restaurants throughout our region, reinforcing our brand and keeping us top of mind with our consumers.
-- CEO Sergio Alonso
Arcos Dorados is an avid user of technology as a means to improve customer engagement and generate incremental sales. In the quote above, investors should note in particular the company's efforts to market "within the mobile gaming environment." Smartphone adoption in Latin America is among the highest in the world. According to research firm IDG, 75% of mobile subscribers in Latin America, or around 350 million people, use their mobile devices to access the internet -- a higher number than in the U.S.
Arcos Dorados has embraced the concept of interacting with guests and running promotions through its country-specific mobile apps. The company has now launched mobile apps in all 20 of the countries in which it operates. It's also introduced app-enabled "McDelivery" in 10 of its markets.
The company is also an enthusiastic participant in the global McDonald's remodeling campaign known as "Experience of the Future," or EOTF. CEO Alonso stated that Arcos had completed 196 of the interactive kiosk-intense remodels as of the end of the third quarter. The company aims to ramp this number up aggressively next year, with a target of 650 EOTF conversions by year end, which will be centered primarily in Argentina and Brazil. For reference, Arcos had 2,195 restaurants in its system at quarter end.
Improving financial condition
On the back of our strong cash flow generation and debt management initiatives, we continue to maintain a strong and healthy balance sheet during the quarter. Our net leverage ratio was 1.3x adjusted EBITDA, well below our target range of 2x to 2.5x and slightly lower than the prior quarter.
-- CFO Mariano Tannenbaum
I've previously chronicled Arcos' journey from carrying unacceptable leverage to the gradual recovery of its balance sheet. Arcos Dorados continues to improve its leverage ratio, both through debt reduction and via higher earnings. While climbing comparable sales are helping to lift EBITDA margin, the company has also implemented numerous practices to improve restaurant-level profitability.
These measures include the hedging of commodity purchases (the company transacts in local currencies but reports earnings in U.S. dollars), a program to reduce food and packaging costs, and the improvement of procurement practices to gain efficiency in Arcos' supply chain.
Such initiatives aid Arcos Dorados in its near-term strategy to keep both commodity costs and general and administrative (G&A) expense growth under the rate of inflation within the countries in which it operates. By gaining this leverage, the company has room for higher flexibility in promotional offerings.
Indeed, management appears to lean toward promotion-driven volume in the short term, in the well-placed bet that newer stores and perceived value will complement the company's "cultura de servicio" (culture of service) to win repeat business and build a loyal following. At least in the current three-month period, the tactic appears to be working.
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