MORAM - Arcos Dorados $ARCO investment thesis + Options strategies + Inter Cars
Sunday 25th June 2023
Today we share 3 publications:
A) The Arcos Dorados investment thesis - $2Bn US listed company which is the main franchisee of McDonald’s, it has a presence in 20 Latin American countries, and we believe that it is an interesting moment to analyse it in detail.
B) Strategies with options for the current market
C) Analysis of the automotive aftermarket sector, a sector we believe that it is quite interesting. We analyse Inter Cars and compare it with its peers in the sector, specially AutoParner
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A) Arcos Dorados Investment thesis
Today, we bring a thesis of a company that operates in a region of the world that we find very interesting for the coming years, but that we have talked about very little until now, Latin America. The company, Arcos Dorados ($ARCO), is the biggest franchisee of McDonald’s globally, and operates in 20 Latin American countries.
What is Arcos Dorados?
Arcos Dorados represents McDonald's brand in Latino America and the Caribbean, being the largest franchisee in terms of revenues (4% of the total) and number of restaurants (6% of worldwide restaurants). It has an exclusive partnership to own, operate and sub-franchise McDonald’s in 20 countries in South America and the Caribbean (in all the most populated countries: Mexico, Brazil, Argentina, Colombia, Peru etc.) where the company already operates 2,313 restaurants at the end of the first quarter. 29% of its restaurants are sub-franchises, although the share of revenues from them is only 4.5% (this number has been quite stable during the last five years).
As you may already know, the franchising business is of much better quality, with higher margins but lower revenues. We want to make clear that Arcos Dorados is not comparable to McDonald’s. While McDonald’s main income stream is the rental income that the franchisees pay, $ARCO is the one paying the royalty fee to McDonald’s. Arcos Dorados main revenue source is the operations of the restaurants.
Arcos businesses is much more similar to a normal restaurant chain. They make an initial investment to buy or lease the land, the equipment and the building to later either operate it or sub-franchise it. If the revenue source was the royalty fee from the sub-franchises, we would be talking about a different kind of business.
The royalty fee expected to be paid to McDonald’s is around 6% of total revenues in 2023 and 2024. We think it will probably rise slightly onwards. This is why McDonald’s EBITDA margin is an extraordinary c.50%, and Arcos stays around 10%. The royalty fee from sub-franchised restaurants to Arcos is 5%.
The company divides their geographic revenues in three different regions: Brasil, NOLAD (North Latin America - main countries are Mexico, Costa Rica and Panama) and SLAD ( South Latin America - main countries are Argentina, Chile and Colombia). In 2022, the revenues evolution per region during the since Covid has been as follows:
The operating margins are much higher in Brazil (13.1%) vs 6.7% and 8.5% in NOLAD and SLAD, respectively. This is mainly due to the higher percentage of sub-franchised restaurants in Brasil. When analyzing the margins in future results it is important to understand the mix between regions. For 2023, we expect the Brazil division to perform very well with also significant growth for the other two regions.
2) Why do we believe that an opportunity exists?
We were initially attracted to Arcos mainly for two reasons:
a) The opportunity to gain exposure to South America with a defensive approach. This is, having a clear view on what is the dynamics affecting the company (trends on food and labor inflation, customer demand, etc.), and limiting the country risk that would have investing in only one country of Latin America or the Caribbean.
b) The strength of McDonald’s brand and the disparity in valuations with other public restaurant chains.
As we continued deepening into it, we liked the cared strategy of growth for the coming years backed with excellent operations from recent history. All the sector was deeply affected by Covid and Arcos as one of the main players in the industry has strengthen their competitive and financial position. Now, the strategy is clear, open more restaurants of the most profitable kind the company operates in strategic locations and implementing digital solutions that drive the ARPU up.
Let’s analyse the feasibility of their strategy, examine their financials, and compare them with their peers to get a better idea of the investment opportunity's magnitude. Additionally, we will provide our perspective and conclusions.
B)Options strategies for the current market
Although we usually focus on equities, the scope of investment opportunities is much broader. In the current market scenario, apart from corporate debt (which we will delve into in detail in the coming weeks because it is what we have been dedicating most of our time to recently - not to prepare any specific article but look for opportunities), we believe that options are a great financial instrument to maximise returns and manage risk in our portfolio.
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C) Inter Cars $WSE:CAR
Today, we are doing a different exercise from what we are accustomed to. It's not an investment thesis on Inter Cars, but rather its analysis has helped us better understand the automotive aftermarket sector, which was previously discussed in the investment thesis competition held this March, featuring the company AutoPartner (investment thesis available on our website).
First, we have a look at the industry, looking for its main challenges and opportunities, then we delve into Inter Cars and finally we compare it with Autopartner and some other players in the industry
The independent aftermarket (IAM) industry has an anti-cyclical component that generally works well in any economic environment but especially in times of economic downturns. When, due to a crisis, the sale of new vehicles decreases, this causes an increase in the age of the vehicle fleet, resulting in the need for more maintenance.
The main factors driving the market are the size of the car fleet , the age of cars and the miles driven.In general, a car becomes a target for the industry at the end of its guarantee period.
The industry is undergoing several trends that will bring changes , some positive and some negative.
Electrification: The electric car will bring changes in the end, but it will take longer than it might appear to have a real impact on the aftermarket. BEVs have around 30 percent lower aftermarket replacement part revenue potential than ICE vehicles. We will use a report by Roland Berger in conjunction with CLEPA to get an idea of the impact.
Before discussing the report, we have to understand that a new car does not become a regular customer of the independent aftermarket until the end of the warranty, a car sold today will not be a potential customer until 2028.
The report presents 3 scenarios a 2040:
1- Regulatory compliance: Share of electric cars in the total fleet, 42 % and of the traditional aftermarket ,13%.
2- contraction Ambitious transformations Share of electric cars in the total fleet, 52 % and contraction of the traditional aftermarket ,16%.
3- Radical Electrification: Share of electric cars in the total fleet, 54 % and contraction of the traditional aftermarket ,17%.
Excluding additional demand for new components exclusive to electric cars nt, in the most optimistic scenario for the electric car, the independent aftermarket would fall by less than 17% in 2040.
In our opinion the electrification of the fleet will not be so simple. These scenarios consider that the 2035 regulatory target will be met. We do not see this leap as easy, especially in the less developed regions where the company operates, where sales of electric cars are much lower. We see the high price of electric cars and the lack of charging infrastructure as obstacles. For example, charging a Tesla at a Tesla Supercharger will take about 30 minutes.
Another challenge that could affect the sector in the long term would be that with the advancement of safety technology, fewer accidents will be seen.
On the other hand, companies in the industry are more optimistic and expect a higher price for new components to offset the drop in volume. They will also have new opportunities in remanufacturing electrical components.
The positive trends are:
An increase of the fleet in Western Europe of 0.8% by 2025 and 0.4% by 2030, in central Europe of 1.7% by 2025 and 1.2% by 2030 and in eastern Europe of 1.3% by 2025 and 1.2% by 2030.
An aging fleet with a current average age of 12 years, where in Eastern and Central Europe the age is even higher.
For all these reasons, the market is expected to grow by 4 to 5 % annually until 2025 and by 1 to 2 % until 2030 according to BGC or 3 % CAGR until 2030 according to McKinsey.
Another point in favor of the larger companies is the fragmented nature of the market, as shown in the following table with an estimated share of the European market. There are several sources of information on market size that vary slightly . According to Global MarKet Insights the market size in 2021 was 168 B USD ( approx 160 b €) and by Graphical Research 166 B USD (165 B €). For the market size estimates , the average exchange rates of 2022 have been used in our analysis.
According to these estimates the top 4 only have 14.4 % of the IAM market while in the USA according to Mckinsey since 2015 already the TOP 4 already accounted for 50 % of the market. The rest of the companies operating in Europe are unlisted companies, smaller in size and losing market share. In an industry in which scale is critical, this trend towards consolidation will continue. This consolidation has taken place mainly through M&A.The entry of companies such as LKQ, GPC or private equities such as Bain Capital former owner of PHE which was acquired by D`leteren Group in 2022, are driving the market to consolidation.GPC through its subsidiary Alliance Automotive Group did 9 acquisitions in the last two years. LKQ since 2011 has done more than 80 acquisitions in Europe, the latest being Uni-Select, a Canadian company that also operates in the UK.