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    MARKET EDGES

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Having visited Asia and Latin America over the past two weeks, I have been spending more time on the emerging markets stories associates with some of the bigger restaurant names.  In particular, YUM, MCD, ARCO, SBUX and DPZ are all benefiting from the current growth trends.  For the time being, it’s an insignificant part of the DNKN story.

The above-trend growth in emerging markets is driven by strong fundamentals including favorable demographics, including a growing middle class, and well-positioned western brands are poised to reap benefits.  In many markets (particularly Brazil and China) the improvement in transactions being seen in the restaurant industry is driven by accelerating wage rates and a burgeoning middle-class.

McDonald’s recently indicated that in China the government wants to double wages by 2015 to help sustain the growth of the middle class.  In Brazil, based on an oft-used formula (GDP from 2 years ago + last year’s inflation), Brazil wage rate inflation should rise about 7% in 2011 and about 14% in 2012.

One of the best ways to play the emerging markets story is by being long ARCO.   ARCO has the exclusive right to own, operate and franchise McDonald's stores in 19 Latin American & Caribbean countries.

The long-term story is supported by management’s extensive operational experience in the region coupled with a strong – perhaps the strongest – brand.  The company also enjoys the benefit of operating within a vast geographic area.  ARCO operates in 19 countries/territories representing a market of approximately 575 million people: bigger than the US, UK, France Germany & Italy combined.  In addition, favorable demographics in the regions will allow for significant unit and same-store sales growth.

Over the next five years, the business model for ARCO looks like 9-10% same-store sales growth, 6-7% unit growth and continued margin expansion.  This should lead to 18-20% sales growth and 25-30% EPS growth.  Importantly, all of this can be accomplished from internally generated cash flow. 

There are some concerns that offset my bullish stance on the stock.  Brazil represents about two-thirds of ARCO’s EBITDA and the four next largest markets (top five comprise 90% of EBITDA) are Argentina, Mexico, Venezuela and Puerto Rico.  Inflation in both food and labor are a concern, but for the time being, increased transactions, pricing and internal efficiencies are some mitigating factors. 

From a MACRO standpoint, ARCO also represents a commodity play insofar as the company’s core markets are sensitive to economic swings, up or down, caused by commodity price moves.  The recent commodity boom has brought significant wealth to Latin American commodity-rich countries.  Our MACRO team is somewhat cautious on Brazil as inflation should trend down and growth should continue to slow through 4Q11 and into 1Q12.  The quantitative set up for the Bovespa is mixed with bullish TRADE; bearish TREND. 

Lastly, while the 180 day lockup period ends on October 12th, there definitely is some potential for selling by the sponsors of the IPO. .

At 10.7x NTM EV/EBITDA, ARCO is priced for growth but sells at a discount to some of the more US-centric restaurant companies which trade between 15-22x NTM EV/EBITDA.  While the company has the ability to double the unit count it’s is still “a franchisee” which historically have traded a significant discounts to the “franchisor.”  ARCO is trading a slight premium to MCD at 10.2 EV/EBITDA.

My take away from meeting management is Buenos Aires was very favorable and I continue to believe that business trends remain robust in all the key markets, while Mexico is still a problem child.  I also believe that a big upside surprise could be the potential geographic expansion outside the core nineteen markets the company currently operates in. 

If you need any specific details please feel free to contact me.

Howard Penney

Managing Director