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Just listening to the Arcos Dorados call last week, it was clear that Brazil was the topic du jour.  The country was referenced 36 times during the 1Q11 conference call versus 13 times in the 1Q10 earnings call.   We think that two key risks exist for ARCO (with repercussions for MCD); in the near term, management may need to bring its same-restaurant sales guidance lower while in the longer term, we believe that unit growth may be overly aggressive.  In that case, margins and returns will deteriorate.

Brazil is a very meaningful market for Arcos Dorados, representing 67% of the company’s EBITDA and 35% of its total units.  Same-store sales are running at 1% in April versus 9.2% in posted for 1Q.  As the chart below indicates, the top-line trend does not look positive for Arcos Dorados.

WHAT’S WRONG WITH MCD BRAZI? - arco brazil comps

So what is it that ails McDonald’s in Brazil?  Management pointed out that “we experienced a noticeable slowdown at the end of 2011 which continued into the month of January.”  The company attributed this to “a temporary low in Brazilian consumer spending, which picked up in February and is expected to accelerate through the remaining quarters.”  What’s confusing to us is that government data detailing consumer spending during the same quarter showed a significant acceleration in 1Q. 

Not only did consumer spending rise, but the services sector expanding in April also.  Moshe Silver, our Portuguese-speaking Chief Compliance Officer and Managing Director, recently informed us that Brazil’s services sector PMI advanced to 54.4 in April, up from 53.8 in March, seasonally adjusted.  This compares to the industrial sector PMI, which declined from 51.1 in March to 49.3 in April, even as the government implemented stimulus programs.

With all of this in mind, taking into account what other consumer companies are seeing, McDonald’s recent fortunes in Brazil are all-the-more perplexing.  Lapping last year’s highly successful Big Mac promotion of last year is a big difficulty for Arcos Dorados but this slow down seems to be reflective of more than tough comps.  On a year-over-year basis, the company is emphasizing its “value platform” much more, which has been a tried-and-tested strategy of McDonald’s when trends slow.  With same-store sales trending at 1%, traffic does not seem to be booming for ARCO.   Current guidance is still calling for high-single digit comps this year; this seems like a stretch to us.

Below we have provided a selection of quotes from consumer-facing businesses in Brazil.  The commentary from each of these companies does not rhyme with the weakness that ARCO is highlighting.  The corollary from this is that the pain McDonald’s is feeling in Brazil could be self-inflicted.  It is difficult to prove, but the first factor that springs to mind as a possible driver of this is the overbuilding of stores.  As the chart below illustrates, Arcos Dorados have been aggressively growing its unit count over the past three years.  The boom in building came at a time when the Brazilian economy was very strong and, if there is now an oversupply of McDonald’s restaurants, it could be a problem for ARCO’s return on its investment.  If an oversupply of units is not behind the slowdown in McDonald’s business in Brazil at the moment then it likely will be if the trajectory of new unit openings continues with comps in low-single digit territory. 

While this is a difficult thesis to prove, we think it is likely that slowing new unit growth could be a tactic pursued by management if comps fail to pick up next quarter.

WHAT’S WRONG WITH MCD BRAZI? - arco brazil units

WHAT ARE OTHER CONSUMER COMPANIES SAYING ABOUT BUSINESS TRENDS IN BRAZIL:

As the commentary, below, states, consumer-facing companies in Brazil did not highlight any macro weakness as a reason for softness in business trends.  The only factor that was offered by way of an excuse was the unseasonably wet weather in January. 

Starbucks: I think we're quite encouraged with what's going on in the Americas on a macro level in markets like Brazil. And in Latin America, markets continue to perform well with strong comp growth and a long runway for additional stores. In fact, our comp growth in Brazil is outpacing our expectations, which is evidence that our stores and brand continues to be well-received.

Starwood Hotels & Resorts Worldwide, Inc.: Latin America continues to be our fastest-growing region with RevPAR up 14% in Q1. Brazil and Chile were both up over 20% with double-digit rate growth. Business and leisure travelers are returning to Mexico where RevPAR grew 17%. Occupancies at our resorts were up almost 1,000 basis points. U.S. groups are once again looking at Mexico as an attractive destination. Argentina lags and we are monitoring the situation closely. At this point, all indications are that Latin America will remain our fastest growing region.

Fidelity National Information Services, Inc.: Brazil was very strong. We're continuing to see nice growth in both not only accounts but also transactions. We're also seeing nice growth in our EBITDA margins.

Marriott International, Inc.: Over the last 12 months, international arrivals to our hotels in the U.S. increased 7%, arrivals from Brazil were up 16%, and arrivals from China were up 32%.

Kraft Foods, Inc.: Developing markets posted a double-digit increase, led by strong growth in Latin America. Brazil was up nearly 30%, driven by strong Easter shipments and leveraging marketing campaigns supporting (03:55) 100th anniversary.

Avon Products, Inc.: Our largest market, Brazil, was us 2% in constant dollars, driven by 6% growth in Beauty, which was partially offset by double-digit decline in Fashion & Home. In Brazil, our new general manager and his team have been focused on understanding the drivers of recent performance and identifying the required steps to win competitively while delivering profitable growth.

Stoneridge, Inc.: Brazil's GNP growth has declined to an annualized rate of 2.8%, which is starting to impact the Brazilian consumer market. PST distributors and retailers are experiencing less demand for aftermarket products as the overall economy softens and they are making adjustments to their inventory positions to reflect the current market demand.

Anheuser-Busch InBev SA: Turning now to Brazil, despite, cooler and rainier weather than normal in January and helped by positive impacts from the increase in minimum wage, industry volumes grew by 3% in the quarter. We outperformed the market with our beer volumes growing by 4%; results in a market share of 69% for the quarter which represents a gain of 70 basis points versus the same period last year.

Procter & Gamble Co.: A few highlights include India delivering a 39th consecutive quarter of double-digit sales growth, Brazil growing sales over 30% and building share for the 25th consecutive period and Russia growing value share for the tenth month in a row.

Coca-Cola FEMSA SAB de CV: Our South America division delivered solid top line results in the first quarter of 2012, despite bad weather conditions in Brazil and Columbia.

Owens-Illinois, Inc.: Overall, Brazil has gone through a little bit of a coaster ride over the last couple of months. The government is clearly opening the faucet at this point in time to drive economic activity again. And certainly in the projections that we're getting from our customer base, that's clearly reflected for the latter part of the year.

PepsiCo, Inc.: Emerging markets revenue growth was particularly strong, up 13% on a constant currency basis, led by strong double digit organic revenue growth of 21% in India, 13% in Brazil, 33% in Saudi Arabia, and 26% in Egypt just to name a few.

Whirlpool Corp.: As we discussed on the last call, the Brazilian government declared an appliance sales tax holiday in December. The program originally set to expire on March 31 was extended for an additional 90 days through June 30, 2012 as expected. Irrespective, however, of the stimulus program, we continue to be very positive about the prospects for our Brazil and Latin American international business.

Howard Penney

Managing Director

Rory Green

Analyst