Arcos Dorados Early Success: What it Means

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Last week&rsquo;s McDonald&rsquo;s Latin and South American master franchisee Arcos Dorados&#39; (ARCO) initial public offering in the U.S. was notable in several respects. As of Friday, April 15, 2011, it is already highly valued, at approximately 34 times 2010 earnings and 12 times 2010 EBITDA. <strong>That&rsquo;s nosebleed territory already.</strong></p><!--break-->
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As we <a href="http://www.seekingalpha.com/author/john-gordon/articles/latest&quot; target="_blank">noted last week</a>, ARCO&rsquo;s company store restaurant margin and franchising margin trail that of parent McDonald&rsquo;s.</p>
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<strong>It was 1000% over subscribed immediately</strong>, meaning there were a boatload of offers to buy the stock but only so many shares offered. And the price was driven up. As CNBC reported Friday (<a href="http://www.cnbc.com">www.cnbc.com</a&gt;), <strong>it was the big instuitional buyers that got first crack at buying</strong>versus the so called &lsquo;retail&rdquo; smaller players. Size of money pool and relationships matter.</li>
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The over subscription and $4 price gain to $21 from its offering price of $17 <strong>will confirm that there is pent up demand in the US for IPOs</strong>. &nbsp;There have been only two other chain restaurant IPOs since 2006, Bravo Brio (BRIO) and Chinese Country Kitchen (CCSC), both in late fall 2010.</li>
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<strong>The success here becomes an irresistible signal for other restaurants IPOs to follow.&nbsp; </strong>As ARCO demonstrated, developing markets are &ldquo;hot&rdquo;.</li>
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The franchising business model is attractive on Wall Street (and elsewhere) because it hopefully makes for more stable cash flows/earnings (as we know franchisors get paid off the top line). There is much lower capital expenditure (CAPEX) in such operations. Generally, franchisors do pay for corporate IT platforms (not the store level POS) systems that hopefully bind the system together. And of course, it&rsquo;s the franchisees invested capital and work that makes these systems work.</p>
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<strong>Franchisor&rsquo;s premium:&nbsp; </strong>While we are all for US economic activity, it&rsquo;s possible that ARCO will eventually fall back to more reasonable price/value. At sale or transaction, restaurant franchisors generally have about a 1 to 2 times extra EBITDA &ldquo;turn&rdquo; or valuation, versus multi-unit franchisees. &nbsp;</p>
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And &nbsp;generally, &nbsp;publicly held &nbsp;franchisees trade at about 80% of the value of their publicly traded parents, partially because the franchisor generally has more territory to develop and less of a CAPEX requirement versus the publicly traded franchisee (ARCOS is predominately company operated) do operate some stores) because the part. <strong>As a result, the franchisor has a theoretical &ldquo;valuation premium&rdquo;.</strong></p>
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<span style="font-size:11px;">About the author: John A. Gordon, Chain Restaurant earnings and Economics Experts,<a href="http://www.pacificmanagementconsultinggroup.com&quot; target="_blank"> Pacific Management Consulting Group</a><br />
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