Over the past six months, Arcos Dorados’s shares (currently trading at $8.42) have posted a disappointing 14.6% loss while the S&P 500 was down 1.7%. This might have investors contemplating their next move.

Is there a buying opportunity in Arcos Dorados, or does it present a risk to your portfolio? Check out our in-depth research report to see what our analysts have to say, it’s free.

Even with the cheaper entry price, we're cautious about Arcos Dorados. Here are three reasons why we avoid ARCO and a stock we'd rather own.

Why Is Arcos Dorados Not Exciting?

Translating to “Golden Arches” in Spanish, Arcos Dorados (NYSE:ARCO) is the master franchisee of the McDonald's brand in Latin America and the Caribbean, responsible for its operations and growth in over 20 countries.

1. Projected Revenue Growth Is Slim

Forecasted revenues by Wall Street analysts signal a company’s potential. Predictions may not always be accurate, but accelerating growth typically boosts valuation multiples and stock prices while slowing growth does the opposite.

Over the next 12 months, sell-side analysts expect Arcos Dorados’s revenue to rise by 3.9%, a deceleration versus its 8.6% annualized growth for the past five years. This projection doesn't excite us and indicates its menu offerings will face some demand challenges.

2. Low Gross Margin Reveals Weak Structural Profitability

We prefer higher gross margins because they not only make it easier to generate more operating profits but also indicate pricing power and differentiation, whether it be the dining experience or quality and taste of food.

Arcos Dorados has bad unit economics for a restaurant company, signaling it operates in a competitive market and has little room for error if demand unexpectedly falls. As you can see below, it averaged a 13.4% gross margin over the last two years. Said differently, Arcos Dorados had to pay a chunky $86.55 to its suppliers for every $100 in revenue.

3. Breakeven Free Cash Flow Limits Reinvestment Potential

Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.

Arcos Dorados broke even from a free cash flow perspective over the last two years, giving the company limited opportunities to return capital to shareholders.

Final Judgment

Arcos Dorados’s business quality ultimately falls short of our standards. After the recent drawdown, the stock trades at $8.42 per share (or 0.4× forward price-to-sales). The market typically values companies like Arcos Dorados based on their anticipated profits for the next 12 months, but there aren’t enough published estimates to arrive at a reliable number. You should avoid this stock for now - better opportunities lie elsewhere. Let us point you toward a safe-and-steady industrials business benefiting from an upgrade cycle.

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