Fitch Affirms Arcos Dorados' IDRs at 'BB+'; Outlook Negative
KEY RATING DRIVERS
Arcos' ratings reflect its solid business position as the sole franchisee of McDonald's restaurants across Latin America. The company operates 2,141 McDonald's restaurants, 321 McCafes and 2,618 Dessert Centers in 20 countries. Arcos' benefits from McDonald's iconic brand, yet is confronted by several economic challenges facing the region, particularly in its key markets of Brazil and Argentina. The economic headwinds facing many Latin American markets and currency volatility across the region have negatively impacted Arcos' EBITDA generation and increased net lease adjusted leverage. Arcos' is also exposed to capital control risk in Venezuela, and to a lesser extent Argentina following the Argentine Peso free float. Despite these challenges, Arcos continues to make progress in its initiatives to improve its capital structure and reduce costs to partially offset the impact of currency depreciation. Fitch expects the company to reach a net lease adjusted leverage ratio below 4.0x by 2017.
NEGATIVE OPERATING ENVIRONMENT
Economic challenges and currency volatility across the region have eroded the company's EBITDA. Arcos' cash flow generation is concentrated in Brazil, which Fitch forecasts will contract by 3.8% in 2016. Brazil is by far the company's largest market contributing 45% to sales and 62% to EBITDA in 2015.
EXPOSURE TO CURRENCY RISK
Arcos is exposed to foreign exchange risk with currency depreciations in Argentina, Venezuela and Brazil, which negatively impacted results in 2015. EBITDA declined to USD217 million in 2015 from USD241 million in 2014 primarily due to the depreciation of the Brazilian real and Argentine peso. During the LTM ended March 31, 2016, EBITDA was USD224 million. Fitch expects continued currency volatility, particularly in Argentina, with projected year-end 2016 revenues and EBITDA to be slightly lower than 2015.
EXPOSURE TO CAPITAL CONTROLS
Arcos is exposed to exchange controls in its Venezuelan operations. Restrictions imposed by the Venezuelan Central Bank have limited the U. S. dollar supply in that country, which constrains the repatriation of available cash and restricts payment for imported goods as well as royalties. Following measures announced by the local government, Arcos obtained a temporary waiver to reduce royalty payments to McDonald's Corporation in 2012, 2013, and 2014. Venezuela represented about 5% of total sales in 2014. Arcos is also exposed to transferability risk with its Argentine operation. However, this risk is mitigated as its local operation does not generate excess cash with Arcos' headquarters being based in Argentina.
IMPROVING CAPITAL STRUCTURE
Leverage is currently weak for the rating level. Arcos is in the process of implementing several initiatives to improve its capital structure, including asset sales, asset redevelopments, refranchising and the restructuring of its corporate office. These asset sale related initiatives are expected to generate approximately $200 million over the next three years to be primarily be used to pay down debt. The company has also implemented several cost savings measures which are expected to add 2% to profit margins over the next three years to support EBITDA generation. Fitch expects these initiatives will allow net lease adjusted leverage to improve to below 4.0x to be commensurate with the rating level over the next 12 - 24 months. Net lease-adjusted leverage was 4.3x, improving from 4.8x in 2014.
MCDONALD'S FRANCHISE STRENGTH
The ratings also incorporate the strength of McDonald's as franchisor and its long standing relationship with Arcos' owners and management. The controlling shareholder of Arcos was the joint venture partner of McDonald's in Argentina for over 20 years and also served as President of the McDonald's South America division from 2004 until the acquisition. On average, the management team has worked for over 12 years at McDonald's. Under the terms of the Master Franchise Agreement (MFA), McDonald's has a call option to repurchase its assets in the region under certain events. Terms of the notes specify that these funds should be applied to debt repayment. The call option price is set as the fair market value of all assets of the operating companies (80% in the case of a material breach), minus debt at operating company and contingencies, plus cash. The MFA requires all group companies to remain current on their financial obligations to avoid a material breach of the agreement.
MFA WITH MCDONALDS
The MFA sets strict strategic, commercial and financial guidelines for the operations of Arcos, which support the operating and financial stability of the business as well as the underlying value of the McDonald's brand in the region. Arcos is the largest McDonald's franchisee in the world in terms of system-wide sales and number of restaurants. About 75% of the restaurants are operated by Arcos, and the remaining 25% are franchised restaurants. The company's strategy is to open 32 restaurants in 2016 (gross openings), with investments of less than USD120 million.
Fitch's key assumptions within the rating case for Arcos include the following:
--Low single digit traffic declines in Brazil and Caribbean;
--Low single digit traffic increases in SLAD and NOLAD;
--Price increases in line with inflation;
--Payment of USD80 million of 2023 notes in 2016 and payment of remaining 2016 notes;
--EBITDA margin improving to 7.5% in 2016;
--No dividend payments in 2016 and 2017;
--Capex in line with company projections;
--Net lease adjusted leverage declining to below 4.0x by 2017.
Arcos' ratings could be negatively affected by significant deterioration of same store sales; and higher than expected investments and dividends, pressuring free cash flow (FCF) and leverage ratios. Additional factors that could lead to consideration of a downgrade include: inability of Argentine and Venezuelan operations to be self-sustaining; failure to comply with the terms of the MFA; and/or a consolidated net lease adjusted debt-to-EBITDAR ratio above 4.0x on a sustained basis. A downgrade of Brazil's sovereign rating would not necessarily trigger a downgrade of Arcos' ratings. The applicable country ceiling for Arcos is Brazil's country ceiling of 'BB+'. In accordance with Fitch criteria, Arcos' Long-Term Foreign-Currency IDR can be rated one to two notches above Brazil's country ceiling given the company's ability to cover hard currency debt service with cash abroad.
A return to a Stable Outlook could result from a net lease adjusted leverage ratio below 4.0x on a sustained basis. The ratings could also be positively affected by higher than expected cash generation from investment-grade countries that would lead to a material improvement in leverage metrics such as net lease-adjusted debt levels below 3.0x.
Arcos had USD266 million in cash and marketable securities as of March 31, 2016, an increase from USD112 million at YE2015 due to the USD167 million secured loan the company received. This loan will be used to pay the company's BRL senior unsecured bond. During the second quarter Arcos launched a tender offer for its BRL notes which was successful and currently the notes have a remaining balance of USD58 million. Arcos has also tendered USD80 million of its 2023 notes with proceeds from asset sales.
Liquidity is enhanced by the company's credit and debit card receivables (USD29 million as of March 31, 2016) and meal voucher receivables (USD8 million). It is important to note that the secured loan is secured by credit and debit card receivables from 100 restaurants in Brazil. AD Holdings also had USD35 million of receivables from franchisees. The company also benefits from a USD25 million committed revolving credit facility with Bank of America and a USD25 million facility with JP Morgan. Arcos first entered into this facility in 2011, and renewed it for up to USD25 million (previously USD75 million) on July 30, 2015. This facility matures August 3, 2016.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings:
Arcos Dorados B. V.
--Long-Term Foreign-Currency IDR at 'BB+';
--Long-Term Local-Currency IDR at 'BB+'.
--Long-Term Foreign-Currency IDR at 'BB+';
--BRL675 million senior unsecured Brazilian-real notes due 2016 at 'BB+';
--USD473.767 million senior unsecured notes due 2023 at 'BB+'.
The Rating Outlook for the corporate ratings is Negative.