Pat McKeough responds to many requests from members of his Inner Circle for advice on stock picks, as well as questions on investment strategy and the economy. Every week, his comments and recommendations on the most intriguing questions of the past week go out to all Inner Circle members. And each week we offer you a report on one of the stocks profiled in these Q&A sessions. Beginning this week, we give you Pat’s buy-hold-sell recommendation as well as his analysis of the stock. This is part of our new approach offering you regular and specific buy, hold and sell advice in our daily posts. Every week you’ll get “A Stock to Sell” on Monday, “Best Canadian Stocks” on Tuesday, and “Our Top U.S. Stocks” on Thursday.

This week we had a question from an Inner Circle member about investing in a fast food franchisee. As its name Arcos Dorados (“Golden Arches” in Spanish) indicates, this company operates McDonald’s restaurants in Latin America and the Caribbean. It is McDonald’s single largest franchisee. Pat examines the pros and cons of doing business in an area that is growing rapidly but unevenly and still faces political and economic challenges.

Q: Pat: What is your opinion on Arcos Dorados? Thanks.

A: Arcos Dorados (symbol ARCO on New York; www.arcosdorados.com) is the largest McDonald’s franchisee in the world by revenue and number of restaurants. It’s also the largest quick-service chain in Latin America and the Caribbean.

Arcos Dorados has the exclusive right to own, operate and franchise McDonald’s restaurants in 20 countries and territories, including Argentina, Aruba, Brazil, Chile, Colombia, Costa Rica, Curaçao, Ecuador, French Guiana, Guadeloupe, Martinique, Mexico, Panama, Peru, Puerto Rico, St. Croix, St. Thomas, Trinidad and Tobago, Uruguay and Venezuela.

The company operates, directly or through franchisees, more than 2,062 McDonald’s outlets, with over 95,000 employees. The restaurants serve about 4.3 million customers a day.

In the three months ended June 30, 2014, Arcos Dorados’s revenue fell 7.2% to $917.9 million from $989.2 million a year earlier. The company lost $0.47 a share in the latest quarter, compared to a profit of $0.04. The falling value of the Venezuelan currency accounted for a large part of the lower revenue and the big loss in the latest quarter.

Decline in sales and profits in Brazil is cause for concern

Arcos Dorados’s Venezuelan restaurants have drawn a lot of investor attention lately, due to that country’s ongoing economic and political difficulties. But the company’s prospects are largely tied to its biggest market, Brazil (47% of revenue), which is struggling economically. Its sales and profits continue to fall in that country, and its profit margins are narrowing because its revenue growth in Brazil isn’t keeping up with labour costs.

However, Arcos Dorados has a number of positives the go beyond current economic difficulties in that region. In particular, its Latin American markets have a higher-than-average proportion (more than 30%) of young people aged 15 to 34, who are the main consumers of fast food.

Arcos Dorados’s market strength in Latin America also gains from the fact that more than 45% of its outlets are in free-standing locations, as opposed to malls. That gives them three key advantages:

First, Arcos Dorados enjoys greater control over its stand-alone restaurants, because their leases tend to be longer than those on mall-based locations.

Second, Arcos Dorados has a bigger say in the appearance of free-standing restaurants, and it doesn’t need to consult with mall owners when remodelling.

Third, Arcos Dorados’s stand-alone restaurants provide lots of indoor seating and come with drive-thru areas and parking lots, unlike mall-based locations, which typically consist of a front counter and kitchen with no seating area.

The stock trades at 47.6 times this year’s forecast earnings of $0.18 a share. However, its earnings could rise as high at $0.45 a share next year if the global economic rebound boosts the Brazilian economy. The stock trades at 19.0 times that estimate. It yields 2.8%.

We view Arcos Dorados as a hold, but only for aggressive investors.

If you missed last week’s Question and Answer Stock, on one of the leading competitors among online search engines, you can see the article here.