Arcos Dorados Holdings Inc.

Good morning and welcome to the Arcos Dorados third quarter 2018 earnings call. A slide presentation will accompany today's webcast, which will also be available in the investors section of the company's website, www.arcosdorados.com. And as a reminder, all participants will be in listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. Today's conference call is being recorded. At this time, I would like to turn the call over to Patricio Enceola, Director of Investor Relations. Please go ahead.

Thank you. Good morning, everyone, and thank you for joining us today. With me on today's call are Sergio Alonso, our Chief Executive Officer, Marcelo Rabat, our Chief Operating Officer, and Mariano Tanemo, our Chief Financial Officer. Please turn to slide two. Before we proceed, I would like to make the following safe harbor statement. This call will contain forward-looking statements, and I refer you to the forward-looking statement section of our earnings release and recent filings with the SEC. We assume no obligation to update or revise any forward-looking statements to reflect new or changed events or circumstances. In addition to reporting financial results in accordance with generally accepted accounting principles, we report certain non-GAAP financial results. Investors are encouraged to review the reconciliation of these non-GAAP financial results as compared with GAAP results, which can be found in the press release and unaudited financial statements filed today with the SEC on Form 6K. The differences in exchange rate and inflation in Venezuela generate material accounting distortions impacting both the reported results of our Venezuelan operation as well as our consolidated results. For that reason, and unless otherwise indicated, all results referenced in our comments today are shown on the accompanying presentation exclude the results of our Venezuelan operations. both at the consolidated level as well as for the Caribbean division. For your reference, we include a full income statement excluding Venezuela with our earnings release. I would now like to turn the call over to our CEO, Sergio Alonso.

Thank you, Miyake. Hello, everyone, and thank you for joining us today. Let's turn to slide three. We have spent the last couple of years We will place the initiative necessary to drive long-term sustainable value creation for all shareholders. Our strategic plan is focused on attracting more guests to our restaurants more often in a consistently profitable manner. Today, we have a leaner, more efficient business structure along with a sound balance sheet. During the third quarter, we saw the benefits of our work as our team and operating structure were tested by volatile environments in our two largest markets, Brazil and Argentina. In this context, comparable sales increased 7.4% on top of the 10.4% achieved last year. Consolidated EBITDA margin expanded 340 basis points to 12.3%. And we deliver strong double-digit net income growth as well as cash generation. These results demonstrate our unique ability to attract customers to our restaurants by offering compelling value and to manage our costs and balance sheet effectively. Many of our markets are performing really well, and I'd just like to highlight some of the turnaround success stories. In NOLA, we saw very positive sales expansion above the blended inflation rate, driven by a continuation of volume and other growth, particularly in Mexico. Comparable sales growth in Colombia and Puerto Rico were substantially above inflation in these countries, and the division delivered a 140 basis point improvement in adjusted EBITDA margin. In this region as well, our initiatives around G&A, payroll, and food and paper are all paying off. While flat results are heavily impacted by Argentina, Volumes, sales, and margins are all improving in each of the Andean countries. We're taking the long view in Brazil. Our business is all about finding the right balance between protecting the customer base without compromising margins. This quarter in particular, we skewed more total margin by volume growth. Turning up our promotional machine allows us to increase volumes, and we are poised to do this going into 2019. Bottom line, offering continued value in modern, family-friendly environments with warm hospitality consistently brings more guests to our restaurants. We strongly believe that there is significant potential for the McDonald's brand to continue growing in the region. Resolvable profitability has been driven by labor productivity improvements from our Cultura de Servicio program. Additionally, our scale, scale procurement teams, and hedging practices delivered production and program paper as a percentage of sales in the third quarter. Our strategy of gaining G&A leverage has been successful. A leaner, highly dedicated team is continuing to deliver in an efficient manner, and in fact, these quotes as G&A costs were below our blended inflation rate. The EBITDA margin expanded 130 basis points as compared to the third quarter of 2017, and excluding a tax-related credit, despite the way that this tip-up, which accounted for 30 basis points, as compared to last year. There is no magic here. These are results based on peer productivity initiatives throughout the business. We expect to see much of the same through the end of the year, and we'll continue to focus on our strategies to drive top-line growth for well-going market initiatives, while strengthening our margins as we move into 2019. Regarding the $660 million CAPEX plan, which includes $390 million of our investment in and the opening of at least 200 restaurants between 2017 and 2019, we remain on track to deliver these investments across our markets. Now I will hand the call over to Marcelo for the review of our operating performance.

Thank you, Sergio. Now please turn to slide four. As you know, innovation is at the heart of what we do and has been a key contributor to our success over the years. Being perceived as a modern brand is a major force driving customer preference, guest traffic, market share, average check growth, and the efficiency that Sergio has already touched upon. Given the connected world that we live in, the importance of mobile marketing is increasing. And as such, we are very proud of the numerous marketing awards that Arcos Dorados received this year from the Mobile Marketing Association, the leading group in the industry. Not only were we recognized as the marketer of the year across all industries in Latin America, but we also won eight of the nine awards that McDonald's received in the global category. helping McDonald's take home honors as the global marketer of the year. The awards that Arcos Dorados won at the global level include marketing within the mobile gaming environment, CRM, promotion, and lead generation. The innovative marketing initiatives behind these awards are a big part of driving traffic to our restaurants throughout our region. reinforcing our brand and keeping us top of mind with our consumers. When customers arrive at our restaurants, they find an inviting environment that reflects the quality and value of the McDonald's brand. Elevating our guests' dining experience is why we remain focused on modernizing our restaurants through the deployment of Experience of the Future, which includes digital upgrades in the form of modern menu boards, self-order kiosks, tables with digital entertainment in some cases, and upgraded Wi-Fi, among other new features. At the end of this quarter, we had 196 EOTF restaurants, and we are making progress on our plan to have approximately 650 EOTF restaurants by the end of 2019, primarily in Brazil and Argentina. Our customers are loving the changes we are making. Elevating our guests' dining experience and the implementation of our cultura de servicio program is resulting in improved customer satisfaction scores. This program encourages our employees to be themselves and empowers them to provide the best possible level of service. And it is really working. In Brazil, for example, customer satisfaction scores have reached their highest levels since we began monitoring them. Our investments in digital capabilities include delivery, and our MAC delivery service is now available in 10 markets. During the same period of 2017, McDelivery was in just three of these countries. As an example, more than 300 of our restaurants in Brazil provide delivery today, which is growing faster than we expected. We continuously enhance the functionality of our mobile app. We have now launched our app in all 20 countries where we operate. totaling more than 17 million downloads by the end of the quarter and growing. It is now one of the most downloaded apps in the food category in those markets. Our menu boards also showcase our focus on innovation. Besides the iconic menu items we offer, we are continually introducing innovative products in each of our markets. In Brazil, for instance, this quarter we launched triple cuarteron, egg cuarteron, and egg junior sandwiches. In Mexico, we launched premium chipotle ranch in the signature line and McFlurry choco rolls in the dessert category. In Argentina, we launched chicken sticks, the first product in Arco Florado's new snacks platform. Earlier, I touched upon the McDonald's brand. Our brand remains the favorite QSR brand across the vast majority of the markets in our region. In good part, our brand's top ranking can be attributed to our market-leading footprint and our award-winning advertising and marketing innovation. Please turn to slide 5. We continue to have as well as grow the largest restaurant footprint in the QSR sector in our region. I would also like to highlight that with over 1,300 freestanding and in-store locations and nearly 2,200 restaurants in total, we have the highest sales per unit of any major QSR chain in Latin America. The combination of elevating our restaurant experience, introducing innovative menu items, and empowering our employees to deliver a higher level of service is creating distinct and sustainable competitive advantages that will support our growth in the years ahead. As always, we look forward to updating you on our progress. Mariano will now discuss our key financial results with you.

Thanks, Marcelo. Please turn to slide six. The third quarter of 2018 was a challenging quarter in terms of the macro trends in some of our main markets. We were able to deliver a solid performance that reflects our ability to navigate very volatile environments. to our continued efforts to streamline our cost structure. Our total revenues increased 8.3% in constant currency in the third quarter, supported by a 7.4% growth in comparable sales. The sharp depreciation of the Brazilian real and the Argentine peso heavily impacted our reported revenues. Please, turn to slide seven. Moving on to our operations, we continued to improve productivity in our restaurants, resulting in significant savings in payroll costs as a percentage of revenues in all our divisions. Our G&A expenses decreased by $9.5 million in absolute terms, or 30 basis points, as a percentage of revenues, mainly benefiting from the depreciation of the Argentine peso and the Brazilian real. As a percentage of system-wide sales, we recorded the lowest GNA since we became public. Please turn to slide eight. Adjusted EBITDA increased 19.7% to $88.2 million, benefiting from a one-time income of $23.2 million recorded in other operating income. This was mainly related to a piece of Fin's tax credit in Brazil. Still, excluding this effect, the adjusted EBITDA margin expanded 10 basis points. Moving to the bottom line, during this quarter, we generated $42.7 million of net income, compared to $25.3 million in the same period last year. that interest expense decreased $2.8 billion year-over-year, mainly resulting from the impact of the BRL depreciation on our debt structure. Please note that for our risk management strategy, we keep a 50-50 balance between debt exposed to BRL and USD that protect us against the depreciation of local currencies. Similarly, we see the same effect in the nine-month period, which last year included the costs related to the liability management exercise implemented in March 2017. Also, we reported better non-cash foreign exchange results and higher income tax expenses. Please turn to slide nine for more detail on our divisional results. In Brazil, as Sergio noted, this quarter we delivered more margin expansion than volume growth. Moving to SLAD, our Indian markets are performing very well, while Argentina was impacted by the volatile macroeconomic environment. Top-line performance in our other divisions remains on track, with NOLA and the Caribbean all generating comparable sales growth well above blended inflation in the quarter. We posted our sixth consecutive quarter of strong comparable traffic growth in Mexico. Through an aggressive affordability platform, our innovative marketing initiative, as well as our focus on delivering an elevated guest experience, we're growing across every single category. In Puerto Rico, we maintained our successful affordability platform, which generated a significant increase in comparable sales, mainly driven by strong traffic growth. Please, turn to slide 10. In Brazil, adjusted EBITDA increased 37%, with the margin expanding from 13% to 21.8%, mainly benefiting from the previously mentioned tax recovery. Adjusting for this, the margin would have expanded 130 basis points to 14.3%. On top of the higher productivity that drove efficiencies in labor costs, we were able to reduce our food and paper costs. This reflects, in part, our ability to manage currency exposure in our supply chain in a very volatile environment. For NOLAD, our adjusted EBITDA margin contracted 140 basis points or 30 basis points if we exclude last year's re-franchising activities. The margin decline in the division was mainly due to higher royalty fees. In SLAD, our adjusted EBITDA margin contracted 180 basis points. Efficiencies in labor costs and G&A were more than offset by increases in other expense line items. Adjusted EBITDA in the Caribbean was $7 million, an increase of $1.9 million year over year. The corresponding margin expanded by 140 basis points with efficiencies in most line items except for royalty fees and occupancy and other operating expenses. Turning to slide 11, On the back of our strong cash flow generation and debt management initiatives, we continued to maintain a strong and healthy balance sheet during the quarter. Our net leverage ratio was 1.3 times adjusted a bit back, well below our target range of 2 to 2.5 times, and slightly lower than the prior quarter. As a reminder, our leverage ratios are calculated using consolidated as reported results. Moving to our capital allocation strategy, cash used for capital expenditure was around $56 million, and we used $8.3 million to repurchase nearly 1.2 million Class A shares under the share repurchase program that we announced in May this year. We are confident that despite the macroeconomic headwind, we will continue our path to grow in our top line, which will drive additional margin expansion. We remain totally committed to generating efficiencies in our business and improving our consolidated results for this year and beyond. I will turn the call back over to Sergio for his closing remarks.

Thank you, Mariano. In terms of slide 12, as I mentioned earlier, we expect continued short-term macro challenges, and we continue to pursue a strategy to manage our margins through the end of the year. We're delivering solid top-line growth across our markets. Our long-term plan includes modernizing our restaurants, providing the best guest experience, and offering the best value for money in the QSR segment, in addition to driving efficiencies. We would also like to take a moment to update you on our social responsibility initiatives. As we have discussed in the past, We're leveraging our scale to make a positive impact on our region. And so we're aligned with McDonough's Scale for Good initiatives related to packaging and recycling, kids' nutrition, and climate change. We're also aligned with some of the United Nations Development Goals. The three pillars that we focus on are youth employment, sustainability, and family well-being. We have dedicated much of our efforts to the nervous challenges surrounding youth employment in the LATAM and Caribbean regions. We employ over 72,000 young people, and for most of them, it's their first job and the first step in terms of social mobility. We also continue to maintain alliances with various nonprofit organizations that support youth employment programs. These organizations include the International Youth Foundation, Chase Foundation, City Foundation, as well as the Ayrton Senna Institute in Brazil. Recently, We established a partnership with the Ayrton Senna Institute for my happy day in this country where 100% of the proceeds from the sale of the Big Bad hamburgers are allocated to fund social projects related to youth and family healthcare and to youth education. Regarding the sustainability pillar, we have eliminated all film packaging from virtually all the restaurants, and are now only providing plastic shelves upon request. We believe it is a margin expansion in the third quarter, and I expect we will do the same in the fourth quarter of this year. These results are coming from management actions that have been taking over the last years. Further, we will continue to seek opportunities to improve efficiency, not only at the restaurant level, but across the entire company. The outlook for Argentina remains complicated, but I'd like to remind everyone that we are not new to navigating challenging environments in this country and others. And even in some of the most complex situations, we have preserved our customer base. Now, we have said several times that during adverse economic scenarios like the one we're currently going through, we need to focus more than ever in finding the right balance between sales and margins. Having said that, there's always the possibility of doing better in one of the two attributes. I believe this quarter we did better in margins, particularly in Brazil. And although we cannot say it's an easy fix, we can push harder on the promotional activities in our marketing calendar than move the needle towards sales. You should expect this to happen right at the beginning of 2019, but also without losing sight of profitability as we have done in all this time. Again, we're managing this business for the long term, and we will capture the significant growth opportunity that our region presents. So thank you for your continued support, and let's go to Q&A.

We will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Please limit yourself to one question and one follow-up. If you have further questions, you may re-enter the question queue. At this time, we will pause momentarily to assemble our roster. And our first question comes from Robert Schweik of RMB Capital.

Good morning. I wonder if you would discuss whether there's been any impact yet from the changing political situation in Brazil. And do you anticipate that your comp store sales in Brazil will show a better than 1% gain in the fourth quarter?

Okay. Good morning, Bob. How are you? This is Sergio. The first political outlook, what I would say, Bob, is that we're culturally optimistic about the near-term outlook for the country, particularly now that the elections are behind us. We also know that the elected president has named in his team of ministers really strong and business-experienced people. So all that are leading us to believe that the context in general will be positive for business development. That's the point surrounding the political situation where obviously the new president will take office January the 1st. Regarding the sales performance in this particular quarter, we said several times, just said it, it's all about finding the right balance between sales and margins. The reality is that in this particular quarter, we did better in margins than in sales. and that is probably because we did not understand and we did not catch how promotional the market was in this time. We sensed that probably the market would recover somehow in a faster pace, so we were not as aggressive, if you will, as we should be, but particularly in the bottom part, of every product per line-up. If you look what happened, Bob, and you know that you're very detailed on numbers, you will see that we did only 1% in sales, but at the same time, we grew gross margin by about 40 basis points, which is an indicator of what happened is we actually did less traction in the lower range of pricing products in our business. We did better in the upper range, which is the signature line. That explains why, I mean, we had an increase in average check simply because we did better in the upper range than in the lower range. And that also explains the margin expansion that we had from full-on paper lines. What you should expect is obviously we're going to turn up the promotional side of our marketing calendar. But the reality is that we consciously concern that out of all the possible combinations, this is, I would say, the most favorable to turn things differently, right? Because it's all about increasing what we do in our activities to promote the lower range of the product, what we call the affordability category.

And Sergio, let me add, hi Bob, this is Mariano. What Sergio mentioned about improvement in margin was not only in gross margin, but margin at the restaurant level improved considerably also when we exclude the tax recovery. Not only we improved the gross margin, but we also have seen improvements in other lines of our cost structure, which is also encouraging.

As a follow-up question, could you be specific on your next store expansion for the fourth quarter and for calendar 2019? Okay, yes.

In terms of openings, as it happened in the last few years, Most of our openings for this 2018 will be in the fourth quarter. We are planning to open between 65 and 70 restaurants for the whole year, so most of those will come in the fourth quarter. The same applies for the deployment of Experience of the Future. We mentioned during the call that we have around 200 restaurants with experience of the future as of September the 30th, but we are planning to close the year with more than 300 ELTF restaurants. We are ramping up the deployment on this initiative. This is related mostly with the idea to localize all the core packages in order to maintain investments at the right level and get the returns that we are waiting for. You will see, again, more openings during the fourth quarter of the year, and we are planning to achieve our guidance around 65 to 70 openings for the whole year 2018.

And regarding the two-year period, I think I said, I believe I said in the first part, we are very well on track to achieve our target of opening at least 200 residents in this cycle. from 2017 to 2019.

Did you discuss the results of the experience of the future conversions? What impact that has had on their business? Have you been able to analyze that in any meaningful way or is it too early?

Yeah, Bob. Basically, we are very, very pleased with the results that we are getting after the implementation of EOTF. We are in line with the expectations that we had previously, which is to have a safe lift in those restaurants of a single dish. Really, the results are very encouraging. We are completely aligned with the budget that we had in terms of investments, and again, in terms of the impact in sales lift and obviously in the returns that we are waiting for those investments.

Also, in fact, for the three-year period.

Yeah, yeah. We mentioned during the call that we are on track to reach at least or around 650 ODF restaurants at the end of next year. So, again, we are very encouraged by the results that we are seeing coming from those restaurants.

Thank you.

You're welcome.

Again, if you'd like to ask a question, please press star then 1 at this time. And our next question comes from Sam Bevan of Aberdeen Asset Management.

Hey, good afternoon. Thanks for the call. I've got a couple of questions. Firstly, on a leverage calculation used under the MFA, so on a rent-adjusted basis, because you haven't presented that. So maybe an update there, and then how close you are to the covenant. And the second question is a bit more info around the hedge that you've done from dollars to BRL, like what instrument have you used? What format? Is it a collar?

Yes, thank you.

Yes, regarding the energy ratios, we are in complete compliance with them. The third quarter, regarding the leverage ratio, the threshold is 425. We're at 383. Regarding the fixed charge coverage ratio, the threshold is 1.5 times. We are 181. So we are in complete compliance of those ratios. So no issue. Regarding the hedges, if the question was related to our debt, we hedged our corporate debt, the two bonds outstanding, with cross-currency swaps. So those are the instruments that we implemented. Regarding the hedges that we do on The food and paper side, what we use is forwards. So we have forward contracts with banks to cover for the food and paper exposure. And we have hedges in place, if you want, in the majority of the countries where we operate. We have in Brazil, Colombia, Uruguay, Chile, Argentina, Mexico, and Peru as well.

Okay. Excellent. Thank you.

And this concludes our question and answer session. I would like to turn the conference back over to Sergio Alonso for any closing remarks.

Okay. Well, thank you for your questions and your attention today. The team always remains available to meet with you and answer any other questions that you may have. So with that, thank you very much and enjoy the rest of the day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.