Arcos Dorados Holdings Inc.

Good morning and welcome to the Arcos Torados second quarter 2019 earnings call. A slide presentation will accompany today's webcast, which will also be available in the investor section of the company's website, www.arcostorados.com. As a reminder, all participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. Also, today's conference is being recorded. At this time, I would like to turn the call over to Patricio Enzanola, Director of Investor Relations. Please go ahead.

Thank you. Good morning, everyone, and thank you for joining our earnings call. With me on today's call are Marcelo Ramos, Arco Morado's Chief Executive Officer, and Mariano Tanemong, Chief Financial Officer. Please try to slide through. Before we proceed, I would like to make the following safe travel statement. Today's call will contain forward-looking statements, and I refer you to the forward-looking statement section of our earnings release and recent findings with the FTC. We assume no obligation to update or revise any forward-looking statements to reflect new or changed events or sequence types. In addition to reporting financial results in accordance with generally accepted accounting principles, we report certain non-GAAP financial results. Inventors 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 audited financial statements filed today with the SEC on Form 6-K. Our discussion today excludes the results of the Venezuelan operation both at the consolidated level as well as for the Caribbean division, due to the country's ongoing macroeconomic volatility. 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, Marcelo Raba. Thank you, Iñaki. Hello, everyone. I am excited to host my first earnings call as Arcos Dorados CEO. I am truly honored to have the opportunity to lead this company as we continue to move forward. I would like to thank our executive chairman, Woods Dayton, and the board for their confidence in me. I spent my entire career within the McDonald's system building solid relationships with my colleagues, suppliers, franchisees, and partners. I am confident that together, we will continue to manage through any challenge while we continue to expand our market leadership across the region. I still remember my first days on the job almost 30 years ago when I started as a crew member in Buenos Aires, Argentina. I am one of many examples of the commitment that Arcos Dorados has always had to providing youth with high-quality job opportunities and professional career development. I have held many senior leadership positions across our four geographic regions before the last job as COO commencing in 2015, including divisional president of NOLAB and divisional president for Brazil. Just as my predecessors, my focus has always been on instilling and driving operational excellence and consistently delivering higher levels of performance. I assure you that this will not change. Luis Raganato, who is stepping into my former role, and I have worked together for many years, and I am looking forward to continuing our partnership. We are committed to leading the company toward the continued successful execution of our three-pillar strategy, comprised of delivering an enhanced customer experience, providing the most relevant and desirable menu offerings, and running the best restaurants. Now, please turn to slide three. Strong momentum continued through the second quarter, reflected not only in our reported results, highlighted by 14.2% comparable sales growth, strong cash flow generation, and an additional 120 basis points of adjusted EBITDA margin expansion, but also across the entire organization through multiple initiatives. Thus, I am confident that we have put in place the right growth strategy and we plan to stay the course. Sharp and disciplined execution of our strategic initiatives will continue to be crucial to near and long-term success. We will sustain our market leading brand and scale and build upon our dominant geographic footprint while delivering the largest and most comprehensive omnichannel guest experience in Latin America. We will continue to meet our customers where and how they want us to meet them. Additionally, we will maintain an agile approach to capital allocation. focusing on those markets that have the most growth potential and investing in the multiple growth initiatives that make up our strategy. These include delivery, EOTF, and digital, which comprise the McDonald's global accelerators of growth, as well as our affordability platform. In fact, we have been so pleased with the performance of our EOTF restaurants that we plan to expand the rollout to six additional countries during this year. The success of our initiatives is a validation of our three-pillar strategy and continues to give us confidence that we can sustain sales growth above blended inflation. We are also committed to remain the most socially impactful as well as the most sustainable restaurant company in Latin America. It's the right thing to do as the leader, and as well it makes good business sense. Our second quarter results demonstrate that our strategy continues to traction well. This is more about what we have been doing as a company than about market conditions. Based on the most recent market data from the Institute of Food Service Brazil, IFB, We are outpacing the growth of the industry in that country, and we think we can do even better. The strong trends from Q1 in Brazil continued in our compatible sales, even when excluding the impact of the tracker strike during the same period last year. We are also encouraged by our discussions with McDonald's regarding our next three-year investment plan. There is still a bit more work to be done on this front, and I'm looking forward to being able to disclose more about this later in the year. I will now turn the call over to Mariano to discuss our top-line performance and some of the underlying elements we are employing to drive growth.

Thanks, Marcelo. Please, go to slide four. The positive momentum continued as we delivered another quarter of strong results. The successful marketing and promotional campaigns that we have been executing since the end of last year, coupled with strong offerings, have proven to be key in achieving significant top-line growth. Given the continued volatility in a number of our key markets, we have focused on offering an appealing affordability platform. making this menu even more relevant to our customers. Following the first quarter trend of double-digit consolidated comparable sales growth, in the second quarter of this year, we achieved comparable sales of 14.2% above blended inflation. We also somewhat benefited from easier comps in Brazil, where a tracker strike in 2018 significantly impacted Q2 consumption across the board in that market. While last reported revenues continued to be impacted by the depreciation of our key currencies, as we anticipated in our previous call, this quarter the currency translation impact was lower. The significant depreciation of the Argentine peso and the Brazilian real took place in the second quarter of last year. Please turn to slide 5 for more details on our divisional top line. We again outperformed the sector in Brazil this quarter and achieved comparable sales growth of 12.1%, well above inflation. On top of the strong marketing campaigns, profit growth was also driven by the rollout of EOTF, the expansion of our research centers, and the continued growth of our delivery channel. Moving to SLAD, comparable sales increased 27.7% below the division's blended inflation. While traffic is still impacted by the weak consumer environment in Argentina, we saw a slight recovery by the end of the quarter, posting better figures than the reports from the Association of Medium-Sized Retailers. However, We remain cautious about Argentina in the short term, as we continue to expect an uncertain operating environment fueled by the electoral calendar. On the other hand, we continue to see good momentum in Chile, Ecuador, and Peru, all posting strong traffic and comparable sales well above inflation, driven by the great performance of our marketing strategies. These are countries with stable and growing economies, and they're acting as counterweights to our business in Argentina. In Peru, we are very pleased to announce the opening of two new restaurants in Lima. These will be located in two of the main shopping malls, one of which will be the first EOTF restaurant we launch in the country. In NOLA, we posted comparable sales growth of 7.3%. well above blended inflation and remain focused on increasing sales and traffic. As a result of this, Mexico continues to consolidate as a key driver of growth within the division. Unlike Q1 2019, in this quarter we benefited from the Easter holiday shift. Panama also contributed to the division's top line growth. remains challenging but is showing signs of improvement. Finally, in the Caribbean, we posted comparable sales growth of 1.9%, driven by strong performances in the French West Indies offset by a soft consumer environment in Puerto Rico. Even though Colombia posted strong comparable sales growth, its revenues in U.S. dollars were impacted by the 14% year-over-year depreciation of the Colombian peso. As noted, the French West Indies, a market that generates hard currency, is performing very well. This is another example of the benefits of having a unique and diversified portfolio. Back to you, Marcelo. Thank you, Mariano.

Liz, turn to slide six. As you can see, our second quarter performance demonstrates the effectiveness of the key growth accelerators that comprise our omnichannel approach to our markets, delivery, digital, and EOTF, with Cultura de Servicio enhancing the overall guest experience that clearly differentiates our brand. Along with our menu, we are driving guest counts, volumes, and market share. With regard to delivery, we continue leveraging more of our restaurant footprint and adding delivery partners such as Uber Eats in Puerto Rico. Delivery is now available in 11 markets at over 1,100 restaurants. This area of our business is growing much faster than we initially anticipated, and incremental sales in restaurants that offer delivery are in line with the global McDonald's system. On the digital front, the number of downloads of our app, an important component of our powerful technology ecosystem, grew to over 26 million. Our app is an important direct channel to communicate product launches and appealing promotions. During the second quarter, we added 79 EOTF restaurants. and it is important to highlight that EOTF restaurants are producing sales lift beyond their first year, going from mid to high single-digit growth in our main markets. EOTF is definitely working. Along with Cultura de Servicio, which results in exceptional levels of hospitality, we offer a truly differentiated guest experience that is 100% consistent with being an aspirational brand. We continue rolling out EOTF and are on track to deliver the 650 target by the end of this year. Please turn to slide seven. Finally, at the end of June, we have opened a total of 71 new restaurants during the prior 12 months, expanding our already dominant footprint. On top of this, we opened 385 dessert centers and six McCafes. Now, back again to Mariano to talk more about our performance below the top line.

Thanks, Marcelo. Now, let's move to our cost structure and profitability on slide eight. Small top line growth above inflation combined with our ongoing efforts to capture efficiencies in all our cost line items resulted in an expansion of our adjusted EBITDA margin of 120 basis points to 7.8% this quarter. Despite currency impacts, adjusted EBITDA increased 15.9% in dollar terms and 25.1% in constant currency. Expanding on our cost structure, the main driver for our operating expenses leverage attributable to scale. Additionally, we continue to achieve efficiencies in payroll due to higher productivity and lower claims, particularly in Brazil. All of these are done while increasing customer satisfaction. Therefore, we were able to more than offset the impact in gross margin resulting from our change in product mix. reflecting our more promotional strategy to drive traffic in a still challenging economic environment. At the same time, it is important to note that we have been able to keep our food and paper costs growth in line or below blended inflation. Finally, our G&A expense decreased by $5.6 million in absolute terms and was down 60 basis points as a percentage of revenues. Please turn to slide 9 for more details on our divisional results. In this quarter, we achieved adjusted EBITDA margin expansion in Brazil and NOLAD, partially offset by the performance of our SLAD and Caribbean divisions. The performance in SLAD continued to be affected by some cost pressures and changes in mix, mainly arising from Argentina. Moving to the bottom line on slide 10. We generated $11 million of net income during the quarter, compared to $10.7 million in the same period last year. On top of higher operating income, we reported better non-cash foreign currency exchange results, partially offset by higher income tax and interest expenses versus last year. Please turn to slide 11. On the back of our strong cash position and better results, we have been able to accelerate our CAPEX program to $57.6 million compared to $39.4 million in the previous year's quarter. We ended this quarter with a net leverage ratio of 1.6 times adjusted EBITDA, which is well below our target range of 2 to 2.5 times. As a reminder, our leverage ratios are calculated using consolidated as reported results. Finally, I am very encouraged by the performance of our company and the opportunities we have ahead. Despite macroeconomic headwinds that we still face in some of our markets, we have never lost sight of the long-term opportunity, and we continue investing in our business to offer the best guest experience while maintaining our streamlined cost structure. We remain totally committed to following this path. Our model is built on leveraging scale, so as we continue to grow our top line, we expect to continue to drive additional margin expansion in the coming years. That concludes the review of our financial and operating results. as some additional remarks before the Q&A portion of this call. Back to you, Marcelo.

Thanks, Mariano. Please turn to slide 12. Before opening the call for questions, I'd like to put our most recent quarter's performance in context and comment on two areas that we are extremely proud of for taking a leadership role in our region. Through agile capital allocation, focused on areas with the highest growth potential, our investments in delivery, digital, EOTF, and cultura de servicio are clearly paying off, further distinguishing our market-leading brand, strengthening customer loyalty, and driving sustainable top-line growth. Importantly, we have been driving operating leverage significantly. With our performance year-to-date, we expect to continue expanding our margin, which, combined with sustained revenue growth above inflation, will generate higher returns for our shareholders. Earlier, I touched upon our company's dedication to youth employment and development, which is one of several Scale for Good initiatives that make us the most socially impactful and sustainable restaurant company in Latin America. Another initiative is the commitment to promoting healthier eating habits for kids and families. I am happy to announce that starting tomorrow, our Happy Meal offering in most of the Arco Dorado's countries will feature food combinations that are even more nutritive, including more fruits and vegetables, with a strong reduction in the levels of fat and sodium, and no added sugar. We are the first QSR player to take this step, and this is a key part of our continuing commitment to offering our consumers delicious and nutritious food. Operator, please open the call to questions.

Yes, thank you. We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. In order to allow all listeners to participate, please limit yourself to one question and one follow-up question. Our first question today will come from Ian Luketic with J.P. Morgan. Please go ahead.

Good morning Marcelo, Mariano and Patricio. I have a couple of questions if I may. So first from Brazil, I would like to know how has the third Q started and what's the outlook for the full year? So in terms of margins, I understand that the 14.5% margin that you reported last year starts to become easy given the bid on first half. So curious to understand expectations. My second question is on Argentina. So with primaries scheduled for Sunday, Has the company already elaborated different strategies depending on the outcome of the elections? And lastly, is it possible to extrapolate how much of the SIM sources in Brazil was helped by delivery and EOTF initiatives? Thanks.

Okay, good morning Ian. Let me begin with Brazil. I'm talking about the trend of the first weeks of the third quarter. What I can share with you is that we are very pleased with the momentum in the first half of the year and we are very pleased that that momentum continues in the first weeks of the third quarter. It's important to mention that the Brazilian economy is not doing as well as expected. we got from the market is that the consensus for the GDP growth this year is below 1%, which is far lower than what we were expecting at the quarter of last year. The good momentum and the good results we are getting from Brazil is completely related with our strategy and the way we are managing the business. I could mention that we have a very strong affordability platform in place, which is gaining traction and bringing more and more customers to our restaurant. And on top of that, you mentioned a couple of drivers of our growth, which are the deployment of the ODF, where we are seeing very healthy, safe lifts in the restaurant that are changing the image and introducing all these digital features that comes with EOTF and on top of that we are growing delivery as we mentioned we are operating delivery in 11 countries in Brazil one of those so those are initiatives those are part of the strategies that we are implementing in Brazil and are helping us to grow sales like we did in the first quarter and in the second quarter and momentum continues in the third quarter obviously we remain cautiously optimistic about Brazil for the rest of the year because there is still some uncertainty, but we are very pleased. Obviously, we are the strong leaders in that market, and I think that we are in the right path with the right strategy in place to keep that leadership position and to increase our market share. Maybe Mariano can comment something about margins.

Yes. Hi, Ian. How are you? Good morning. Yes, in terms of margins, also, we are very pleased, as we already mentioned during the call. We are seeing the sales going well above inflation. We are seeing that gross margin is decreasing, but at the same time, it's important to note that the cost of food and paper is not increasing. The gross margin is decreasing mainly because because of a change in mix, because we are being promotional, as Marcelo just mentioned, and that's the strategy we are following. And on top of that, mentioning that the cost of food and paper is not increasing above inflation, it's important to note that we are seeing some leverage in the payroll line actually overcoming the loss of gross margin. And on top of that, we are managing the GNA and we are seeing leverage on that line as well. As we have been mentioning in the past, that's something as long as our sales are growing well above inflation or above inflation, we are able to manage the P&L in order to gain leverage on the EBITDA margin and that's what we are seeing so far this year and that's what we are expecting for the remaining of the year. The only comment we want to make is on the third quarter of last year, remember that we have a positive tax recovery that was recorded on the third Q, and that was approximately $20 million that was going through the EBITDA. But on top of that, I think that's mainly the explanation. Okay, so that's for Brazil.

In the case of Argentina, I think that your question was around if we have different strategies depending on the outcome of the elections. No, we do not have that kind of approach. What we are seeing in Argentina, obviously, is a consumer environment which is soft. We need to be aggressive in terms of our price points, in terms of our affordability platform, and on top of that, we take advantage of our app which brings us a very good channel of communication with customers in Argentina where we can share with them the new promotions and some coupons in order to bring additional traffic to our restaurants. In the case of Argentina, that's the outlook we have for the remaining of the year. We will continue to work with this kind of approach with an aggressive FWD platform for the next coming months. But it's important to mention that obviously for Argentina this is a very important market for us. We remain very positive in the long-term possibilities and potential of this market. That's why we continue to roll out ELTF in Argentina at this time at a lower pace for now In that sense, we are taking advantage of our flexibility to reallocate investments towards other promising markets in the SLAP division. That's the case this year for Chile, Ecuador, and Peru. That's why we announced that we are introducing EOTF in six additional markets this year. Two of those are Ecuador and Peru, which are doing extremely well. That's an advantage of our portfolio of markets. and how we deal with this agile approach to investment. So that's, I think, what I have to say about Argentina. Thank you for your question.

Thank you.

Our next question will come from Robert Ford with Bank of America Merrill Lynch. Please go ahead.

Thanks for taking my question, and good day, everybody. Marcelo, first, congratulations on the promotion. I don't think there are many folks in the entire system with your level of experience across multiple markets and functions, and I wish you all the very best. Now, I know you're lapping the truck strike, but I was still very impressed with the gains in Brazil. In your press release, you mentioned productivity, labor claims, and G&A sources of leverage, and I was curious if those were listed in the order of importance, and, you know, with labor productivity being listed as possibly the biggest source of operating leverage when it comes to productivity, are there processes or technology elements that contributed to that margin lift, or is the productivity gain simply coming from better use of existing capacity?

Okay, thank you. Thank you very much for your comment. As you say, you are right. The main contributor for our leverage in labor costs was productivity. That's because our increases in sales and volumes were very strong and typically a portion of our labor cost is fixed. For example, most of the management cost at restaurant level Obviously, at GNI2, it's almost fixed, so we gain leverage with the kind of increases in sales and guest counts we are having in that area. There's no big changes in technology, but obviously, we are focusing the execution at restaurant level and looking for additional improvements and gaining efficiencies in every single restaurant, in every single initiative that we deploy in restaurants. In some case, the ODF is helping with that too. The main contributor was the productivity increases and we are very pleased with the kind of management we are getting in Brazil at restaurant level for the line of labor.

Let me ask Vogue, how are you? Good morning. Yes, payroll in general was the main contributor to the increase in margins. Secondly, I would mention the GNA in the market. We are continuously looking for opportunities for efficiencies in our GNA structure, but obviously when sales increase at this pace, GNA is mainly fixed. So it's logical that we see leverage on that line. On top of that, we are seeing also leverage on occupancy and other. Many of the others, for example, include utilities and other fixed costs like insurance that when the sales are increasing above inflation, it's normal and natural to see leverage on those lines as well.

Thank you, Mariano. And I was curious with respect to the big tax increase. I don't know if that's just because the foreign exchange gain or if this is incurred or largely deferred, but I was curious as to why the big step up in the expected tax rate during the period and your expectations for 2019. And then, again, within this tax hit, how much of this is deferred versus actually being incurred?

Yes. Related to the tax, we always mention that it's more understandable to see the tax throughout the year and not in each quarter because sometimes it's a bit misleading when you see it in the other quarters. You see an increase of approximately $3 million in this quarter compared with last year. It has to do as well with the different tax rates in different markets. So it's mainly, it's not that much about deferred taxes but it's about different rates in different markets and where we have the income and where we don't have it. So in this case, it's mainly coming from more income in Brazil and that's the main contributor to this increase. But going forward, we are not seeing any changes in this line, and it should be in line with what we saw last year and what we are expecting for 2020 is in line with what we are seeing here so far in 2019.

Great. Thank you very much. Thank you, Bob. As a reminder, if you would like to ask a question, please press star, then 1. At this time, there are no further questions. It looks like we have a follow-up from Ian Luketic from J.P. Morgan. Please go ahead.

Thanks, guys. So a quick follow-up here. So I was wondering if you're already negotiating your protein prices for the following year. So if you could give us a couple of sensitivity maybe here or outlook on what are the negotiations going and what we should expect for the next year. Thank you.

We are not ready to share much more detail on that. We are very impressed with the discussions we are having with McDonald's regarding our next three-year cycle investment plan, but we do not have all the details. a bit work to be done in this area in order to close the discussions and the negotiations with McDonald's. And as soon as we have any information to share with you, obviously we will do that. So sorry, but that's the situation with this matter.

I'm not sure if I was clear. So my question was regarding the negotiation with the protein companies. So regarding beef, poultry, and pork prices for the next year.

Sorry, I misunderstood your question. We are beginning to work in our 2020 plan, particularly in terms of costs. We are not foreseeing any relevant additional pressure. There were in the past some questions around the swine fever and if that was impacting somehow in a relevant manner our beef costs, which is not the case. I will tell you that our supply chain team is doing an extremely good job in the area of keeping our costs, food and paper costs, growing in line or below inflation, which has helped us to be as aggressive as possible in terms of the offers and the promotions that we ran. in the different markets. So that's the outlook right now. Maybe Mariano can add some color on this.

Yes, I just wanted to add that we already finished our hedging program for 2019 and we already started hedging for the first quarter of 2020. Remember that we hedged our food and paper, imported part of our food and paper costs on a rolling basis, on a nine-month rolling basis. That's our hedging policy. So we already have some certainty on the effects that we would face for the coming months. We do that not only, of course, in Brazil, but in all the markets where these instruments are available, mainly Colombia, Uruguay, Chile, Argentina, Mexico, Peru.

Great. Many thanks, guys.

Our next question will come from Pedro Fagundes with Bradesco BBI. Please go ahead.

Yeah, hi. Thanks for taking my question. Good morning, Marcelo, Mariano, and Iaki. I have a very quick follow-up, actually. I think we've touched on it a couple of times, but I just wanted to check. Regarding margins for... for delivery orders, I think you guys mentioned last time that it is accretive for EBITDA. So I was just wondering, when you say accretive, you mean that delivery margins are accretive to EBITDA margin or for cash EBITDA? Thanks.

Yeah, thank you. Yes. If you want, Pedro, what we are meaning there is that this is adding to our margin. We are making cash out of the business. That's what we meant. Sorry if that was not clear.

Okay, got it. So the margin per se is lower for delivery orders, right?

It depends. It depends. You have different... things to take into consideration. It's a different business. You have to pay a fee to the third-party operator. You have different pricing strategies. You have some fixed costs at the restaurant level that are diluted when it starts to take advantage of those fixed costs when you do delivery at times when the restaurant has capacity in terms of payroll in terms of utilities in terms of a lot of things so analyzing that in a different way it's a different type of business also we mentioned that there's no 70% of delivery sales are incremental with all of that what we are saying is that delivery is bringing cash additional cash to the business okay got it awesome thank you

You're welcome. This concludes our question and answer session. I would now like to turn the call over to Mr. Rabach for any closing statements.

Okay. I would like to thank everybody. In my first earnings call as CEO of Barracos Rados, I was a little bit nervous here. But thank you. Thank you, everybody. Obviously, as always, we will be available, our IR team, for any additional questions or follow-up. And I look forward to speaking with you again soon. So have a very nice day, and thank you.

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