Sonja Filitz
The last five months or so have been challenging ones for BRF SA (NYSE:BRFS). Brazilian consumers are under pressure from high inflation, and although input costs have been better of late for this large poultry and packaged food producer, margin leverage is still sub-optimal. What’s more, as the company continues to invest into transformative capex, liquidity has come under pressure, leading to a higher net debt position.
It’s harder to find strong arguments for a bullish stance on BRF today. While the situation in Brazil seems to be stabilizing, there’s still quite a bit of uncertainty in key foreign markets. What’s more, rivals like JBS (OTCQX:JBSAY) have more flexibility when it comes to pricing and assortment. Maybe the best bullish argument at this point is that expectations have come down for this stock and the shares don’t look all that expensive; if the company can execute on its multiyear turnaround strategy, there is greater upside potential, but execution has been pressured here of late.
A Q2 Beat Against Lower Expectations
After an awful first quarter, sell-side analysts reset their expectations for BRF for the remainder of the year. I think BRF’s better-than-expected second quarter results have to be viewed in that context, as well as some helpful trends like gross spreads and strong pricing in certain foreign markets.
Revenue rose more than 14% year over year on a pro forma basis, coming in slightly ahead of expectations according to one third-party source and slightly below expectations according to a different source. Adjusted EBITDA, though, was solidly above expectations in either case – beating by around 10%-11%.
Revenue growth was underpinned by improved results in Brazil (close to half of revenue), where revenue rose more than 12% year over year and 11% quarter over quarter, with volume down 4% yoy and price up 17%. In the processed food business, volumes were down 3%, while price increased 19%. All things considered, large producers like BRF and JBS are seeing less of the trade-down effect (customers shifting consumption to cheaper options) than smaller players.
Gross margin in Brazil declined 220bp to 15.9%, and adjusted EBITDA declined 19% yoy and reversed a quarter-ago loss to R$398M, with margin declining 170bp to 9.2%. While BRF didn’t see the same hit to its cost structure from weaker demand as in the first quarter, profitability is still suboptimal today.
The International business saw 13% yoy and 11% qoq revenue growth. The largest segment, the Halal business, reported 28% yoy and 1% qoq growth, with volume and price growth relatively balanced on a yoy basis. Sales to Asia declined 16% yoy on a 20% volume decline, while direct export sales rose 25% on an 8% volume decline.
International gross margins benefitted from a better spread between higher poultry prices and more stable grain prices, helping drive International gross margin up four points to 21.5%, with the Halal business up 920bp to 29.5%. EBITDA rose 40% yoy as reported (margin up 280bp to 14.2%), but the Halal business did get a boost from hyperinflation in Turkey, with reported EBITDA up 114% to R$595M and adjusted EBITDA up 63% to R$453M (with margin up 370bp to 16.9%).
Ongoing Challenges In Brazil
Although BRF reported data from the Brazilian Supermarket Association that suggests a surprising level of consumer resilience in the face of sharp inflation (prices up 11% to 12% depending upon the source), other third-party sources suggest that there’s been more trading-down in the market and that this could accelerate as the gap between wages and prices increases.
BRF is facing a delicate balancing act in its domestic operations. While the company does have a tiered branding strategy that can help a bit with pricing/assortment flexibility, the reality is that Brazil is a significant market, and the company’s profitability and liquidity challenges don’t lend as much pricing flexibility as JBS’s stronger operations do. BRF’s market share held up rather well in the second quarter, but this could be a more challenging balancing act in the second half of the year, and particularly so if input prices were to start reaccelerating (corn prices have been declining while chicken prices have been fairly steady at a higher level).
The International Situation Still Merits Monitoring
BRF’s Halal business has long been a jewel in the company’s crown, and I expect that to continue. That said, management did note some concerns about the hyperinflationary environment in Turkey (a key market).
There’s also ongoing uncertainty about the Saudi Arabian market, as the country recently (May 2022) suspended chicken imports from 11 Brazilian plants (including several JBS plants but no BRF plants). Saudi Arabia has been pushing for greater self-sufficiency in food production, and this has created turmoil for BRF in the past, though the company and the kingdom have been working more closely of late to increase domestic production within Saudi Arabia.
On a larger macro level, I have some concerns about the poultry market. Export demand from Brazil has remained healthy, but I do have concerns that the market could correct/normalize faster than the beef market, leaving BRF in a more challenging position relative to other Brazilian protein producers.
The Outlook
It’s worth remembering that the restructuring underway at BRF is a multiyear project and one that is still closer to its start than its end. Initial efforts like refocusing around the core Halal business, introducing/growing a pet food business, and streamlining domestic go-to-market activities have looked good so far. Still, the company has a long way to go with its overall margin structure and with its efforts to improve liquidity (reduce debt).
The reality of modeling BRF is that it’s always going to be difficult to get the numbers right beyond a year or two, given the significant impact of global commodity chicken and cost input prices (corn, et al.). Nevertheless, I do still see BRF improving its international footprint and continuing to grow its branded packaged/processed food business, both in Brazil and in key overseas markets. Over time that will lead to less revenue and margin volatility, but it will take years to get there.
I’ve increased my revenue expectations for FY’22 on the back of stronger pricing, but my full-year EBITDA margin estimate is about three points lower now, and I don’t expect 11%-plus EBITDA margins for at least the next three years. With that, my free cash flow estimates over the next three years are also lower (FCF margins of -3% to 2%), though I still believe long-term FCF margins in the mid-single-digits are attainable and credible. Long term, I’m looking for around 6% annualized revenue growth and FCF growth of close to 10%.
The Bottom Line
Between discounted cash flow and a margin/return-driven EV/EBITDA (6.75x forward twelve-month EBITDA, below the historical average of close to 8.5x), I believe fair value for these ADRs is around $4.00 to $4.25. While I do see opportunities for BRF to outperform and I believe this can become a significantly more profitable food company with attractive exposure to growing markets, the reality is that execution has been inconsistent (even if not always the fault of management) and there is still a lot of execution risk to this name today.
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