BRF Shares Look Almost Left For Dead But Sustainable Momentum Is Still Lacking (NYSE:BRFS)

Very little is going well for BRF S.A. (NYSE:BRFS) these days. High production costs are sapping margins, while high prices seem to be leading to some demand destruction in the Brazilian processed/branded food business. At the same time, new management has yet to give the Street a clear sense of what they will do differently or how they will achieve meaningfully better results than the frustrating run of inadequate profitability seen for many years now.

That gloom is amply reflected in the share price, which has fallen another 30% since my last update, noticeably worse than the weak results of other protein peers like JBS S.A. (OTCQX:JBSAY), Marfrig (OTCPK:MRRTY), Minerva (OTCPK:MRVSY), and Tyson (TSN). At this point, it’s not too much of a stretch to say that the market is valuing BRF as though it has almost no future and/or that Marfrig will make a lowball offer to sweep up the remainder of the company it doesn’t own.

I honestly don’t know what to tell investors at this point. The valuation seems harsh, but results aren’t going to get meaningfully better soon and I don’t see the company generating enough free cash flow to meaningfully reduce its debt for some time. At a minimum, while expectations may be washed out, investors should remember that it can always get worse from here and this is, at best, a high-risk deep value/turnaround story.

Third Quarter Results – It Could Have Been Worse, But It Wasn’t Great

There was some growth in the quarter for BRF, and the company managed to more or less meet expectations that had headed lower into the earnings report. That’s about the extent of the good news, though I think you can argue that the international operations continue to perform relatively well.

Revenue rose more than 13% year over year and about 5% quarter over quarter in the third quarter, coming in just shy of expectations for the quarter (again, those expectations were revised lower throughout the quarter). Revenue in Brazil rose about 7% yoy and 4% qoq, with processed food revenue up 11% and “in natura” product sales down 6% yoy.

Gross margin declined 160bp year over year, but rose 320bp qoq to 18.5% as international margins held up pretty well and the company saw some price/cost relief. EBITDA was up slightly on a yoy and qoq basis, with margin down 120bp yoy and 80bp qoq to 9.8%. Relative to sell-side expectations, BRF came in a bit below (around 2%) published expectations, though more like 5% off relative to the sell-side expectations a month ago.

Brazil Remains Under Pressure

BRF’s Brazilian results showed some ongoing pressure from strained consumers trading down and more effective competition. Revenue rose 7% yoy and 4% qoq, with the processed operations helping offset weaker in natura results. Gross margin declined 700bp yoy and rose 10bp qoq to 16%, as the company is under pressure from higher input costs (grain, et al), partly offset by a mix uplift from increased processed food sales. EBITDA declined 48% yoy and rose 15% qoq, with margin of 6.7% (down 700bp yoy and up 60bp qoq).

Looking at the results of Seara, BRF’s largest local processed food rival (owned by JBS), BRF didn’t keep up with the 23% yoy revenue growth, and JBS Brasil (a closer comp to the in natura business) saw 5% revenue growth. Combined EBITDA margin was 9.3%, showing again that while there are universal cost pressures in Brazil now, there are issues unique and specific to BRF where costs/margin performance is concerned.

The new CEO has yet to say anything of consequence about his vision for BRF or what he will do differently (the management change was less than three months ago), but there will be an investor day at some point in the future to go over the company’s new short/medium-term strategies. The good news is that BRF still has good brand share and brand value within Brazil, and it would seem to me that the problems are more on the operations/fulfillment side. Given Miguel Gularte’s long history of operational excellence at similar businesses, that’s reassuring on balance.

International Results Showing Some Vigor

I found BRF’s international results solid on balance. Total revenue rose 20% yoy and 7% qoq, with gross margin up 470bp yoy and down 120bp to 20.3%. EBITDA almost doubled from the year-ago period (up 95%) and declined 8% sequentially, with a margin of 12.2% (up 470bp yoy and down 200bp qoq).

In the halal business, BRF posted 26% yoy growth and almost stable results sequentially, despite ongoing challenges in the Turkish market. Overall volumes rose 17% yoy and 3% qoq, with 8% sequential growth in processed food volumes. EBITDA margin couldn’t maintain the exceptional level of Q2’22 (22.2%), but 12.1% is not bad on a longer-term historical basis.

The Asia business also performed well, with revenue up 7% on strong pricing in China, Japan, and South Korea. Gross margin was strong (up 880bp yoy and 1140bp qoq to 19.5%), helping drive strong EBITDA growth and margin of 12.5% (vs. 4.7% last year and 2.8% last quarter).

I don’t have too much to say about the International operations, other than that I believe BRF continues to do a good job with the halal and Asian operations. I’m concerned about the risk of increased poultry supply undermining pricing in the Asian operations, but with the Russia-Ukraine war ongoing, it’s hard to see where the market will be in six months.

The Outlook

Given where global corn and soybean stocks ended the year (as per the USDA’s latest report), I’m concerned that a recent respite in local grain prices may not last. BRF could see some improvement in input costs late in Q4’22 and into the first quarter of 2023, but I’m unconvinced that prices will get back to 2014-2020 levels. Given ongoing pressure on Brazilian consumers, I think aggressive pricing actions will be hard to pass through without demand destruction (share loss), putting the business in a tough spot with respect to margins.

Looking at other operators like JBS, I do see plenty of room for improvement in BRF’s domestic operations (and some parts of the international operations), but the market is understandably skeptical after many years of fruitless restructuring and self-improvement efforts. Hopefully, the new CEO will announce more concrete plans for substantive changes at some point in the relatively near future.

I haven’t meaningfully changed my revenue outlook, and I’m expecting BRF to generate around 6% long-term revenue growth as it continues to see a mix shift toward processed/packaged foods in both its domestic operations and its international operations. This shift will be good for margins, but management needs to do more to improve its underlying operations in Brazil.

I believe BRF can get back to double-digit full-year EBITDA margin next year, but I don’t see a clear short-term road map to mid-teens EBITDA margins without more dramatic cost reduction efforts. Long term, I’m looking for free cash flow margins in the low single-digits, which is enough to drive high single-digit adjusted FCF growth.

The Bottom Line

BRF shares look undervalued on the basis of discounted cash flow and margin/return-driven EV/EBITDA. The shares look priced for a double-digit annualized return on cash flow, while a 6.75x forward EBITDA multiple can support a fair value of almost $4/ADR on my ’23 EBITDA estimate.

It’s well worth remembering, though, that estimates have been heading steadily lower for some time and there is a significant amount of debt here (net debt is about 2.7x my ’23 EBITDA estimate). While it may be true that the Street is currently giving the stock little credit for the company as a going concern, the financial results haven’t argued for substantially better. With that, I can still see value here, but I wouldn’t ignore the risks, given the market’s penchant for providing painful answers to questions like “how could it get worse?”.