BRF Lays Out A Good Restructuring Plan, But No Quick Fixes

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About: BRF-Brasil Foods S.A. (BRFS)
by: Stephen Simpson, CFA

Summary

BRF's Brazil Investor Day laid out a restructuring plan that emphasizing execution, efficiency, and attention to detail.

Improving brand value and portfolio offerings in Brazil makes a lot of sense, and the overseas halal operations still have significant untapped growth potential.

BRF shares seem slightly undervalued today, but the real value opportunity is tied to showing some meaningful progress in improving margins and reducing leverage over the next year.

Investors, as a group, aren’t often the most logical creatures, so maybe there will be some disappointment at the restructuring plan that BRF SA (BRFS) management laid out on October 8 during its Brazil-based Investor Day (with a New York-based day to follow on October 10). Management didn’t offer up any quick fixes or any reason to think that the business will suddenly turn on a dime. What they did offer, though, was a very sound and credible strategy for building a stronger-for-longer company with substantial upside in both its home market of Brazil and its large foreign markets.

Valuation remains tied to the eventual long-term outcomes of this restructuring plan. If and when the restructuring activities start showing the expected benefits in 2019/2020 and beyond, I fully expect the multiple to expand again. Likewise, through that process the company will put some ugly near-term annual FCF results in its rear view mirror. While the current share price looks basically fair for what BRF is today, a more bullish outlook on that restructuring plan supports worthwhile upside for long-term investors.

As Expected, A Detail-Oriented Plan Focused On Execution And Efficiency

Investors who have paid attention to the restructuring effort he led at Petrobras (PBR) probably a had a pretty good idea of the sort of restructuring plan Chairman and CEO Pedro Parente would devise for BRF, and there really haven’t been many surprises here relative to the scenarios I’ve laid out in past articles on the company.

Above all else, BRF is moving forward with a much greater management-level focus on improved execution and consistency. Rather than radically shifting the focus of the business (apart from some asset sales, which I have discussed before), management is instead looking to do more or less everything better than it has been done recently. Given BRF’s leadership position in Brazil’s poultry and processed food market, its strong position in global halal markets, and its long-term international opportunities, I continue to believe that that is the right strategy. I would also note that the company is now shifting toward a planning horizon of five years – a smart move, I believe, from a company that had established a recent track record (over the last five years or so) of seemingly shifting strategy and focus every six to 12 months.

Financial Discipline

BRF management is clearly looking to be more disciplined with respect to its balance sheet, and they really don’t have much choice in the matter given the current debt situation. Management looks to reached a leverage ratio of 1.5x to 2.0x within the next five years, after which time dividends could resume. Management is also running the business now with a much clearer focus that ROIC must exceed the cost of capital – a no-brainer to many readers, I’m sure, but you’d be surprised how many companies don’t operate that way.

Operational Improvements

I was very happy to hear that one of my prior projections for BRF is now a management priority – one of the ways that management will pursue improved margins is by embracing automation and digitalization. BRF management is targeting waste reductions of up to 20% and production efficiency gains of up to 30% through greater automation, and I believe this is a critical margin-improving opportunity in a business that will always be subject to uncontrollable (or at least difficult-to-control) external cost pressures.

BRF is also going to get more aggressive on improving its supply chain and purchasing costs, including leveraging more global supply options and leveraging its stocking capacity for grain purchases.

Within Brazil, BRF management seems to appreciate that the current brand structure is a hot mess. There’s differentiation among the brands in terms of pricing, but brand identity and brand value are very, very weak. I believe that partly explains why the most recent Nielsen numbers for Brazil show BRF’s Perdigao brand doing okay (volume down a bit, price up 6%0, but the Sadia brand getting pummeled (volume down 11%, price up 2%). In addition to investing in the brands, BRF wants to improve its product line-up, including more frozen, cold cut, and sausage products – all of which I support, as processed food margins are stronger and more consistent.

Outside of Brazil, BRF is keeping its halal business as its top priority, and looking to leverage its local production capacity in Turkey. Although Turkey’s punishing currency problems are a near-term challenge, BRF’s operations in-country can support a much larger enterprise and BRF has been investing in local distribution across halal markets for years. Saudi Arabia remains a challenge, though, as the country seems committed to a stronger food independence policy, but I believe a long-term shift from BRF toward more processed food (as opposed to raw poultry) would offset that risk.

Globally, BRF is still looking at challenges. The import restrictions in Europe will pinch for a while - redirecting an integrated supply chain doesn’t happen quickly, and the volumes involved are large enough to be disruptive to a volume-driven model. Management seems somewhat optimistic that the Russian market could re-open fairly soon, and frankly the entire ex-halal overseas market is very nearly a perfect storm for BRF now, so I think the odds favor improvement from here.

Boiling it down to margin guidance, management is targeting stabilization and reversal of margin erosion in 2019, a return to historical margin levels in 2020 (historically BRF has produced an EBITDA margin of around 11% to 12% on average), and improvements thereafter. Higher grain prices and lower poultry prices could certainly threaten those goals, but I believe management understands this and is looking at a wide range of process improvements that can help mitigate commodity price risk.

The Opportunity

BRF also announced that current CEO Pedro Parente will step down from his role as CEO by mid-2019, with COO Lorival Luz taking over. Parente will remain as chairman, and is almost certainly to be a very active chairman. The motivation for this move is simple – complying with the laws and rules in place for publicly-listed Brazilian companies. Companies listed on the Novo Mercado have to split the Chairman and CEO roles within a year, and Parente himself said that he may well become an “Executive Chairman” to facilitate a more active role in the day-to-day operations of the business.

Frankly not much surprised me about the presentation BRF made, and the company’s plans largely fit with my expectations and the hopes I had for its restructuring. Now comes the multiyear process of putting those plans in place and (hopefully) reaping the benefits. Given that the plans were in line with my expectations, I’m not really making any major modelling changes.

I’m expecting long-term revenue growth in the neighborhood of 6%, with improvements in margins driving the FCF margin back toward the high single-digits, with long-term potential in the low double-digits in a more bullish scenario. My own modeling suggests a return to historical EBITDA margins in 2021, so I suppose I’m conservative/bearish relative to management’s internal goals and targets.

As far as valuation goes, I think $6 to $6.50 is a reasonable range today, but if management hits its early goals/targets and margins and market share start showing meaningful improvement in 2019, I expect sentiment to shift positively and put higher fair values into play.

The Bottom Line

Although I think BRF shares are a little undervalued today, this is still a largely binary play on whether this turnaround will succeed. I believe it will, but I no longer have a substantial stake in the company and there are certainly easier ways to play themes like a Brazilian recovery or the growth of emerging market consumer spending. I believe BRF’s plan is the right one, and I believe this will be a stronger company in a few years’ time, with shareholders enjoying the rewards if they can afford the patience that will be required.

Disclosure: I am/we are long BRFS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.