BRF Underway With Its Turnaround, But A Lot Of Self-Improvement Remains

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About: BRF S.A. (BRFS), Includes: TSN
by: Stephen Simpson, CFA
Summary

BRF's fourth quarter results were messy, but the core numbers were basically in line, with double-digit top-line growth in both Brazil and the halal businesses.

Management's asset sale efforts were disappointing, with the company missing its target by 20%, but the asset sale and inventory correction processes are done and management can now address operations.

BRF shares look undervalued assuming a successful turnaround process, but a lot of execution risks remain.

BRF (BRFS) has to be glad to put 2018 behind it, as the only real positives to come out of that year will likely be the hiring of Pedro Parente as the Chairman and CEO and the decision to launch a far-reaching deleveraging and divestment program. Management’s projections for 2019 still look a little on the bullish side, but the company does have a relatively solid base in Brazil and Middle Eastern halal markets from which to rebuild the business.

I do expect margins to improve from here, but it won’t be a fast turnaround and I believe the company faces ongoing challenges from competition within the Brazilian market and protectionist measures in key export markets like Saudi Arabia. Although a successful turnaround could likely support a fair value in the double digits some years down the road, I believe a fair value in the $6 to $7 range remains reasonable today.

Decent Core Operating Results In Q4…

Although some accounting changes and charges, not to mention dealing with the discontinued ops the company is selling, make the year-over-year comparisons murkier than they should be, I’d say BRF’s fourth quarter results were basically on target.

Revenue rose about 7% overall in local currency (but fell 9% in U.S. dollars) against an underlying 2% decline in volume. The two important businesses going forward, the Brazilian operations and the halal (One Foods) operations, both did fairly well. Revenue in Brazil rose 12% with volume and price contributing roughly equally. The One Foods business saw 15% revenue growth despite a 2% decline in volume. The International business saw a 12% decline in revenue on a 15% decline in volume, while revenue from the Southern Cone operations rose 16% on a 6% volume decline.

Margins remain a work in progress. Due in part to a higher mix of fresh food (versus processed) and higher grain prices, Brazil gross margin declined almost three points, though the One Foods gross margin improved by nearly three points. Overall, adjusted gross margin declined about three points.

EBITDA was messy due to charges and accounting changes. Reported adjusted EBITDA rose 69%, with a margin of 8.8%, but I think a truer representation of underlying EBITDA leads to a year-over-year growth number of 34% and a 7% margin. EBITDA grew nicely in both Brazil (up 29%) and One Foods (up 53%).

… With Some “Green Shoots”

BRF lost a little bit of market share in Brazil during the quarter, but the change was less than half a percent, so it’s not something I’m too concerned about. More importantly, pricing was solid, the company’s brand management seems more organized, and inventory levels (particularly of frozen products) are more or less at normal levels now.

I believe management can now start turning its attention from stabilizing the business to improving it. As I’ve outlined in prior pieces, there are a lot of areas management can look at, including improved input sourcing (better grain purchasing), increased automation to increase productivity and reduce waste, and improved processed food sales and particularly in the frozen food segment. Brazil gross margins are still several points below what I’d view as normal, and that doesn’t include the benefits of future automation and other changes. Grain prices remain a risk, but market prices for poultry and processed food have been improving.

Outside of Brazil, the One Foods business is doing okay even though Saudi Arabia continues to implement protectionist measures designed to support its domestic poultry business. Earlier this year, Saudi Arabia banned poultry imports from more than half of the plants it had approved in Brazil (33 of 58), though BRF saw only two of nine plants banned, and management can reallocate volumes to compensate for the change.

African swine fever could be a boost to prices this year, and management is looking to reallocate some volumes to take advantage of opportunistic pricing where it can. Management is also looking to improve the operating efficiency and leverage of its operations in Turkey.

Disappointing Divestments, And Debt Pressures Aren’t Gone Yet

With the early February announcement that it was selling its European and Thai operations to Tyson (TSN) for about $340 million (or R$1.3 billion), BRF completed its targeted asset sale program. Unfortunately, virtually every transaction saw the company accept a lower-than-expected price for the asset in question, and the overall sale process yielded about R$1 billion less than expected, a roughly 20% shortfall.

Management can talk about the weaker present conditions in Argentina and uncertainties over Brexit, and I suppose both are true to a point, but the reality is that BRF was basically a forced seller into an oversupplied market. What’s more, the operational chaos at BRF in recent years likely led to some internal operating deficiencies that were reflected in the prices BRF could command for those assets.

In any case, the process is largely finished. Management sold the assets it wanted to sell, raised nearly R$1 billion through selling receivables, and largely fixed its inventory issues. The company missed its year-end leverage target, and I think the 3.65x target for year-end 2019 is too aggressive, but the near-term liquidity situation is okay even if the company cannot find attractive terms for extending the debt with nearer maturities.

The Outlook

Now management can turn its full-time attention to improving the operations it has retained – a process that I expect will take the better part of three to four years to show real results. I believe EBITDA margins can be improved in the low-to-mid teens over time, but there are limits to what self-help can achieve – a lot of this business still relies on commodity products (fresh/frozen poultry) and commodity inputs like grain will always be volatile. There’s a lot that I believe management can do through better sourcing/purchasing, automation/operating efficiency, and an ongoing shift toward branded processed foods in both Brazil and the halal business, but these changes take time.

My core assumptions haven’t really changed much given the largely on-target fourth quarter results. I’m still expecting long-term revenue growth in the neighborhood of 6%, and I do believe mid single-digit FCF margins can be achieved in four to five years’ time.

Using both a DCF and EV/EBITDA approach to valuation, I continue to believe fair value is around $6.50, though that fair value could climb into the double digits in a few years with successful execution on this turnaround plan.

The Bottom Line

BRF ADRs do look undervalued, but that has to be considered in the context of the company’s serious recent struggles and the ongoing challenges of operating what is still a largely commodity-driven business. While a successful turnaround can certainly drive good returns for patient shareholders, the turnaround is still in its early stages and there is a lot left for management to prove.

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.