The last five months or so have been challenging BRF SA (NYSE: BRFS). Brazilian consumers are under pressure from high inflation, and although the input costs for these large poultry and packaged poultry have been better recently For food manufacturers, margin leverage is still suboptimal. As the company continues to invest in transformative investments, liquidity has come under pressure, resulting in higher net debt.
It’s harder today to find strong arguments for a bullish stance on BRF. While the situation in Brazil seems to be stabilizing, there is still uncertainty in important foreign markets. What’s more, rivals like JBS (OTCQX:JBSAY) have more flexibility in terms of pricing and assortment. Perhaps the best bullish argument here is that expectations for this stock have fallen and shares don’t look all that expensive; If the company can execute on its multi-year turnaround strategy, there’s greater upside potential, but execution has been pressured recently.
A Q2 blow against lower expectations
After a terrible first quarter, sell-side analysts have scaled back their expectations for BRF for the remainder of the year. I think BRF’s better than expected second quarter results need to be viewed in this context, as well as some helpful trends such as gross spreads and strong pricing in certain overseas markets.
Revenue rose more than 14% year over year on a pro forma basis, coming in slightly above expectations according to an outside source and slightly below expectations according to another source. Adjusted EBITDA, however, was solidly ahead of expectations on both counts, beating by about 10% to 11%.
Underpinning the revenue growth was improved results in Brazil (nearly half of revenue), where revenue rose more than 12% year-on-year and 11% qoq, with volume down 4% year-on-year and price down 17% year-on-year % has increased. In the processed food business, volumes fell 3% while prices rose 19%. All in all, large manufacturers like BRF and JBS see less of the trade-down effect (customers shift consumption to cheaper options) than smaller providers.
Gross margin in Brazil declined 220 basis points to 15.9% and Adjusted EBITDA fell 19% year over year, reversing a loss from the previous quarter to BRL 398 million, with margin down 170 basis points to 9.2 % decreased. While BRF didn’t have the same impact on its cost structure as it did in the first quarter due to weaker demand, profitability remains subpar today.
The international business saw revenue growth of 13% year over year and 11% quarter over quarter. The largest segment, Halal business, saw growth of 28% year-on-year and 1% qoq, with volume and price growth relatively balanced year-on-year. Sales to Asia fell 16% on a 20% decline in volume year-on-year, while direct export sales rose 25% on an 8% decline in volume.
International gross margins benefited from a better spread between higher poultry prices and more stable grain prices, which helped international gross margin rise four points to 21.5%, with Halal business up 920 basis points to 29.5%. EBITDA was up 40% year-on-year as reported (margin up 280 basis points to 14.2%), but the Halal business received a boost from hyperinflation in Turkey, with reported EBITDA up 114% to R595 million $ and Adjusted EBITDA up 63% to R$453 million (with margin up 370bps to 16.9%.
Ongoing challenges in Brazil
Although BRF has reported data from the Brazilian Supermarkets Confederation that suggests a surprising level of consumer resilience in the face of soaring inflation (prices up 11%-12% depending on the source), other third-party sources suggest there have been more trade falls in the market and that this could accelerate if the gap between wages and prices widens.
BRF faces a delicate balancing act in domestic business. While the company has a tiered branding strategy that can help a bit with price/range flexibility, the reality is that Brazil is a significant market and the company’s profitability and liquidity challenges don’t give it as much price flexibility as JBS’s stronger operations . BRF’s market share held up fairly well in the second quarter, but this could be a more difficult balancing act in the second half of the year, especially if input prices pick up again (corn prices are down while chicken prices are down). fairly constant at a higher level).
The international situation still deserves observation
BRF’s Halal business has long been a jewel in the company’s crown and I expect it will remain so. However, management expressed some concerns about the hyperinflationary environment in Turkey (a key market).
There is also continued uncertainty about the Saudi Arabian market as the country recently (May 2022) suspended broiler 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, which has caused turmoil for BRF in the past, although the company and the kingdom have recently worked more closely to increase domestic production in Saudi Arabia.
On a larger macro level, I have some concerns about the poultry market. Export demand from Brazil remains healthy, but I am concerned that the market could correct/normalize faster than the beef market, leaving BRF in a more challenging position compared to other Brazilian protein producers.
It should be remembered that the restructuring at BRF is a multi-year project and it is closer to the beginning than to the end. Initial efforts such as refocusing on the Halal core business, launching/expanding a pet food business and streamlining domestic launch activities have been looking good so far. Still, the company has a long way to go with its overall margin structure and efforts to improve liquidity (reduce debt).
The reality when modeling BRF is that it will always be difficult to get the numbers beyond a year or two given the significant impact of global commodity chicken and cost input prices (corn etc.). That said, I still see BRF improving its international presence and continuing to grow its branded packaged/processed food business both in Brazil and in key overseas markets. Over time, that will result in less revenue and margin volatility, but it will take years to get there.
I’ve raised my FY22 revenue expectations due to stronger prices, but my full-year EBITDA margin estimate is now about 3 points down, and I’m not expecting at least 11% more EBITDA margin for the next 3 years. This also lowers my free cash flow estimates for the next three years (FCF margins of -3% to 2%), although I still believe long-term mid-single-digit FCF margins are achievable and credible. Over the long term, I’m aiming for around 6% annual sales growth and close to 10% FCF growth.
The final result
Given discounted cash flow and a margin/yield oriented EV/EBITDA (6.75x forward 12 month EBITDA, below the historical average of almost 8.5x) I believe the fair value for these ADRs is around 4.00 to 4. $25 lies. While I see opportunities for BRF to outperform and believe it can become a significantly more profitable food company with an attractive presence in growing markets, the reality is that execution has been inconsistent (though not always management’s fault) and it still is is a high execution risk for this name today.