BRFS - BRF: Ongoing Deleveraging Not Much Else

2023-08-16 16:41:51 ET

Summary

• BRF's stock price has shown volatility, rebounding after two difficult years due to high global corn and soy prices.
• Positive trends for BRF include a decrease in commodity prices, potential sale of non-core assets, and a shift in poultry protein supply-demand dynamics.
• BRF reported a net loss in Q2 2023, but Brazilian operations demonstrated margin growth and robust cash generation.
• While BRF is making strides in reducing its leverage, the company's heavy dependence on the domestic market limits the potential for substantial growth.

BRF S.A. ( BRFS ) is well-known for its popular brands, such as Sadia, Perdigão, and Qualy. However, its stock price has shown volatility, particularly this year, rebounding strongly after two difficult years due to high global corn and soy prices. These factors have increased costs and subsequently impacted product pricing. Notably, the company has chosen not to distribute dividends and has experienced an almost 35% devaluation since August 2022.

The outlook for BRF reveals several positive trends, including a notable decrease in key commodity prices, especially soy and corn, crucial components of its cost structure. The potential sale of non-core assets also presents an opportunity for significant deleveraging, strengthening the company's financial standing. Furthermore, a positive shift in poultry protein supply-demand dynamics sets the stage for operational enhancements.

However, exercising patience is paramount due to the company's historical trajectory and intricate ties with Marfrig ( MRRTY ), which holds almost half of BRF's stake. Marfrig's acquisition has introduced challenges such as excess inventory and heightened leverage, which have impacted BRF's current situation.

Despite witnessing a substantial increase in net revenue, BRF has encountered difficulties in consistently generating profits, as evidenced by its recent earnings results. Furthermore, BRF shares seem to have limited upside potential due to the prevailing market conditions. Given these dynamics, I am cautious about BRF shares at the moment.

Q2 Earnings

The second quarter didn't bring solid results for BRF. They reported a net loss of R$1.34 billion in the year's second quarter, nearly tripling compared to the loss in 2022, which was R$451 million.

Net revenue declined by 5.7%, reaching R$12.2 billion. EBITDA totaled R$1 billion, marking a 32.7% drop in the same comparison. The EBITDA margin fell by 3.3 percentage points, settling at 8.2%.

BRF's net debt grew 7% over the year, reaching R$15.3 billion, resulting in a leverage (net debt-to-EBITDA ratio) of 3.75x - a 25.5% increase. However, considering the effects of the R$5.4 billion follow-on in July, the pro forma leverage drops to 2.42x. Additionally, the average debt maturity decreased from nine to 7.2 years.

The most concerning aspect was the company's international sales, which experienced a significant reduction in margins. With EBITDA in the second quarter being 75% lower, totaling R$241 million, the company witnessed a decrease of 11.8 percentage points in margins, reaching 4%.

During the earnings call , BRF's CEO, Miguel Gularte, explained that an oversupply of poultry hindered this performance in the international market.

"Exports were affected, even though prices improved abroad. We see a balance in the global market and anticipate a better second quarter, although we don't have specific guidance for it," he stated.

However, in my assessment, the worst seems to be behind. I see the supply and demand dynamics for global poultry markets are pointing toward normalization, particularly given the relatively short cycle of the poultry industry.

Conversely, the Brazilian operations demonstrated margin growth and robust cash generation. Despite a slight 0.6% decrease in net revenue, amounting to R$6.49 billion, BRF managed a commendable 1.2% increase in the average selling price. The adjusted EBITDA surged to R$627 million, marking a substantial 46.8% growth compared to last year.

The EBITDA margin for the second quarter expanded by 3.1 percentage points, reaching 9.6%. Heightened sales of value-added products, such as processed foods, propelled this boost. Around 75% of BRF's sales were attributed to processed items, contributing to more favorable margins.

Despite these advancements, there's anticipation within the market for margins to re-enter the double-digit range. On this front, the company's management reinforced BRF's steadfast dedication to efficiency and a strategy initiated the previous year. During this quarter, BRF reported operational enhancements amounting to R$540 million, with the company asserting an operational gain of approximately R$1.2 billion over nearly a year.

Progress in deleveraging

The company has been dealing with elevated levels of leverage in recent quarters. As of Q1 2023, BRF reported a Net Debt/EBITDA leverage ratio of 3.35x. By Q2 2023, this ratio had increased to 3.75x.

However, considering the impact of the company's follow-on offering, which amounted to R$5.4 billion and involved contributions from Marfrig and the Salic Arab fund, the company achieves a more favorable net debt/EBITDA leverage ratio of 2.4x. This is a positive development in my view.

With the follow-on process now completed, BRF will likely resume negotiations to sell its non-core assets, furthering its deleveraging strategy. By the end of 2023, I believe there are reasonable prospects for selling its primary non-core asset, the pet food division. Such a sale could inject approximately R$2 billion into the company's cash reserves.

Valuations

When comparing BRF to another major player in the Brazilian food industry, JBS ( JBSAY ), it becomes evident that BRF is trading at a premium. BRF's EV/EBITDA multiple stands at 7.3x, with a price-to-sales ratio of 0.21x. In contrast, JBS boasts a lower EV/EBITDA multiple of 6.2x and a slightly lesser price-to-sales ratio of 0.12x.

The current price-to-sales multiples of BRF indicate a value approximately 50% below the average of the last five years. However, the timid revenue growth projections for the next two years have little impact on the forward price-to-sales multiples.

It's important to note that BRF derives approximately 65% of its revenues from the domestic Brazilian market and around 35% from international operations. On the other hand, JBS generates roughly 75% to 80% of its revenues from international operations and about 20% to 25% from the Brazilian domestic market. This is largely credited to its subsidiary Seara, which directly competes with the product portfolio of BRF.

The critical point is that JBS exhibited exceptional performance in 2021 until mid-2022. JBS has been actively acquiring value-added brands and making strategic acquisitions in Australia and Europe, resulting in a notable increase in the company's leverage from 1.6x in Q2 2022 to 4.1x in Q2 2023. Despite facing obstacles, such as U.S. criticism of high concentration in the protein sector and favoring smaller local players, JBS's shares have outperformed BRF over the past two years and still trade at lower multiples.

The bottom line

In summary, I have identified favorable and unfavorable aspects that could influence the trajectory of BRF's outlook in the coming periods.

• Downward Trend in Key Commodities: A noticeable decline in prices for vital commodities constituting BRF's cost of goods sold, particularly soy and corn.

• Deleveraging Potential: The potential sale of non-core assets promises significant leverage reduction, strengthening BRF's financial position dropping from 3.75x to 2.4x.
• Normalization of Supply-Demand Dynamics: The equilibrium between poultry protein supply and demand seems to be progressing towards normalization, potentially benefiting the company's operations.

However, it's important to acknowledge certain negative aspects:

• Lack of Operational Clarity: Uncertainty persists regarding the timeline for operational enhancements, especially in the International segment, in the short and medium term.

• Intense Domestic Competition: The Brazilian domestic market faces fierce competition, particularly from Seara, which might impact BRF's market positioning.

• Limited Upside Potential: Given the current market conditions and heavy dependence on the domestic segment, BRF's shares appear to have relatively restrained upside potential. Valuation is no longer so attractive, especially compared to JBS.

Given these factors, I am cautious regarding BRF shares and adopting a wait-and-see approach.

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