BRFS - BRF S.A.: Still Strong Trends But No Upside Potential

Summary

• Rising prices for key products continue to support the company's top line.
• However, cost growth is outpacing price growth and is putting pressure on margins.
• According to my DCF model, I see no potential for further growth based on a fundamental approach.

Introduction

Shares of BRF S.A. (BRFS) have risen 12.7% YTD. While I still maintain a positive outlook on consumer staples, in my personal opinion, now is not the best time to buy shares of the company, according to my assessment based on fundamental analysis. Although the company operates in a conservative sector where the company is the beneficiary of rising prices for its own products, at the moment I do not see the potential to improve the operating margin of the business, because the growth of part of the expenses in the business outpaces the growth of prices for the main products, which has a negative impact on operating profitability.

Revenue model

In order to more accurately forecast future cash flows, I made my own forecasts for the company's revenue in future periods. The main drivers of revenue growth are: growth in sales volumes and growth in prices for the company's goods.

Volumes: We see that in real terms, the company's sales volumes continue to stagnate due to rising prices, macro and geopolitical tensions, declining consumer confidence and real incomes. Thus, in my model, I assume volume growth of 1% in Q4 2022 and 2% through 2026.

Prices: I expect elevated inflation to continue into 2023. Therefore, I predict a price increase of 11% in Q4, 10% in 2023 and 5% until 2026. I believe that the company is able to pass on the increase in prices to the end consumer.

Revenue model (Quarterly)

Revenue model (Yearly)

Projections

In November, the company published operating and financial results for the third quarter of 2022. Despite the increase in prices for key products and a slight increase in sales volumes, the business's operating margin and gross margin decreased relative to Q3 2021. Based on my revenue projections for the company, I made assumptions about future costs to build a future cash flow model to value the business.

Gross margin: I forecast that the gross margin will increase to 20% in Q4 2022 due to the seasonal factor, then I forecast a level of 16.5% until 2026.

At present, I believe that the company, in my personal opinion, will not be able to demonstrate improvements in the gross margin, due to continued high inflation, which has a negative impact on business costs:

1) grain price (soybeans, soybean oil, soybean meal)

2) rising fuel prices (Brent)

3) rising labor costs

In addition, I took a close look at the Q3 2022 Earnings Call Transcript , where management did not mention how the operating margin of the business could be improved. I believe that in the coming quarters we may see an increased level of operating expenses. In my personal opinion, the market expects margins to rise to reprice the stock up against the backdrop of high inflation and the company's ability to pass on higher inflation to the end consumer.

You can see the dynamics of the continued growth of " Cost index " in the chart below

Thus, my own assumptions about future gross margins are based on expectations of continued high inflation in fuels and soybeans. At the moment, I predict a conservative level of 16.5%.

Selling expenses: In my personal opinion, the level of selling expenses (% of revenue) will increase to 14% in Q4, then I conservatively forecast a level of 13.2% until 2026. I don't think the company will be able to show efficiency gains here, as business volumes in real terms don't show the significant growth needed for economies of scale.

G&A expenses: I predict expenses for general and administration (% of revenue) at the level of 1.4 - 1.5% (of revenue) until 2026.

The company model is very sensitive to the forecast level of gross margin. If the company can show improvements, especially in the Brazil segment, I think that will help the stock. In that case, I will gladly update my own forecasts and update my view on the company's stock.

Quarterly projections:

Yearly projections:

Valuation

To value a company, I prefer to use the DCF method because:

1. The company operates in a conservative and stable market where the use of DCF is most preferable

2. The company has a long public history from which I can make assumptions about future growth and profitability

3. When using DCF, I am able to use my own price and volume growth inputs for the company's main commodities.

I use the following assumptions in my model:

WACC: 8.3%

Terminal growth rate: 3%

Volumes: increasing sales volumes, increasing market share, entering new markets and new segments can have a positive impact on revenue growth.

Macro: rising real disposable income and increased consumer confidence could have a positive impact on consumer spending and company revenue.

Prices: inflation and continued growth in prices for the company's main products are a positive driver for business revenue, because the company is able to pass on the increased inflation rate to the end consumer.

Risks

Macro: declining real incomes and macroeconomic uncertainty may have a negative impact on the dynamics of consumer spending and the company's revenue

Margin: high inflation contributes to the growth of business operating costs, which puts pressure on the operating profitability of the business. In addition, higher levels of freight costs can have a negative impact on profitability too.

Conclusion

While I like the consumer staples sector at the moment, in my personal opinion, now is not the best time to go long in a company's stock. Although, as I wrote above, the company is the beneficiary of rising prices for its own products, in my opinion, in the near future, the growth rate of expenses will continue to outpace revenue growth, which may have a negative impact on profitability in the next periods. I would like to see Q4 2022 and Q1 2023 financials before making a purchase decision.

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