BRFS - The Struggle Continues At BRF S.A. But Management Seems Focused On Operational Improvement

Summary

• BRF SA's fourth quarter results once again came in well short of Street profit expectations, but there was at least progress in the Brazilian operations.
• The Brazilian operations saw share gains in the processed food business and meaningful production/operating cost improvement.
• The international business is under pressure from weaker global poultry prices (oversupply) and a cost structure that is just too high to achieve sustainably attractive margins.
• Management seems to be on the right track with its improvement plans, and the share price is beaten down, but there are still significant operating and macro risks in play.

At this point I can understand if a BRF SA (BRFS) investor assumes that any light at the end of the tunnel is just an oncoming train. I'm losing count of the number of restructuring efforts this company has launched over the last 15 years, and the business has repeatedly whipsawed between growth projects meant to diversify the business and boost the top line and "back to basics" projects meant to improve the cost structure and boost margins.

We're back to the latter strategy, with management looking to sell the pet food operations and refocusing on core operational efficiency. Given a high cost base (relative to other Brazilian and emerging market protein producers), that makes sense, but investors should absolutely treat this as a "believe it when you see it" proposition.

Down another 40% since my last update , the market is basically pricing BRF as if it's doomed to go out of business - or, more realistically, that Marfrig ( OTCPK:MRRTY ) will consolidate it into its own operations with a token payment to BRF shareholders. Relatively modest operating improvements could drive a meaningfully higher price, but investors need to realize that this is pretty much a speculation at this point.

Another Below-Average Quarter, Albeit With A Few Bright Spots

There were a few positive takeaways from the fourth quarter, but all in all it was a weak quarter to close a weak year and there are still significant fundamental operational issues here holding the company back.

Revenue rose about 8% year over year and 5% quarter over quarter, beating by 3%, with stronger operating results in the Brazilian operations. Company-wide volume improved 2% yoy and 6% qoq, while pricing rose about 6% yoy and fell about 1% sequentially.

In Brazil, revenue rose 8% yoy and 14% qoq, driving the upside in the quarter, as BRF saw almost 3% adjusted sequential volume growth in its processed food business and continued to gain share in the market. Overall volume improved close to 9%, with price up 5%.

The international operations were weaker, though, with revenue up 7% yoy and down almost 5% qoq. Sales in Asia declined almost 14% qoq on weaker pricing (down 9% qoq) due to strong global poultry supply and volumes (down 5% qoq) were soft in South Korea and Japan due to oversupply. The Halal business saw 4% qoq growth on 8% volume growth, but the business has been challenged by ongoing hyperinflation in Turkey and food affordability issues. The Direct Export business saw an 8% sequential revenue decline on nearly 14% price erosion, again due to the robust global supply of commodity poultry.

Costs remain a meaningful challenge for BRF. There were improvements in the Brazil market, and BRF benefited from share gains in higher-margin packaged/processed foods, helping to drive gross margin up 420bp sequentially to 20.2% (down about three points year over year, though). Overall gross margin fell more than five points from the year-ago level and two points from the prior quarter (to 16.5%), with elevated costs in the commodity business and challenges in the Halal business (inflation-driven operating costs) hurting results.

Adjusted EBITDA fell 39% yoy and 25% qoq, missing by 12%, with the margin contracting more than five points yoy and about three points qoq to 7%. BRF did see a nice rebound in Brazil on cost-improvement efforts (EBITDA up 50% qoq, with margin up 210bp to 8.8%), but the international business saw a 74% sequential decline, with margin down about nine points to 3.3%. There was really no "better" operation within international, as all segments saw significant margin erosion.

BRF once again burned cash in the quarter and the trailing net debt/EBITDA ratio was 3.75x.

As far as bright spots go, there were some. First, the improved results in Brazil were encouraging, as is the market share re-growth in processed foods. BRF has been trying to walk a fine line between passing along cost pressures to maintain margins and alienating customers and creating affordability issues. Management also pointed to R$100M in efficiency gains, with another R$180M already in hand during the first quarter (which is two-thirds complete).

A Lot Of Work Is Left To Do

The efficiency gains in the Brazilian operations are certainly positive developments and I think they were a main driver of a relatively positive reaction to the earnings report. There's a lot of work left to do, though. BRF has had a persistently high cost structure for years and that's just not workable for a business where a large percentage of sales are still from commoditized products.

I like the recent attention management has been paying to its grain processing operations and I like the progress with automation in its plants - both of these are going to be critical in driving better production costs. I also want to see more on the logistics side - logistics in Brazil are complicated and expensive, but I believe there are opportunities to improve distribution efficiency even within those limitations, and this is the sort of business where small improvements on a unit basis can add up meaningfully over time.

Provided that management continues on with these operational efficiency improvements, I think they're on the right track. I believe the best path forward for BRF is to continue to focus on building up the branded processed food operations in Brazil while stripping costs out of the production and distribution operations. The problem, or at least the problem in the past, is whether management can stick to these programs and achieve some measure of consistency - intermittent attempts to improve production and/or distribution efficiency can actually cause more problems over the long term.

I'm still concerned, though, that BRF management may find it difficult to do enough on the cost side. There's more global poultry supply coming online (from markets like Thailand) and while grain prices should improve later this year (and there's usually a six-month lag between grain prices and their impact on BRF's financials), I see a risk from ongoing growth in Chinese demand for Brazilian corn and soy. That means potential pressure on prices and potential pressure on feed costs, which really emphasizes the importance of optimizing the operational cost structure.

The Outlook

Among the changes to the business, management has announced that they're pursuing the sale of the pet food business. This is an unfortunate development in some respects, as I think it was an attractive complementary business with good growth prospects, but the reality is that BRF needs to reduce debt and build up some breathing room. I found the speculated price tag of R$2B (as per a Bloomberg article) disappointing, but that will still help reduce the debt burden.

I've adjusted my modeling assumptions again, taking into account increased global poultry supply and so on. The end result cuts back my long-term revenue growth rate to about 5%. I've also once again reduced my margin assumptions, leading to long-term FCF margins in the low single-digits and a long-term growth rate in the 3% to 4% range.

There's absolutely potential for BRF to exceed these targets, but the reality is that it has been almost a decade since the company produced three straight years of positive free cash flow and there are still significant operational challenges. I do think mid-to-high single-digit FCF margins are possible if things go right, but there's a lot that BRF management has to prove before that should become a base-case assumption.

Between what I hope are low-ball long-term estimates and another whack to my forward EBITDA multiple (to reflect ongoing weakness in margins), I get a fair value for the ADRs around $2.50.

The Bottom Line

As I said before, I think management is largely focused on the right areas to improve - the cost structure and sustainable margins need to be the focus, not growth projects - and there has already been some progress. Whether they can maintain that progress and achieve real benefits for shareholders remains to be seen; there are, after all, some businesses that just can't really be fixed.

I likewise still see meaningful risk from commodity prices (grain prices, global poultry prices, packaging prices, et al), as well as the risk that Marfrig doesn't do right by BRF shareholders. Given all of that, while the returns from today's price could be significant, it's a high-risk proposition that could still easily fail.

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