BRF: A Long Opportunity For Value Investors

By Eduardo Junqueira Gomide, Panda Agriculture & Water Analyst

BRF or Brasil Foods (BRFS or BRFS3), quoted in Sao Paulo and New York, ranks as one of the largest poultry producers in the world. It is also one of the world’s five biggest pork producers and leader in processed/frozen food distribution in Latin America and Middle East (through One Foods). None of its customers (or groups of affiliated customers) accounted for more than 5% of net sales in 2016. About 52% of sales are exports, with the Middle East accounting for 19%. Asia and Europe represent 14% and 7%, respectively. Only Saudi Arabia represents 10% while Japan represents 5%.

They are the result of a merger process in 2009 between Perdigão (corporation mostly owned by Pension funds since 1994) and Sadia (founded by Fontana family in 1945 in Santa Catarina). HQs are in São Paulo and Itajaí, Santa Catarina. In 2008, Sadia had BRL2.5bn losses with derivatives related to currency exchange.

The company entered FX contracts that would lead to gains should the Brazilian currency stay almost stable but, with the 2008 economic crisis, the Real quickly lost value leading to this huge loss. The same happened to Aracruz, the Brazilian largest pulp and paper producer at the time. This huge loss led Sadia to be sold to Perdigão 9 months later.

Its CEO, Pedro Faria, is a partner of Tarpon Investments (TRPN3) and joined the Board of Directors when Tarpon together with Pension Funds and Brazilian entrepreneur Abilio Diniz, Founder of Cia Brasileira de Distribuiçao (PCAR4 or CBD), Brazilian leading food retail chain also known as Pao de Açúcar Supermercados, took the control of the company back in 2013. Abilio Diniz is the president of the Board of Directors. Tarpon was a shareholder of Sadia between 2003 and 2006. 

The Board of Directors decided last Thursday, 31st August, to replace its CEO by the end of the year for an executive with experience outside the company currently under search by the Board (“CEO should be an outsider“).

In 2016, Brasil Foods processed 1.7 billion chickens and other poultry and 9.6 million hogs. It has stayed almost stable the last years with no significant acquisitions in terms of production plants.

In 2016, it had huge losses from higher grain costs and soybeans/corn undersupply in Brazil (mainly Mato Grosso state, see more on page 2)

Revenue 2016, ‘15, ‘14: $10,27BN, $8,25BN, $11,8BN. Net income ’16, ’15, ‘14: $ (372)M, $2.93BN, $2.13BN

We believe BRF is an attractive long investment because at its current stock price and low valuation multiples compared to peers, caused by the Brazil “weak flesh” news, poor 2016 and 1H2017 results due to high corn prices, and higher leverage than peers, the market is ascribing little value to the following:

• The value of OneFoods, the world leader in Halal foods, which has been suffering low profitability due to import taxes implemented in Saudi Arabia last year and contractionary macroeconomic policy in that market, but is poised to deliver strong cash generation, being the largest food company focused in Halal food consumed by the 1.8bn fast-growing Muslim population. OneFoods plans to carry out a private placement or IPO in 2018 (BRL mulls options to OneFoods IPO) domestically.
• Brasil Foods is positioned to take advantage of the fragility of Seara, JBS’s (JBSS3 or OTCQX:JBSAY) subsidiary and main competitor of Brasil Foods, on the back of penalties amounting to more than USD3bn imposed by the Brazilian Government to the main shareholders of JBS to settle a corruption probe (JBS holding to pay BRL10.3bn for corruption probe). Brasil Foods was able to recover some of its lost market share last quarter (from 53.6% to 54.4%) mainly in margarines and sausages (BRF recovers market share).
• Poultry margins benefitting from lower corn prices.
• The reduction of chicken hatchery of around 5% over the LTM according to APINCO (Brazilian Poultry Breeding Association).
• The possible devaluation of BRL should the pension reform not be approved before elections in late 2018.

First, BRFS3 closed the deal of Banvit (BANVT), the largest poultry producer in Turkey (216 million poultry/year) a few months ago (BRF and QIA acquires Banvit), for a price of $470M through a partnership with Qatar Investment Authority (which owns a 40% stake). OneFoods will consolidate this asset, increasing even more the participation of direct distribution in total sales of Brasil Foods and therefore, decreasing the exposure of the company to commoditized and volatile prices of broilers and grilled chicken.

After being impacted by an unexpected competition from Ukrainian, Argentinean and local chicken producers, BRF expects higher sales and margins going forward in the Middle East and further reduction in costs. The company is also assessing alternatives for unlocking the value of OneFoods through an IPO or private placement. The company has already reached 55% of total volume with direct distribution last quarter in OneFoods, representing 85% of its profits.

We see OneFoods as a huge hidden gem for Brasil Foods, considering the long-term growth of Food and Beverage expenditures in Muslim majority countries (8.5%) vis-a-vis other countries (6.5%). Brasil Foods’ brands are top of mind food brands in the Gulf Cooperation Council. OneFoods is a global company in compliance with sharia law, likely to be invested by Islamic banks with reserves restricted to invest in this kind of company. Almost 40% of sovereign funds are owned by Islamic states holding up to 46% of the assets (USD3.3 trillion out of USD7 trillion).

Second, JBS is facing a relevant forced deleveraging process following the corruption probe and the fine of USD3bn to its parent. The company has a high financial leverage of 4.2x LTM EBITDA and the main shareholder (J&F Participaçoes) has a deal with Brazilian banks which should lead to the sale of assets (JBS closes deal with Brazilian banks) and reduction in marketing expenditures at Seara’s level. BRF was able to recover market share in 2Q2017 after several quarters of losses to JBS’s subsidiary (Seara) mainly in the biggest market, cold cuts.

In its last reported results (2Q17), the company recovered 80bps in market share to 54.4%. We expect them to continue recovering market share due to the difficult situation of JBS, as explained above. In this regard, it is worth mentioning that BRF will create a new brand, Quideli, focused on the lower income class, to be launched by the end of 2017.

Most of the market share losses for the last years were due to the increase of participation of lower value brands (Brazilian economic crisis and loss of purchasing power by families) and the fact that Brasil Foods was restricted until last July to create a new brand focusing on this market due to restrictions imposed by the Brazilian anti-trust commission (CADE) after the merger process between Sadia and Perdigao.

Third, the company has strong exposure to corn and soybean prices, the largest components of its total feed cost (COGS represent 72% of total revenues and commodities account for more than 90% of COGS). It is worth mentioning that the company benefits from highly discounted prices of corn in Mato Grosso State, where it has its largest poultry slaughtering mill. Find below the discount of corn prices in percentage points compared to São Paulo State in the last 17 years and the median point.

As we can see, between April 2016 and April 2017, this discount fell to an average of 31% against the median point of 49% due to the El Niño effect and huge production losses in corn harvesting, explaining the huge losses that the company faced in 2016 and beginning of 2017. In the last two months, the discount of corn prices in Mato Grosso recovered to a percentage higher than average.

Fourth, the chicken hatchery in Brazil has been falling quarter over quarter since 2Q2016 (source: APINCO). In 2Q2017, it posted a fall of 5% y-o-y. This market discipline should lead to higher prices towards the end of 2017, helping BRF recover its margin to the levels observed in 2015.

And fifth, the company has a great percentage of its revenues coming from exports (52%) priced in US Dollars. The Brazilian real is expected to depreciate following the uncertainty regarding the approval of pension reforms and uncertainties related to 2018 elections. Former President Lula, seen nowadays as much more leftish than before and with proposals related to control media vehicles, is the frontrunner with a 30% approval.

Regarding the approval by Congress of pension reforms, it needs a qualified majority of 308 votes in the lower house and the Government has less than 250 votes currently. The unpopularity of the reform should decrease this number as elections get closer.

In terms of multiples, Brasil Foods currently trades at 9.4x EV/EBITDA 2018 and 22.8x Price/Earnings 2018 versus consumer staples sector multiples of 13.4x and 21.7x, respectively. Earnings are still depressed given high financial expenses, which should go down as they reduce leverage.

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.