Improved Execution Is Letting BRF SA Fully Benefit From A Strong Poultry Cycle

seekingalpha08-20

A healthy global poultry market and good execution on operational improvements has driven strong gains in BRF's share price.Second quarter results exceeded expectations for revenue and margins, with ...

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if the cycle follows past trends, BRF is likely to see poultry margins flatten out from here.I'm bullish on the prospects for further growth in processed foods and operational efficiency improvements, but investors shouldn't get too far ahead of the story, as commodity cycles still matter.   pidjoe I’ve said this many times before – successful turnarounds can far surpass initial expectations, and when it’s a cost-driven company operating in commodity markets, the combination of improved execution and cyclical upswings can be powerful indeed. Such is the case for BRF SA (NYSE:BRFS), as this Brazilian poultry, pork, and processed food producer has managed to deliver on meaningful operational improvement targets at a time when global poultry prices are quite attractive. That, in turn, has helped drive a nearly 50% jump in the share price since my last update, a performance not quite as good as that of JBS SA (OTCQX:JBSAY), but quite good next to Marfrig, Pilgrim’s Pride (PPC), and Tyson (TSN). I’m torn on what to do with the stock in terms of a recommendation. This could prove to be a higher-for-longer cycle in poultry, and BRF SA’s well-developed international infrastructure lets management pick and choose among the most attractive markets. Likewise, further operational improvements are certainly not out of the question. On the flip side, the poultry industry is what it is and has shown pronounced, if not fully predictable, cyclicality over the years. I’m not willing to call it a day yet on this turnaround story, but it does require some definite bullishness on poultry prices to want to buy in at today’s price. Second Quarter Results Show More “Nature AND Nurture” Synergy Not unlike the first quarter, BRF’s second quarter was one characterized by outperformance driven by a powerful combination of better-than-expected execution on internal, controllable self-improvement initiatives and a healthier-than-expected international market, with particularly strong results from the halal/Gulf Coast (as in Persian Gulf) markets. Consolidated revenue rose 22% year over year and 12% sequentially, beating by more than 5%, as volume rose 5% yoy (8% qoq) and realized pricing rose 16% yoy (and 3.5% qoq). Revenue in Brazil rose 6% on 8% volume growth, with the company continuing to see some price contraction as food inflation eases. In the international business, revenue rose 17% with volume up almost 5% and realized pricing up more than 10% on a combination of stronger pricing in the halal/Gulf region and an improved mix of processed food. Gross margin improved 14 points from the year-ago period and a further two-plus points from the prior quarter, reaching 26.3% and over 27% in both the Brazilian and International operations (there is an “Other” business that is largely pet food and ingredients). Overall cost per kg sold declined 3%, with 10% or better declines in both Brazil and International on lower grain prices and improved feed conversion. Adjusted EBITDA jumped 161% yoy and 24% qoq, beating expectations by 9%, as the margin improved more than nine points to 17.6% (and from 15.8% in the prior quarter). The Brazilian business saw 72% yoy growth and over six points of margin improvement to 15.7%, while the International operations grew substantially more, with margin improving 17pts to 21% (and from 16.9% in the prior quarter). Cash flow generation has been quite good of late (R$1.3B in the second quarter) and is certainly helping to ease longer-term fears about liquidity. How Long Will The Good Times Last? Global chicken prices have been relatively stable of late, but that stability is fragile given double-digit declines in grain prices and ample willingness from producers in exporting countries (including Brazil, Thailand, and the U.S.) to increase production and grab some incremental profits. As recently observed by Bank of America analyst Isabella Simonato, in past cycles, producers have seen two to three cycles of improved margins and a peak/plateau that lasts about a year, with a decline then following. If that pattern holds true again, BRF could see chicken margins flatten out through about the middle of 2025 and then start declining (not withstanding self-improvement efforts). Looking at this cycle, I don’t think there’s all that much room for grain prices to head substantially lower. On the flip side, there are ongoing worries about avian flu and other diseases hitting producing countries (Brazil was hit by a brief outbreak of Newcastle disease that led to a suspension of exports from one state for a few weeks in July). Moreover, production growth in key-to-BRF regions like the Gulf looks limited through at least the end of the year, and Saudi Arabia has been pulling back on subsidies. Trying to predict poultry prices a year or more ahead is usually an exercise in folly beyond saying “relative to the past, today’s margins are high/low”. After all, an avian flu outbreak in a major exporting country, another swine flu outbreak in China, or further disruptions to global trade (like the disruptions in the Red Sea) could all meaningfully impact prices and are basically unpredictable. What I can say, though, is that BRF is executing better than it has in many years. Not only has the company been seeing increased uptake of higher-margin processed foods, the company is also finding new markets for products like chicken breasts that have previously dragged down margins. Likewise, the company continues to expand its export license portfolio, allowing the company to pick and choose among more desirable markets, and the company’s strong in-market distribution in halal/Gulf Coast markets gives it a leg up on commodity rivals. Self-Improvement Isn’t Necessarily Over BRF has already made significant progress with its self-help efficiency initiatives, including improved feed conversion, reduced mortality (well … “unscheduled” mortality), improved production efficiency, and improved retail execution. I still see room for further improvement on the retail side. Management has focused on its higher-margin channels and has seen improved shelf space and store adherence to suggested prices. The company has been trying to “thread the needle” and improve margins without ceding too much share to rival JBS (and its Seara brand), and that seems to be working. Looking ahead, I see more opportunities for product line and channel expansion. I likewise still see long-term opportunities to improve the “in natural” and processed food mix throughout key markets like Turkey and the Gulf Coast. The arguments in favor of processed food (convenience, wastage, etc.) are just as valid in these markets and while affordability will be an issue in many cases, there is still room to grow a category that is seen as desirable (if not aspirational) by many consumers in these countries. The Outlook A stronger-than-expected poultry market and better-than-expected execution have been a powerful one-two punch for BRF’s profitability. While my revenue estimates for the next three years have gone up (by more than 3% in FY’24 and more than 2% for FY’25), the bigger improvement has been with margins and free cash flow, where I now expect a better than 16% EBITDA margin in FY’24 (the strongest margin in a very long time). How long these margins stay firmly in the double-digits is a major unknown. I’m pretty comfortable and confident assuming over 5% revenue growth over the next three years (and over 5% over the long term), but I’m not as confident as where margins will be in FY’26 or FY’27 – “cut and paste” cyclicality would suggest a return to the lower double-digits (around 12%), but I think it’s possible that margins could stay at 13% or higher given a prolonged positive poultry cycle and BRF’s self-improvement efforts. That all should allow BRF to continue producing free cash flow and keep FCF margins in the mid-single-digits. Over time, I expect further improvement toward the high end of the mid-single-digits (around 6% to 7%); while the company has had individual years of 10% or better FCF margins, that’s never been sustainable, and I think the commodity side of the business is still too large for that to change in the foreseeable future. Long-term revenue growth of around 5% and FCF growth of around 7% can support a high single-digit long-term annualized return from here. An EV/EBITDA-based methodology is more favorable, with a 6.25x multiple on 12-month EBITDA getting me to a fair value in the $5’s. I haven’t changed the multiple despite improved profitability, as I do think sustainability is still a question, and it’s typically unwise to raise multiples in a peaking commodity cycle. The Bottom Line  I do have some concerns that the poultry market will plateau for a little while and then decline, making it harder for BRF to continue generating the revenue growth and margin expansion that the Street always wants. On the other hand, there are still levers to pull with self-improvement and opportunities to grow the processed food business in Brazil and abroad. I’m reluctant to really pound the table and argue for readers to buy in at this late date, but I do still see room for longer-term upside that validates some level of bullishness even here.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2460887088"}