Brf sa looking at a long road back – brf-brasil foods s.a. (nyse brfs) seeking alpha electricity billy elliot instrumental

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"How can it get any worse?" certainly has a place of distinction among the most foolish validations that investors will try to use with struggling companies, and Brazil’s BRF SA ( BRFS) is a case in point. In addition to ongoing criminal investigations, BRF has been effectively banned from the EU for the time being, is facing rising costs and weak market share, has high debt and modest near-term free cash flow prospects, and has to find a new CEO and craft a turnaround strategy.

BRF’s new board does appear to be an upgrade, and the company still has some positives going for it – including a meaningful overseas presence and a still-strong presence in the Brazilian market. While the valuation may look modest relative to the long-term potential of a successful turnaround, investors need to appreciate that such a turnaround is going to take time, and success is far from certain. Okay Results, But Likely To Get Tougher From Here

I would argue that BRF is on the cusp of where investors care less about quarter-to-quarter profitability and more about liquidity. Be that as it may, BRF’s first quarter wasn’t too bad relatively to repeatedly lowered expectations, but the year ahead is likely to be more challenging.

Brazil saw a surge in fresh product volume (up 23%), while the processed food business ticked down slightly as weaker pricing (due in part to a mix shift away from higher-value brands) offset volume growth. OneFoods saw good growth in both businesses, but processed food is still less than 20% of the mix in this segment.

Gross margin was up very slightly, helped by a four-point improvement in OneFoods that helped offset six points of erosion in Brazil. With grain prices shooting up in Brazil, it is likely that gross margin is going to come under severe pressure in the next couple of quarters. EBITDA was actually better than expected, with reported EBITDA up 54% (and adjusted up 41%), despite a 30% decline in Brazil.

Due in large part to the efforts of large unhappy investors, BRF shareholders elected a new 10-member board in late April. The board will be headed by Pedro Parente, the current CEO of Petrobras ( PBR) and a well-respected executive in Brazil with a track record of leading companies through challenging circumstances. The new vice-chairman, Augusto Marques de Cruz Filho, is also well-known in Brazil as the former CEO of one of its largest retailers. Three of BRF’s former board members are part of this new board.

One of the first tasks for the board is finding a new CEO. The former CEO Jose Aurelio Drummond resigned unexpectedly before the board election. While there’s little to be gained from spending much time speculating as to the reason for his resignation (either way, he’s gone), it was clear before the election that Mr. Parente was going to become the new chairman and the former CEO may have resented what he was sure to be a more active and hands-on board constraining his power to lead the turnaround his way.

BRF has a growing issue with margins. About one-third of the company’s costs are grain, and despite an effort to build the processed food business, fresh/frozen poultry is still about half of the revenue base. What’s worse, there’s been a steady rise in other COGS items (including "indirect costs") and new rules for poultry exported to Saudi Arabia (banning the use of electricity to stun the birds before slaughter) could lead to even higher production costs. BRF likely needs a thorough cost reduction/restructuring effort and likely needs to look at making investments in automation and improved go-to-market capabilities, but both of those will cost money.

BRF also still has to build its branded processed business. The company has lost over six points of market share in Brazil in less than three years, with the Sadia brand bearing the brunt. Launching yet another new brand (Kidelli), this time to address the value-priced segment, makes some sense but is liable to worsen the margin mix in the short term. Outside of Brazil, BRF is still largely just a provider of bulk poultry to areas/countries like the Middle East and Japan. Although OneFoods is a viable long-term means of shifting the mix towards processed foods, the key is "long term".

BRF also has challenges and limitations in its capital structure. Over the last five years, the company spent about R$5 billion on M&A and a similar amount on buybacks. With only about a R$6 billion change in revenue and much lower margins since that M&A binge began, it’s hard to argue that it has been money well-spent so far. I actually think most of those acquisitions will prove to be worthwhile over time, but the fact remains that, with around R$14 billion in debt and R$3.5 billion to R$4 billion in near-term annual EBITDA, BRF has spent itself into a tighter spot.

Last and not least, BRF has to work its way past this food safety and corruption scandal (the so-called "Weak Flesh" investigation and subsequent Trapaca investigation). The EU has moved to ban imports from 20 Brazilian facilities, including 12 BRF facilities, basically excluding the company from the European market. Although Europe is a small part of the company’s overall volume, the global poultry markets aren’t exactly strong now, and there aren’t a lot of great options for redirecting that volume. I fully expect BRF to eventually get this ban lifted, but that things got to this point at all shows that there is a need to strengthen a lot of basic compliance functions within the company. The Opportunity

With higher grain prices, increasing poultry production in other regions, and the risk of further challenges/changes to export markets (including those new halal rules in Saudi Arabia), I believe 2018 is going to be a tough year for BRF. I also believe that the company has a much improved board, and I think the board will take its time to find the right person for the job. Although this is a challenging situation, it’s also the sort of set-up that can really establish a CEO’s reputation if the turnaround goes well, and that will hold a lot of appeal to some candidates.

Longer term, I believe Brazil’s consumer goods market remains attractive, and I believe BRF has done a lot of the heavy lifting needed to lay the groundwork for branded processed food businesses in multiple emerging markets that can drive future growth. Unfortunately, those businesses are still too small to meaningfully offset the other headwinds in the business today. The Bottom Line

While I still own these shares, my position is only a fraction of what it once was (I sold down at higher levels in years past) and I’m carrying that largely just to offset future capital gains in other positions. I believe the shares are undervalued on the basis of long-term revenue growth around 6% and FCF margins improving back into the mid-single digits, but I expect a lot of investors will stay away until the new CEO is in place and a turnaround plan has been presented to investors. I can understand the temptation to argue that the company’s still-sizable (over 50%) market share in Brazil’s processed food market provides some floor for valuation, but that value is tempered by the possibility that the company may need to dilute shareholders with an equity offering to build liquidity.