BRF SA Holds Impressive Long-Term Potential

Analysts and investors like to talk about "the next Apple" or "the next Microsoft," but they don't often talk about "the next Nestle (NASDAQOTH: NSRGY  ) ". That's a shame, as Brazil's BRF (NYSE: BRFS  ) , or Brasil Foods, has set that goal for itself; it has a long-term target of becoming a global packaged-foods leader with a particular focus on emerging markets. The path between here and there is not going to be smooth and setback-free, but BRF looks like a somewhat beaten-down name to consider in the emerging markets.

A huge player, just not here
BRF is the largest food company in Brazil and it is a rather large food company on a global scale (bigger than Tyson or Hormel, though it is dwarfed by Nestle, Unilever (NYSE: UL  ) , and Danone (NASDAQOTH: DANOY  ) ). Despite significant competition from local rivals like JBS and global players like Nestle, Unilever, and Danone, BRF has built itself into a market leader across many processed food categories in Brazil, with 50% to 60% share in areas like specialty meats, frozen meats, pasta, and frozen pizza.

Growing the company's mix of higher-value processed foods is a major priority for management, but the company is still significantly involved in its traditional fresh protein business. Roughly 29% of BRF's revenue comes from poultry, with another 9% from beef and pork and about 44% from processed foods.

The export business is even more heavily weighted toward proteins. BRF's revenue is split pretty close to 50/50 between domestic and export sales, and BRF is responsible for about 20% of the world's poultry exports (and nearly 10% of animal proteins overall). BRF is particularly strong in the poultry markets of the Mideast and Japan, but the global proteins market is a turbulent one, as unpredictable supply levels and local inventories lead to significant swings in both volumes and price. In contrast to its large presence in certain international markets, BRF has almost no presence in the U.S.

Looking to up the value
Taking a page from Hormel's playbook (not to mention Nestle's and Danone's), BRF is attempting to shift away from a focus on commodity proteins toward becoming an international packaged and processed-food player.

Only about 20% of BRF's exports consist of processed foods at present. Instead of buying local brands (something Nestle and Unilever did years ago), BRF is instead building up its distribution and production assets in key markets like China and the Middle East. With improved distribution, BRF hopes to essentially export (and build) brands and products that have already been successful in Brazil.

To that end, BRF has recently acquired sizable stakes in two Middle Eastern distributors (Al Khan Foods in Oman and Federal Foods in the UAE) and it is exploring some sort of tie-up or transaction with Kuwait's Americana. BRF's management has also talked of making strategic moves to better serve growth markets like Africa and Indonesia in the not-so-distant future.

BRF is simultaneously looking to reduce its exposure to lower-margin and lower-value businesses. The company swapped two beef processing plants to Minerva Foods in exchange for almost 300 million reais in Minerva shares, and the company is openly considering the sale of its dairy business. Although the dairy business has 11% share in Brazil, the returns have been poor and it may be valuable as an asset to be sold to Nestle or Danone (the two leading dairy companies in Brazil) or a company like Lala that wants to enter the Brazilian dairy market.

A lot of activity in the coming years
It took seemingly forever, but the Brazilian regulators have finally approved the 2009 deal that created BRF (from Perdigao and Sadia), which has given the company a chance to make significant structural changes. Management has already targeted nearly R$2 billion in cost synergies from the merger that were on hold before final approval. Looking ahead, management is also talking of streamlining the sales force, improving the company's pricing and branding strategies, and refining its product lineup by doubling R&D and culling perhaps as many as 30% of its existing SKUs.

Those are major moves, but in combination with the company's extensive new product launches (50 in the fourth quarter and more than 200 in 2013), they should meaningfully upgrade the company's margins and the stability of its revenue -- paving the way for double-digit returns on capital, better free cash flow, and less of a risk premium.

The bottom line
Global food giants like Nestle, Unilever, and Danone are hardly eager to see a new rival emerging, let alone one that could threaten their plans to augment slowing growth in developed markets with much more significant growth in emerging markets. That said, Unilever has clearly been active in selling off its food business one brand at a time, while Nestle and Danone are both trying to readjust their product portfolios toward growth. With an advantaged cost structure by virtue of its access to cheaper Brazilian proteins and labor, BRF does have an opportunity here to become a global player.

All of that may sound great, but it is going to take time. I am modeling high-single-digit long-term revenue growth (9%), but I believe it will take at least five years for free cash flow margins to rise to the mid-single digits (and a decade or more to reach double digits). To account for the currency risks of a Brazilian company as well as its large commodity protein export business, I use a discount rate two points higher than I do for Nestle and Unilever. The result is a fair value estimate of about $22.

As the last year has shown, BRF is not going to march steadily upward without seeing pullbacks. In addition to currency issues, BRF has been challenged by erratic export markets and high inflation in Brazil. Those challenges won't disappear overnight, but investors looking for good long-term emerging market growth stories should give BRF a closer look.

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