Brasil Foods (NYSE:BRFS) Expecting Cost Savings of 500 Million USD By 2013; Outlook For High-Margin Products

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By: Elliott Gue

Over the past two decades, Brazil has emerged as the world’s leading poultry exporter. In 2011, the country produced 13.2 million metric tons of the meat and exported about 4 million metric tons—about 36 percent of the global market. Brazil’s leadership in this product category reflects several competitive advantages: ready access to potable water, huge swathes of arable land for feed grains, and relatively low production costs.

However, in recent years, Brazilian poultry producers have faced several headwinds, including price fluctuations in the grains market, rising labor costs as the domestic economy grows and a strengthening Brazilian real, which reduces the appeal of the nation’s exports.

The supply-demand balance in the global poultry market also is a cause for concern, largely because of developments in Russia. The world’s leading chicken importer until 2009, Russia has scaled back imports significantly and, thanks to subsidized financing for the industry and other government supports, should soon produce enough of the fowl to outstrip domestic demand.

Russia last year accounted for only 2 percent of Brazil’s poultry exports, while the US Dept of Agriculture (USDA) estimates that this rapidly disappearing market received 7 percent of US chicken shipments. Some analysts have expressed concern that the US will redirect these exports to Brazil’s core markets of Japan, the Middle East and South Africa.

Nevertheless, US chicken producers are a step behind their counterparts in Brazil and Argentina, which have focused on delivering value-added, dark-meat products tailored to local tastes in rapidly growing emerging markets. To catch up, US operators will need to shift their focus from developing innovative white-meat products to please domestic palates and apply this creativity to the bird’s darker portions.

Moreover, Brazil enjoys a reputation for delivering superior quality products relative to the birds exported by US operators. Brazil’s whole chickens also dominate key growth markets in the Middle East, though US exports have made some inroads in Saudi Arabia and other nations.

At the same time, Brazilian poultry exports to China—a market that’s closed to US producers because of tariffs—have ramped up over the past two years. Investors also shouldn’t overlook rising poultry consumption in Brazil and Latin America as household incomes rise and elevated beef prices enable poultry producers to push through higher prices.

In May 2009, Brazil’s two largest meatpackers, Sadia and Perdigão, combined to form Brasil Foods (Sao Paulo: BRFS3, NYSE: BRFS), the country’s leading food company and the world’s top poultry exporter. Two years later, Brazil’s Administrative Council for Economic Defense approved the deal, pending the disposal of certain assets. Management expects the integration of the two companies to generate BRL1 billion (about USD530.4 million) in cost savings by the end of 2013.

Although management has set the ambitious goal of doubling the company’s 2011 net sales over the next four years, Brasil Foods faces a number of near-term headwinds that could weigh on profitability. Corn and soybean costs should remain flat in 2012, but a 14 percent increase to Brazil’s minimum wage will ensure that rising labor costs take a bite out of the food giant’s profits.

Meanwhile, temporary oversupplies in Japan and the Middle East have weighed on Brasil Foods’ export business.

Management attributed this weakness to Japan’s aggressive imports in the wake of the devastating earthquake that hit the country in March 2011 and noted that pricing and volumes should recover by the back half of 2012.

In the Middle East, poultry supplies destined for Egypt, Syria and Libya—countries whose imports were disrupted by political upheaval associated with the Arab Spring—flooded Brasil Foods’ core markets of Saudi Arabia and the United Arab Emirates (UAE), depressing prices. Management expects this headwind to also dissipate in the back half of the year.

Despite these challenges, I like Brasil Foods’ long-term growth prospects. In the third quarter of 2011, the company pushed through an 18 percent price increase in the domestic market without sacrificing much market share. In the same vein as my other top growth stock picks, demand for the company’s products should increase as household incomes improve, enabling Brasil Foods to raise prices and grow sales volumes.

I also like management’s efforts to expand into promising product categories such as high-margin processed foods. Brasil Foods last year launched roughly 300 new products, about 200 of which targeted the domestic market, and has focused on ramping up its cheese business.

The company also purchased a two-thirds stake in Argentine chicken producer Arvex and a two-thirds stake in Danica, another Argentina-based company that produces margarine, sauce and pasta. These businesses will combine with the Argentine beef operations that Brasil Foods acquired from an asset swap with Marfrig Alimentos (Sao Paulo: MRFG3), which owns Argentina’s most popular hamburger and hot dog brands, to provide a platform for growth.

Outside South America, the company is building processing facilities in key markets such as the UAE, China and North Africa, with an eye toward growing its presence in these regions and tailoring its products to local tastes.

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