Description

JBS SA

 

In the current environment, it is rare to find a company that (i) is extremely cheap on a variety of metrics due to identifiable, but inaccurate, concerns, (ii) has imminent catalysts to unlock substantial additional value, and (iii) operates in an industry that is, to a large extent, unaffected by the macro environment.  JBS SA (JBSS3 on the Brazilian Bovespa Exchange) satisfies all three of these criteria.

 

We believe the upside in this name is >100% over the next 9-12 months, with a considerable margin-of-safety based on the company’s excellent hard assets.  Following an acquisition that we expect to close within the next 1-2 months, we believe JBS’s earnings power on a go-forward basis will be roughly R$1.00/share.  This compares favorably with the Bloomberg consensus estimate of R$0.60/share, and is more than twice what we believe the market is currently pricing in.  In our opinion, a well-run protein company with a majority of its assets in the United States should be assigned a 10-11x forward earnings multiple, implying that the company’s fair value ought to be >R$10.00/share; the stock currently trades at R$4.43/share.  This represents a return on investment of ~125% once the upcoming catalysts unlock the company’s intrinsic value.

 

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Investment Thesis

 

From a 30,000-foot view, the story is essentially one of industry consolidation.  The beef packing industry has historically experienced lengthy periods of irrational competition due to its lack of concentration.  Within the next 1-2 months, however, we expect the U.S. Department of Justice to approve JBS’s acquisition of National Beef Packing Company, LLC, which – on the heels of JBS’s recent acquisitions of Swift & Co. and Smithfield Beef – will consolidate the #3, #4, and #5 players into the industry’s new #1 packing company.  As a result of the transaction, the top-3 companies will control >75% of U.S. industry slaughter capacity.

 

The effect on the bottom line will be significant.  In the 1990’s and early 2000’s, beef packers earned an average EBITDA margin of 2.5%-3.0% (superior competitors typically have earned 100-200bps above the industry average).  Following the discovery of “mad cow disease” in the U.S. on Christmas Eve, 2003 – which caused many large importers of U.S. beef, most importantly Japan and South Korea, to stop purchasing U.S. beef – packing EBITDA margins collapsed to 1.0%-1.5% (largely due to the resulting excess slaughter capacity).  As reversion-to-the-mean value investors, we believed this situation was unsustainable: the industry simply was not earning its cost of capital, which meant that either conditions needed to change or excess capacity needed to exit the market to restore the industry to profitability.

 

Over the last 2-3 years, this thesis began to play out.  Significant slaughter capacity exited the market as packing plants shut down, and the Korean export market gradually re-opened to exports, further tightening the supply-demand balance.  Even more importantly, JBS’s recent efforts to consolidate the market will lead to a much more rational industry structure.  Finally, we believe the Japanese beef export market – which remains largely closed to U.S. exports – is on the verge of re-opening to U.S. beef exports (following in South Korea’s footsteps), an event we expect to occur within the next 6-12 months.  The exit of slaughter capacity over the last few years has already returned the industry to historical levels of profitability, and we believe the game-changing move to rational competition – along with the benefit of a Japanese catalyst – will take average EBITDA margins to 4.0%-6.0%, more in line (on a pound-for-pound basis) with the EBITDA margins earned in other major beef-producing regions of the world.  It is important to note that the best operators (we consider JBS to be an outstanding operator) will likely earn as much as 100-200bps above this level.

 

In our opinion, JBS is the best way to play this thesis.  Not only does the company stand to benefit most from this change in industry conditions as the closest thing to a “pure-play” on the thesis, it also is a highly misunderstood business trading at a deep discount to intrinsic value.  Our analysis shows that JBS’s stock is pricing in permanent U.S. EBITDA margins of 2.1%, substantially below not only what we believe the company will earn going forward, but also well below normalized margins historically achieved in a much more fragmented U.S. beef industry.  We take further comfort in the fact that JBS has a strong franchise, a wide moat that’s getting wider, a best-in-class management team, a strong balance sheet, and that the company trades at a material discount to the replacement cost of its assets.

 

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Business Description

 

JBS SA is the global #1 producer of beef.  The company currently owns the #1 market share in Italy, Argentina, Brazil, Australia, and (pending the National Beef transaction, which is discussed further below) the United States.  The latter four represent the global low-cost production countries due to a combination of favorable climate, a large supply of available land for pasture, and proximity to inexpensive sources of feed.

 

JBS’s assets are primarily located in the United States, which accounted for 57% of revenues in Q3 2008 (43% from Beef USA, 14% from Pork USA).  The rest of company revenues are split between Beef Brazil (22%), Beef Australia (13%), Beef Italy (5%), and Beef Argentina (3%).  Factoring in JBS’s just-completed acquisition of Smithfield Beef and assuming the National Beef deal is approved per the detail below, >50% of revenue will come from Beef USA moving forward.

 

The company’s profitability is largely unrelated to movements in commodity prices such as those for beef, pork, corn, or soybeans.  Instead, JBS operates a spread business model, purchasing cattle (or pork or sheep), efficiently slaughtering the animals, and then marketing the various products globally to achieve best price.  The key earnings drivers are scale, efficiency, and capacity utilization.

 

JBS SA is listed in Brazil under the ticker symbol JBSS3 BZ.  The market cap is $2.8bn, although only 23% of the shares freely trade on the exchange.  Average trading volume is $7-$9mn per day.

 

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The Story

 

JBS initially crossed our radar during our due diligence of the protein industry.  Since the discovery of BSE (“mad cow disease”) in the U.S. in December of 2003, the U.S. beef industry had earned terrible returns on capital at historically-low margins.  Between 2006 and today, JBS executed what we believe has been a tactically brilliant strategy to first enter, and then consolidate, the U.S. beef industry.  As a result of the company’s efforts, the industry is now effectively a “tri-opoly” with privately-held Cargill, Tyson Foods (NYSE: TSN), and JBS now controlling >60% of U.S. slaughter capacity (should the National Beef deal go through, that figure will rise to >75% of industry capacity).  We believe this new market dynamic will lead to significantly more rational competition and return the industry to higher margins and adequate returns on capital.

 

Following its successful roll-up of the Brazilian beef industry via both organic and acquisitive growth, JBS entered the U.S. market by acquiring Swift & Co., the #3 player in the U.S., in 2006.  The acquisition made sense – with the Brazilian real trading at all-time highs, and the U.S. beef industry operating at historical trough margins, 2006 was an ideal time for JBS to make its first foray into the U.S. market.

 

After assuming control of Swift – which had been a money-losing operation – JBS immediately removed senior management, slashed SG&A costs (headcount at Swift’s headquarters in Greeley, CO, was reduced from 550 to 350, while revenues increased 30% over the same time-frame), and increased operating efficiency by double-shifting the newly-acquired facilities.  These efforts reduced Swift’s cost-per-head from $212.30 in Q2 2007 (before JBS took control) to $164.20 in Q2 2008, a cost reduction of $48.10 per head.  In a spread business with tight margins, this was an enormous improvement.

 

At the same time, the double-shifting of capacity drove industry margins deeply into negative territory, forcing Tyson to shutter a plant in Kansas and both National Beef and Smithfield Beef to sell their operations to JBS for bargain prices.  In a matter of months, JBS had (i) entered the U.S. market at an ideal time based on relative purchasing power and industry fundamentals, (ii) demonstrated the company’s ability to outperform experienced U.S. operators, (iii) returned the industry to rational behavior and higher capacity utilization rates by forcing a competitor to scale back operations, and (iv) established what is expected to be the undisputed #1 position in the U.S. industry by acquiring good assets at bargain prices.

 

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Valuation

 

JBS currently trades at roughly R$4.43/share (the exchange rate is ~R$2.35/$1.00), giving the company an approximate market capitalization of R$6,400mn and an approximate enterprise value of R$8,900mn.  Over the trailing twelve months, the company earned EBITDA of R$1,032mn in its continuing operations, which translates into EPS for continuing ops of roughly R$0.26/share.  On a trailing basis, the business therefore trades at ~8.6x EV/EBITDA and ~17x P/E.

 

However, these figures do not accurately reflect the company’s earnings power going forward.   At the beginning of Q4 2008, JBS closed on the acquisition of Smithfield Beef, increasing the company’s U.S. beef slaughter capacity by ~35%.  Furthermore, these LTM numbers include Q4 2007 and Q1 2008, which represent some of the worst operating conditions the U.S. industry has experienced in the last quarter-century (as a result of JBS double-shifting its Swift plants).  The numbers in the first half of 2008 were further beaten down by the Argentinean government’s decision to effectively cut off exports from the country, a situation which has since been resolved.  Finally, these numbers do not consider the possibility that JBS may acquire all or part of National Beef in the near future.

 

On a go-forward basis, we assume JBS will earn 8% EBITDA margins in Brazil and Argentina, 5% EBITDA margins in Italy, and 4% EBITDA margins in Pork USA.  For comparison, Brazil and Argentina have historically earned 10-12% EBITDA margins, Italy earned 4.8% margins in 2006, 5.0% margins in 2007, and 5.4% margins year-to-date in 2008, and Pork USA earned 7.6% margins in Q3 2008 which management called a “sustainable” figure on its Q3 2008 earnings call.

 

The key swing number is the earnings power in Beef USA (which includes the Australian operations).  In just the last two quarters, this segment (ex- Smithfield Beef and National Beef) earned $288mn USD in EBITDA, and Smithfield Beef as a stand-alone business earned LTM EBITDA of $138mn USD.  Lapping Q4 2007 and Q1 2008 (when both JBS Swift and Smithfield Beef had negative EBITDA), and accounting for the ample operational synergies from the transaction (consider, for example, the benefits of reducing three global sales forces and three national cattle procurement operations to one sales force and one procurement operation) and a much more rational industry structure, we would be surprised if the Smithfield Beef assets earned anything less than $200mn USD in EBITDA.  JBS Swift, which is slightly less than 3x the size of Smithfield Beef, ought to earn EBITDA of at least $500mn USD.  A shrunk-down National Beef (see below) would be a good bit larger than Smithfield Beef and with better assets, and ought to be capable of earning at least $250mn USD in EBITDA (National Beef earned $90mn in EBITDA in Q2 2008 alone).

 

All-told, ex-National Beef we believe JBS should be more than capable of earning EBITDA of R$2,415mn, which translates into EPS of R$0.80/share.  On this measure, JBS would be trading at 5.5x P/E and 4.2x EV/EBITDA.

 

A full year of results that include the shrunk-down National Beef acquisition (per description below) would add an incremental R$700mn of EBITDA for a total of R$3,120mn, or an EPS of R$1.04/share.  The company would therefore be trading at 4.3x P/E and 3.6x EV/EBITDA.

 

JBS SA								Ex-National Beef				Including National Beef
R$ 000's										R$				R$
	2006	2007		Q1 2008	Q2 2008	Q3 2008		2009e		2009e		2009e		2009e
JBS SA
Net Revenues
JBS USA Beef (US $)	7,324.0	7,375.0		1,976.0	2,630.0	2,755.8		14,000.0	x2.35	32,900.0		18,500.0	x2.35	43,475.0
JBS USA Pork (US $)	2,070.0	2,175.0		536.0	619.9	682.2		2,500.0	x2.35	5,875.0		2,500.0	x2.35	5,875.0
Inalca JBS (EUR)	522.0	521.0		132.0	155.0	143.1		550.0	x3.33	1,831.5		550.0	x3.33	1,831.5
JBS Brazil / Argentina (R$)	3,967.6	4,892.0		1,271.0	1,425.0	1,811.0		7,000.0	->	7,000.0		7,000.0	->	7,000.0
Total										47,606.5				58,181.5
EBITDA
JBS USA Beef (US $)	(67.6)	25.8		(0.9)	132.9	155.6		650.0	x2.35	1,527.5		950.0	x2.35	2,232.5
JBS USA Pork (US $)	73.3	70.3		15.7	19.9	52.1		100.0	x2.35	235.0		100.0	x2.35	235.0
Inalca JBS (EUR)	25.0	26.0		7.4	7.5	7.6		27.5	x3.33	91.6		27.5	x3.33	91.6
JBS Brazil / Argentina (R$)	452.3	692.0		132.7	58.2	102.2		560.0	->	560.0		560.0	->	560.0
Total										2,414.1				3,119.1
EBITDA Margin %
JBS USA Beef (US $)	-0.9%	0.3%		0.0%	5.1%	5.6%		4.6%		4.6%		5.0%		5.1%
JBS USA Pork (US $)	3.5%	3.2%		2.9%	3.2%	7.6%		4.0%		4.0%		4.0%		4.0%
Inalca JBS (EUR)	4.8%	5.0%		5.6%	5.3%	5.3%		5.0%		5.0%		5.0%		5.0%
JBS Brazil / Argentina (R$)	11.4%	14.1%		10.4%	4.1%	5.6%		8.0%		8.0%		8.0%		8.0%
Total										5.1%				5.4%
									EBITDA	2,414.1			EBITDA	3,119.1
						0.7% of revenues			D&A	(333.2)			D&A	(407.3)
									EBIT	2,080.8			EBIT	2,711.8
						Assume 9% coupon			I	(333.0)			I	(441.0)
									PBT	1,747.8			PBT	2,270.8
						34% Brazilian rate			Tax	(594.3)			Tax	(772.1)
									E	1,153.6			E	1,498.7
									EPS	0.80			EPS	1.04

 

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Catalyst #1: National Beef Transaction

 

A little under a year ago, JBS announced the purchases of Smithfield Beef and National Beef in rapid-fire succession.  The U.S. Department of Justice (“DOJ”) reviewed both transactions for anti-trust violations, a process which lasted roughly seven months.  In mid-October, the DOJ decided not to contest the Smithfield Beef acquisition (which has since closed), but to sue to block the National Beef acquisition.  The attorneys general from seventeen states joined the DOJ in the lawsuit.

 

On December 16, the DOJ agreed to a stay on the antitrust litigation pending a settlement of the dispute.  We believe the most likely outcome will be that the DOJ requires JBS to divest itself of 1-2 packing plants that are part of the National Beef acquisition.  In particular, we believe that DOJ investigators are focused on plants either in the southwest or in the high plains.  At worst, we believe that two plants will need to be divested, with a more likely outcome that JBS will only divest one plant to satisfy government lawyers.  Our estimates above assume that JBS divests a single packing plant with slaughter capacity of ~3,500 heads/day to complete the transaction.  We expect that JBS will seek to close the deal before a new Administration enters office.

 

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Catalyst #2: The Japanese Export Market

 

South Korea’s decision to re-open to American beef products earlier this year was a critical move in the effort to re-open the Japanese market.  For the last five years, the two countries have been waiting for the other to step forward and consummate a deal; now that South Korea has done so, we believe the only remaining obstacle is the scheduling of a high-level government meeting between Japan and the United States to consummate a deal.  We expect such a meeting to occur within the first twelve months of an Obama Administration.

 

The impact of a new trade deal would be substantial, as Japan remains closed to the vast majority of U.S. beef exports.  Historically one of the most avid consumers of U.S. beef, the “mad cow” scare in 2003 caused the Japanese government to restrict U.S. imports to cattle under the age of twenty months.  While 90-95% of the U.S. industry is under thirty months of age, only 20-25% of slaughtered U.S. cattle meet Japan’s strict standard.  The higher cost of meeting the requirement has shut off the vast majority of beef exports to Japan.

 

Prior to 2004, Japan was by far the largest export market for U.S. beef.  According to the U.S. Department of Agriculture, in 2003 the value of U.S. beef exports to Japan was $1,182mn.  In 2004, that number fell to $31mn, and by 2007 had only recovered to $294mn.  Japan, South Korea, Canada and Mexico account for >90% of all U.S. beef exports.  A re-opening of the Japanese market would be a game-changer for U.S. beef demand.

 

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Why It’s Cheap

 

Given the imminent catalysts, attractive valuation, and the fact that 60% of JBS’s assets are in the United States, the key question is: why is the stock so cheap?

 

Clearly, the primary cause is the tidal wave of investment exiting the Brazilian market.  More than a quarter of Brazil’s main index, the Bovespa, is made up of two companies: Cia Vale do Rio Doce (Brazil: VALE5 BZ) and Petroleo Brasileiro SA (Brazil: PETR4 BZ).  These two companies produce iron ore and oil, respectively.  As the commodity bubble collapsed, investors fled commodity-heavy markets like Brazil, crushing both stock valuations and the Brazilian currency.  From the Bovespa’s peak in May through October – a five-month period – the Bovespa lost more than half its value,  the Brazilian real lost more than one-third of its value relative to the U.S. dollar, and JBS’s share price collapsed from a high of R$9.90/share to below R$3.00/share.

 

Ironically, this is exactly the opposite of what should have happened if investors had been looking at the fundamentals.  As a significant exporter, a weak Brazilian real is good for JBS.  Furthermore, a majority of the company’s revenues and earnings now come from the U.S., which means an appreciating dollar against the Brazilian real actually boosts the earnings power of the business in reais.  According to JBS, the best currency landscape is “a weak dollar and a weaker real” – exactly what we have right now.  Finally, the company had previously raised the funds for both the Smithfield Beef and National Beef acquisitions via an equity offering, and those funds had been shifted into U.S. dollars ahead of the purchases; in other words, as the dollar appreciated, the earnings power in reais for the company’s U.S. acquisitions increased while the purchase price remained the same.  This is a classic case of throwing out the baby with the bath water.

 

A secondary cause was a downgrade the company received from Moody’s.  On September 2^nd, Moody’s notified the market that should JBS receive U.S. Department of Justice approval for the acquisitions of National Beef and Smithfield Beef, Moody’s intended to downgrade JBS’s $575mn of USD-denominated long-term debt securities from B1 to B2.  Curiously, rather than focusing on JBS’s balance sheet, debt maturity schedule, or whether JBS’s operating profits were likely to cover the expected interest payments on that debt, Moody’s noted that the downgrade stemmed from concerns over “added integration risks and the challenges associated with such rapid growth.”  In particular, Moody’s said that “the pace at which JBS is expanding its operations leaves little room for unexpected events or delays in realizing operational synergies.”

 

This seems to reflect a profound misunderstanding of both the company and how a rating agency should determine the credit-worthiness of an issuer.  Essentially, Moody’s was concerned about integration risk; while this is a fair concern, the commentary flies in the face of (i) the company’s long history of growth through acquisition, including a series of successful forays into international markets, (ii) JBS’s rapid success after the purchase of Swift, as the company turned that business from a money-losing operation into a highly-profitable entity, and (iii) the fact that JBS will be retaining the management teams of each of the acquired companies, significantly lessening whatever integration risk there may be.  Interestingly enough, no other ratings agency concurred with Moody’s view of the situation, and the value of the company’s debt has rallied significantly over the last number of weeks.

 

Third, at the end of July JBS asked bondholders for several covenant changes, one of which was to raise the Net Debt / EBITDA ceiling from 3.6x to 4.75x.  The rationale was “peace through strength” – knowing that JBS had extra ammunition to weather a storm would make it less likely that a competitor would seek to drive down margins to oust JBS from a market (an example of this is Tyson’s recent refusal to cut chicken production, in the face of enormous losses, in order to drive Pilgrim’s Pride (NYSE: PPC) into bankruptcy).  Management has repeatedly promised the market that it has no intention of taking the Net Debt / EBITDA ratio above 3.0x, and bondholders overwhelmingly approved the changes, but the market was spooked.  We expect the management team, which we believe is highly credible, to deliver on its promises.

 

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Impact of Credit Crunch

 

Beef consumption has been relatively resilient in past downturns.  Between 1998 and 2007, American consumption of beef never varied more than 3% in any year despite the popping of the internet bubble, 9/11, and the discovery of “mad cow disease” in the U.S.  A similar trend holds true globally.  According to the USDA, the largest annual decline in global beef consumption since 1960 has been in the mid-single digits.  While some consumers may trade down out of filet mignon, sales of Big Mac’s or Whoppers typically go through the roof.

 

The implications of the credit crunch for JBS’s business are mixed.

 

On the positive side, a lack of financing has hurt smaller protein exporters to a greater degree than large exporters, especially in South America.  Industry contacts lead us to believe that a significant number of marginal players have been forced out of the export arena altogether due to an inability to secure trade financing.  In addition, several major international producers of chicken and pork have experienced fiscal stress or entered into bankruptcy proceedings due to a lack of credit availability, which has reduced the supply of proteins across the board.

 

On the negative side, beef importers throughout the world have generally sought to extract working capital from their businesses by reducing inventories.  A number of countries now have beef stocks at critically low levels, which has recently forced buyers back into the market with large orders.  We anticipate that this will have a small impact on JBS in Q4 that will likely be offset as importers rebuild stocks in 2009.  An additional negative is a fall-off in the value of the by-product value of the cattle, also known as the drop credit.  Reduced demand for leather, especially in the form of car seats and apparel, has caused a reduction in hide values in the United States.  However, due to JBS’s extensive hedging programs and ability to sell by-products anywhere in the world, it is not immediately clear that this will have much of an impact on JBS’s bottom-line.

 

From a trade perspective, more than 95% of JBS’s exports do not require the use of Letters of Credit, so any disruption in this market has little effect on the business.

 

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The Balance Sheet

 

Getting comfortable with JBS’s balance sheet is critical to having an investment in the company; we encourage you to do your own work here.  Specifically, we recommend consulting pages 7-9 of JBS’s earnings release from Q3 2008, which can be found on the company’s website.  These pages include JBS’s excellent disclosure of its short-term debt maturities, which we believe the company can more than cover just with the cash on its balance sheet, even if no financing was rolled over.  The company has disclosed to the market that in a “probable scenario”, it expects to be able to roll over 92% of its short-term debt, and in a “pessimistic scenario” it would only be able to roll over 77% of that debt.  Again, in our opinion the company has more than enough cash to continue financing its operations well into the foreseeable future.

 

A majority of JBS’s debt is long-term in nature (ie, 3+ years until maturity).  The remainder is almost exclusively trade-financing – collateralized loans that serve as short-term working capital for the company’s export products.  FINAME/FINEM enterprise financing is backed primarily by equipment, and JBS’s other loans (which include ACC, EXIM, NCE/COMPROR, and export prepayment financing) are primarily backed by exports.  Importantly, the cash on the company’s balance sheet is greater than the company’s working capital needs.  JBS’s Net Debt/EBITDA ratio, which was 2.3x at the end of Q3 2008, may fall below 2.0x by the end of the year.  By the end of 2009, we believe this ratio will be under 1.5x.

 

As a side note that may be helpful in reading the balance sheet, we recommend obtaining a good feel for how the company manages its finances.  JBS is currently seeking to match its borrowings to the geographies where the company generates revenues.  Consequently, currency fluctuations have a significant impact on the company’s cash flows.  This was particularly true in Q3, when the company generated materially positive cash flow, paid down a large amount of debt, yet ended the quarter with a higher net debt in reais than at the beginning of the quarter.  The cause was the translation effect of debt held in non-Brazilian currencies, which needs to be taken into account when analyzing the business.

 

If you have further questions on the balance sheet, we would be happy to reply to them in a post.

 

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Investment Risks

 

The key investment risks are (i) a swift appreciation of the Brazilian real against the U.S. dollar, (ii) the U.S. government blocking the entire acquisition of National Beef, (iii) new trade barriers put up restricting the flow of beef into export markets, (iv) a competitor deciding to make a money-losing play for market share in any of the company’s core markets, and (v) the company is effectively controlled by the Batista family, which includes the company’s CEO and COO.  We have found the Batistas to be both highly competent and dedicated to their business.

 

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Alternative Play

 

Another way to play this is to buy the company’s 2011 or 2016 bonds.  The 2011’s trade at 85 cents-on-the-dollar, and the 2016’s trade at 73 cents-on-the-dollar, despite offering a 9.375% and 10.5% coupon, respectively.  The company has publicly stated it is considering buying back some of these bonds due to the current discount to par.

 

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Disclosure

 

We are long JBSS3.  We may buy additional shares, or sell some or all of our shares, at any time.  We have no obligation to inform anyone of any changes in our view of JBSS3.  VIC members should do their own work before deciding whether to buy or sell shares.

 

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Catalysts

 

1.       DOJ approval of the National Beef transaction

2.       The re-opening of the Japanese market to U.S. beef exports

3.       JBS reporting Q4 2008 and Q1/Q2 2009 results, lapping last year’s numbers and demonstrating the company’s significant and underappreciated earnings power

Catalyst

1. DOJ approval of the National Beef transaction

2. The re-opening of the Japanese market to U.S. beef exports

3. JBS reporting Q4 2008 and Q1/Q2 2009 results, lapping last year’s numbers and demonstrating the company’s significant and underappreciated earnings power