Description

Link to the PDF of this write-up: https://www.dropbox.com/s/ccv6pxyq4cqacgl/JBS%2020170503%20Write%20Up%20-%20Published.pdf?dl=0

We believe JBS SA (JBSS3) offers the potential to make ~60%-100% return over the next 12-18 months

         JBS SA (“JBSS3”), headquartered in Brazil, is one of the world’s largest protein packers and producers of branded prepared protein product.  It has operations within the beef, pork, and chicken segments.

We believe JBSS3 is an attractive long because at its current stock price and low valuation multiples compared to peers, caused by the Brazil “weak flesh” news, poor 2016 results in JBS’ Seara unit, and higher leverage than peers, the market is ascribing little value to: (a) the upcoming IPO of its international businesses & branded segment, which would highlight its evolution from a pure commodity company to an industrial food company with a portfolio of branded, value-added products and a diversified production platform, (b) the recovery of the US cattle herd, (c) Seara, JBS’ Brazilian branded food segment, benefitting from lower corn prices and (d) growing Chinese demand for protein leading China to import more meat, especially beef, which coincides with the potential near-term opening of US beef imports into China.   

First, JBSS3 is embarking on an IPO of its international assets and branded Brazilian segment (“JBSFI”), separating the domestic Brazil beef packing operations (“Mercosul”) from JBSFI.  Despite JBS generating 75% of its revenue outside of Brazil and 68% of its revenue within the United States, Bloomberg’s default comparables companies for JBS are only Brazilian & Latin American food companies and don’t include Tyson.  Hence, we view the JBSFI IPO as positive because the IPO would highlight the similarities between Tyson and JBSFI, attract new US-domiciled investors, and ultimately close the valuation gap between JBS and Tyson.   

Second, we believe the US beef cycle is in the early innings of a recovery cycle benefitting JBSS3’ US beef segment.  We think this segment’s EBITDA margins will increase from 2-3% to 5-6% for the next several years.  Because US beef segment represents 40% of JBSS3’s revenue, a doubling of this segment’s EBITDA would increase the overall company’s EBITDA by ~15%, assuming all else stays equal. 

Third, JBS’ Seara unit will benefit from lower corn prices in Brazil which we think will lead to a 5-6% EBITDA margin increase for the segment.  Seara’s EBITDA margin decreased from 18% in 2015 to 9% in 2016; JBS mgmt. attributed ~5-6% of the EBITDA margin decrease to rising corn prices.

Fourth, JBS, particularly its US beef segment, benefits from China’s secular protein consumption growth, which is driven by its population increasing and per-capita beef consumption growing with GDP/capita increases & catching up to consumption levels in other Asian countries.   

These items are expected to increase JBS’ EBITDA by ~50% from 2016 to 2018 and at its current market capitalization, JBS is trading at a 20% levered ‘18E FCF yield to equity.  

Valuation: We believe JBS is conservatively worth R$16 per share, which represents a 60% return potential if JBS only traded in-line with the comps.  But with our favorable view of the industry environment, we expect that at a 10% ‘18E FCF yield, JBS’ stock would be a double from here.  In our conservative scenario, we value JBS in a sum of the parts valuation using the assumptions laid out below. 

•  USA Beef: 7.4x ‘18E EBITDA.  The most relevant comp in terms of business mix and size, Tyson (TSN), trades at 7.4x '18E EBITDA. 
•  USA Pork: 7.4x ‘18E EBITDA.  Tyson trades at 7.4x ‘18E EBITDA while branded prepared pork consumer goods companies, such as Hormel and Maple Leaf Foods, trade at 10-11 ‘18E EBITDA.
• USA Chicken:  JBS’ Pilgrim Pride (“PPC”) has a public equity stub representing 23% ownership.   PPC has a ‘18E EBITDA multiple of 6.3x, compared with SAFM’s ‘18E multiple of 6.0x. 
• JBS Europe (Moy Park): 6x ‘18E EBITDA, an average of Societe LDC SA, a family-owned French food processing company focused in poultry, trading at 5.7x ‘18E EBITDA and JBS’ acquisition multiple of Moy Park in 2015 (6.5x EBITDA).
•  Seara (Latin America branded products): The most relevant Latin American branded food company, BRF SA, trades at 7.6x '18E EBITDA
•  Mercosul (Latin America beef processing): The most similar comp, Minerva SA, trades at 5.6x '18E EBITDA.

     US-LISTING

        JBS plans to conduct an IPO on the NYSE of its subsidiary, JBS Foods International B.V (“JBSFI”), which would include the US Beef, US Pork, US Chicken (Pilgrim’ Pride stake), JBS Europe, and Seara business units. JBSFI will be domiciled in Netherlands and the likely timing of this IPO is in Q3 of 2017.  The notable difference with the previous initial proposed reorganization & structure is that instead of JBSS3 shareholders getting shares in the newly listed company, current holders of JBSS3 will continue to hold the Brazilian shares and the Brazilian company will control JBSFI.  Below is the JBS’ proposed new group structure from JBSFI’s F-1 filing.

As mentioned above, the most relevant comparable company to JBSFI is Tyson due to their similarities in scale, protein mix, and value-added products.  Hence, we believe applying Tyson’s valuation multiple to pro-forma JBSFI is warranted.  Below is a table of JBSFI and Tyson’s similarities.

OVER-REACTION TO BRAZIL'S MEAT PROBE 

We believe the R$5 billion decline, or 20% decline, in JBSS3’ equity value was an over-reaction to the Brazilian “weak flesh” probe because the affected business units’ estimated temporary EBITDA impact represents ~7% of JBSS3’s total EBITDA.

Situation Overview: On March 17, 2017, Brazilian authorities announced an investigation into an alleged bribery scheme between federal inspectors and employees at several Brazilian food companies where bribes were said to have been paid in exchange for federal sanitary approvals & certificates.  A total of 21 plants are being investigated, of which one was a JBS Seara chicken plant.  Unlike the other private meat companies that are being investigated for potential corruption, the JBS Seara plant is being investigated for a minor issue: “irregularities in sanitary certificates”.   Furthermore, while the initial export reaction seemed significant, countries that initially banned Brazilian meat, such as China and Hong Kong, have already lifted their bans.  

Impact on JBS: We believe the negative impact of “weak flesh” on JBS to be minimal and short-term.  First, Mercosul halted a quarter of its beef packing plants for roughly a month to adjust for China’s short-term ban, which has since been lifted.  Second, Mercosul and Seara temporarily incurred additional warehousing expense for internal inspections and advertising expenses for reassuring Brazilian citizens.  Third, the “weak flesh” probe pushed out the timing of the JBSFI IPO from this May/June to September, but the spin-off is still expected to occur this year.

BUSINESS OVERVIEW

Below is a summary of JBSS3’s business units:

JBSFI

·         USA Beef: beef processing in USA, Australia and Canada.

·         USA Pork: pork processing in the USA.

·         USA Chicken: consists of JBS’ majority stake in Pilgrim’s Pride, which does poultry processing and makes prepared products in the USA and Mexico.

·        JBS Europe: poultry & pork processing and prepared products in UK, Ireland, Italy, France and Netherlands.  Main brands include Moy Park, O’Kane, and Rigamonti.

·        Seara: branded prepared meat products, primarily poultry and pork, packaged and sold throughout Latin America.

Remaining Segment in JBSS3 Equity

·         Mercosul: beef production in Brazil and other South American countries like Argentina, Paraguay and Uruguay

JBSFI Assets 

US Beef

Asset Overview:  The US Beef business unit includes its US beef packing operations, which make up ~80% of this business unit’s revenue, and its Canadian & Australia beef packing operations.  JBSS3’s US beef packing unit is the 2^nd largest beef packer in the US, with a market share of 22%.  Tyson is the largest US beef packer and has a market share of 24%.  JBS USA operates 9 beef slaughter facilities, and 11 cattle feedlot units which supplies 30% of JBS’ cattle needs.  JBS US Beef centralizes cattle procurement at its Colorado HQ and works with ~3,000 cattle suppliers.  JBS believes its US beef segment can obtain a 5-6% EBITDA margin in this current cattle expansion & consolidation cycle and that throughput (heads processed) can conservatively grow at the industry slaughter growth rate of ~2.6% annually for the next two years.

Beef cycle: Compared to other proteins like pork and chicken, beef has a much longer cycle; adjustments to changing supply-demand balances for beef is a slower and more cyclical.  This is because of biological reasons.  A minimum of ~2 years is required to raise a new-born calf into a ready-for-slaughter cow; in addition, 18 months prior, cattle farmer choose to either send the heifer to slaughter or to raise the heifer.  Hence, there is a ~42 months lag between ranchers’ decision to either cull or increase the herd and the consequences of that decision.  Thus, it takes several years for regional cattle availability to recover from herd liquidation and grow.  Below are the general stages of the cattle cycle:

1.      Expansion (heifer retention): Because of high cattle prices, favorable pasture conditions, and/or low feed prices, ranchers hold back heifer (female cattle) from slaughter for breeding.  Initially, heifer retention leads to lower slaughter rates, but heifer retention ultimately drives an expansion in the herd.
2.      Consolidation: As cattle supply increases, cattle prices fall and cattle margins contract.  Thus, ranchers retain fewer heifers.  This leads to greater supply for slaughter (higher throughput in packing plants) and lower cattle prices for packers.  Higher beef supply drives retail prices lower, which increases end user demand because the greater affordability of red meat incentivizes switching from competing proteins.
3.        Contraction (herd liquidation):  Cattle oversupply, drought, and/or a spike in feed costs depresses margins for cattle farmers.  Hence, ranchers send more heifers to slaughterhouse (heifer retention drops).  This temporarily increases the supply of slaughtered cattle, but ultimately leads to a significant decline in the cattle herd.  Decline in cattle availability negatively impacts the beef packers.

USA:  We believe the current beef cycle is favorable for the packers because the expansionary cattle cycle provides packers with more cattle and lower cattle price.  Additionally, there is less packing capacity after the previous cattle contraction forced packing plant closures (e.g. National Beef’s Brawley plant, L&H Packing Co.’s San Antonio plant, and Tyson’s Denison plant).  Third, there is higher potential demand from the possible opening of China market to US beef.  

Per the table below, the current cattle expansion started in 2015, which marked end of the contraction cycle and the low point in the number of cattle slaughtered at 29 mm.  Cattle slaughter resumed growth in 2016.  Thus far, heifer retention (the opposite heifer slaughter rate) has remained high which indicates a 4-5 year recovery, per JBS mgmt. expectations, and in-line with historical cycles.  The 2008-2015 period marked a contraction cycle that was caused by a combination of high cost of feed and poor pasture conditions.  The high cost of corn and grain resulted from droughts that occurred in Texas (2008) and the Mid-west (2012), and from the implementation of ethanol minimum blending mandate.  The drought also negatively impacted pasture conditions.

  China’s Potential Near-Term Acceptance of US Beef will be a Secular, Long-Term Demand Driver for US Beef

China’s protein demand is expected to continue to grow because of its 1) population growth and 2) per-capita protein consumption, especially in beef, closing the gap to developed nations’.

First, China’s population is expected to grow 1.5% from 1.38 billion today to 1.4 billion by 2020.  Its’ population within urban areas is expected to grow 9% from 800 mm to 874 mm by 2020.  China’s urban population as a % of its total population will grow from 58% today to 62% by 2020.  Urbanization generally leads to an increase in GDP per capita because it creates more middle class households.

Thus, protein consumption, especially beef, is expected to increase as China’s GDP/capita and wealth rise.  For example, China’s per-capita beef consumption grew 34% over the past five years to 5.6 kg/capita; over the same period, China’s GDP/capita increased 68%. Looking forward, China’s GDP per capita is expected to grow to 6% annually through 2020; hence, it is reasonable to expect that China’s beef per-capita consumption to grow at least 3% annually.  This matches the ratio of the 5 year (2011-2016) per-capita beef consumption growth to the 5-year GDP/capita growth.  Furthermore, China’s per-capita beef consumption is still very low compared with other countries (US at 36 kg/capita, Japan at 10 kg/capita, and South Korea at 15 kg/capita) and compared with China’s consumption of other proteins (pork at 40 kg/capita and chicken at 9.5 kg/capita).  This implies there is significant room for beef per-capita increases.

Per the following projections in population, GDP/capita, and per-capita beef consumption, China’s beef consumption is expected to grow from 7.6 mm tons to 8.8 mm tons.  

China beef supply and need for imports:

China’s local beef production cannot keep up with demand growth.  Hence, China has a structural beef supply shortage that needs to be met by rising imports. Structural causes for this shortage include poor pasture quality and low water availability, both of which there is no near-term visibility for China to solve.

China’s domestic cattle industry produced 6.9 mm tons of beef in 2016 and is expected to produce 7 mm tons in 2017.  However, thereafter, local Chinese beef production is expected to grow by only 1% annually through 2020.  Because of the supply shortage, Rabobank, a Dutch investment bank focused on agriculture, expects beef imports to make up ~20% of China’s total supply by 2020 and that beef imports into China will increase from 0.7 mm tons in 2016 to 1.5 mm tons in 2020.  

In addition to the local supply shortage, local suppliers of beef cannot produce qualified premium beef and do not have a trustworthy reputation.  This contrasts with urban Chinese consumers’ demands for fresh, reliable, natural, and high-quality food.  JBS believes their beef and other proteins fill this need & gap.  

JBS’ advantage: We believe JBS’ global presence and existing buyer relationships in China, from its Australia & Canadian beef exports to China, provide the company with a first-mover advantage in China.  Second, JBS expects China’s export market to help absorb increased US beef production volume, especially if domestic US demand for beef remains stable.  With Chinese demand for US beef, JBS believes domestic boxed beef pricing would not decrease as much as cattle costs’ declines.  Third, China’s demand for US beef would not cannibalize JBS’ Brazilian beef exports to China, because Brazil’s beef product is lean beef, in contrast to US’s beef export product of high-end cuts.

Situation overview: Opening the Chinese market for US beef is a top priority for Terry Branstad, the U.S. ambassador to China.  As the former governor of Iowa, which has ~26,000 cattle farmers, Bransted has recently stated: “I want to serve it at the [US] embassy [in China], and I certainly want to convince the Chinese leadership to do that sooner rather than later.”  Second, after President Trump’s recent meeting with China President Xi Jinping, it was reported that China will loosen its “traceability” rules to more easily allow imports of US Beef.  Chinese’s ban on US was originally lifted in September 2016, but its strict “traceability” rules have prevented US beef from entering China.

We also believe a beef deal between China and the US would benefit both nations.  For China, it would provide much needed supply of beef protein supply for its citizens.  For the US, it would help increases Trump’s popularity among farmers and reduce the current trade deficit with China ($347 billion in 2016).  For example, if US beef exports into China grew to 1 mm tons, this would reduce the deficit by ~$5 billion (assuming $4.5/kg)

US Chicken

Asset Overview: JBS’ US Chicken business unit consists of its 77% stake in publicly traded Pilgrim’s Pride (PPC).  JBS acquired its PPC stake in 2009, after PPC emerged from its 2008 Ch.11 filing.  Under JBS’ ownership, PPC changed from a high-cost operator to a low-cost competitor because of cost improvement, stronger plant level accountability, and a reduction in the use of annual fixed price contracts.  Once JBSFI is publicly traded on the NYSE, we believe that the stub PPC stake would be acquired by JBSFI, because the primary reason for the public PPC equity stub, access to the US equity capital markets, would be made moot and redundant with its JBSFI equity currency. 

PPC Business Overview:  PPC sells small-bird, commodity deboned big-bird, tray-pack products, and also prepared chicken products.  It serves the retail, foodservice, and export markets.  PPC holds a 17% market share in the US; Tyson, its largest competitor, maintains a 21% market share.  

Chicken Cycle:    The chicken market is volatile because of the industry’s vertical integration and exposure to feed costs such as grain.  However, the largest competitors, Tyson and Pilgrim, have behaved more rationally and tried to lessen the volatility by 1) buying part of their chicken supply vs. growing it internally; 2) building fewer new plants during peak profitability period; 3) changing contract structure by linking chicken prices to grain prices instead of annual fixed price contracts, although these contract changes are in the minority .

On the negative side, 1) chicken inventories are high because of steady production growth 2) export markets remain sluggish because of disruption caused by avian flu induced ban on US chicken in 2015 and because of the strong USD. 

US Pork

Asset Overview: Following its acquisition of Cargill USA Pork in July 2015, JBS USA Pork is now the 2^nd largest pork processor in the US with a 19% market share.  Smithfield, owned by WH Group, has a 26% market share and Tyson has a 17% market share.  The Cargill Pork acquisition served several purposes: 1) JBS acquired complementary processing assets; 2) JBS increased its exposure to more value-add pork products such as bacon.  ~15-20% of JBS US pork operations are vertically integrated, which means JBS owns and raises its own hogs, while the majority is a spread business like beef, where JBSS3’ US pork segment buys hogs from 3^rd parties.  ~85-87% of USA Pork’s revenue is domestic, with the remaining generated by exports.  In March 2017, JBS acquired Plumrose USA, which primarily sells prepared foods and high-value added products such as bacon, hams, sliced diced meats and cooked ribs. Per JBS’ financial filings and mgmt, Plumrose annual revenue is estimated at $500 mm.

Pork Cycle: The pork business is less volatile and cyclical than both the chicken and beef business because 1) hog availability adjusts quicker than cattle availability to changing demand/supply due to shorter reproduction time; 2) unlike a fully-integrated poultry business, the hybrid pork business model does not shoulder all the fixed costs of an integrated business in a down-turn.  

On the supply side, hog availability is expected to grow slightly in the near-term.  On the demand/production side, additional new slaughter capacity is coming online. (e.g. plants), which could drive up prices for raw hogs.  However, JBS believes start-up plants would have trouble maximizing capacity because of labor constraints and that it believes the end-consumer for pork is resilient and can absorb price increases, which preserves margin.  

JBS mgmt. cited its experiences in 2014 and 2015 as evidence for pork being a stable EBITDA margin business.  In 2014, the US pork industry was impacted by lower supply because of the PEDv (porcine epidemic diarrhea virus) outbreak; but lower hog supply/higher raw input costs, and volume declines were offset by JBS’ price increases of 13%.  In 2015, the opposite happened: hog supply increased and both JBS’ cost of hogs and cut-out prices declined ~25%.  In both years, JBS USA pork maintained EBITDA margins of 10-11%.  

JBS Europe

Asset Overview: JBS Europe is JBS’ newest business unit, formed when JBS acquired Moy Park from Marfrig in 2015.  Strategically, the Moy Park acquisition was JBS’ first relevant foray into Europe with a value-added branded business.  In addition, JBS wants to apply its knowledge from Europe, where the food retail market is more sophisticated, onto Seara/Brazil.  Moy Park is a vertically integrated chicken business, similar to Pilgrim Pride and Seara.  Moy Park’s core operations are in UK, but it maintains a sales presence in France, Netherlands, and Ireland. Geographically, UK revenues makes up ~80% of the business unit’s revenue and JBS Europe’s primary customers in UK are Tesco and Sainsbury.  In the UK, Moy Park is the largest producer of organic and free range chicken, which sell at a premium to regular chicken.  Processed value-added chicken products (coated, just cook, and convenient full meal solutions); make up ~51% of the business unit’s revenues while the remaining are in-natura fresh chicken cuts.   

Seara

Asset Overview: JBS Seara is JBS’ largest branded processed food operation.  Besides Seara, other brands include Massa Leve, Brig Brango, and Ceu Azul.  JBS opportunistically acquired Seara in 2013 from Marfrig.  Seara was JBS’ first major acquisition in the processed food industry; previously, JBS acquired commodity protein production.  Seara marked an evolution in JBS’ strategy: to focus on acquisitions in the processed, branded, and value-added food products.  

Business Details: Within its domestic unit, Seara sells branded processed products such as ham, sausage, mortadella, and salami, and also commodity chicken products.  Processed food revenue makes up ~55% of Seara’s domestic revenue and commodity poultry makes up ~45% of its domestic revenue.  Seara’s processed/branded food unit has a ~15% market share in Brazil’s processed food industry.  Its main competitor, BRF, is the market leader in Brazil’s processed food business with a 47% market share.  Seara’s Brazilian domestic processed food and chicken sales was under pressure in 2016 because of the high cost of corn and Brazil’s recession causing consumers to trade down to cheaper food categories. 

Within its export unit, Seara exports commodity poultry, such as frozen whole chicken or chicken cuts, to Asia and Middle East.  Asia makes up 32% of Seara’s export revenues while Middle East comprises 28% of the unit’s export revenues.  Export unit profitability is exposed to cost of chicken feed (corn and soybean) and pricing changes caused by supply-demand imbalances.  These factors are amplified by FX volatility, as both feed costs and the global chicken export market are dollar-based.  In 2015, Seara benefitted from these favorable variables: 1) cost of corn was low, 2) the BRL depreciated sharply; which incentivized Asian and Middle Eastern nations to buy more Brazilian chicken 3) there was a supply deficit of chicken because the avian flu restricted the US chicken trade.  In 2016, Seara suffered from these unfavorable variables: 1) cost of corn increased 52% YoY; 2) BRL appreciated; 3) depressed pricing because of high inventory levels of chicken overseas.  

Per JBS mgmt, of the ~9% EBITDA margin contraction Seara suffered in 2016 vs. 2015, the increased corn cost caused a ~5-6% EBITDA margin decline.  Thus far in 2017, Brazil corn prices have decreased ~25% because the recent safrinha was positive and harvest estimates for the next two years are favorable.  Hence, we assumed a normalized EBITDA margin of 15% in our projections.

JBSS3 ASSET

Mercosul

Asset Overview: Mercosul encompasses JBS’ traditional beef packer operations in Latin America.  Brazil makes up ~90% of Mercosul’s revenue; the remaining countries include Paraguay, Uruguay, and Argentina.  After the JBSFI spin-off, Mercosul would remain listed in the Brazilian stock exchange under the existing JBSS3 stock ticker.  In Brazil, JBS has production capacity of ~37K heads per day and accounts for 25% of industry volumes within the country.  Its main competitors, Marfrig and Minerva, have 8% and 5% market share respectively.  Brazil beef exports are highly concentrated within the three above-mentioned packers; JBS, Minerva and Marfrig accounts for ~85% of total exports of Brazilian beef.

Industry Fundamentals: Notwithstanding the recent meat probe/meat wash news in Brazil, the supply fundamentals for the Brazilian beef packing industry are positive.   First, the Brazilian cattle cycle is showing signs of improvement.  Cattle data in 2016 showed heifer retention to be high, which meant a build-up of the cattle herd.  Since 2010, cattle herds in South America have been growing while other large beef producing countries had shrinking cattle herds.  Advantages include plentiful pastureland and water resources.  In addition, many South American producers can benefit from increased technology use to boost both yields and productivity. 

On the export demand side, South American beef exporters as a key beneficiary of both long-term structural herd growth and a relaxation of export restrictions.  On the domestic demand side, the Brazilian recession is impacting its consumer’s discretionary spending patterns.

CAPITAL STRUCTURE: A DELEVERAGING STORY

We expect JBS to use its free cash flow to reduce its debt balance by $3 billion over the next two years.  This would reduce its net leverage multiple from 3.5x to 2.7x by the end of 2018.  A lower leverage ratio, in addition to the JBSFI IPO and improving business fundamentals mentioned above, would help close the valuation gap between JBS and its peers such as Tyson, which has a net leverage multiple of 1.5x (excluding Tyson’s AdvancePierre Foods acquisition).

COMPARABLES

RISKS

• Corn prices and soybean prices increase significantly.
• Poor pasture conditions in the US and/or Brazil.
• JBSFI IPO is further delayed

DISCLAIMER

We had long exposure to JBSS3 at the time of submission (5/2/17). We have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation.

Catalyst

• IPO of JBSFI 
• Bountiful harvests that leads to lower corn prices