Brazil-based meat processors posted very strong second-quarter results, especially JBS S.A., Marfrig Global Foods S.A., and Minerva S.A., and to a lesser extent, BRF S.A. The COVID-19 outbreak affected consumer eating habits and production standards, but these companies were able to adjust their portfolios and channels. At the same time, their sound diversification in terms of plants and protein types offset disruption in sales.

The four companies' robust margins and free cash flows in the first half of 2020 resulted in significant debt reduction, enabling their credit ratios to approach their upgrade triggers. The dollar's dip against the Brazilian real boosted exports, but also raised the companies' debt in the latter currency. But companies haven't deviated from deleveraging amid non-recurrent costs, such as overhauling plants for safety and social-distancing measures.

Second-quarter results have increased ratings cushion and strengthened the companies to face potential volatilities. Below, we discuss specific characteristics of the Brazilian meat-processing sector and of each of the four companies.

Frequently Asked Questions

How has the COVID-19 pandemic affected protein producers?

Due to the pandemic, demand for the retailers' packaged and ready-to-eat foods has surged, while that for foodservice plummeted 30%-40%. Nevertheless, the four protein companies' sales to this channel in Brazil, Argentina, Paraguay, and Uruguay only accounted for a maximum of 10%-15% of total sales. The companies also adjusted their packaging strategy to adapt to consumers' shifting preference. At the same time, their exports shot up thanks to the weakening of the regional currencies and China's strong demand.

Many plants had to be temporarily shut down to stem the spread of the virus among employees and to implement new safety measures. The companies also had to purchase protective equipment and cleaning supplies to bolster hygiene at the production lines, and absorb extraordinary bonuses and additional payments to compensate for the rising employee absenteeism in the industry with already high turnover ratios.

What's our short- to medium-term outlook for the sector?

The sector's fundamentals are favorable. We estimate the pork supply disruption in China, because of the African Swine Flu outbreak, to lower that country's pork herd by at least one-third. This considerably increases the demand for protein because China is the world's largest pork consumer. But it also raises demand for beef, poultry, and fish.

We believe prices and volumes should remain high over the next few years, at least until China's hog herd recovers, and because of the concerns over the quality of food, with demand for packaged products and frozen foods from large and widely known companies likely gaining share from the informal slaughtering. The supply of protein from large and competitive meat suppliers such as those in Brazil and the U.S. has also resulted in a rational competition, with no significant new capacity added, which help maintain a favorable supply–and-demand influence on prices.

The four Brazilian protein companies might benefit further from an already largely consolidated market. Despite competition from small and informal players in the domestic market, the four companies control more than 70% of Brazil's beef exports and 65% in poultry, while the country's pork exports are much smaller.

We had a positive outlook on BRF and Minerva in early 2020, because the companies were reducing their debt through higher cash flows. However, we revised the outlook to stable amid the uncertainties stemming from the pandemic. The four players currently have a stable outlook, with plenty credit ratios' headroom in the current ratings, while approaching their upgrade triggers.

What are the main challenges despite recent strong results?

We believe most of costs in the sector caused by the pandemic occurred in the second quarter, and we expect expenses to plateau starting in the third quarter 2020. However, the companies are still exposed to the risk of temporary plant shutdowns because of the increasing infection cases and mortalities. But we view the likelihood of a large disruption in volumes as limited, because of the four companies' diversified operations and the governments' support on maintaining slaughtering operations, which are deemed as essential business activity.

A major risk would be the second wave of the virus, its impact on population's purchasing power and production disruptions. The risk of sanitary-based barriers to protein imports is also substantial amid the lingering concerns about the virus showing up in food and packaging. An offsetting factor is that the four companies have production facilities in a wide range of countries, which blunts the impact of trade barriers, but large consumer markets can impose restrictions and deny export certifications that would impair volumes and margins.

Other factors to monitor:

• ESG risk factors – particularly from the increasing concerns among investors regarding cattle purchases from the Amazon region and pressures to implement specific targets for such purchases.
• Exceptionally high margins for beef in the U.S. tend to moderate as slaughtering volumes rise towards the industry's maximum capacity, while a more balanced supply and demand smoothen out cutout margins.
• Risk of weaker margins in the U.S. where some of Brazilian players have substantial operations.
• Uncertainties about litigation mainly in the U.S. stemming from safety concerns and high virus infections among the industry's employees.
• Somewhat higher grain prices--mainly in South America-- because of higher exports of grains amid the region's weak currencies, which will compete with grain sales to the protein industry and increase input costs.
• Rising cattle prices mainly in Brazil, given that farmers are also gaining part of the higher margins at exports.
• Companies' exposure to currency fluctuations. The latter could weaken short-term credit ratios and increase debt on one side, or could reduce cash flows in hard currency if the regional currencies appreciate.
• Aggressive acquisitions, which is typical among the sector's major players, and how debt financing or financial policies can impact metrics.

What are main factors to monitor in each company?

BRF (BB-/Stable/--).   BRF's sound margins at its domestic operations--thanks to robust demand for packaged food--and export prices and volumes offset the shrinking foodservice volumes. However, BRF's margins were lower than those of its main competitor in Brazil, JBS's subsidiary Seara. At the same time, higher input costs can pressure margins in the second half of 2020, depending on grain inventories and hedges, given that price hikes could be difficult to implement and unpopular amid Brazil's recession caused by COVID-19. The company also reported a relatively weak performance at its international operations, because the pandemic and collapse in oil prices took a hit on the halal meat market. Nevertheless, BRF improved its liquidity significantly, adding more cushion against potential future market volatility. Still, debt to EBITDA reached 4.2x for the 12 months ended June 30, 2020, and an upgrade would depend on this metric staying close to 3x.

JBS (BB/Stable/--).  JBS reported extraordinary results at its U.S. beef and all Brazilian operations, thanks to export earnings in South America and the sound cutout margins in the U.S. Free operating cash flows reached a record high of R$15.8 billion in 12 months ended June. U.S. poultry operations at Pilgrims' Pride suffered because of a drastic drop in sporting events and foodservice flooding the market with poultry supply, which cut into pricing pressures. We believe the U.S. poultry supply has been shrinking, but it takes time to adjust the live animal production chain, which could cause margins to remain weak for the next couple of quarters. We believe Seara's margins would slip in the second half of 2020 because of difficulty to adjust protein prices if grain prices in Brazil were to rise, but export profits will continue to bolster cash flows. JBS's U.S. beef profits will likely soften in the next few quarters, as all players are already close to full capacity, diminishing supply imbalances such as those in the second quarter following plant closures. However, cattle availability should remain strong at least for the next 6-12 months, which will support JBS's EBITDA margins above historical levels of 5%-7%.

The ratings on JBS are currently constrained by qualitative factors, especially its historically aggressive financial policy including debt-financed acquisitions and the use of derivatives, along with governance concerns stemming from corruption investigations of the company owners and executives. Public controversies regarding cattle sourcing from the Amazon also weighs on ESG assessment, with rising pressure from investors to have specific targets for sourcing cattle from the deforested area of the Amazon. If governance and financial policy scores remain unchanged, an upgrade is possible if the company delivers net debt to EBITDA consistently below 2x and generates sound FOCF. It posted debt to EBITDA of 2.5x in June 30, 2020.

Marfrig (BB-/Stable/--).  Marfrig's impressive second-quarter results at its U.S.-based National Beef (NB) operations and sound exports from its South American operations resulted in record high EBITDA, which was roughly equal to 85% of EBITDA for the entire 2019. The company took market share from Tyson and JBS in the U.S. following the closure of both companies' several plants, while Marfrig was holding large inventories and enjoyed high prices in the retail channel with consumers' increasing food storage panicking supply disruptions. In addition, NB's exports to premium markets such as South Korea and Japan, along with minced meat sales, increased, both bringing higher value add and margin gains. Like its domestic peers, Marfrig benefited from a weak Brazilian real that boosted exports, more than offsetting the weaker foodservice demand. The company reduced debt and is gradually lowering its interest burden. Moreover, as of June 30, 2020, Marfrig posted debt to EBITDA of 2.6x, FFO to debt above 31.9%, and FOCF to debt of 13%, which have crossed the upgrade triggers of below 3x, above 30%, and above 10%, respectively. We expect margins at its U.S. operations to slip in the third quarter as the industry's capacity normalizes, but an upgrade would be possible if large operating cash flows continue, allowing the company to keep reducing debt.

Minerva (BB-Stable/--).  Minerva reported very strong results in the second quarter, despite a 12% reduction in slaughtering volumes than those in a year earlier because of retrofitting plants for new safety measures. The company also increased its exports to Asia thanks to robust prices and volumes. We believe Minerva doesn't need to have its operations normalized in forthcoming quarters, it enjoys historically sound operating efficiency and large exposure to export sales, while benefiting from debt refinancing and export profits to reduce leverage. The company recently crossed the upgrade triggers of debt to EBITDA below 3.0x and FFO to debt close to 20% by posting 2.9x and 17.4%, respectively, as of June 30. We would like to see consistently improving FFO with interest burden reduction and lower debt, given that Minerva also just announced a small debt-financed acquisition in Colombia and plans to start paying dividends.

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