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Global Trade At A Crossroads: As Stresses Eat At Profits For U.S. And Brazilian Meat Producers, Most Will Survive The Cut

The world's two biggest livestock-producing nations--the U.S. and Brazil--are contending with numerous potential industry disruptions, not least of which are the unfolding and unsettling geopolitical risks. In the ever-evolving trade war between the U.S. and China, the livestock sector, particularly pork manufacturers, face mounting pressure with stiff Chinese tariffs on American pork. Moreover, Mexico retaliated against U.S. steel tariffs by placing tariffs on pork.

While most news headlines recently featured the U.S. livestock sector, Brazil has also faced several restrictions on its meat exports, mostly stemming from last year'smeat-safety scandal--referred to as "Carne Fraca." Brazil's federal government accused industry players of bribing inspectors to overlook safety breaches at various plants. This led to a ban by Russia on all meat exports from Brazil, and other countries implemented various restrictions, as well. At the same time, China temporarily levied anti-dumping tariffs on Brazilian poultry. Earlier this year, the EU banned imports on poultry produced in 20 specifically identified Brazilian plants, leading to excess supply. Because of Brazil's weak internal economy, these boycotts significantly pressured meat industry margins and credit metrics.

With heightened uncertainty about the profit outlook for the U.S. and Brazilian meat industries given the rise in trade constraints, S&P Global Ratings has tested a simulated margin stress scenario across the U.S. and Brazil meat companies we rate. Our goal was to identify those issuers that could withstand the pressure in a downside stress-case scenario, in which trade restrictions combined with an industry downturn significantly weaken profits.

Despite the uncertainties arising from trade wars, scandals, and a simulated industry downturn, our meat sector outlook for both the U.S. and Brazil remains broadly stable though the ride could get bumpy depending on tariffs and trade embargos. We think most U.S. companies will face higher leverage but because most companies run with fairly low leverage they are not likely to materially weaken; Brazilian producers should continue deleveraging as they seek new markets to capture profits.

Table 1

Ratings And Assessments On Select Meat Processing Companies
Ratings/outlook Business risk profile Financial risk profile Liquidity

Hormel Foods Corp.

A/Stable/-- 3. Satisfactory 1. Minimal Strong

Cargill Inc.

A/Stable/-- 2. Strong 3. Intermediate Strong

Tyson Foods Inc.

BBB/Positve/-- 2. Strong 3. Intermediate Strong

Smithfield Foods Inc.

BBB-/Stable/-- 4. Fair 4. Significant Strong

BRF S.A.

BB/Negative/-- 4. Fair 5. Aggressive Adequate

Minerva S.A.

BB-/Stable/-- 4. Fair 5. Aggressive Strong

Marfrig Global Foods S.A.

BB-/Stable/-- 4. Fair 5. Aggressive Strong

JBS S.A.

BB-/Positive/-- 3. Satisfactory 5. Aggressive Adequate

Pilgrim's Pride Corp.

BB-/Positive/-- 4. Fair 3. Intermediate Adequate

Simmons Foods Inc.

B/Negaitve/-- 5. Weak 6. Highly leveraged Adequate

CTI Foods Holding Co. LLC

CCC+/Negative/-- 5. Weak 6. Highly leveraged Less than adequate
Note: Ratings as of Dec. 1, 2018. Source: S&P Global Ratings.

Industry Outlook For The U.S.

Pork

Pork producers played a bad hand well last summer, keeping leverage in check by selling excess domestic supplies. 

Our outlook for U.S. pork processors would be more negative were it not for their fairly low leverage levels, with most companies keeping debt leverage well-below 2x. The sector has been hit hardest by trade restrictions just as it had ramped up production following the untimely addition of two new production facilities earlier this year. U.S. pork exports to China have declined nearly 20% so far this year following China's implementation of tariffs. Mexico, too, has levied tariffs on American pork in response to the U.S. steel and aluminum tariffs--thus curbing exports to Mexico (U.S. pork exports to Mexico declined about 45% year over year in the 2018 June-August timeframe). However, Mexico could lift these tariffs now that the U.S., Mexico, and Canada have agreed to the U.S., Mexico, Canada Trade Agreement. Despite fewer exports to China and its northern and southern neighbors in Mexico and Canada, the U.S. is poised to increase pork exports by mid-single digits this year. Shipments to Japan, South Korea, and several other countries have made up for the lost Chinese and Mexican demand. That's why pork average inventories were down 20% this summer despite the USDA's expectation for total pork production to increase by 3.3% this year.

Although producers have quickly found new markets for their added production, prices and processing margins took a big hit. Average hog prices traded on the Chicago Board of Trade were down nearly 30% before rebounding nearly 20% since the announcement of the new North American trade deal. Average pork cut-out margins (the margin a processor earns from processing live animals into lean meat) have tumbled 23% so far this year, according to Bloomberg data, and are now trending higher. With the combination of new production and strong projected pork litters in the second half of the year, margins are likely to remain under pressure, leading to weaker but not dire credit ratios for the sector as a whole.

Chart 1

image

Beef

Healthy beef margins are likely to continue, but trade disruption could pinch margins. 

We expect margins to remain robust for U.S. beef processors for at least the next year because of affordable cattle prices, which means the downside risk to ratings will be fairly low. U.S. beef supplies are plentiful as the strong cattle cycle enters its fourth year, boding well for processor margins. Herd sizes and cattle weights continue to grow from their post-drought bottom of about five years ago as feed costs remain low. In addition, increasing exports should encourage more production. The USDA forecasts total U.S. beef product to steadily grow by mid-single-digit percentages through next year. This should keep cattle prices affordable for processors such as Tyson Foods Inc., JBS USA Lux S.A., and Cargill Inc., which means margins will likely remain robust for U.S. processors. So far, the lower cattle prices from continued beef production don't appear to be dissuading farmers from producing more. This is partly because of growing export markets, which are slowly approaching 20% of total livestock exports compared with about 15% a year earlier. At the same time, domestic demand remains supportive. An increasing reliance on export markets to help sell growing production means any unforeseen trade restrictions could weaken pricing for beef packers and reverse the healthy margin trends.

Chart 2

image

Poultry

Poultry faces building inventories and margin pressure.  The U.S. poultry sector is the most vulnerable to price swings because its production cycle is much shorter than other livestock. Therefore, ratings for poultry companies tend to be more volatile. The still-strong cattle cycle also means less ability for competing proteins such as chicken to take away market share, since they have to contend with the cheaper beef offerings. Moreover, building breast inventories (up 3.5% year to date in 2018) are pressuring prices downward, resulting in an average 20% year-over-year decline in breast production this year through October.

Another factor for weak poultry prices is competition from pork. Fewer pork exports to China have led to aggressive promotional pricing for pork domestically. Whole-bird prices will likely stabilize in the second half of this year, particularly because of supply shortages in the U.S.--Hurricane Florence decimated flocks in the eastern region. However, wholesale poultry pricing for individual cuts like breasts, wings, and legs will likely continue to face price competition from pork and keep margins from expanding. Moreover, a new production facility is set to begin operations next year, which could further weaken prices if the domestic markets get saddled with too much pork. The one silver lining is cheap feed costs, which the USDA projects will remain largely unchanged after another large U.S. corn and soybean harvest.

Chart 3

image

Industry Outlook For Brazil

Beef

Significant turbulence lies ahead for beef, but margins should recover.  

The Brazilian beef market is only now recovering following last year's political corruption scandals involving Brazil's largest global protein producer JBS S.A.. The malfeasance shook the competitive landscape, and led to industry overproduction as JBS's competitors smelled blood and ramped up production to gain share. The two main opportunists were Minerva S.A. and Marfrig Global Foods S.A., which had been concentrating efforts on deleveraging, until JBS halted slaughtering twice for about 10 days each, casting doubts on its ability to remain a reliable producer. Both companies increased volumes in Brazil by renting slaughtering plants from smaller processors, and increasing utilization capacity. Minerva also acquired JBS's assets in Argentina, Paraguay, and Uruguay.

JBS's production cuts proved temporary, resulting in much higher production from the three largest players when consumer demand was weak, because the Brazilian economy was still in a recession. At the same time, the export ban of beef to important consumer markets such as Russia beginning in November 2017--and which only began to ease in October of this year--and Brazil's currency appreciation added to the strife, leading to weak margins for large stretches in 2017. The shock to the sector was threefold: weak margins from excess supplies, a sluggish domestic economy, and bloated balance sheets from working-capital buildup.

With Brazil's economy rebounding modestly and the meat industry rightsizing production capacity, including potential cuts by small players; still-high cattle supplies from herd buildup; and greater export volume due to a more depreciated Brazilian real, we currently expect margins to continue improving. We've already observed improved margins in the third quarter of this year. We believe overall margins should be about 8%-12% by 2019.

Despite the various setbacks, we are maintain our stable outlook for Brazil's beef sector mainly because we believe companies will deleverage.

Chart 4

image

Poultry

A perfect storm collapses margins in the poultry market, though a brighter horizon lies ahead. 

Brazilian poultry processors faced a perfect storm this year, with operations reaching historically weak margins, as input costs rose more than 25% year over year. Inventories were costly at the start of the year following the fragile South American grain harvest due to the drought in Argentina, unfavorable weather in Brazil, and currency volatility. The sector was further hit by a truckers' strike in Brazil in the second quarter that led to a stoppage in production--including a halt in bird growing because of suspended feed deliveries. At the same time, very weak domestic demand, excess volumes pressuring export margins (e.g., high inventories levels in Japan) and the involvement of the largest poultry producer BRF S.A. in bribing safety inspectors (referred to as "Operação Trapaça") led to the ban of exports to the EU and import restrictions from China in response to alleged dumping eroded margins. As if that wasn't enough, key Middle Eastern countries such as Saudi Arabia increased product-certification requirements for the large Arabe Halal market, leading to higher production costs and production delays to meet the new requirements.

Diminished export market volumes and lower prices internally resulted in the bankruptcies of small players leading to reduced production of almost 10% in the first half of the year. The adjustment in supply capacity, expected record levels of grain harvest in South America reducing input costs, and a more profitable export business amid the depreciated real is gradually helping to recover profits for the larger players.

We expect a gradual improvement in earnings and profits, but not to the extent of the mid-teen margins we saw a couple of years ago. We estimate margins would gradually reach high-single digits at the end of 2019.

Chart 5

image

Pork

Adverse conditions in other proteins pressured pork margins.  

Pork production in Brazil is much less relevant than beef and poultry, and margins suffered significantly due to the excess supply of other meats and fierce competition for consumers from all proteins and among competitors. The sector also suffered with somewhat higher grain prices and production disruptions due to the trucking strike. In addition, the Russian barrier was deactivated again in October, but not for the largest players: BRF and JBS. This at least helped to stabilize Brazilian poultry and swine exports.

On a positive note, we saw the fourth-largest global poultry importer (according to the USDA)--the South Korean market--open for Brazilian pork,which could be another alternative for pork consumers if trade restrictions to the U.S. increase from important Asian and European consumer markets. Recent African swine fever outbreaks in China and Eastern Europe could also trigger a positive trend for Brazilian producers' profitability, although still uncertain. Along with poultry, margins should gradually improve amid an adjusted supply and an increase in domestic demand and export profits.

Margin Stress Rationale Across Rated Issuers

Not all companies face the same stress magnitude for several reasons, including their degree of concentration in one commodity, geographic mix, as well as portfolio mix between commodity and branded products. Based on these factors and each company's historical standard error of regression (SER) on historical EBITDA (a seven-year measurement of a company's EBITDA volatility compared with its average), we have segmented our rated universe into three stress categories by order of magnitude: less severe, moderately severe, and severe. We are stressing EBITDA as that is the key cash flow proxy in the core debt-to-EBITDA ratio we use when assessing debt leverage.

Companies assigned a less severe stress

The companies to which we assign the lower stress typically have a large branded component to their product mix, or have a flexible pricing model that enables them to quickly adjust prices in response to changes in market conditions. Geographic diversification is another reason why we might apply a less severe stress. The final factor is the degree of commodity concentration. We usually apply a less severe stress to companies with a balanced mix between the three large globally traded proteins (i.e., beef, pork, and chicken). Usually, when these factors are present, we assess the business risk profile as at least satisfactory.

The level of EBITDA stress we've assigned for the less severe stress is 15%. This is largely based on applying a stress that is higher than a company's historical volatility by about 10 percentage points. The SER for companies assigned a less severe stress demonstrated an average EBITDA SER below 10%.

Companies assigned a moderately severe stress

The companies to which we assigned a moderate stress typically have some degree of portfolio diversification (either by participating in a different business or by offering a branded component to their product mix) that offsets exposure to few commodity proteins. They may also have a high degree of regional concentration including high exposure to foreign exchange fluctuations, which can unduly affect margins and leverage.

The level of EBITDA stress we have assigned for the moderately severe stress is 25%. These companies have higher levels of historical volatility (closer to 15% average EBITDA volatility as measured by SER).

Companies assigned a severe stress

The companies to which we assigned a severe stress typically are concentrated in one protein or have very little brand strength and often operate in one region, albeit typically with a strong export component to their sales mix too.

The level of EBITDA stress we've assigned for the highest stress severity is 35%. These companies have a history of pronounced earnings volatility (above 20% average EBITDA volatility as measured by SER).

Table 2

Assigned EBITDA And Stress Case To EBITDA
Biggest EBITDA YoY decline (%) SER (%) Biggest YoY leverage increase (x) Assigned stress (%) Current TTM debt to EBITDA (x) Stress case debt to EBITDA (x)

Hormel Foods Corp.

(4.4) 6.64 (0.2) 15.0 0.6 0.7

Tyson Foods Inc.

(11.3) 13.81 3.2 15.0 3.0 3.5

Cargill Inc.

(25.8) 12.99 0.8 25.0 0.7 1.3

Minerva S.A.

(3.0) 11.25 1.1 25.0 4.6 6.2

Simmons Foods Inc.

(44.0) 12.48 3.8 25.0 6.7 8.9

JBS S.A.

(19.4) 16.93 1.5 25.0 3.4 4.6

CTI Foods Holding Co. LLC

(27.4) 14.41 4.7 25.0 18.8 25.1

Smithfield Foods Inc.

(19.9) 31.69 1.3 35.0 2.8 4.4

BRF S.A.

(36.1) 27.98 1.7 35.0 6.7 10.3

Pilgrim's Pride Corp.

(139.1 39.56 12.7 35.0 2.3 3.6

Marfrig Global Foods S.A.

(21.7) 23.07 1.8 35.0 8.1 12.5
YoY--Year over year. SER--Standard error of regression. TTM--Trailing 12 months. Source: S&P Global Ratings.

Under Stress, U.S. Companies Would Fare Better Than Brazil's

Brazilian and U.S. companies currently have opposite leverage profiles, and their exposure to several trade-related stresses are polar opposites. By and large, U.S. companies have fairly healthy balance sheets and significant headroom to withstand a trade-related stress test to their cash flows. Nevertheless, the likelihood of a stress event is higher for the U.S. given the ongoing trade war with China. But given the U.S. sector's fairly low leverage levels, companies with less flexibly to withstand our stress tests are limited to those that have recently announced acquisitions or are in distress for other reasons such as elevated capital spending or increased default risk due to product recalls (e.g., Simmons Foods Inc. and CTI Foods Holding Co. LLC).

By contrast, the protein-processing sector in Brazil is coming off a very weak profit cycle for various reasons, including the corruption scandal, but our outlook is much more favorable over the next year. Given this expected pending rebound and some mergers and acquisitions that still aren't fully consolidated, our base-case projections have supported a flurry of favorable rating actions so far this year such as JBS (upgraded twice this past year: to 'B+' from 'B' on May 15 and then to 'BB-' on Oct. 11) and Marfrig Global Foods S.A. (upgraded to 'BB-' from 'B+' on Aug. 20). Still, our expected profit rebound for the sector in Brazil is only now underway and needs to be sustained before trailing-12-month credit measures are in line with our base case projections. Therefore, any trade-related disruption in our currently anticipated rebound would pressure ratings.

Chart 6

image

Our Stress Test Results

This report does not constitute a rating action.

Primary Credit Analysts:Chris Johnson, CFA, New York (1) 212-438-1433;
chris.johnson@spglobal.com
Flavia M Bedran, Sao Paulo + 55 11 3039 9758;
flavia.bedran@spglobal.com
Secondary Contact:Diane M Shand, New York (1) 212-438-7860;
diane.shand@spglobal.com

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