The downgrades reflect Marfrig's weak operating performance and negative free cash flow generation that resulted in increased debt since the end of 2011. The ratings build in the expectation that Marfrig will sell assets during 2013 to lower leverage. The size and timing of these sales will determine the status of the Rating Watch Negative.
Marfrig's EBITDA increased to BRL2.0 billion ($942.8 million) in 2012 from BRL1.8 billion ($848.6 million) during 2011. Despite EBITDA growth, working capital needs were high due to rising grain costs and costs associated with the integration of assets received from BRF S.A.'s (BRF) in an asset swap. Consequently, the company's cash flow from operations declined to BRL 111 million ($52.2 million) from BRL 768 million ($361.4 million) in 2011. With capex at BRL870 million ($409.4 million) and dividends of BRL15 million ($7.058 million), Marfrig's free cash flow was negative BRL775 million ($364.7 million) in 2012. This compares unfavorably with the company's negative free cash flow of BRL 175 million ($82.4 million) in 2011.
To bolster liquidity Marfrig issued BRL1.05 billion of equity during December 2012 and a $600 million note in January 2013. Marfrig's operational challenges of lowering its costs and integrating the assets received from BRF continued during the first quarter of 2013, as the company's cash flow from operations was a negative BRL179 million ($84.2 million). Fitch expects the second quarter to be equally, if not more difficult, and the company to continue burning cash through the end of 2013. As a result of the aforementioned, Marfrig's ended March 31, 2013 with BRL13.6 billion ($6.4 billion) of total debt and BRL3.2 billion ($1.51 billion) of cash. The company's total net debt to EBITDA ratio was 5.1x as of March 31, 2013, an increase from 4.3x as of Dec. 31, 2013.
The national 'B' and 'BBB (Brazil)' ratings reflect Fitch's expectation that Marfrig will sell assets during 2013 but that its capital structure will remain highly leveraged relative to its cash flow. The asset sales are essential for maintaining Marfrig's liquidity and avoiding acceleration of $2.2 billion of public debt that could be precipitated by a breach of financial covenants. At the end of the first quarter, the company announced that it had targeted gross debt reduction by up to BRL2.0 billion by the end of 2013.
At the end of March 31, 2013, the test of Marfrig's most restrictive financial covenant of net debt to EBITDA stood at 4.4x. The maximum allowed level is 4.75x. With the expected deterioration of operating results during the second quarter of 2013, this covenant's test is expected to approach or even exceed its maximum level as early as June 30, 2013. The Negative Rating Watch reflects Marfrig's tightening liquidity and proximity to covenants violation.
Marfrig's 'B' and 'BBB (Brazil)' ratings are supported by the quality of the company's business portfolio, which includes strong performers such as Key Stone, Moy Park in the UK and its beef business in Brazil. The company acquired some of those assets in a series of acquisitions that resulted in both product and geographic diversification which is positive for the ratings, but also led to highly levered capital structure. Marfrig is in the process of selling some assets. Fitch believes some of these assets will be sold in 2013 to meet the company's deleveraging goals. The presence of BNDESPAR as a shareholder of 19.63 percent of Marfrig's equity provides additional support for this company that operates in a strategic sector for the Brazilian economy.
Ultimately, Marfrig's ability to maintain a sustainable capital structure will depend on its ability to start generating positive free cash flow, which in turn hinges upon the company's success in executing its strategy to realign business priorities, cut down cost, improve logistics, and establish itself as a viable niche player in the branded food segment.
Marfrig's branded food portfolio grew in importance with the acquisition of Seara a few years ago. This segment's contribution increased substantially in the middle of 2012 with the acquisition of some of BRF's lower tiered brands, production and logistics assets. Marfrig's Seara brand is positioned in the second and third-tier of the industrialized food products, trading at 10 to 15 percent to leading competitors in Brazil. The company aspires to reduce this price gap, which, in Fitch's opinion, would require redefining Seara's brand strategy. Additional investments would also be needed to allow Marfrig to benefit from the market opportunity created by the CADE ruling of last year that led to the suspension of product categories of BRF's Perdigao brand. The company's financial and operational challenges could prevent them from capturing this opportunity.