The argument I've made for some time with BRF S.A.  (Nasdaq: BRFS) is that this company is on a long-term plan to transform itself from a commodity- and export-driven protein company into a global branded food company like Kraft (Nasdaq:KRFT) or Nestle (Nasdaq:NSRGY). With that, I not only expect significant growth, but significant margin and free cash flow expansion over the next decade. BRF S.A. is by no means cheap according to conventional metrics, but the shares are still slightly undervalued on a cash flow basis and offer investors good exposure to emerging market consumer spending growth.
Q2 A Little Light On Sales, But Strong On Margins
BRF S.A. came in just slightly (1%) below average sales growth expectations, with 10% growth for the second quarter. Growth was driven by the company's large export business (up 19%), as domestic sales (up 4%) were weighed down by a weak demand environment across the Brazilian food sector. 
With a better mix (more processed foods) and improving export conditions, BRF S.A. saw significantly better margins this quarter. Gross margin improved about three points from the year-ago period, beating the average estimate by almost a point and a half. Operating income jumped 79% on a huge improvement in export margins, while EBITDA rose 49% and the company logged an almost three-point margin improvement.

SEE: A Clear Look At EBITDA
Export Conditions Generally Better
One of the reasons BRF S.A. management wants to increase its exposure to packaged foods is to get off (or at least mitigate) the roller coaster that is the global protein export business. Chicken volumes were down about 2% from last year, pork was down 17%, and beef was down 3%, but pricing was significantly better. With that, export income more than doubled, with margin almost tripling over last year.
As the year goes on, export business ought to improve. Grain price pressures should ease in the second half, and the company is hopeful that it may get clearance to export chicken to Mexico. At the same time, pork exports to Ukraine should return to normal, while the entry of the company into Japan's pork business ought to help margins as this business will likely be centered on premium cuts.
A Multi-Year Value-Generating Transformation
It's not hard to work out why BRF S.A. is looking to transform its business. If you look at the historical financial performance of Tyson Foods (NYSE:TSN) or Pilgrims Pride (NYSE:PPC), it's difficult to argue that these companies have generated significant excess economic value. While a meat processor like Hormel (NYSE:HRL) has done substantially better, even Hormel has come to appreciate that it needs to go further into the center aisles of the supermarket to generate better results.
While Hormel's long-term average free cash flow margin is a little more than double that of Tyson, Kraft and Nestle are yet again double that of Hormel (though they all have double-digit returns on invested capital). With only about 40% of sales taking the form of higher-value processed foods (and about half that number as a percentage of exports), BRF S.A. still has a long way to get to that level. But with over 450 new products launched last year, and another 70 so far this year, the company is on the path.
The Bottom Line
In an ideal world, I'll be owning BRF S.A. for a long, long time. Along the way, I expected some significant ups and downs, particularly as the economy of Brazil and the emerging markets that BRF S.A. targets are still comparatively volatile. With economic growth, inflation, currency, and tax policy still in flux, investors can generally expect to get a chance to buy BRF S.A. on a pullback at least once every year or two.

SEE: Investing In Brazil 101
As of now, the investment case for BRF S.A. shares is mixed. I believe the shares are still undervalued on a cash flow basis, but then I expect the company to execute a long-term transformation in the direction of Hormel/Nestle/Kraft that will see sales grow more than 9% a year, with free cash flow growing more than 20% as the free cash flow margin moves into the high single digits. By other conventional metrics like EV/EBTIDA it's much harder to make the case that BRF S.A. is a cheap stock today.
Disclosure – At the time of writing, the author owned shares of BRF S.A..