We wrote this up originally roughly a month ago, before the recently announced BBI deal was finalized. In light of this, we view this opportunity to be even more attractive and timely all things considered.
Update – The deal is done
We recommend taking a look at the company’s latest and updated November pdf of the new and improved BIP at http://www.brookfieldinfrastructure.com:
Brookfield Infrastructure Partners is a high return business with attractive growth prospects and a world class management team, on the cusp of a highly attractive, transformative acquisition. Yet it is currently trading hands at roughly half of its “pro forma” NAV – implying that it’s a poorly run, low return business in terminal decline. This simply makes no sense, as any competitively entrenched financial enterprise that has the ability to consistently generate above average returns on equity (in the mid to upper teens), and can grow at mid to high single digits for the foreseeable future, should trade at or around its NAV at an absolute minimum.
Despite the positive foundation being formed through its recent BBI acquisition, the high quality assets backing BIP’s underlying value, its attractive secular growth profile (BIP sits at the center of what I believe is an emerging mega trend), and the variety of catalysts that should help bring about the realization of its underlying value…this above average business remains relatively under-followed, underappreciated, and above all, cheap.
In a nutshell, BIP is a limited partnership that owns, in whole or in part, a collection of premier infrastructure assets consisting of various electricity transmission lines and timber fields throughout North and South America. It makes its money by buying, selling, and managing infrastructure assets – its primary objective being the creation of per share economic value.
The LP’s investment activity is managed by their general partner, Brookfield Asset Management (BAM) – a multi-faceted, dynamic, global investment and asset management company with a long and incredibly impressive track record of successfully buying high quality assets on the cheap, generating outsized cash returns from them, and selling them at a premium. BAM’s management is value oriented, risk-averse, transparent, and shareholder friendly. Interests are aligned as they own roughly 40% of BIP’s units – notably they plan marginally upping their ownership stake after the completion of the BBI deal.
Why is it Mispriced?
Reasons for today’s mispricing are numerous. They include…
A convoluted/complex financial structure – BIP’s complex organization generates financial statements that muddy the cash flow characteristics of its underlying assets. Further clouding the picture is the fact that Brookfield’s adjusted net operating income (BIP’s preferred method of calculating operating cash flow) is temporarily depressed due to a combination of both lower earnings from its U.S. timber operations and a variety of non-recurring “one off” charges associated with the recent spin-off. Both of these temporary issues have gone a long way in masking the underlying earnings power of BIP’s legacy asset base.
Due to BIP’s limited operating history, there isn’t much for institutional investors to look at as a benchmark for performance; moreover, the limited track record that does exist is relatively unimpressive due to the cyclical recession in BIP’s timberland assets. This in turn has caused the market to price in low expectations. Given time, this dynamic will almost certainly reverse. Also, assuming the potential acquisition gets done, the track record that does exist will essentially be meaningless as BIP’s future operating performance will look absolutely nothing like its past.
Brookfield is a spin-off and has experienced the typical waves of selling pressure for un-economic reasons that usually accompany them.
It is small, underfollowed and underappreciated. Currently its 350m market cap is too small to attract much institutional interest. If the expected BBI deal in the works gets done, it won’t be small or under the radar for very much longer, as BIP will essentially triple in size overnight (its post-deal market cap will likely be north of $ 1 Billion).
A Classic Low Risk, High Return Opportunity
Whether the deal gets done or not (more on that below), I feel it is hard to lose money (under nearly any outcome I can imagine) paying 50c on the dollar for a collection of highly attractive, long-lived infrastructure assets that generate consistent, high margin cash flows and possess attractive organic growth prospects. After all, these are assets that in a normal environment should generate fully-levered returns on equity in the mid to high teens. They enjoy significant barriers to entry (for regulatory and capital reasons), low maintenance capital expenditures, and usually possess long-term contracts (often with built-in price increases and significant operating leverage). Did I mention they tend to get more valuable over time?
Leverage isn’t an issue with BIP’s assets. They have highly visible, recurring cash flows (much of which is supported by regulated and contractual frameworks) and therefore can support substantial non-recourse leverage and remain investment grade. Brookfield has always conservatively financed their assets, usually at low fixed rates with long terms and no recourse.
Liquidity isn’t an issue. BIP’s fortress-like balance sheet, coupled with the outstanding capital allocators at its helm, put it in an incredibly strong position to capitalize on the expanding opportunity set before them. Between its current cash position, available credit lines, the types of assets they own, the institutional relationships they have, and the contractual nature of the free cash flows they generate every year – coming up with cash is not IMHO is an issue. Their financial strength allows them to remain flexible and opportunistic, and they have more than enough dry powder to take advantage of the occasional fat pitch that comes their way.
I want to quickly note that management, unlike the majority of BIP’s competitors, is extremely unlikely to do something dumb with their cash. With any investment company there is always a risk that management will overpay for any given asset (witness BBI below) and blow the business up. Considering the quality of BIP’s management, I feel this worry is another non-issue.
Quick and Dirty Value Proposition on BIP’s pre-deal asset base (bullet point outline below):
Premier electricity transmission and timber assets
• Units at significant discount to asset value
• Current yield of roughly 7% with sufficient liquidity to fund near term dividend
Substantial growth within existing portfolio
• Significant upside from recovery of log prices
• Inflationary increases in transmission revenues
• Backlog of accretive transmission investments
Upside from new investments originated by Brookfield
• Attractive vintage period to invest in infrastructure
• Targeting 15%+ average after-tax levered returns on equity
I don’t think it’s much of a stretch that BIP’s existing assets (pre deal) could generate somewhere around $ 60 million in FCF in a more normal environment. As their timberland operations normalize and the backlog of accretive transmission investments come on line, BIP will begin to reach its normalized earnings capacity over the next few years. As this happens, my guess is that Mr. Market will wake up and begin to award a much more appropriate multiple on both Brookfield’s assets and earnings power – driving outsized returns in the process. The BBI deal and/or any other opportunistic, accretive investments will be icing on the cake.
An Expanding Opportunity Set Still to Come:
As long-term investors, we should generally be excited if a company has value-accretive reinvestment opportunities available, even more so if the company in question is run by expert capital allocators with a long history of buying quality assets on the cheap. In BIP’s case the opportunity is enormous over the next few years and beyond for two reasons.
First, they are in the perfect position to capitalize on the distress of their less disciplined competitors, many of whom will need to be recapitalized/restructured over the next few years. BIP (through BAM) has significant competitive advantages here, as they are one of the few companies that have the financial resources and necessary skill set to get the job done. They have the operating expertise to maximize the value of the acquired assets, the restructuring people to deftly manage these complicated situations, as well as the capital to invest – a combination that should allow them to generate some enormous profits as this dynamic plays itself out over the next few years.
Second, they are perfectly positioned in what I believe will almost certainly be an emerging megatrend – namely, the privatization of public infrastructure. The combination of aging public infrastructure and global population, and economic growth in conjunction with the large (and growing) deficiencies in government budgets (at least in the developed world), is creating a near perfect storm that, in my opinion, will make private sector involvement absolutely necessary. Current estimates for global infrastructure spending over the coming decades are enormous – clocking in at roughly 2 trillion annually through 2015. With governments in the developed world increasingly unable to foot the bill for their large and growing infrastructure needs, it is my contention they will have no other choice but to open the door to private investment. Considering BIP/BAM are one of the handful of institutions with the human and capital resources necessary to assist in alleviating this increasingly large problem, they are in a rather attractive position to help (not to mention profit) as this mega-trend plays itself out over the coming 10+ years.
I think it is worthwhile to quote management on these issues, as I feel they paint the picture better than I. Per BAM’s latest quarterly letter to shareholders…
“During the last three years, infrastructure assets have largely performed as expected. With a few exceptions they have been resilient and have continued to generate cash flows. Unfortunately, many new investors entered the market over the past four years and made at least one of three fatal mistakes. They either: (1) paid too much; (2) had growth assumptions that were too high; or worst of all, (3) employed excessive debt leverage. As a result, many owners of infrastructure assets are in financial difficulty and this has bruised the reputation of infrastructure as an asset class in the eyes of a number of investors. We believe this is unwarranted and think that with proper capital allocation and underwriting assumptions, these assets represent one of the most compelling “real return” investment opportunities available to institutional investors.
Moving forward, we believe that private infrastructure funding (new build and sales of in-place assets) is set to boom for at least the next decade, and likely longer. Our vision is based on the premise that governments across the world, but in particular in developed markets, have overspent in relation to their resources and now need to right size their debt positions by selling assets, in order to work their way out of significant budgetary deficits. These efforts will surely involve tax increases, but we believe the global infrastructure market is being set up for enormous growth as state and federal governments across the U.S., UK, Europe and other indebted nations, liquidate capital assets to generate proceeds for the purpose of paying down liabilities.
The UK government has long been a leader with respect to infrastructure privatization. The UK government’s recent announcement of its intention to raise £16 billion through infrastructure privatizations, including the Channel Tunnel and the Dartford Crossing, is just the beginning of this next phase. In the U.S., governments have been slow to start as a result of political and historical reticence. But today, we believe the tide has turned because the U.S. federal and state governments have no choice but to start, or accelerate their own programs. With few other alternatives to get their fiscal houses in order, many governments will be forced to act.
The positive aspect for the global capital market is that privatizations should assist indebted nations in alleviating a portion of their fiscal issues. Developed countries are rich in assets but, like any asset-rich company, need to raise capital by selling assets. By doing so, foreign and local ownership of U.S. and UK treasuries, in essence, will be converted into ownership interests in infrastructure assets. As a result, we believe there will be a fundamental re-appraisal of hard assets. We believe these changes will reward investors with strong risk-adjusted returns, deleverage government balance sheets and also tax users of the infrastructure at the source, thereby enhancing fairness in the allocation of the economic costs of this infrastructure in society.
In summary, we think that the private infrastructure market is still in its infancy. As a result, infrastructure investing will be a growth area for many years to come for those who have both operating expertise and the financial wherewithal. We plan on continuing to capitalize on our inherent strengths to expand our operations in this sector further.”
Quick background on BBI acquisition and its implications
Over the past several years, BBI has assembled a high quality portfolio of globally diverse infrastructure assets. However, like so many others in the infrastructure space and beyond, they made two fatal mistakes as they grew their portfolio – First, they systematically overpaid for their assets; second, they bought these assets with large amounts of debt raised in the bank market with short-term maturities. We all know what happened next. Due to the credit crises, BBI ran into severe liquidity issues and BBI’s creditors, well aware of the level of financial difficulty the company was facing, refused to roll over the $160mm in debt they were owed this month. Faced with defaulting and the prospect of declaring bankruptcy, BBI was essentially out of options. In comes Brookfield and company in the role of the white knight and a deal was reached.
The bottom line here is that by all accounts, this deal is classic Brookfield. By taking advantage of a distressed, highly motivated seller, Brookfield was able to acquire a collection of best-in-class assets at a fire-sale price (Bravo).
As I mentioned above, I doubt this will be the last time we see Brookfield capitalize on the distress of their competition, far too many of whom own high quality assets but who through a combination of overpaying and excessive leverage, find themselves in significant distress. Feasting on the bad decisions of others is something Brookfield has always done extremely well.
If the BBI deal gets done, an outcome I feel is a near certainty, BIP will undergo an impressive transformation almost overnight. By adding a variety of restructured low risk, high return cash cow utility and transportation assets (located around the world in Australia, the U.S, the U.K, continental Europe, New Zealand and China) on the cheap, BIP will become not only bigger, but a meaningfully better business. Post deal, Brookfield’s operations will possess a more valuable collection of attractive hard assets that will generate considerably more excess cash. The partnership will be more globally diverse and their financial resources and scale will be significantly enhanced.
The one negative is that U.S. shareholders could not participate in the offering of additional units to fund the acquisition (@ $14.50 per share). The deal is still very much accretive, yet the inability to participate in the offering does diminish the potential value U.S. shareholders could have realized.
With a substantial margin of safety, backed by valuable hard assets and substantial appreciation potential due to its large and growing cash generating capabilities, this is a classic low risk, high reward fat pitch. Investors in BIP at or around today’s price of roughly $15 should earn a double or more over the next 3-5 years.
BBI deal closes and the improved, more diverse operational asset base and a larger market cap leads to more analyst coverage, and greater institutional interest/awareness
An increase in the dividend
Any improvement in timber ops
The announcement of another value accretive acquisition
*The author has a position in Brookfield Infrastructure Partners (BIP). This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only