|Shares Out. (in M):||92||P/E||0||0|
|Market Cap (in $M):||2,119||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
Brookfield Business Partners L.P. (BBU-US)
I believe BBU is a great investment opportunity because: 1) I like the setup, primarily the spinoff dynamics, 2) the lack of disclosure which gives informed investors an edge on valuation and understanding the downside, and 3) the ability to participate, at a discount, a compounder with better alignment and constraints than the other Brookfield spin-offs.
I will spend most of the writeup expanding on points 1) and 2) as a previous write-up already does a good job highlighting Brookfield Asset Management’s (BAM) strong record as a shareholder friendly capital allocator.
I followed BAM for many years and have seen it transform from BAM holding a difficult to analyze mix of assets (mostly real estate) to pruning and upgrading its portfolio into higher quality and easier to understand asset groups including real estate, infrastructure and private equity. As BAM’s success attracted third party capital, BAM wanted to transform into more a fee based business to generate returns while being less capital intensive. As a result, BAM began spinning off groups of its assets into Brookfield Infrastructure Partners (BIP), Brookfield Property Partners (BPY) and (the most recent one) Brookfield Business Partners (BBU).
As we know, spinoffs generally create pretty interesting dynamics because holders of the “parent” company typically: 1) receive a small position in the spinoff making the spinoff holding irrelevant, 2) do not bother analyzing the spinoff because of its small size and the amount of work required to understand it and 3) the lack of the spinoff’s independent operating history precludes some investors from being comfortable investing in the spinoff.
In BBU’s case, forced selling is likely exacerbated by: 1) BAM holders only getting 1 BBU unit per 50 shares of BAM, a tiny amount when compared to BAM’s other spinoffs, 2) the BBU spin being taxable so there is less incentive to hold onto the position to avoid triggering taxes, 3) the limited partnership structure which some mutual funds are simply not allowed to hold, 4) the lack of index inclusion and 5) the limited disclosure around the eclectic mix of assets (unlike BAM’s infrastructure and real estate spins).
Knowing there is non-fundamental selling pressure for BBU is nice, but why should one be interested in BBU now?
With BAM having spun out both BIP and BPY over the past decade or so, it is interesting to see how BAM has managed the spinoffs in terms of setting a low(er) hurdle to generate incentive payments from a low fair value mark then marketing, getting sell-side coverage and increasing its distribution for the spinoff and even buying back units help the companies rerate higher over time.
Specifically, for BIP, BAM shareholders got 1 share of BIP for every 25 BAM shares and BIP took about 2 years to rerate that came as distributions were increased and as we exited the financial crisis.
For BPY, BAM shareholders got 1 BPY unit per 17.4 BAM shares and it took about a year to rerate. Interestingly for BPY, BAM likely wanted BPY to trade poorly because its incentive fee was calculated using the initial capital level calculated using the 30 day initial trading BPY VWAP. Over the course of a year, BPY was active in getting BPY back into indices, executing on leasing its properties, buying back units, getting sell-side coverage and raising the distribution.
See my previous writeup here: https://www.valueinvestorsclub.com/idea/BROOKFIELD_PROPERTY_PRTRS_LP/119185
So approximately 6 months after the BBU spin-off, why should it rerate faster than the previous BPY spin?
I think BBU will shake off the usual negative spin-off dynamics sooner than the previous BAM spins mostly because of one important detail in the BAM/BBU Master Service Agreement (page 132 in BBU prospectus). Basically BAM gets a 1.25% management fee on total capitalization (recourse debt + weighted average trading price of equity by quarter) and an incentive fee as follows:
As a result of holding Special LP Units, Brookfield will be entitled to receive from the Holding LP incentive distributions calculated as (a) 20% of the growth in the market value of our units quarter-over-quarter (but only after the market value exceeds the “Incentive Distribution Threshold” being initially $25.00 and adjusted at the beginning of each quarter to be equal to the greater of (i) our unit’s market value for the previous quarter and (ii) the Incentive Distribution Threshold at the end of the previous quarter) multiplied by (b) the number of units outstanding at the end of the quarter.
This is quite different from the BPY spinoff where BAM gets a flat management fee and incentive payment where BAM gets 1.25% of growth in total capitalization plus essentially IDR splits in distributions similar to MLPs in the US:
For purposes of calculating the equity enhancement distribution at each quarter-end, the initial total capitalization against which the quarter-end total capitalization is measured will always be the company’s total capitalization immediately following the spin-off. For purposes of calculating the initial total capitalization, securities will be valued based on their volume-weighted average trading price on the principal stock exchange (determined on the basis of trading volumes) for the 30 trading days commencing on the date of the spin-off; provided that if a security is not traded on a stock exchange, the fair market value of such security is determined by the BPY General Partner.
Put simply, in the BBU spinoff, BAM’s incentive is to: 1) set an equity value threshold low enough that they will certainly cross and generate 20% incentive distributions and 2) have BBU rerate quickly as there is no need to depress BBU unit price to set a low bar unlike BPY.
I cannot stress this enough but the difference in incentive structure is a significant nuance investors need to understand here. In BPY’s case, the incentive is to let BPY trade as poorly as possibly to have a low and non-resetting low bar set by the 30 day VWAP so BPY generates incentive fees on total capitalization growth over the initial 30 day VWAP (they have $12.5 mln base management fee). As well, there is less of a rush for BPY to rerate because the big incentive fees come from the distribution splits (like IDRs in MLPs). This is pure speculation on my part but perhaps from the BPY experience, BAM realized it did not like leaving the base total capitalization calculation to chance based on the 30 day post spin VWAP (i.e. BPY held up ok post spin and got worse as funds who could not hold LP units got extensions from their compliance department to dump it later).
My speculation is that this time around, BAM wants to set a bar conservative enough that they will generate good incentive fees going forward. BAM, knowing BBU’s assets best, would be incentivized to set as low a hurdle as possible to virtually guarantee incentive payments and not leave the determination of said hurdle to a post-spin VWAP unit price in case something wonky happens again. Perhaps with this in mind, BAM sets up a management fee structure at 1.25% of total capitalization (that fluctuates with the unit price) and a 20% incentive fee over a $25 BBU unit price. Again this is significant here, BAM has set a price where if BBU is below $25, it gets LESS of a management fee (instead of a flat $12.5 mln for BPY) AND gets no incentive payment. Whereas at $25 or above, BAM gets a FULL management fee AND an incentive payment. Again to put it gently, if I were BAM, I am setting the number at a price I know reflects a downside/worst case valuation scenario for BBU (but I am speculating here). Finally, as you can read in the prospectus, BBU does not intend to increase its distribution and there is no IDR splits like BPY – so all of BAM’s incentives are in compounding value in BBU over S25. There is no incentive to let BBU units trade poorly like BPY – in fact it is the opposite this time around.
Armed with an understanding of incentives, we can now review some actions BBU has taken to suggest BBU/BAM’s incentive for this new vehicle to trade well ASAP:
Less than 3 months post spin, BBU announces unit buyback program: https://bbu.brookfield.com/press-releases/2016/08-02-2016
~ 4 months in, BBU is already hosting its investor day with a marketing presentation detailing valuation and the range of value BBU should be worth:
The difficult part of this idea is coming up with a valuation range for BBU given the many different businesses under the BBU umbrella and limited disclosure in underlying business and KPI’s/unit economics. From the filings, BBU only really separates its business into 4 segments: 1) construction services, 2) other business services, 3) energy and 4) other industrial operations. Although segment “company FFO attributable to parent company” is provided, one can’t really do much valuation work other than slapping on FFO multiples on comparable businesses (which is hard to define) and guess how much BBU is worth. Using this method and really stealing from BBU guidance, you get $24-28.