Brookfield Asset Management is a best-in-breed asset management company focused exclusively on delivering value to shareholders by producing increasing, recurring high-quality free cash flow. The recent pull-back, which I believe is mistakenly predicated on problems in the US housing markets, provides a very compelling and safe opportunity to buy into what I consider to be one of the pre-eminent wealth creation companies on the market. With a market cap of $18.4 billion, the company provides enough size and liquidity for even the largest portfolio.
To avoid confusion
with Brookfield Homes (BHS, the more commonly known "Brookfield"), I'll
refer to this company by their stock symbol BAM in this write-up.
Though the two stocks (BAM and BHS) seem to be moving in lock step
recently, BAM's exposure to the housing and mortgage problems is far
less than the market seems to realize, and I believe the sell-off in
BAM is tremendously overdone. Despite its size, BAM seems to be
under-followed and misunderstood, and is subject to problems of
BAM has generated over $1 billion of free cash flow in the first half of 2007, most of which is derived from sources that have little to do with housing or residential mortgages, including a strong presence in international infrastructure assets and financial asset management. The company also pays very little in the way of income taxes due to a natural tax shield. With a current market cap of around $18.3 billion, the company is trading at less than 10x run-rate cash flow, while it grew operating cash flows by 37% CAGR for the 5 years ending in 2006, and returns on equity have grown from 16% to 34% during that time. While 2006 results may have been somewhat unusually good, I think the stock is a screaming bargain at these prices.
Some BAM affiliate companies have been written up on VIC over the years, but to my surprise I didn't find a writeup on BAM itself (formerly known as Brascan trading as BNN), surprising since this company seems so squarely in the cross-hairs of value investors. There were two write-ups of Brookfield Homes (BHS) on 3/3/2003 and 9/27/2006, and another is Fraser Papers on 8/8/2005.
BAM is a multi-faceted, dynamic, global investment and asset management company, and like other companies of this type such as Leucadia and Berkshire Hathaway, it is difficult to quickly summarize or categorize. Let me touch on what I believe are the most important aspects of the company and its position in the current market, refer you to supplementary information, and hopefully respond to any questions in the Q&A.
Their basic strategy is to opportunistically acquire and manage long-lived assets, at reasonable prices, that generate sustainable and growing free cash flow, and finance them with cheap debt and equity financing, and manage them actively to maximize total returns. Asset classes include commercial and residential property, financial assets, power generation and transmission, timberlands, and renewable energy.
The key metrics to track the company's high-level progress are fully levered returns on equity and growth in free cash flow. ROE has grown from 16% in 2002 to 34% in 2006, and and free cash flow has grown from $580M in 2002 to $1887M in 2006, and is $1011M in the first half of 2007. With a current market cap around $18.3 billion, this puts them at less than 10x run-rate free cash flow, which I believe is an absurdly low price considering their growth, cash flows, returns on equity, stable and high-quality asset base, and inherent inflation and recession resiliency.
(numbers in US$ millions)
2007 YTD 2006 2005 2004 2003
Assets under management 77,412 71,121 49,700 27,146 23,108
Consolidated balance sheet assets 44,513 40,708 26,058 20,007 16,309
Revenues 3,966 6,897 5,220 3,899 3,370
Operating Income 2,503 3,776 2,319 1,793 1,532
Cash flow from operations 1,011 1,801 908 626 590
Net Income 736 1,170 1,662 555 232
Return on equity 34% 21% 19% 18%
These astonishing figures were achieved by a combination of opportunistic buying, brilliant execution, organic growth, steady deal flow on numerous fronts, a global reach, and favorable capital market conditions which have provided them access to ultra-cheap financing. Fortunately, I don't think there is anything about these results that are not sustainable, with the exception of some particularly good results in 2006.
BAM includes realized gains in their operational results, which bears some explanation. Just like investment conglomerates like Berkshire Hathaway, BAM has "one-time" gains that recur frequently as it exits various investments. These results are lumpy, but undoubtedly of a recurring nature. This leaves the analyst with a dilemma on how to treat them.
On one hand, these gains aren't part of the organic growth of the company and might be excluded from an analysis of the operating businesses. On the other, the investment activity is a core part of their business and the exits occur with enough frequency that to omit them would ignore a major source of value creation. In many cases, the appreciated value of an investment is not manifest on the financial statements until the exit.
This is the same type of challenge that exists when valuing conglomerates with a lot of transactions. BAM usually exits several investments per year, and if the financials are examined over multi-year periods, I think that including the realized gains in the operational results provides a fair representation of their results. When looking at results from a single period, it is probably prudent to back out the one-time items to get a clear picture of the underlying business.
BAM does an excellent job of providing investors with a transparent view of its many operations. They publish "supplementary information" with each earnings release which goes into more detail about the details of each area of business, and its financing and performance. Rather than re-hash that data here, let me refer you to those documents, and touch on some less obvious things that I have learned about the company after following it closely for more than 5 years.
With BAM's stock falling, let me touch on their possible exposure to the various problems in the current market environment.
The most obvious potential problem is BAM's exposure to the US housing and mortgage markets. As of Q2 2007, BAM owns 47% of Brookfield Homes (BHS) and 50% of Brookfield Propertries (BPO).
BHS is a residential luxury home builder primarily in Southern California and Washington DC, and is exposed to the current housing problems in fairly obvious ways. BHS was written up on VIC as a short in September 2006, and that thesis is so far playing out pretty much as anticipated, and there is no doubt that BHS is going through some hard times. However, BAM's interest in BHS is small relative to its other operations, as I'll detail in a moment.
BPO is a premier commercial property management company, and while they are also in the real estate business, the exposure here is quite different. You can draw your own conclusions about whether or not the current housing and mortgage problems will expand to the premier commercial real estate property management market, but I think the two markets are quite different, and in many ways inversely correlated.
(numbers in US$ millions)
2007 YTD 2006 2005 2004 2003
BPO Invested Capital 1,662 1,633 999 1,114 1,038
Operating Cash Flow 196 243 221 231 218
BHS Invested Capital 191 174 128 122 195
Operating Cash Flow 5 69 108 85 64
These numbers show the clearly deteriorating values of BHS, but also that this is not very relevant to the business. With $40.7 billion of assets on the balance sheet and $77.4 billion of assets under management at Q2 2007, the equity interest in BHS is a drop in a bucket, and with operating cash flows of over $1 billion in the first half of 2007 despite almost no contribution from BHS, clearly BAM is not impaired by BHS's lackluster performance.
Despite the problems in residential real estate, BPO appears to be performing fairly well, and we have good visibility into BPO since they are separately publicly traded. In regards to BAM, it seems clear that BPO is not causing a significant impairment.
BAM has other exposure to US residential properties, as detailed in their "supplementary information" reports. About half of their residential property exposure is in the US, the other half being in Brazil and Canada, where the markets are not behaving as badly. Predictably, only about 13% of the operating cash flow in 2007 YTD from residential properties has come from the US, despite half of book value being in the US, but the numbers here are still very small compared to their aggregate asset and cash flow base.
Another concern might be BAM's exposure to the ABS and capital markets. This was discussed in the most recent conference call. While they acknowledge that the ultra-cheap non-recourse debt of a few years ago is no longer available, they are not finding any problems obtaining financing. They recently issued $250 million of US 10 year notes at 5.80% -- less than 100 bp above treasuries. Bruce Flatt, the CEO, said that their exposure to sub-prime is minimal -- their residential operations are in luxury homes which do not have much sub-prime exposure. Some of their asset-backed deals may be delayed in the current environment, but over the long term they have broad reach in many capital markets with minimal exposure to low-credit or exotic instruments, and should not be impaired in any way.
BAM owns assets of their own which are consolidated on their balance sheet, and also manages assets on behalf of other parties. A thorough analysis of their exposure to different markets requires reading through their annual to see what they own and just manage (which is easy as things are well laid out). But just to give an idea, here is a high-level breakdown:
(numbers in US$ millions)
Assets Under Management
Specialty Investment Funds 28,327 39.8%
Property 26,027 36.6%
Power generation 5,390 7.6%
Investments 3,450 4.9%
Transmission infrastructure 3,143 4.4%
Other assets 1,921 2.7%
Cash and financial assets 1,673 2.4%
Timberlands 1,190 1.7%
And to break down the two largest categories:
Specialty Investment Funds
Fixed income and real estate securities 20,460 72.2%
Real Estate Finance 5,438 19.2%
Bridge Lending 1,452 5.1%
Restructuring 977 3.4%
Property Assets under Management
Core office properties 20,314 78.0%
Residential properties 2,403 9.2%
Infrastructure development 1,424 5.5%Opportunity investments 1,086 4.2%
Retail properties 800 3.1%
Remember that these are assets under management, not assets held on BAM's balance sheet. You are probably wondering about scary-sounding line items like $20 billion in "real estate securities". These are primarily BAM's portfolio of premier office properties, and have little to do with residential housing or mortgages. BAM's balance sheet exposure breaks down quite differently:
Fee Bearing Assets, BAM's share
US Core Office 7,712 59.5%
Transmission 2,810 21.7%
West Coast Timberlands 925 7.1%
Bridge Loan I 637 4.9%
Canadian Core Office 490 3.8%
East Coast Timber Forest 199 1.5%
Real Estate Finance 139 1.1%
Mortgage REIT 23 0.2%
Royal LePage Franchise Fund 19 0.1%
Directly Held and Non-fee Bearing Assets
Other 8,392 33.0%
Core Office - North America 8,049 31.7%
Power Generation - North America 5,126 20.2%
Residential Properties - US 1,355 5.3%
Residential Properties - Canada / Brazil 1,048 4.1%
Core Office - Europe 765 3.0%
Transmission - Canada / Brazil 333 1.3%
Power Generation - Brazil 264 1.0%
Timber - Brazil 66 0.3%
In terms of balance sheet exposure, BAM does not have a lot of exposure to US residential or mortgage markets, and electricity generation and transmission runs a close second to their property exposure. Their primary real estate exposure is managed, premier commercial properties in the US, which has different dynamics than the troubled US residential markets, and in many ways is inversely correlated.
One of the most attractive aspects of BAM is their crystal clear shareholder orientation. It is clear that the entire organization is structured to deliver maximum value to shareholders.
To start with, BAM has one of the best management incentive programs I've come across. Executives are required to purchase stock in the company equal to five times their annual salary, and directors are required to purchase stock valued at three times their fees (the company will help with financing if necessary). Meanwhile salaries and cash compensation vary from low to reasonable. Clearly the organization is highly focused on delivering value to the common shares.
The company has a long history of buying back stock, though historically the buybacks have been largely offset by shares granted in management share programs. Their most recent buyback authorization was for 10% of the outstanding shares, which we hope they are making use of in today's market. They mentioned on the last CC that once their current blackout period expires, they'll be looking to buy back stock.
Best in Class Assets
BAM was criticized in the past for having a hodge-podge of unrelated assets of mixed quality. This included a lot of junky real estate and empty land around the globe, cyclical assets that did not produce cash, etc. Aside from poor asset performance, this made it difficult to acquire good financing. About 5 years ago Bruce Flatt set out to change this and focused on acquiring only best-in-breed assets and divesting lower quality assets. The transformation has been impressive.
Today, BAM's commercial properties focus on major financial, energy and government centre cities in North America and Europe, including having one of the highest quality commercial real estate portfolios in lower Manhattan. The hydro power assets are well-located in eastern Canada and northeastern US, where demand for electricity is strong and growing. They recently expanded their electricity transmission infrastructure to Chile, which is said to have one of the most attractive regulatory structure in South America. Examination of each of BAM's recently acquired assets shows that they are buying best-in-class or close to it with each deal.
BAM makes substantial use of debt financing. They tend to lever aquisitions between 1:1 and 4:1, and then have non-recourse debt at the parent company level. The overall debt:equity tends to be around 3:1, which is high compared to say a private equity fund or BDC but low compared to say a bank or hedge fund.
An investor in Brookfield has to be comfortable with their approach to leverage, as a high level of leverage can obviously be cause for concern. I am comfortable with it for these reasons:
1) The debt is generally at very good terms. Third Avenue Management is a longtime shareholder, and Marty Whitman referred to BAM's access to the capital markets as "super attractive". In the MRQ the average rate on their debt was 7% and the average term was 11 years. They recently issued $250 million of US 10 year notes at 5.80% -- less than 100 bp above treasuries. Generally they obtain financing at low-fixed rates with long terms and little recourse.
2) Most of their assets produce extremely reliable recurring cash flows that can easily support the leverage. Their commercial real estate is in solid markets with 95%+ occupancy, about 90% of the electricity from the hydro power are sold in forward contracts, etc.
3) Book value is understated on their balance sheet because the assets tend to depreciate (i.e. real estate) even while it is increasing in value, thus skewing debt to equity type analysis. A better way to look at the debt may be debt service, by taking the operational cash flow minus one-time items and compare that to the interest expense. On a deal or consolidated basis, BAM has excellent coverage, since generally their cash flows increase organically while their debt payments do not.
The leverage of course is what allows them to produce high returns on equity and fuel growth, and is an essential part of their business.
A key aspect of BAM's strategy is to be opportunistic in entering new investments, usually buying during a temporary period of weakness. One dramatic example was their activity after 9/11. BAM (then known as Brascan) was already one of lower Manhattan's largest landlords, and owned two of the buildings adjacent to ground zero, which were remarkably unscathed. In the quarters after the attack, BAM went on to make substantial new investments in Manhattan real estate at a time when many were wondering if anyone would ever want to live or work there again. Those fears of course turned out to be overblown, and BAM was able to expand its property profile in Manhattan on excellent terms, and now enjoys one of the best commercial real estate portfolios in Manhattan with over 95% occupancy.
Another example was their expansion into hydro power assets. They acquired most of their hydro power assets in 2002-2004, when energy prices were much lower and water levels were also low, making the hydro power assets relatively cheap. Since then, energy prices have obviously risen while the cost to operate the power plants is largely fixed, meanwhile the deals were financed with the cheap, fixed-cost debt available at the time. Today with the focus on renewable power sources, these assets may become more valuable still.
In years past, BAM (then known as Brascan) was known for investing in cyclical assets such as mining and commodities. Recently they have showed skill in divesting these assets near their cyclical peaks in recent years. Going forward, they are focusing more on cash-producing assets than cyclicals.
Returns on Equity
BAM has a stated 20% "cash return on equity" goal, which they have been exceeding in recent years (including 34% in 2006). This dovetails with their shareholder orientation and focus on free cash flows, and the way they achieve this target bears some explanation.
The low-cost leverage is obviously a major contributing factor to their returns on equity. Capital can be invested at modest cap rates, and if the asset produces cash and appreciates while the cost of financing remains low, the returns on invested capital gradually increases, and the asset can be refinanced at a later date to continue the trend. Then apply parent-company level financing to this arrangement and returns are further juiced.
There are also more subtle strategies employed by BAM to boost returns on equity. One is their focus on deriving fee income from investees. Many of BAM's ventures are structured so that BAM is the management company or general partner (GP) with an equity interest in the venture. Thus, aside from having an equity participation in the investment, they also derive fee income, thus boosting their overall returns. This not unlike the GP of a hedge fund whose assets are invested in the fund but who also gets a "carry", so that the GP's total returns are greater than that of clients, given the same investment performance.
In the last conference call, BAM mentioned that their goal is to achieve a fully levered return of 12-18% on assets they manage on behalf of others. Meanwhile their own ROE goals are 20%. The difference here is their management fees, which serve to provide fee income on top of their investment performance.
Another strategy is for BAM to create or spin off entities so that they are largely controlled but not fully consolidated on their balance sheet, meanwhile BAM derives fee income and economic benefit from the entity. This is roughly analogous to what Coca-cola did some time ago to break the syrup franchise, distribution, and bottling units into three separate businesses, leaving the highest ROE and asset-light business in the parent company to enjoy the best returns, meanwhile the subsidiaries were saddled with the assets, personnel, and financing of the less attractive businesses.
This strategy is employed by other levered equity funds such as the large BDC's, who will create a new entity focused on a particular market segment, IPO the entity to raise cash, and then stay involved to derive management fees. ACAS in the BDC space for instance has been pursuing this strategy, and I believe the goal is to increase fee income and justify higher multiples to book value.
This divesting strategy also allows BAM to keep the highest quality assets on their own balance sheet, which improves their access to cheap financing.
Another quality of BAM's asset base is that they tend to be resistant to inflation and recessions. Infrastructure assets generally tend to provide increasing, recurring cash flows, and assets such as power (especially renewable power) and commercial real estate tend to serve as a natural hedge against inflation.
BAM has historically paid very little in the way of income taxes, due to the nature of their asset base (i.e. high depreciation). From their 2006 AR:
"Brookfield has access to significant tax shields as a result of the nature of our asset base, and we do not expect to incur any meaningful cash tax liability in the near future from ongoing operations, other than in our U.S. home building operations which, because they are owned separately, do not enjoy the benefits of tax shields from our other U.S. operations."
Thus, reported income tends to significantly understate cash flows, and may lead to very different perceptions of valuation for the casual observer. This also helps to explain their high returns on equity -- higher numbers are obviously easier when you don't pay taxes on the cash flows. This is why I advocate using operating cash flows as a metric for evaluating their ongoing operations.
Since BAM's market cap has gone from less than $4 billion to over $18 billion today, it bears asking if their size will be an impediment to future returns. I think that their size is actually an asset, given the markets in which they are participating. Global infrastructure is a very big business, with trillions of dollars of assets that require financing and management. It is no mistake that the large pension and private equity funds are turning more and more to global infrastructure assets to deploy huge amounts of capital.
BAM's presence is primarily in the Americas and western Europe. They recently completed a deal for Australian construction and property company Multiplex Group, which is their first major foot hold in Australia. They have mentioned many times that they are interested in moving more into the Asian region. Suffice it to say that, with an established global reach, I think there is plenty of room for them to continue to execute their plan on a large scale.
BAM recently announced that they are spinning off some infrastructure assets as a publicly traded partnership. The new entity will be 40% owned by BAM and the remaining 60% will be publicly traded, and it will have book value of about $1 billion and market value of about $600 million. BAM shareholders will receive one unit in the new entity for each 25 shares of BAM that they hold, so the spin-off is in essence about 4% of BAM's market value.
There is plenty of publicly available information about the spin-off, and in short, my take is that BAM is furthering their strategy of partially spinning off entities and deriving fee income from them so as to boost their own recurring free cash flows and ROE, while giving the entity its own access to capital markets and deals.
Market realizing that BAM's exposure to housing and credit is minimal;
10% share buyback;
Continued expansion of free cash flows and investment activity;
Broad trends in privatizing and managing of global infrastructure assets