Brookfield Asset Management BAM
August 06, 2007 - 1:23pm EST by
oscar1417
2007 2008
Price: 31.54 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 18,350 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

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 perception.

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.

Current Environment

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.

Asset Base

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%

Total                          71,121


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.

Shareholder Orientation

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.

Leverage

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.

Opportunistic

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.

Inflation Resistant

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.

Taxes

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.

Size

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.

Recent events

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.

Catalyst

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
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    Description

    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 perception.

    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.

    Current Environment

    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.

    Asset Base

    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%

    Total                          71,121


    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.

    Shareholder Orientation

    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.

    Leverage

    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.

    Opportunistic

    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.

    Inflation Resistant

    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.

    Taxes

    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.

    Size

    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.

    Recent events

    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.

    Catalyst

    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

    Messages


    SubjectValuation
    Entry08/07/2007 08:00 AM
    Memberyarak775
    Oscar - How do you think about valuation for BAM? I find the lumpiness in earnings make traditional multiple analysis tricky. Is sum of the parts or some sort of normalized cash flow analysis the way to go? I'd be curious to hear what you think BAM is worth today and what you think it's appreciation potential is over the near and longer term.
    Thanks,
    Yarak

    Subjectre: Valuation
    Entry08/07/2007 09:04 AM
    Memberoscar1417
    As I mentioned in the write-up, I think that operating cash flows, including cash flows from exits, is the best metric to use for valuation. Whether the source of cash flows is a hydro power plant, asset management agreement, a dividend, or an exit, operating cash flow provides a fairly apples-to-apples figure to evaluate the business units and each of their contributions, without the vagaries of tax accounting. Analogous to Buffett's "owner earnings", this shows what cash is produced by the business and what is available for re-investment.
    Even this metric is not perfect though, as some assets don't produce much cash until they are sold, or the cash production changes based on their financing. Flatt (the CEO) actually addressed this specific point in the Q2 shareholder letter, which I'll excerpt in the next posting.
    In terms of valuation, I think that the operating cash flow figure can be analyzed with a multiple or DCF analysis just as you would any other cash-producing asset. Consider a highly reliable cash-producing asset such as a pipeline or toll bridge that might grow at the rate of inflation or slightly more (since you might have a modicum of pricing power). Fair value might be something like 9-11x cash flows. But if the cash flows were growing at say 15% per year, the multiple should be higher, say 14-16x. The multiple is just a shorthand for a DFC analysis, into which you can plug your risk-free and discount rate assumptions.
    Each of BAM's existing cash flows has the characteristics of a toll bridge or pipeline -- long-lived assets producing very reliable recurring cash flows that should grow at least as fast as inflation. The aggregate cash flows are growing since they continually make new investments, and each new cash flow stream is also highly reliable. This is not dissimilar to Buffett's strategy of accumulating high-quality slow-growth businesses to build value.
    Thus I think that putting a suitable multiple on the aggregate cash flows makes sense. Given their growth rate, quality assets, and shareholder orientation, I think that something like 14-16x operating cash flow represents fair value, and that fair value has been increasing at 15-25% per year for 5 years, and should continue this rate into the future. Considering their multiple is currently less than 10x, I think there is currently 50% upside to fair value, and the opportunity to have that fair value grow at very acceptable rates going forward.

    SubjectFinancial Reporting, 1/2
    Entry08/07/2007 09:05 AM
    Memberoscar1417
    From the Q2 2007 shareholder letter:

    http://www.brookfield.com/newsroom/pressreleases/r2007/resources/2007%20Q2%20Letter%20to%20Shareholders.pdf

    INVESTMENT RETURNS AND FINANCIAL REPORTING
    We are often asked about the make-up of our cash flow from operations, and in particular, whether we focus on current cash flows or cash flows on a total return basis. The short answer is that we focus on both, but predominantly on total return.
    These discussions usually include a question about how shareholders should look at one-time gains. Over the last number of years, one-time gains have occurred on a recurring basis, but have been irregular. As you will see below, the reported amount of one-time gains in our cash flow statement far understates the value being created in our equity base.
    To date, for simplicity purposes, we have focused our reporting to you on the cash flows generated on an ongoing basis from our operations and realization gains as they occur. Given our continued focus on total return investing, we thought it appropriate to explain how total return accrues to the shareholders as we invest capital and how it is reflected (or not) in our financial results. The concept is quite simple. How it works in a large organization is less simple to explain, but we will attempt to do this.
    On average, we currently invest capital, excluding management fees we generate (both ours and our clients) at an approximate 12% to 15% leveraged return (although we certainly try for more). We assess returns on a total basis – meaning that we include the present values of cash flows received over the life of our investment as well as the “terminal value,” which represents the value of the investment at a future point in time. This is commonly referred to as an internal rate of return, or “IRR.”
    As you know, we focus on assets that we believe will generate increasing levels of cash flow over time, and that appreciate in value as a result of the characteristics of these assets. In many cases, the current cash return from an investment at inception may be well below the targeted IRR. This means that for accounting purposes, the returns that are reflected in our financial results are typically significantly below our internal rate of return in the early years of our ownership. Over time, as the cash flows increase, higher returns will be reflected in our reported results.
    What are usually not reported in our financial results are increases in the values of our investments over the amount of the original invested capital. The values of assets such as ours typically increase by an amount equal to the capitalized value of the increase in the associated cash flows. This appreciation in value is generally not reflected in our financial results until such time as we sell the asset, at which point we will record a realization gain. And, as discussed in our letter of February 10, 2006, we are generally inclined to hold assets indefinitely, preferring to monetize the accrued value by refinancing the asset as opposed to an outright sale. This has the added benefit of deferring any accrued tax liability, but as a result of no crystallization event, the accrued value may never appear in our financial results.
    As an example of the above, assume we purchase an asset for $1 billion, at an initial return of 6%, and finance the acquisition with $700 million of debt with a similar cost. This investment will generate an approximate 12% IRR if the cash flows from the asset increase at 2.5% per annum (inflation only) over a 20 year period and capitalization rates remain unchanged. In this example, our reported cash flows will initially be approximately 6% on our equity investment, and will increase over time, with such increases being reflected in cash flows as they occur. The value of our investment will increase by approximately $600 million over the 20 year period (assuming capitalization rates do not change), but this increase will not be reflected in our financial results unless we sell the asset (if ever).

    SubjectFinancial Reporting, 2/2
    Entry08/07/2007 09:05 AM
    Memberoscar1417
    Accordingly, a very important component of our return, which would otherwise represent nearly 60% of our reported cash flows over that period of time, may never be reflected in our financial results.
    In addition, we have many assets that do not produce any meaningful annual cash flows on a current basis (sometimes they are negative starting off), and therefore further depress current cash flows. The amount of equity invested in these types of assets on our balance sheet today is more than $4 billion. We believe these assets, because of their risk profiles, will earn annualized returns in excess of 15% over the longer term on a leveraged basis. Included in this group of assets are our hydroelectric and commercial property development projects; residential, agricultural, timber and higher and better use lands; other development assets; investments which pay no regular dividends such as our investment in Canary Wharf Group; and our limited partnership interests in funds which are opportunistic in nature (like our restructuring fund) and therefore do not generate meaningful current earnings.
    We also purchase securities of companies in our areas of operations when we believe they trade at less than their intrinsic value. At best, the dividends paid by these entities generate a 2% return, which is included in our reported cash flows. It goes without saying that it is not our expectation to merely earn a 2% return when buying these securities. In these situations, we believe the underlying assets that we are acquiring will generate total returns for us of at least 15% which, if we are correct, will ultimately accrue to us.
    The implications of this analysis are twofold. The first implication is that the cash flows reported on a meaningful amount of our capital are not, in our view, representative of the total return that we expect to receive over the life of the investment. This is particularly so for newer investments, development initiatives, and securities investments. The second implication is that realization gains, when they do occur, form an important part of our total returns and typically represent only a small portion of the overall increase in intrinsic value that is built each year within our operations.

    SubjectCompare and Contrast
    Entry08/07/2007 02:46 PM
    Memberneo628
    Thanks for the idea. I would love to hear your take on how BAM compares with LUK (and to a lesser extent) BRK from a method of operations, management quality, valuation, long-term return potential, downside risk perspective.

    SubjectRe: BAM vs. LUK
    Entry08/07/2007 03:48 PM
    Memberoscar1417
    I have not followed LUK nearly as closely as BAM over the past few years. But let me take a shot at a comparison off the top of my head.
    I would say the primary difference between the two is that LUK seems geared towards increases in book value, while BAM is focused on recurring cash flows and increases in equity are secondary. I think this is partially driven by the accounting treatment of their preferred asset classes. If portfolios of commercial real estate were marked to market, it may be different. But I think that BAM has much more capability for multiple expansion, whereas LUK will be more tied to book value.
    Another important difference is attitudes towards debt and leverage. BAM clearly embraces debt and leverage, and an investor in BAM must be comfortable with it, whereas LUK uses it sparingly. LUK is running debt:equity of around 0.35 while BAM is at around 3:1. I think that BAM is safe (as does "safe and cheap" Marty Whitman), but leverage is leverage.
    With LUK, my impression is that the exit is clearly in sight when they get into an investment, and that they are generally more transaction oriented. BAM could conceivably hold many of their assets for decades, and seem to prefer to buy, hold, and manage. This isn't to say that BAM doesn't have a lot of transactions nor that LUK couldn't hold something for the long term, but it seems to be a different preference. BAM has proven adept at building up asset-specific management expertise, which is already proving to be very valuable for deriving management fees from managed assets, a trend that I expect to continue. I just don't see Cumming and Steinberg managing a group of 100 operational managers.
    LUK seems to have a "two guys in a quiet office" approach, and decision making seems very centralized. Given their age, succession is a big question for me. BAM on the other hand seems very distributed, Flatt operates as more of a conductor. Their management team must be wide and deep and cover many facets including deal-making, financing, capital markets, and expertise in each asset class. I feel more comfortable about BAM being an organization with a singular purpose rather than a hodge-podge of investments, which I think provides better longevity and succession. BTW, Flatt is only 41.
    I personally find LUK to be almost completely opaque. I can never seem to get a handle on what they're doing, even after they explain it. Rail cars, Russian Pepsi bottlers, California wine, distressed telecom... nobody can argue with their results, but I think a strong element of faith is required. BAM on the other hand I find to be very transparent. Their businesses are quite simple. They provide copious amounts of supplemental data on their operations, at a high level and for all of the business units. Their larger partially-owned subsidiaries (i.e. BHS and BPO and soon the infrastructure partnership) are publicly traded and thus provide additional transparency. Flatt is obviously a value investor and Buffett disciple and follows the "if our positions were reversed" principle when presenting results.
    BAM has pretty clearly defined asset classes where it focuses (more true recently), whereas LUK obviously feels free to participate anywhere they want.
    Things they have in common are an international reach, deal-making, shareholder orientation, and paying little in the way of taxes (though the way they each go about avoiding taxes is quite different).
    Well I guess that is more contrasting than comparing...
    I am a lot more comfortable with the cash flows and asset types at BAM, but that may just be preference. I also see a tailwind as municipalities and governments around the world seek financing for, and seek to upgrade or replace, infrastructure assets. I would never bet against LUK but I have no idea what they're going to get into next, and at over 2x book I find them too expensive.

    SubjectRe: BAM vs. BRK
    Entry08/07/2007 04:16 PM
    Memberoscar1417
    I guess a lot of the same comments could apply to BRK. Attitudes about debt, centralized decision making, variety in asset classes, and size of management team are similar at BRK and LUK and different at BAM. Though BRK is not without leverage, considering its insurance operations, and debt in some subsidiary operations.
    It would not surprise me to see BRK and BAM competing on some deals, as infrastructure type assets both domestic and abroad would appeal to both of them. For instance I would think that BRK's MEC would love to have BAM's hydro power assets, and I could imagine BAM looking at PacifiCorp when it was available. Of course Buffett would be paying cash from retained earnings while BAM would be financing the deal with 7% debt.
    The main similarity between BAM and BRK is the focus on free cash flow (i.e. owner earnings) regardless of the accounting treatment, and the building of shareholder value by establishing numerous diverse streams of recurring, high-quality, growing free cash flow. Buffett does it with carpet and candy while BAM does it with hydro power and real estate, but I think it is the same concept.
    I think that BAM's international presence is an advantage over BRK, especially in the current market environment. BAM is just getting into Australia and is looking at Asia, and could be a lot more diversified geographically in a few years, which I find very appealing.
    One thing that LUK and BAM have in common different than BRK is the willingness to take simple actions to benefit shareholders such as buybacks, dividends, and spin-offs. I don't think you'll see tens of billions of surplus capital accumulate at either LUK or BAM.
    The downside of each of the three companies is interesting to compare. BRK's downside is probably minimal in almost any market event, the minimum conceivable fair value is probably still a premium to book. I think that LUK has to continually justify its premium to book, and it does, but that would seem to be a floor valuation if something went wrong or if the principals depart. BAM, at 3x book, might have more downside here, but the market value of many of their assets is far in excess of book value, so if the assets were marked to market, their premium to book would be much less. The floor valuation would probably be a liquidation value of their assets which is probably further down than BRK or LUK but not all the way to GAAP book value. But in all of these scenarios we're talking about a catastrophic impairment of huge amounts of assets or managers.
    BAM is probably focused more in areas that are susceptible to natural or man-made catastrophies than either BRK or LUK. I have to assume that they have decent insurance (including terrorism) given their infrastructure orientation, and this is probably a nonzero risk.
    Obviously with the leverage, if BAM somehow got upside down on a substantial portion of their assets, things could go sour quickly. This would seem to be more likely early on in an acquisition, so a large, bad acquisition with a lot of leverage could really hurt them. They have been swinging bigger as they've been getting bigger, so this is a potential risk.
    Enough rambling. Hope that answers your questions!

    SubjectCC transcript
    Entry08/08/2007 08:49 AM
    Memberoscar1417
    Here is a transcript of the last CC in which Flatt addresses concerns about credit and the debt markets.

    http://seekingalpha.com/article/43506

    SubjectSpin-off
    Entry08/08/2007 04:23 PM
    Memberdavid101
    Oscar,

    On the spin-off of the infrastructure assets, will BAM retain the GP? If so, what are the management and incentive fees?

    David

    SubjectRe: Spin-off
    Entry08/09/2007 09:57 AM
    Memberoscar1417
    Q: On the spin-off of the infrastructure assets, will BAM retain the GP? If so, what are the management and incentive fees?

    A: Here is a link to a diagram showing the ownership structure of the spin-off:
    http://www.sec.gov/Archives/edgar/data/1406234/000090956707000970/o36695exv12w1.htm#107
    I think BAM will have 100% of the GP and 40% of the LP. This is a fairly typical structure for them based on other deals.
    If you search lower in that document for "Infrastructure GP LP" you can get the full text of the incentive structure.
    It looks like they get a 1% fee for cash received in excess of costs up to a certain cash value per period, then above that there is an 85/15 split up to a second tier, then a 75/25 split above that. The dollar values on the tiers are not yet available.
    This too I believe is a fairly typical structure for them.

    Subjectre: comp
    Entry08/13/2007 07:10 PM
    Memberoscar1417
    Thank you for the questions. Of the names you mention, I'm most familiar with Macquarie.
    I have looked at the various vehicles from Macquarie and one thing I've never quite been able to do is understand the unit economics of each of their investments and see how they add up to provide the reported consolidated EBITDA and cash flows. This isn't to say that their cash flows are insufficient or that anything is amiss (as suggested by Chanos recently), but I just haven't been able to get from A to B. I find their financials to be very opaque, with lots of deals and partial ownerships and spin-offs, but the results reported at a high level, without the detail I need to get comfortable, but that might just be me.
    I do think that management should eagerly provide everything an investor needs to understand the investment, and I believe BAM does this in spades, they practically spoon feed analysts.
    In contrast to Macquarie, BAM is structured as a total return vehicle, not a high yield investment, and I think it can get dangerous to obligate yourself to a high dividend yield when the underlying business has a lot of transactions and variance (true of MREIT's, BDC's, MLP's, etc). I am more comfortable with BAM for that reason, they are a "retained earnings" vehicle and they have more discretion over what happens to their surplus capital because the dividend yield is only about 1.4%.
    Also, perhaps most importantly, the unit economics of each of BAM's deals are available, and you can put them together to see how the whole adds up to the sum of the parts. Let me post the unit economics of one of their deals in another message.
    Hope that addressed your questions. I am not that familiar with B&B, MFS, and Challenger. If you care to raise more specific questions about them I'm happy to give them a shot.

    Subjectre: 1985 to 1995
    Entry08/13/2007 07:28 PM
    Memberoscar1417
    The company has a long history going back decades. In the 80's and 90's they were involved in some lines of business that are present today, such as natural resources and power generation, and other lines of business that are either absent or insignificant today, such as merchant banking and brokerage. They had different management and a different focus, and a lot of that is probably just water under the bridge at this point.
    I would say that their success over the past ~7 years was a combination of superior leadership, focusing on shareholder value, and a few tail winds. It is important to mention that BAM's results over the past 10 years were not achieved in a difficult environment. The combination of low interest rates, relatively easy credit terms, boosts to their held assets, and solid deal flow has helped them. The long bull market for commodities also allowed them to unload some resource based assets and interests at very attractive prices, which gave them capital for new opportunities.
    That said, I think they made many deliberate changes that made a huge difference, and I attribute these to Bruce Flatt who formally took the reins in 2002. Focusing the organization on returns on equity and recurring cash flows helped to make sense of the hodge-podge of assets and helped them choose the ones that provided the most shareholder benefit, and embark on strategies such as the focus on management fees. This encouraged them to divest the "mines and forests" and focus instead on long-lived cash flow producing assets. They have also shown to be very savvy in buying assets when they were temporarily distressed (i.e. good price discipline). I've just been impressed with deal after deal from them, in an environment when I am sure that other entities are willing to pay more than they are.

    Subjectsample deal
    Entry08/13/2007 07:42 PM
    Memberoscar1417
    In mid-2006, BAM bought Transelec, which delivers electricity to approximately 99% of the Chilean population.
    The purchase price was $2.5 billion, which was financed with $1.0 billion of debt (about $600M assumed and $400M raised) and $1.5 billion in equity. BAM provided 30% of the equity, and raised the other 70% from their institutional investment partners.
    The asset produces about $195M of cash flow after cash costs such as debt but before non-cash costs such as depreciation. BAM manages the asset and charges a management fee which I estimate to be around 1% after cash expenses (similar to the terms of their infrastructure partnership). The cash flows are controlled a favorable rate regulatory environment, and BAM also gets regulated returns on invested capital for additional cap ex.
    The returns for the different stakeholders breaks down as follows. The debt holders are secured by secure, unique, long-lived, and appreciating asset financed at a reasonable debt/equity of about 0.67. Assuming the operating cash flow is split proportionately between the equity partners (i.e. 30/70 for BAM/others), BAM's equity partners get a cash return of around 11% (i.e. $136.5M of cash flow, minus ~$25M mangement fee, on an equity investment of $1.05B). BAM's 30% equity interest gets about 18% (i.e. $58.5M cash flow plus ~$25M in management fee on an equity investment of $450M). Meanwhile the cash flows from the asset should grow steadily according to inflation and population growth.
    There is some slop in these numbers, I'm guessing on a few items such as the exact management fee and break down of cash flows, but it adds up to a picture that makes sense. Each stake holder is getting a reasonable return, and BAM's ROE is squarely within their 15-25% target and seems sustainable. The equity partners get a reasonable return, and the asset was acquired for about 13x operating cash flow.
    Going forward, these terms may not be achievable, but overall none of the present terms strike me as unreasonable or unsustainable.

    Subjectre: comps
    Entry08/14/2007 10:13 AM
    Memberoscar1417
    The accounting on the infrastructure deals usually merits some examination. For example the financials of the Dulles Greenway (a toll road in the Virginia suburbs owned 50/50 by two Macquarie entities), are available. It shows that the toll road is not currently profitable nor cash flow positive, yet most of the financing is through zero coupon bonds. The bank bought the asset in 2005 and then sold 50% of it to the Macquarie Infrastructure Partners (MIP) in 2006, and there is not a lot of data on MIP available. Meanwhile Macquarie bank doesn't provide details of their unit economics of that deal.
    Not suggesting that anything fishy is going on, though a skeptical analyst could look at the non-cash accounting, lack of profitability and cash flows, and insider deal to a private entity and develop theories.
    This is where I believe BAM really stands out, by providing excellent transparency, and with deals that are pretty clearly oriented around recurring cash flows and not accounting gimmicks.

    SubjectUpdates
    Entry09/14/2007 10:57 AM
    Memberoscar1417
    I thought I'd post some updates for anyone still following this stock.
    BAM has a group of private equity and restructuring funds that are starting to represent a meaningful amount of its capital and income. The restructuring group is named Tricap. One of Tricap's funds (in which BAM has a 48% interest) participated in the restructuring and recapitalization of Stelco, Canada's largest steel maker, following a bankruptcy. Stelco was recently sold to US Steel for $38.50 per share, and Tricap's cost basis was reportedly about $6.00, representing a 6.4x return on investment in less than 2 years. Based on the success of this and other deals, they are launching the "Tricap II" fund, and are looking for $1 billion of institutional money:
    http://www.preqin.com/article.aspx?articleid=99
    I think this is interesting for those that think BAM is just about commercial real estate.
    BAM is anticipating spinning off the infrastructure partnership ("BIP") in "early to mid" October. We still don't have final terms on the deal, but I have some thoughts on the motivation for this deal.
    BAM is positioning themselves to attract large pools of institutional money, particularly in the US, and are creating vehicles that meet the requirements of those investors. The structure of BIP seems targeted towards these investors as a pure-play in certain infrastructure assets (primarily timber and electricity transmission). While the spin-off will not be accretive initially (since it basically involves moving assets at fair value into another entity), I believe this will allow them to attract larger pools of money. This is consistent with their other "pure play partially owned public entity" holdings in BPO and BHS.
    BAM's assets under management was around $77 billion in Q2 and will be around $83 billion after Multiplex closes. However, around half of these assets are directly held or are low-fee specialty funds. BAM is clearly looking to increase their asset base to include assets from which they can derive more fees.
    I think BAM is extremely well positioned to take advantage of the current turmoil in the credit markets. They have ample liquidity, fresh capital, and excellent deal flow in many areas.

    SubjectMore updates
    Entry09/26/2007 12:49 PM
    Memberoscar1417
    The stock is up around 21% since the write-up, but I believe this is the beginning of a long and happy story for BAM longs. I think the recent price increase is primarily due to the smoke clearing around the credit crunch as investors realize that BAM's exposure was not tremendous. The stock is still very cheap in light of likely future improvements in its business.
    BAM gave an investor presentation on Sept 20, and the slides make for interesting reading:
    http://www.brookfield.com/investorcenter/investorpresentations/resources/BAM_NY_Investor_Day_2007.pdf
    They lay out their 5-year strategic plan. The slides are brief and make for easy reading, but I'll provide some comments.
    One important thing that has changed for BAM over the past 5 years is that they now have audited track records in many asset categories, whereas before they did not. BAM has its roots in commercial real estate and has entered the asset management game on a large scale fairly recently. Professional asset managers here on VIC will recognize an audited track record as one of the most important milestones to reach in terms of attracting assets to manage, and typically allows an asset manager to enter the major leagues. This in combination with entities geared specifically to attract large pools of capital such as the pending infrastructure partnership spin-off helps us understand how BAM is going to meet their AUM goals.
    The presentation shows a current $28 billion of third-party equity AUM, and goals for increasing this to $100 billion within 5 years, which includes converting $20 billion of currently held assets into third party equity. There is also a goal of achieving fees of 1.5% on these assets, or a management fee income stream of $1.2 billion. This figure is close to $90 million today, so this represents more than 13x growth in 5 years. While this seems to be a lofty goal, I believe BAM is very well positioned to achieve this goal and they break down their strategy in detail.
    The presentation also shows that BAM intends to invest their own ~$20B of equity to achieve another $2.8B of cash flows, a cash ROE of 14%, way below their recent 5 year average of 37%. This in combination with the $1.2B of management fees adds up to $4B of annualized cash flows in 5 years. This excludes what they call "NAV creation", which is appreciation and back-end cash flows such as from exits and refinancings. You can apply what multiple you wish to this $4B cash flow figure (BAM suggests a range of 10-25x and they are current at around 11x), but this adds up to 5 year returns that range from good to spectacular for BAM equity holders.

    Subjectupdates
    Entry12/04/2007 10:52 AM
    Memberoscar1417
    Some updates for anyone following this.
    BAM's Q3 report showed fairly weak results across many units, but I believe the results are largely explained by cyclical weaknesses, not the dramatic impairments that many expected. The worst impairment was a "residential land provision" of $42M, associated with writing down some US residential real estate land in connection with their luxury home builder operations (BHS) which of course are sucking wind. But aside from that, there were no impairments from the assorted sources that we've seen in other companies -- sub-prime loans, CDO's, CMBS, mark to market impairments, etc. So far it looks like my thesis is reaffirmed that BAM, as a direct owner and manager of hard assets, simply doesn't have a lot of exposure there.
    Power operations were impacted by abnormally low hydro conditions during the Q. Other hydro operators reported similar results, and those of us who live in the NE US know that we had near-drought conditions during Q3. The year-ago quarter had unusually high hydro conditions, making the year-over-year comparison a bit skewed. These results are very lumpy in the short term but very reliable and very long tail. I'm very excited about the power generation segment.
    On Nov. 30, Brookfield Power completed the financing for Prince Wind, the largest operating wind farm in Canada. Wind power is relatively new for Brookfield Power which is currently primarily in hydro, and provides another area for growth. Financing wind power projects is often difficult because of the irregular power production. BAM figured out a way to fix the financing for 5 years and sell the power in 19-21 year contracts.
    Through Brookfield Power, BAM is clearly creating a diversified pure-play in renewable power, which is particularly attractive in the current political climate. Following their strategy of building and spinning off pure plays in various asset classes, I expect this to be spun off in subsequent years. Assets in Brookfield Power are around $5 billion and they've stated a goal of building this up to $10 billion.
    On Oct 31, BAM exited their Stelco investment (mentioned here earlier) for a pre-tax gain of about $250M during Q4. Also on Oct 31, they monetized their interest in the Brazilian stock exchange (the "Bovespa"), which IPO'ed and provided about $160M of proceeds. During Q3, BPO (the commercial property subsidiary) refinanced one of their premier properties (One Liberty Plaza) and was able to realize about $240M of cash from the property. Their ability to close a major refi during the darkest days of the credit markets demonstrates their strong access to capital. These three transactions alone raised $650M of fresh capital, giving them dry powder during this time when opportunities are rife. They ended the quarter with about $2 billion of liquidity and their operations should produce something like $250M of free cash flow per quarter. I am sure they are busy making deals in this environment of higher spreads, constrained capital, and widespread distress and panic.
    Fraser Papers is a small pulp, paper, and timber operation that has been crushed by not only weak market conditions but very unfavorable US/CDN exchange rates. Their Q3 was the worst reported quarter by any company that I've ever seen that was not actually in bankruptcy. BAM bought more of Fraser equity to bring their ownership up to 56% and has consolidated Fraser on their own financials. Fraser recently announced a rights offering to raise capital (at 30% of book value) to pay down debt. This looks to be a disaster so far, but it is a small part of BAM's capital base and they obviously seem intent on supporting the entity until the cycle turns.
    On Nov. 19, BAM announced the acquisition of KG Redding, "an investment manager of North American and global real estate securities with more than $6 billion in assets under management, for consideration including $80 million cash and Class A limited voting shares of Brookfield and potential contingent consideration based upon future performance." BAM has a stated goal of bringing their assets under management up to $100 billion within 5 years, and this helps them move toward that goal. Offhand, paying 1.3% of AUM sounds like a pretty decent price, and demonstrates BAM's ability to make deals during terrible market conditions.
    Overall I'm very pleased with how things are progressing despite the volatile stock price. I think 2008 will be very interesting to watch.
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