In 2012 we estimated Brookfield Infrastructure Partners (NYSE:BIP) [Source] would be $40-46/unit (share) in a 3-5 year time frame. The investment thesis is playing out and BIP has reached the lower end of the range a little early for a total return of 43% or about 16%/year. While investors may consider selling to lock in these returns, the company continues to perform well and in the updated thesis below we think there is more to come.
Brookfield Infrastructure Partners is an owner and operator of real assets known as infrastructure assets. An early mover, they established a preeminent position in infrastructure assets that serve as the foundation for the delivery of goods and services necessary to support the global economy. The demand for these assets tend to be relatively predictable, sustainable and inelastic as they help deliver the essentials needed by the economy. They are often long life, require relatively low maintenance capital, tend to appreciate in value over time and many enjoy varying degrees of barriers to entry.
Brookfield Infrastructure Valuation Summary:
The company has a significantly larger footprint of assets than it did a couple of years ago, many with strong organic growth prospects. Facing solid demand around the world, BIP and its industry retains attractive investment characteristics including: relatively inelastic demand for essential services; often protective moats; and stable cash flows. In BIP’s case, cash flow is about 90% regulated or contracted, 70% indexed to inflation, and 60% with no volume risk supporting the valuation update.
The interim case explained below shows an attractive 94% return may be realized in the 5 year investment horizon for a potential average annual return of about 19%. While we wait for the share price appreciation we’ll receive a growing distribution currently yielding about 4.7%/year on today’s price of $41/share and enjoy a 25% margin of safety.
BIP was spun out of Brookfield Asset Management (NYSE:BAM) in early 2008 and they continue to own 30% of the company. At the time of the spinoff the company consisted of electricity transmission assets in Chile, North America, and Brazil, and standing timber assets in Western Canada and United States. Through a combination of acquisitions, mergers, recapitalizations and organic growth the company has grown significantly now owning and operating assets in three major groups.
Brookfield Infrastructure’s funds from operation (FFO), a measure of cash flow, and consolidated total assets, assets under its control, quantifies this growth. The asset decline in 2013 was due to the opportunistic sale of the timberland business as part of their ongoing capital recycling program.
The growing, diversified and stable cash flows continue to pay a high and rising distribution. Annualized total returns for the one, three and five year periods ending June, 2014 were 19%, 23% and 34% respectively surpassing their total return performance target of 12-15%/year.
Infrastructure Assets have Attractive Investment Characteristics
Infrastructure is a class of real assets that provide many desirable investment characteristics including:
- Assets costly to construct with long lives providing a vital service.
- Demand tends to be inelastic given the scarcity of the resources being offered.
- Monopolistic pricing power often regulated with long term stable cash flows.
- A mix of both fixed income like cash flows with potential capital gains.
- Assets that tend to appreciate or can be expanded; allowing for value to grow over time.
- Investments range from low-risk regulated assets to moderate risk loosely regulated assets.
- Varying amounts of inflation and volume protection with varied levels of vulnerability to economic cycles.
Infrastructure Asset Spending Increases
Globally, infrastructure assets provide essential products and services for modern economies. Examples include: midstream oil and gas, power generation and transmission, water supplies and treatment, rail, roads, bridges, tunnels, ports and airports. Global population and economic growth with a growing middle class is increasing demand for infrastructure. Current estimates of global infrastructure spending range considerably; a survey of 300 senior infrastructure professionals showed infrastructure investments will be between $34 and $60 trillion through 2030 according to Infrastructure Investor [Source].
In a White Paper, Real Assets-The New Essential [Source], Brookfield Asset Management notes:
Importantly, as demand for Real Assets continues to rise, the supply of Real Asset investment opportunities is expected to expand as well. Global population growth and increasing urbanization around the world are leading to rising demand for new development. When combined with the overdue refurbishment or modernization of existing assets in many mature markets, a significant need for capital has become apparent. Recent estimates indicate that this need may total as much as $55 trillion through 2030 in the infrastructure asset class alone. Over the same time period, an analysis of global property markets reveals that over $15 trillion will need to be spent in order to simply maintain existing ratios of property investment relative to Gross Domestic. Given the current strain on government balance sheets around the world, public financing will not be able to subsidize this $70 trillion price tag alone, creating a significant opportunity for the investment of private capital.
You are encouraged to read “The New Essential” in its entirety as it provides thoughtful insights into the merits of real assets investments. These estimates will be revised as the story unfolds, however, even with a large margin for error; the magnitude of these numbers make a compelling case for the growth potential.
Organic Growth Opportunities
Complementing these external growth dynamics is Brookfield Infrastructure’s increased presence and as both an owner and operator it provides a growing slate of organic growth projects. Incremental investment economics are often more attractive because they expand from existing facilities, with local market knowledge and corporate and operational support already in place. This larger footprint will likely continue to create more opportunity for internal growth as existing capabilities become increasingly important. As an example, BIP’s pipeline of organic growth projects currently stands at about $1.2 billion up from $700 million a year ago:
Markets and companies routinely go through cycles and BIP’s value orientation causes it to become more acquisition focused during economic downturns and times of market stress. Their international presence enables them to go where the bargains are and to buy high quality assets that are available at reasonable or distressed prices supporting strong returns for shareholders.
Market Diversification Advantage
During more competitive times, as now in North America, infrastructure assets are getting attention as an attractive asset class. New market entrants with lower return expectations compete for assets driving up prices. The use of leverage and valuation multiples to justify mergers and acquisitions are approaching pre-crises levels and the valuation levels of infrastructure assets are further inflated by historically low interest rates. This reduces infrastructure investment opportunities in North America for the value oriented.
Brookfield companies have operations in 25 countries enabling their investment and operating professionals to redeploy when and where the opportunities occur around the World. The developed markets are now flush with cash but emerging markets (Brazil, China, India) lack capital as investors flee during the downturns. In Brazil for example, where Brookfield has a long operating history, BIP acquired a rail and port businesses recently, and increased ownership in the toll road business as other investors moved on.
BIP’s larger footprint, affiliation with Brookfield Asset Management, and on the ground presence in many markets enable it to take on a larger slate of prospects than many. And if successful, even fewer have the resources to finance multiple projects that may come to fruition.
For example, in Europe the focus is now on deleveraging by governments and financial institutions selling infrastructure assets to recapitalize or focus on their core operations. As BIP was developing the rail, ports and toll roads in South American they were also negotiating for assets in Europe. BIP just announced it would acquire a 50% interest in a portfolio of 6,700 telecommunications towers in France for $2.2 billion. These towers are essential infrastructure for broadcasters and telecom companies.
The scale and scope of the larger diversified footprint gives BIP more levers at their disposal to drive future growth. In addition to originating new opportunistic investments as an investor, as an operator, BIP has insights to enhance the cash flow resulting in a substantial pipeline of organic growth projects typically with higher returns and lower risk. The operations background also provides this insight into the organic growth potential in assets under consideration for acquisition.
Stable Cash Flows
Macroeconomic trends can affect business operations but the impact tends to be relatively muted in Infrastructure Because of the long-term, contractual nature of the underlying revenue streams where cash flow growth can then be achieved across market cycles. Using publicly listed companies as a proxy for real asset performance the relative stability of the underlying asset cash flows is shown below.
Brookfield Asset Management: Real Assets-The New Essential [Source]
Diversified Cash Flows
Current distribution yield is supported by stable cash flows and diversification by segment and geography.
BIP’s policy is to pay a sustainable distribution while retaining sufficient liquidity to fund recurring growth capital expenditures. A payout ratio of 60% to 70% of FFO and annual distribution growth of 5-9% is targeted over the long term. Accordingly, if FFO continues to grow so should the distribution to shareholders. This is seen in past distribution increases, at times well above the target.
Shareholder Friendly Management
The directors and executives of Brookfield own roughly 20% of the parent company, Brookfield Asset Management, and the parent company owns 30% of Brookfield Infrastructure so their financial interests are aligned with ours. Key measures of shareholder friendly management include consistency and transparency. Consistency is reflected in BIP’s long term investment horizon and transparency in the supplemental disclosures and analysis routinely provided during quarterly earnings releases and management presentations. From my experience management provides a refreshing dose of openness, honesty and humility.
Brookfield Infrastructure is a limited partnership and its parent company, Brookfield Asset Management, is the general partner and the manager of the Infrastructure partnership. It owns a 30% equity interest. The partnership relies on BAM to provide day to day management and administrative services. BAM receives a base management fee of 1.25% of the market capitalization of BIP annually. It is also is entitled to receive incentive distributions based on the amount that quarterly distributions per share of the Infrastructure partnership exceed thresholds. BAM is entitled to 15% of distributions between $0.305 and $0.330 per share per quarter, and 25% of distributions above $0.33 per quarter. So the parent is incentivized to grow BIP and increase its distributions.
Some investors avoid Master Limited Partnerships (NYSE:MLP) in the U.S. because U.S. MLPs can become complicated with state income tax filing requirements and concerns with the Unrelated Business Taxable Income (UBTI) issues. Brookfield Infrastructure states it is committed to structuring its operation to avoid generating UBTI and the table below demonstrates the favorable structure of BIP relative to MLPs:
[Source] BIP Corporate Profile
The historically low interest rates are beginning to rise and the U.S. Federal Reserve has tapered asset purchases. Studies show that asset classes that produce both capital growth potential and attractive yields typically perform relatively well in a rising rate environment. Investors looking for longer term protection to rising interest rates and inflation should consider infrastructure and other real assets due to their inflation hedging properties and low historical correlation to financial assets.
Real assets are defined as physical or tangible assets that tend to provide a “real return” when linked to inflation. This wide range of investments, include real estate, infrastructure, timberlands, agriculture lands, commodities, precious metals and natural resources.
Benjamin Graham, the father of value investing, addresses this issue to some extent in his book, “The Intelligent Investor” with the following (bolding added for emphasis):
Where prime emphasis is not placed on growth the stock is rated as an ‘income issue,’ and the dividend rate retains its long-held importance as the prime determinant of market price. At the other extreme, stocks clearly recognized to be in the rapid-growth category are valued primarily in terms of the expected growth rate over, say, the next decade, and the cash-dividend rate is more or less left out of the reckoning.
It is our belief that shareholders should demand of their managements either a normal payout of earnings-on the order, say, of two-thirds-or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings. Such a demonstration could ordinarily be made in the case of a recognized growth company.
In the case of Brookfield Infrastructure we are fortunate to have both an income and growth component and management’s policy is already a payout of about two-thirds. The dividend is supported by a sustainable competitive positions with almost 90% of the cash flow regulated or generated under long term contracts. Further, as many of the assets capture inflation through indexation mechanisms the compounding effect on cash flows should continue. Although BIP may still be in the early stages of growth the distribution policy and history provides a reasonable valuation basis.
In recent presentations management shows the 5-9% distribution growth target was achievable relying on internally generated organic growth projects increasing FFO through inflation indexation, available surplus capacity and reinvested cash flows as shown in this graph. New investments, if they were to occur, could be considered upside.
FFO organic growth over the past five years was 15% per year and in 2014 it was 12% while management is targeting 10% over the long term. Although below past performance the 10% seems reasonable given the larger size of the company.
BIP’s total return will be realized from both the distribution payments and as the distribution increases occur a corresponding share price appreciation. Assuming 10% FFO annual growth and mid-range distribution growth target of 7% three terminal yield cases were used to determine the implied share price at the end of the 5 year investment period.
Base Case (4.8% annual yield): Represents BIP’s average past two year yield and assumes it remains constant.
Peer Yield Case (3.8% annual yield): Represents the average yield of BIP’s 25 member diversified utilities peer group as presented by Morningstar and assumes overtime BIP’s performance will become more well-known and it will eventually enjoy a similar yield profile as its peer group.
The Interim Case (4.3% Yield): The average of the base yield and peer yield cases assuming over time BIP will command a yield structure closer to its peer group.
Valuation Discounted @ 8%:
In the five year Interim Case, BIP shows attractive total returns of about 19% per year, a $68/share price to be realized in the 5 year investment horizon while we get paid cumulative distributions of almost $12 waiting for the appreciation. The distribution increases will provide an approximate 6.7% yield in 5 years on our cost today of $41.00/share. Applying a 25% margin of safety yields an attractive entry price at about $41.00/share.
Reasons to Consider this Investment:
The market environment continues to present challenges as investors seek alternatives to improve returns while minimizing volatility and risk. Institutional investors are turning to real assets as an option that can provide attractive yield, stability and growth through market cycles and macroeconomic volatility. Brookfield Infrastructure provides the individual investor an opportunity to invest in these assets alongside some of the savviest investors in the world. BIP should be considered for investment because:
- BIP owns and operates infrastructure assets with favorable investment characteristics including; stable cash flows; barriers to entry, providing necessary goods and services needed by the global economy. These real assets provide geographic and sector diversification.
- It can be considered a hedge against inflation. If inflation increases, BIP’s hard asset base and inflation indexed pricing provide some investor protection against a decline in the purchasing power of the dollar.
- If repression is used to “manage” government debt by keeping interest rates low longer term; BIP’s current 4.7%/year and growing yield and the potential for growth and capital appreciation is very attractive compared to many alternatives for those wanting long term real returns.
- Demand for infrastructure assets is expected to grow to meet global population and middle class growth. Increasing urbanization around the world and overdue modernization in many mature markets adds to this significant need for capital.
- Institutional investors are becoming increasingly aware of real assets as they are viewed as a compelling alternative to traditional fixed income and equities. BIP is an opportunity for the individual investor to invest in infrastructure assets an opportunity typically not accessible; and under the oversight of an outstanding management team.
- Brookfield Infrastructures growth over the past five years from $6 billion in total consolidated assets to $16 billion and 29% annualized total return attests to management’s capital allocation skills.
- BIP larger footprint, affiliation with Brookfield Asset Management, and on the ground presence in many markets enable it to take on a larger slate of prospects than many.
- Over the years external growth appears to be a significant opportunity but no credit is taken; credit is taken only for internally generated organic growth in this valuation. The external growth can be considered potential upside or an addition to our margin of safety.
- The distribution increase target is 5-9% per year funded primarily from organic growth opportunities. We get paid a nice yield, currently 4.7% per year, to watch this growth story unfold.
- It is likely that the BIP share price will respond negatively to a rising interest rate cycle. High yield and growth investments tend to fare better in a rising rate environment however, and the future distribution growth could help insulate the company from interest rate risk longer term.
- BIP’s ability to support distribution increases is dependent on growth. The risk is mitigated with $1.2 billion of identified organic growth projects, new acquisitions and a strong forecasted industry growth but it requires access to favorable capital markets for finance and equity issuance.
- BIP offers investors limited volatility through stable cash flows characteristic of infrastructure’s toll road business model. However, a decline in economic activity overtime could result in reduced cash flow growth. Although a risk, it is not believed to be material and further offset by BIP’s diversification and ability to refocus on favorable sectors and geographies.
- BIP’s current growth opportunities appear strongest in emerging markets where social or political risk may be relatively high. This is offset somewhat because the bulk of their emerging investments are located in Brazil where they have over 100 years of operating history.
- BIP assets are subject to various regulatory reviews in a number of jurisdictions, any of which could result in cash flow reductions and other adverse changes. This is offset somewhat in that they provide infrastructure supporting the basic needs of economic development.
- As a global company BIP is exposed to foreign exchange risk, interest rate risk, global economic conditions and other material impacts that could adversely affect the business.
- Brookfield Asset Management is the general partner of BIP providing services for a fee subject to contractual rights but not fiduciary rights. However BIP is 30% owned by BAM and material to that business.
Brookfield Infrastructure is creating a unique opportunity for individual investors to invest in real assets with strong growth prospects under the guidance of an outstanding management team with a proven track record. Over the next five years BIP shows attractive total returns of about 19% per year, a $68/share price to be realized in the 5 year investment horizon while we get paid cumulative distributions of almost $12/share waiting for the appreciation.
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