BIP - Brookfield: Complex But Worth It

2023-09-19 02:48:08 ET

Summary

• Brookfield stock has historically delivered strong returns, with a 3,000% gain since 2000.
• The perceived complexity of Brookfield's structure is sometimes overstated. The company looks confusing at first glance, but some of the complexity disappears when you read up on it further.
• BN's hard-to-follow accounting comes from GAAP accounting requirements, not management's own choices.
• Rising interest rates pose a risk to Brookfield's earnings, but overall it is a strong company with valuable assets.

There are few value stocks out there as beloved as Brookfield ( BN )( BN:CA ). The company has legions of loyal fans, among whom the phrase " in Flatt we trust " (referring to CEO Bruce Flatt) is often uttered. Historically, BN has delivered the results needed to earn its reputation. Since 2000, the stock and its predecessor have risen 2,865% , a market-beating return by any standard. Factoring in reinvested dividends, the shareholders have seen a 3,000% return.

Granted, really parsing out Brookfield's returns is complicated, as the current company is not identical to its predecessor. Previously, both Brookfield and Brookfield Asset Management ( BAM )( BAM:CA ) traded as "Brookfield Asset Management," the name of the smaller successor company. "Brookfield" is the former "Brookfield Asset Management" minus a 25% stake in the asset manager, which is now publicly traded as BAM.

Many investors are aware of Bruce Flatt and his stellar track record at BN, but are hesitant to invest because of Brookfield's perceived complexity. The company owns a number of subsidiaries that are also publicly traded entities in their own right. This tends to cause confusion because Brookfield's ownership in its publicly traded entities gets mixed with the other investors' ownership in Brookfield's financial statements. Thanks to GAAP accounting rules, companies report earnings from 50% to 99%-owned subsidiaries in a peculiar way that isn't exactly intuitive. In a later section of this article I'll explain these GAAP rules in detail to demonstrate that Brookfield's ownership structure is not actually that complicated, but the rules required to account for it are.

There are two basic things you need to know in order to understand the Brookfield Empire:

1. The ownership structure. What percentage of Brookfield's publicly traded entities are owned by Brookfield, and what percentage are owned by other investors.

2. The accounting rules that Brookfield is subject to. These rules determine how much earnings and balance sheet assets Brookfield has to report. As we will see momentarily, the rules are fairly complex, resulting in some of the confusion people report when reading Brookfield's financial statements.

The perception that Brookfield is overly complex or confusing is understandable. The company does have a relatively complex structure, and its accounting is hard to understand. However, these points are not really a dig against Brookfield, as the structure is not as complex as it looks at first glance, and the complicated accounting isn't a deliberate choice by management to obfuscate. For these reasons, I do not consider Brookfield's structure or accounting choices to be meaningful risk factors.

When I last wrote about Brookfield, I rated it a weak 'buy' because it was cheap though in the midst of a series of defaults . Since then, Brookfield put out an earnings release that beat expectations on revenue and adjusted EPS, and has ceased defaulting on properties. So, the main risk factor (i.e. defaults) and the earnings performance have both improved. For this reason I'm upgrading my rating to 'strong buy.'

The Most Recent Quarter

Before looking at Brookfield's overall structure, we should look at its most recent earnings release. This will give us an idea of how the company is doing today.

In the second quarter, Brookfield delivered :

• $23.67 billion in revenue, up 1.7%. This figure beat analyst expectations.
• $1.5 billion in GAAP net income.
• $0.03 in GAAP diluted EPS, down 91%. This figure missed analyst expectations.
• $0.75 in distributable earnings per share. This figure beat analyst expectations.
• $50 billion invested in new deals in the first half of the year.

On the whole, the earnings performance was satisfactory. The big decline in net income was disappointing, but distributable earnings were more than adequate the cover the company's dividend. The release did show a fairly large increase in interest expenses, some of it coming from higher rates on variable rate debt. This item was less flattering than some of the other metrics in the release, as it suggested that Brookfield's interest expenses will increase if the Fed keeps hiking interest rates. With oil prices on the rise, it's possible that the Fed will hike again. If it does so then higher interest expenses will take a bite out of Brookfield's earnings.

Brookfield's Structure

Many investors find Brookfield's corporate structure to be overly complex. First, you have Brookfield itself, which is a publicly traded company. Then, you have Brookfield Asset Management, which BN owns 75% of. Finally, you have all the other listed entities, which Brookfield Asset Management runs and partially owns. Examples of these include Brookfield Infrastructure Partners ( BIP ) and Brookfield Renewable Partners ( BEP ).

The basic structure looks like this:

• On top, you have Brookfield, a holding company.

• Below that, you have several operating subsidiaries in real estate, insurance and asset management. Brookfield Property Group and Brookfield Insurance are wholly owned by Brookfield, Brookfield Asset Management is 75% owned by Brookfield. Note that Brookfield Property Group is not the totality of Brookfield's real estate ventures. Some of them, such as Brookfield REIT, are publicly traded and not wholly owned by Brookfield.

• One level down from that you have various listed entities like BIP and BEP. These are partially owned by Brookfield Asset Management, which is in turn 75% owned by Brookfield. For example, we can see in Brookfield's most recent 13F that it has 8.6% of its portfolio in BEP. The stake rises to 48% when you include BAM's holdings.

While this might "sound" like a complex structure when you read about it, it's in fact basically a two level structure. On top, you have Brookfield. A level below that, you have the operating businesses, Brookfield Asset Management, and investments in other Brookfield listed entities. Brookfield Asset Management itself invests in the listed entities, so you could perhaps say they are one level down from BAM, giving BN a three level structure, but on the other hand Brookfield directly invests in them as well. I wouldn't count the listed partnerships as a third level in Brookfield's corporate structure, because they are simply minority equity stakes, they are not a layer of bureaucracy at Brookfield. So, to put it as simply as possible: Brookfield consists of a holding company at the top, and various wholly or partially owned businesses a level down from it. It's not that 'complex' a company when viewed in that light.

Accounting

Next up, we have Brookfield's accounting-another aspect of the company that some have described as 'complex.' Brookfield's financial statements are definitely complicated but, as we'll see, this situation is due to what the Financial Accounting Standards Board ("FASB") requires companies to report, not Brookfield's own choices.

Brookfield reports earnings by U.S. GAAP accounting standards. This means that it has to report subsidiary earnings in keeping with the FASB's rules. This is not a problem for small stock holdings or 100% owned subsidiaries-the former is reported in terms of how the stock performed, the latter's numbers are simply added to those of the parent. Companies that are 50% to 99% owned, on the other hand, are reported in a somewhat counterintuitive way-this is where Brookfield's accounting complexity comes from.

When a company owns more than 50% of another one, it's considered a " business combination ," and the subsidiary's entire earnings are reported on the parent's income statement. This is the case even if the parent's ownership interest is less than 100%. When a company owns between 50% and 99% of another company, the subsidiary's earnings are initially shown as if they were wholly attributable to the parent. Further down the income statement, we get a figure known as "non-controlling interests," which tells us how much of the subsidiary's earnings the parent does not own. Finally, we get to "net income attributable to common shareholders" and "earnings per share,"--these figures subtract the minority interests. So, to figure out what Brookfield owns or earns, you simply need to look at the financial statement line items that come below "non-controlling interests." This will tell you what is attributable to you, the shareholder.

Brookfield: Valuation

Having established what Brookfield does and doesn't own/earn, we can now move on to valuing the business. We can use Seeking Alpha's figures for the GAAP P/E ratio, price/sales ratio and price/book ratio, as these come from GAAP numbers that are not contentious. According to Seeking Alpha Quant, Brookfield trades at :

• 377 times GAAP earnings.

• 0.59 times sales.

• 1.12 times book value.

• 8.6 times operating cash flow.

The GAAP P/E ratio is very high, due to a large increase in interest expense and non-controlling interests taking a bite out of the earnings attributable to common shareholders last quarter. Should the investments that Brookfield borrowed money for work out, then the earnings will turn around and the P/E ratio will come down.

A more complex matter is distributable earnings. This one is non-GAAP; the figure came in at the following levels over the last 12 months:

• Q2: $1.2 billion.

• Q1: $945 million.

• Q4 2022: $1.17 billion.

• Q3 2022: $1.2 billion.

• TTM: $4.5 billion.

Brookfield had 1.578 billion shares outstanding at the end of Q2, giving us $2.86 in DE per share. The P/E ratio based on that measure of earnings is 12.6-not super high. Brookfield clarifies in a press release that DE is "distributable" to common shareholders, so it looks like this metric accounts for the effects of minority interests. Therefore, it is a reasonable earnings metric to use.

The Big Risk to Keep in Mind

As we've seen, Brookfield's corporate structure is fairly complex, but not unreasonably so. It has basically a two-level corporate structure and its apparently complex accounting is simply a result of the FASB having tricky standards for consolidation. Taking these factors into account, we can fairly use DE as a substitute for GAAP earnings in Brookfield's earnings, and when we do so, we find the stock to be fairly cheap.

So far so good. Brookfield is cheap, and is a good business. That's pretty enticing, but there is a big risk for investors to keep an eye on:

Rising interest rates.

Higher rates on variable rate debt took a big bite out of Brookfield's earnings last quarter. In the quarter, interest expenses increased by $1.4 billion, contributing to a large year over year decline in net income. Part of the increase was due to new borrowings, but much of it was simply due to higher interest rates on variable rate debt. If the Federal Reserve and Bank of Canada continue hiking interest rates, then these interest expenses will only go higher. So, Brookfield investors will want to keep an eye on monetary policy in the months ahead.

Nevertheless, Brookfield is a strong company overall. It has a fast-growing insurance business, a valuable property portfolio, and a well-established asset management business with sky-high margins . Given that it trades at just 12.59 times distributable earnings, the stock appears worth the investment.

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