TRTN - Brookfield Infrastructure: An Opportunity Is Available

2023-09-22 14:02:41 ET

Summary

• The stock of Brookfield Infrastructure Partners has remained stable over the past six months, but has become slightly more attractive with two additional reported quarters.
• At its current price, BIP promises ~5% yield plus ~6% growth for a total of 11% return.
• Selling BIP $30 March 15, 2024, puts represents, arguably, the most attractive opportunity.

Half a year ago, I published "Brookfield Infrastructure: Checking Numbers Before Rushing In" ("previous article"), in which I recommended holding the stock despite it being seemingly inexpensive.

The stock is trading precisely at the same level as half a year ago. However, with two additional reported quarters, it has become slightly more attractive. Moreover, selling Brookfield Infrastructure Partners ( BIP ) puts represents an additional and, arguably, the most attractive, opportunity.

For convenience, I will be talking primarily about BIP, but every point, except those related to options, will also relate to Brookfield Infrastructure Corporation ( BIPC ). Economically, partnership BIP and corporation BIPC are equivalent. They enjoy identical distributions and a BIPC share is exchangeable to a BIP unit. However, due to different taxation, many investors prefer BIPC, which trades persistently higher than BIP.

How to think about BIP

In the previous article, I provided a company's brief description and will not repeat it here. Nonetheless, I have to revisit a couple of facts to make this post easier to understand.

BIP exists mostly to benefit Brookfield Corporation ( BN ) and Brookfield Asset Management ( BAM ). They harvest rich cash flows primarily in the form of management fees and incentive distributions. Due to the direct holding of BIP units, BN also receives regular distributions on par with retail investors.

In this regard, BIP is similar to other BN subsidiaries such as Brookfield Property Group ("BPG"), former ( BPY ), Brookfield Business Partners ( BBU ) ( BBUC ), and Brookfield Renewable Partners ( BEP ) ( BEPC ). In the bizarre world of Brookfield, the more successful a subsidiary is the less of it BN owns. You can check it yourself: BN owns all of BPG, about two-thirds of BBU, close to one-half of BEP, and less than a third of BIP (if you count BIP and BIPC combined, it will be noticeably less).

This may seem paradoxical only for those who are not familiar with Brookfield. Others understand that successful subsidiaries can allow attractive replacement of Brookfield's capital with third-party capital. Since both management fees and incentive distributions are not dependent on who owns units, this replacement makes BN's ROE higher.

So, if you want to hold one of Brookfield's subsidiaries for the long term, your best chance is to stick with BIP.

The best metric of BIP's performance is AFFO which measures cash generation. Almost all of it (~90%+) is paid out in incentive distributions, preferred distributions, and regular distributions. Since retail investors get only regular distributions, BIP's yield is quite good for valuing the company.

During the last several years, BIP has bumped its distributions at 6% per year starting in Q1. In the previous article, I explained that this trend is likely to continue though I would not exclude a 7% bump in 2024.

From the last two paragraphs, it follows that BIP becomes attractive when its yield is at least 5%. Bought at this yield, the stock promises 11% of total return (5% in yield plus 6% in appreciation) and can potentially beat the index with its 10% return.

The stock is now trading at ~4.8% yield ($1.53 in annual distributions for 2023 divided by $31.74 at the time of writing). In 2024, its distribution is expected to become 1.53*1.06 ~ $1.62 with a forward yield of ~5.1%. It exceeds our threshold but not convincingly so. A better margin of safety is highly wanted.

Two recent quarters

Q1 and Q2 reported since my previous publication were quite successful though one particularly promising milestone had not been reached.

How do we know they were successful? The company reported an ROIC of 13% for the first six months which is the best it can do (I will not go into details of how BIP measures its ROIC here as it is covered in the previous article). Historically, BIP's ROIC has been in the 11-13% range (14% was reported for a single quarter as far as I remember).

BIP reached this ROIC despite a certain setback with its HPC (Heartland Petrochemical Complex) project. For those who are not familiar with the project, HPC is expected to produce 525,000 tonnes per year of polypropylene in Canada. Most of the production will be sold through long-term contracts (similar to "take or pay" contracts for pipelines) which guarantees high profits and low risks. This is a huge thing that at this point ties up a lot of BIP's capital without generating any AFFO. Here is what the company reported about the project in its Q2 Letter to unitholders:

At HPC, we completed repairs at the propane dehydrogenation ("PDH") facility that resulted in the temporary shutdown of the entire complex for much of the quarter. During the repair period, we accelerated planned maintenance to take advantage of the downtime. Prior to the outage, both the PDH and Polypropylene facilities achieved nameplate capacity for sustained periods. Valuable operational learnings have been considered in the subsequent ramp-up, which took place in July, and the complex is achieving high operating capacity. Looking ahead, the third quarter is anticipated to partially contribute to results, while the fourth quarter is expected to provide full run-rate contribution

In short, the company expects HPC to function at full capacity in Q4 and this is the reason why I think BIP may increase its distribution in 2024 by more than its standard 6%.

Selling puts

I am not an options trader and sell puts only when four conditions are met: 1) If a put expires without being executed, my pretax annualized return for a cash-secured put should be at least 15% (i.e. in line with 10% on the after-tax basis); 2) The business should be of high quality to hold the stock for at least 5 years if a put is executed; 3) Under the latter scenario, my entry point must be attractive enough to account for the margin of safety; 4) The acquired stock should be high-yielding to start delivering immediately regardless of what is going on with the stock market.

The most attractive BIP put is $30 March 15, 2024. It is currently trading at $1.50 with half a year before expiration. For options, I am using only a low-cost Interactive Brokers account that allows selling puts on margin. I.e. you do not have to reserve cash for a potential stock purchase and can keep all your assets invested while shorting the put.

If at the expiration the stock trades above $30, an investor will pocket $1.50 plus interest on $30 kept in Treasuries for half a year or ~1.50+30*(0.05/2) ~ $2.25. The return will be 2.25/28.50 ~ 7.9% for a half-year or 15.8% annualized. This is just above my threshold and ideally, I would prefer to sell this put slightly higher than for $1.50.

I have held a significant position in BIP for 10 years and do not mind holding it for 5 years longer. If I have to buy BIP, my effective purchase price will be $28.50 accounting for put sale proceeds. With expected at least $1.62 in distributions for 2024, my in-place forward yield will be 1.62/28.50 ~ 5.7%.

How good is a 5.7% yield for BIP as a starting point? Measured on Dec 31, BIP's highest yield was 5.4% over the last 12 years. The average yield was 3.8% with a 0.8% standard deviation. I.e. 5.7% is more than two sigmas away from the average. Statistics tell us it is highly unlikely for BIP to remain suppressed at the yield of 5.7% or higher for long.

Statistical exercises matter only as long as fundamentals are in place. That's why I spent some space on BIP's ROIC and HPC potential. Nothing indicates any problems within the company, quite on the contrary though I do not expect the stock to revisit its ~4% yield level as long as interest rates remain high. But first, high interest rates are a temporary issue albeit they might last for several years. Secondly, we do not need low interest rates for our option strategy to be successful. And thirdly, there is always the implicit Brookfield put in place. BN holds so little of BIP because it has been successful. If it gets less successful, I believe BN will buy more of it to indicate its value and support the price. While I do not consider the last factor important, it is still something to keep in mind.

Conclusion

When I was finishing this post on Sep 21, BIP dropped to $30.30 and I sold $30 March 15 puts at $1.80. It promises an annualized pretax total return close to 18.5% if the puts are not executed. In case of execution, I will purchase BIP at the effective price of $28.20 which is still equivalent to the same 5.7% forward yield.

On the same day, BIP had its Investor Day with the presentation available on its website . I did not discover anything new in this presentation though it discusses some interesting investment cases. A couple of slides are devoted to the acquisition of Triton International ( TRTN ) which will close within days. This is bullish for BIP. A significant part of the acquisition (slightly less than a billion USD) is financed via issuing BIPC shares. Since BIPC is trading much higher than BIP, it makes the acquisition cheaper for BIP holders.

Despite certain efforts, I have uncovered only two stocks that I am comfortable enough to sell cash-covered puts with Enterprise Products ( EPD ) being the second one. However, I treat BIP and EPD puts differently. I am willing to increase my EPD position at the proper price and intend to keep shares that I may acquire through puts for a long time. For reasons that I explained in the previous article, I do not want to increase my BIP position. If I happen to acquire additional units via put execution, I intend to sell them as soon as they appreciate enough.

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