BIP - Brookfield Infrastructure's Valuation And FFO Are Not A Reason To Sell

2023-11-02 17:56:06 ET

Summary

• BIP has delivered exceptional long-term distribution growth while also maintaining a strong balance sheet.
• We aggressively bought the recent dip in the unit price caused by concerns about interest rates, valuation, and the validity of BIP's FFO metric.
• We debunk claims recently made by BIP shorts.

I am very bullish on Brookfield Infrastructure ( BIP )( BIPC ) and rate it a Strong Buy. In this article, I discuss why I aggressively bought the recent dip in the unit price (at a price of $22.15 per unit) caused by concerns about interest rates, valuation, fiduciary issues, and the validity of BIP's FFO metric.

Why I Am Bullish On BIP Stock

The bull case on BIP hinges on a few key factors:

1. There is a significant need for infrastructure across the world, with a global infrastructure financing gap that is projected to reach $15 trillion by 2040. Sovereign wealth funds and pension funds, with assets over $65 trillion, are seen as potential investors to bridge this gap due to their long-term investment horizons that match the nature of infrastructure projects. As a result, growth in public-private partnerships is likely. Given that BIP - with the assistance of its parent ( BN )( BAM ) - is a leading global infrastructure operator and investor, it therefore has a massive growth runway and numerous opportunities to invest on a value basis and add further value to its investments through its operational expertise.
2. BIP has an impressive BBB+ credit rating and a solid balance sheet with no corporate debt maturities for several years. Moreover, its cash flows have significant indexation to inflation which is expected to more than offset increased interest expense in its asset level debt in the coming years.
3. BIP has an impressive track record of growing distributions and AFFO per unit. with the exception of 2020 - both FFO and AFFO grew very consistently year-over-year at a 10.9% and 11.6% CAGR, respectively, along with considerable distribution growth from 2012-2022.
4. Finally, BIP is well-positioned to deliver strong returns to unitholders moving forward given its elevated distribution yield and strong track record of growth and guidance from management for a continued double-digit AFFO per unit CAGR moving forward. BIP should be able to achieve this continued growth momentum given its significant liquidity (over $2 billion), strong embedded organic growth from revenue escalators and value-add operations enhancements, ability to leverage its BBB+ credit rating to improve financing costs in many of the assets that it acquires, and very active opportunistic capital recycling program that has greatly accelerated the wealth compounding process for BIP over the years.

Why BIP Stock Has Struggled Lately

One of the big reasons why BIP has dipped lately is due to rising interest rates. This has caused many investors to be concerned that:

• Its capital recycling program will slow down significantly as it will not be able to get great prices on assets that it tries to sell.
• Its underlying cash flows will take a hit as debt matures and gets refinanced at higher interest rates.

While I have already discussed why these concerns about interest rates are not a major issue, a short report was also recently released on BIP that has caused quite a stir on Seeking Alpha, including causing several readers to state that they are now disillusioned with Brookfield securities and are dumping everything they hold. Even one contributor who was formerly bullish on some of the Brookfield entities decided to dump his holdings after reading the short report. While I encourage you to read the full short report for yourself and you can see my full rebuttal of it here , the points I will counter against here in this article are:

1. Unjustifiably High Valuation : The core of the author's thesis is that BIP's stock is trading at an unreasonably high multiple of its Net Asset Value ((NAV)), suggesting that the stock is significantly overvalued and likely to experience enormous downside.

2. Flawed Financial Metric (FFO) & Lack Of Per Unit Value Creation : BIP uses Funds From Operations (FFO) as a proxy for cash flow to determine distributions to limited partners. The author argues that FFO significantly overstates cash available for distributions because it includes a proportion of FFO from equity-accounted investments instead of actual dividends received from them. As a result, he asserts that BIP is eroding unitholder value over time by paying out more in distributions than it is actually generating in underlying cash flow and therefore calls into question the long-term sustainability of BIP's distribution level. He also points to the lack of NAV per unit growth to prove his point that BIP is not actually creating value for unitholders.

Here is my discussion of each of these points:

BIP's Use Of FFO/AFFO & Lack Of Per Unit Value Creation

The main complaint over BIP's use of FFO and AFFO (which is simply FFO minus maintenance CapEx) is that it includes gains from asset sales and also does not differentiate between the proportion of FFO from equity-accounted investments and the actual dividends received from them. As a result, the claim is that FFO overstates the amount of cash available for distribution to unitholders.

While we understand his point, we would give it much more weight if BIP's distribution had not grown as quickly and consistently as it has or if BIP's leverage ratio had soared over time. However, BIP's distribution continues to grow at a brisk pace (you can't fake distributions), BIP's leverage ratio has remained range-bound, and its balance sheet looks as strong as ever (BBB+ credit rating and no corporate debt maturities for several years with very successful asset level refinancings executed in recent quarters despite rapidly rising long-term interest rates). What this tells us is that BIP is truly generating value for unitholders from its holdings over time that is being at least somewhat accurately reflected in its FFO and AFFO metrics and that BIP is not just playing short-term funny games with non-GAAP numbers to put lipstick on a pig. If BIP were truly a "wasting fund" as the short report claims, it would have been unable to grow FFO and AFFO so impressively alongside significantly growing distributions over such a long period of time while also maintaining a BBB+ credit rating and maintain its leverage ratio at a range-bound level. If it were truly not able to sustain its payout over such a long period of time, it would have had to increase its leverage by a massive amount over the past decade, and that has not happened.

Sure, it is easier to assess a distribution's sustainability when you have a cleaner metric like CAFD, DCF, conventional REIT AFFO, or something similar to use, but the reality is that - due to the nature of BIP's role in investing across the Brookfield ( BN )( BAM ) empire, including holding numerous minority stakes in businesses that are held within Brookfield's funds - this is the reality of its situation. Again, BIP's track record of building value as demonstrated by its FFO/AFFO/distribution per unit CAGRs over a lengthy period of time while still maintaining a strong balance sheet and credit rating should mitigate much - if not all of - the concern about its use and definition of FFO/AFFO as a metric for setting its distribution level.

Unjustifiably High Valuation

The short report's claim that BIP trades at an unjustifiably high valuation relative to its NAV misses some key points:

1. It is evident to me that Brookfield believes its shares are worth much more than the IFRS figures indicate, given their regular practice of buying back units at prices above that level. The company specifically pointes to the fact that several of their subsidiaries have repurchased substantial amounts of units at significant premiums to their IFRS value in the past (with BEP repurchasing units as recently as last quarter), to support this claim. In fact, BIP just announced in their Q3 report that " In light of our strong conviction in the intrinsic value of our business and its growth trajectory, we see the merit in deploying capital to repurchase our equity. Following quarter end, we began repurchasing equity and have bought close to 1 million units under our normal course issuer bid. Going forward, we will consider further buybacks... " Unit repurchases at the subsidiary level actually reduce their assets under management, so there is no way that Brookfield would do this so often over such a prolonged period of time unless they truly believed that their underlying businesses were worth more than their equity prices were at the time.
2. BIP's substantial growth in FFO/AFFO/distribution per unit over the past decade shoots a huge hole in the short report author's claim that BIP's NAV is the best measure of its intrinsic value. Unless he can show that BIP is inflating its FFO/AFFO numbers on a massive scale (which he failed to do in any convincing fashion, and at the end of the day you can't fake distributions), it is obvious that BIP has created enormous value for unitholders over the past decade. In fact, its P/FFO and P/AFFO metrics are currently trading below where they were a decade ago, punching another hole in the short report's claim that ~2/3 of all of BIP's total returns are based on multiple expansion. It is also worth noting that BIP's net debt to EBITDA ratio has remained range-bound over the past decade, indicating that the growth in FFO and AFFO per unit was not a product of increased leverage.
3. The short report's focus on NAV also fails to take into account the fact that the BIP business model is much more than just the sum of its individual assets. Brookfield has thousands of investment professionals who excel at underwriting deals and optimizing the financing (by leveraging its BBB+ credit rating and significant liquidity) in each of BIP's businesses and assets, a huge global business network that provides superior deal flow to BIP for both acquisitions and dispositions and significant operational expertise with relationships built across many industries and countries. As a result, BIP is far more than just a private equity fund that is a passive investor in various holdings. BIP - through its relationship with Brookfield - is a very active investor that adds value across all facets of an investment. This capability is proven by BIP's impressive track record of generating strong returns on assets it has sold in the past.
4. For those who point to the elevated interest rate environment as reducing BIP's ability to continue generating attractive returns through its capital recycling efforts, it is important to keep in mind that BIP has a diversified global presence and is active across a wide array of business segments, giving it plenty of opportunities to transact opportunistically. Moreover, BIP carries the vast majority of its leverage at the asset level, typically with lengthy fixed-rate terms. As a result, they can sell these assets to counterparties who will then assume that project-level debt. Given that interest rates have risen, long-term fixed-rate debt now has considerable value and largely offsets any reductions in value on the asset itself, preserving their ability to sell assets at strong returns. They have proven their ability to do this so far this year and remain optimistic that they will continue to be able to do it moving forward. Additionally, a high percentage of their cash flow is indexed to inflation, so if inflation remains stubbornly elevated, so will their organic cash flow growth, further helping to offset headwinds to their growth from higher interest rates. Additionally, the higher interest rate environment means that BIP has access to higher-yielding investment opportunities on the acquisition side and its declining unit price also gives it the option to buy back units at cash flow yields that will meaningfully improve its per unit FFO/AFFO growth numbers as well. Also keep in mind that BIPC trades at a substantial premium to BIP though it is still economically equivalent, so as a BIP unitholder, whenever BIPC units are issued, it is an automatically accretive event for us.

Investor Takeaway

Ultimately, regardless of what you think about how accurately BIP's IFRS valuations match up with the value of its underlying assets, what is undeniable is the fact that BIP is a growth business that has grown FFO, AFFO, and distributions at an impressive pace over an extended period of time and the long-term macro trends point towards a continued robust environment for growth in global infrastructure growth. As such, we would argue that it should be valued on a discounted cash flow basis rather than on a NAV basis. Barring a dramatic and sustained further rise in interest rates and/or the failure of several of its investments, BIP appears poised to continue enjoying long-term growth in FFO/AFFO/distributions per unit, making the current sell-off in the unit price overblown in our view.

Yes, higher interest rates are on the net negative to BIP's growth profile, but we see no reason to believe that it will break its business model as it is not dependent on issuing units to fuel growth due to its capital recycling efforts. While the short report claims that the most profitable business activity for BIP is issuing new units, a comparison of the long-term growth in EBITDA relative to units outstanding reveals that BIP is generating the vast majority of its growth from sources other than issuing units:

Could BIP see a significant further downside in its unit price? Absolutely. We have no idea how the unit price will perform over the short term. In the event of a severe and prolonged global recession accompanied by higher for longer interest rates, could BIP struggle to generate growth and even see AFFO decline on a per unit basis through that environment? For sure. However, both of these risks apply to virtually every other publicly traded entity.

BIP is not risk-free by any means. Overall, I do think it is a relatively low-risk investment from a long-term perspective given its strong track record, diversified portfolio of quality assets, and low risk of financial distress due to its significant liquidity, low debt level at the partnership level, diversified portfolio of mostly contracted or regulated assets, and backing from Brookfield Corporation. However, in the short term, the unit price is completely subjected to the market's whims, there are always risks that Brookfield will fail to act in unitholder interests, and a rising interest rate environment does have a corrosive effect on BIP's intrinsic value, just as it does to many other businesses.

That being said, while I can see the short report author's concerns about the impact of rising interest rates on BIP as well as the fact that investors are likely paying a premium to the sum of BIP's individual parts, I think he is overlooking the fact that interest rate headwinds apply to leveraged real asset businesses in general and not just BIP uniquely as well as the fact that BIP is a growth business and should be valued as such rather than as a liquidating/deep value investment.

Between its impressive track record, a portfolio that is well-diversified by asset type and geography, strong balance sheet and access to attractively priced debt, strong value-add operational expertise and deal flow through Brookfield that power its capital recycling program, massive global infrastructure demand and keen investor interest, and attractive combination of current yield and growth potential, I believe that BIP is a Strong Buy on the dip.

For further details see: