CA - Brookfield: You Can Likely Ignore The Defaults

2023-07-13 12:10:37 ET

Summary

• Brookfield's stock performance has been lackluster this year, underperforming the S&P 500, due to factors such as a decline in earnings and a string of defaults.
• Despite these challenges, the company's exposure to defaulted-on loans is minimal, and credit rating agencies have not downgraded Brookfield's debt due to the defaults.
• The company's valuation remains healthy, with potential for earnings recovery due to recent deals.
• Brookfield's profitability ratios remain above average for its sector even with last quarter's collapse in net income.

Brookfield ( BN )( BN:CA ) stock has delivered a lackluster performance this year. Up 1% for the year, it has under-performed the S&P 500 (which is up 16.2%). Although Brookfield’s dividend boosts its total return, it isn’t quite enough to save the stock from its underperforming status.

Why is Brookfield underperforming this year?

On the surface, it looks like it’s not for much reason at all. Insiders are buying shares , deals are getting done, and the company beat on revenue last quarter. What's all the hand-wringing about?

One possible factor is the earnings performance. Brookfield’s earnings declined last quarter. In fact, they declined by a full 85% year-over-year. That certainly isn’t a good look, but it was almost entirely due to an increase in interest expense partially due to deals, such as the buyout of American Equity ( AEL ). Net income should start rising once earnings from this and other deals make their way into Brookfield’s income statement – AEL had $385 million in net income in the trailing 12-month period, and Brookfield only paid 11.1 times earnings for the company.

The recent decline in Brookfield’s net income was not a simple matter of higher costs. Of the $1.5 billion increase in interest expense, only $664 million worth was due to higher rates on existing debt, the rest was new borrowings, of which $483 million was used to finance new deals.

Investors generally expect asset managers like Brookfield to do deals, using leverage when necessary, so it seems unlikely that last quarter’s decline in earnings is the culprit behind Brookfield’s lagging stock price. If you borrow heavily to do a deal, and the borrowing occurs before the deal closes, then your earnings will decline, all other things the same. So, last quarter’s decline in net income probably wasn’t the only factor behind the relative weakness in Brookfield’s performance year-to-date.

A second factor that may have contributed to Brookfield’s underperformance was a string of defaults by the company and its funds this year. At least two defaults have occurred, and another might occur in the coming months. The loans in question include:

• $784 million worth of loans on Los Angeles office towers. These loans went into default.

• $161 million worth of loans on Washington, DC office buildings . These loans also went into default.

• Another $130 million in loans being negotiated with creditors.

The fate of the $130 million is yet to be determined, so we’ll say that Brookfield has defaulted on $945 million worth of property loans. This fact was widely publicized, so it may have contributed to BN’s tepid performance this year. However, as you’re about to see, Brookfield’s exposure to these loans and the related properties is quite minimal, meaning that they don’t significantly damage the long thesis on the stock in my opinion.

What’s Brookfield’s Exposure?

Before going any further, we need to know exactly what Brookfield’s exposure to the defaulted-on loans actually is. This is a trickier topic than it appears. Brookfield has a famously complex corporate structure, with Brookfield Corporation at the top, several wholly or partially owned subsidiaries in the middle, and various limited partnerships at the bottom. Brookfield typically owns between 75% and 100% of its subsidiaries, which in turn may operate funds exclusively – as is the case with Brookfield Asset Management ( BAM )( BAM:CA ) - or may invest their own funds alongside limited partners.

Brookfield’s real estate segment is among the most difficult of all its segments to unpack. It consists of a wholly owned operating subsidiary as well as investments in several funds. So, figuring out Brookfield’s exposure to the defaulted-on loans requires knowing who is invested in what – Brookfield and its various limited partners.

As the company’s first quarter earnings release makes clear, Brookfield owns 100% of Brookfield Property Group, the real estate arm. That seems pretty simple – Brookfield owns the property group, therefore, its exposure to the real estate loans is 100%... right?

Not exactly. Brookfield Property Group is itself an asset manager, investing both its own money and that of limited partners. The funds are invested through Brookfield Asset Management. In its Q1 supplement, BAM says that it has $98 billion in fee bearing capital in real estate:

Elsewhere, Brookfield says that it has $7.75 billion invested in BAM’s flagship real estate funds, and $1.375 billion in other BAM real estate funds (calculated as percentages of the $12.5 billion total equity portfolio):

If this were the whole story, then Brookfield would be responsible for 9.3% of the $945 million worth of defaulted on property loans. A mere $87.5 million!

However, it is not the whole story. Brookfield also lists real estate as an operating business, and this has $25 billion in assets. If this were invested alongside Brookfield’s funds, in the exact same properties, then Brookfield would own $34.125 billion worth of a $123 billion real estate portfolio. Here the interest would be 27.77%, or $262.42 million.

In the most recent quarter, Brookfield had $456 billion in assets and $39.9 billion in common equity. We can gauge how much of Brookfield’s portfolio is in default by comparing its exposure to defaulted on properties to its total asset base. I was not able to find anything on the degree of overlap between Brookfield Property Group’s portfolio and BAM’s real estate portfolio, if any. So, I’ll present three possible scenarios: one where BPG and BAM’s funds both own the troubled properties (scenario A), one where only BAM’s funds own them (scenario B), and one where only BPG owns them (scenario C).

Percentage exposure in each scenario is shown in the table below

As you can see, in the absolute worst case scenario, where Brookfield owns all of the defaulted-on properties directly on its balance sheet, only 0.215% of assets or 2.36% of equity is affected by the defaults. As a percentage of Brookfield’s total business, these defaults are quite small.

Credit Ratings

Having established that Brookfield’s exposure to its defaulted-on properties is minimal, we can now move on to the impact of the defaults on Brookfield’s cost of capital. If credit rating agencies downgrade Brookfield’s credit scores because of its defaults, then borrowers will probably demand higher yields on loans. So, is that what credit rating agencies have been doing?

In a word, no.

Some recent updates to Brookfield’s credit scores include:

• Fitch last rated Brookfield as a whole in October 2022 and the A- rating was affirmed.

• Fitch rated Brookfield’s junior unsecured debt at A- last month, consistent with the previous A- whole firm rating.

• Moody’s ( MCO ) last rated it in January of 2023, when it upgraded the company to A3.

• DBRS Morningstar rated Brookfield at A, which was unchanged.

So we have Fitch and DBRS Morningstar basically maintaining their ratings, and Moody’s with the most recent rating occurring before the defaults. Broadly, it does not look like the rating agencies are downgrading Brookfield’s debt because of the defaults. So, we would not expect BN’s cost of capital to increase beyond what the effects of tight monetary policy would predict.

Valuation

Having looked at Brookfield’s debt situation and found it to be basically healthy, it’s time to turn to the most important question:

Valuation.

We know that Brookfield isn’t going to collapse because of a small number of bad debts, but is the company as a whole a good value? That’s a different question. To answer it, we need to look at Brookfield’s valuation and compare it against its performance. So, let’s take a look at those multiples.

According to Seeking Alpha Quant, Brookfield trades at :

• 78 times GAAP earnings.

• 0.53 times revenue.

• 1.24 times book value.

• 5.64 times operating cash flow.

Apart from the GAAP P/E ratio, these multiples are quite low. Of course, there’s a reason for this: net income collapsed 85% last quarter. Not only did it collapse, but it collapsed because of a rise in interest expense, which is a cost we’d expect to recur. Will Brookfield’s recent deals be able to get its earnings up again? Possibly, yes. We know that American Equity did $385 million in net income last quarter. Excluding transaction costs, that would cause Brookfield’s earnings to spike by 47%. It would not quite take earnings back to the level observed a year ago, but it would make a difference. Also, Brookfield has done $50 billion worth of deals since the beginning of January, of which American Equity represents just $4.3 billion. Assuming the companies purchased are profitable, then we could see BN’s earnings start to recover rapidly.

Another thing worth noting is that even with last quarter’s collapse in net income, Brookfield is highly profitable. According to Seeking Alpha Quant , it boasts the following profitability ratios:

• Gross margin: 18%.

• EBIT margin: 17.3%.

• EBITDA margin: 25.6%.

• Net margin: 0.85%.

• Free cash flow margin: 9.16%.

Apart from the net margin, these ratios are above average for Brookfield’s sector, scoring the company an ‘A’ on profitability in Seeking Alpha Quant. Combine that with the strong top line growth , and the minor impact of the recent defaults, and we’ve got a stock that looks very enticing at today’s prices.

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