Posted by Davy Bui on November 11th, 2008 in Enlightened-American Portfolio, Stock Research

All results US$ unless otherwise noted:

• Through nine months of 2008, net operating cash flow (FCF) came in at $1.2B, down 12% y/y.  With the Wall Street meltdown, the performance of BAM’s largest segments (commercial properties, power, infrastructure) is reassuring, with increases across the board except for the infrastructure segment, which was partially spun off earlier in the year.  Unfortunately, expenses jumped by 24% y/y, depressing FCF.
• As covered in my initial report on BAM, the balance sheet is misleading.  Without getting deep into it, the balance sheet seemed fairly stable from YE 2007.  The company has managed its capital well and has over $3B in liquidity on-hand which more than covers all short-term maturing corporate debt.
• While gross and net income aren’t keeping up with total revenue growth, the numbers are still up 22% on gross income and 8% net.  Despite the turmoil in the global markets, BAM’s stable asset base is reflected in its income statement and management expects this to continue going forward.

Brookfield has one of those dense reports packed with so much detail, it makes my head spin but I premised my investment in BAM on trusting management.  As such, there are a few key markers I focus on to monitor BAM:

1. Cash flow generation.
2. General operations status.
3. Access to capital markets and rollover financing.
4. Commerical properties market outlook.

My initial valuation was based on annual cash flow (FCF) of $1.5B - $2B.  Despite difficult markets this year, Brookfield generated over $1.2B FCF through 9 months 2008.  They’ve shown little strain across the company from operations to financing.  Additionally, BAM has over $3.5B of capital (cash, financial securities and credit lines) available to prey upon unfortunate competitors or, in the worst case scenario, deleverage.  Fresh from my review of ACAS, I see no pending catalyst that would force them to delever.

As of Q3 2008, operations were humming along:

• solid results with commercial properties at 96% occupancy with average rents @ $23/sqft
• power generation benefitting from water levels 15% higher than average
• infrastructure segment stable with the transmission business offsetting weakness in the timberlands
• While specialty funds and private equity are down (as would be expected in a financial market downturn), development cash flow increased 54% y/y.
• Additionally, the company managed to arrange several transactions include selling some timberlands, insurance business and property with expected net proceeds of $1.2B.

The company’s access to capital markets seems unimpaired relative to other players.  Several properties were refinanced (as always, non-recourse to the corporate level) and BAM itself recently issued $150M of notes at 6.5%, which is a good rate post-Lehman.  Browsing over their supplemental disclosure, the company has modest debt maturing in the short-term, with $300M due in 12/08 (already financed) along with $582M in subsidiary-related financing.  I don’t anticipate any issues here but if there are, the company has cash on hand to simply pay it off.

While the company’s commercial property segment has shown absolutely no signs of weakness with 96% occupancy and new leases being signed at rates above the current avg in-place rents, one can not help but worry about this area.  Most of Wall Street has disappeared and now the energy sector is witnessing unbelievable contraction in such a short time.  Brookfield, as one of the largest landlords in Manhattan and with a good foothold in energy-related cities like Calgary and Houston, would seem to be affected by this turmoil.

CEO Flatt and company recognized this concern and reiterated their office property strategy which they insist has not changed throughout the years.  This strategy is centered on 5 principles:

1. High quality properties at a decent price.
2. Supply constrained markets (think Manhattan, not Sacramento).
3. Quality credit tenants.
4. Term leases, often with tenants customizing the space at their cost.
5. Non-recourse long-term financing which allows BAM to walk away from a poorly performing property and “jingle-mail” it back to the bank(s) with no recourse back to the corporate level.

What’s notable about Brookfield’s philosophy is its similarity to Warren Buffett’s Berkshire (Flatt actively seeks to emulate the Oracle).  While other players (like, say, ACAS) feel like they “have to dance while the music keeps playing”, Berkshire stops underwriting insurance once the pricing doesn’t make sense.  BAM actively avoided overbidding for properties during the peak of the credit bubble and now are in great position to pick off distressed assets.  So even though I would expect some softness as corporate tenants go bust, arbitrarily chopping a third off commercial property cash flow (42% of total FCF 2008 YTD) leaves $700M in FCF.   That suggests a nice cushion.

Finally, if you need further proof of management’s prudence and capability, look at the share repurchase program.  While other companies (half my portfolio, it seems) are suspending buybacks with share prices at multi-year lows after paying twice current prices just a few months back, BAM are actually buying back shares when they are cheap. In fact, new investments have to clear the hurdle of the return rate on their own shares, which they estimate at over 20%.  Value, indeed.

I am paring back my intrinsic value for the company at $26 - $40 per share due to the probability of lower FCF going forward ($1.5B as the high end, not the low end as before).  With shares below $18, I’m looking to add to my position around $15.

For additional reference, see my initial report here.

PERFORMANCE MEASUREMENTS

• Cash flow targets of ~$1B - $1.5B.
• Increase asset management business relative to operations.
• Maintain dividend as economic crisis plays out.
• Shrinking share count.