Description

Brookfield Business Partners L.P. (BBU-US)

I believe BBU is a great investment opportunity because: 1) I like the setup, primarily the spinoff dynamics, 2) the lack of disclosure which gives informed investors an edge on valuation and understanding the downside, and 3) the ability to participate, at a discount, a compounder with better alignment and constraints than the other Brookfield spin-offs.

I will spend most of the writeup expanding on points 1) and 2) as a previous write-up already does a good job highlighting Brookfield Asset Management’s (BAM) strong record as a shareholder friendly capital allocator.

https://www.valueinvestorsclub.com/idea/Brookfield_Asset_Management/2811

Background

I followed BAM for many years and have seen it transform from BAM holding a difficult to analyze mix of assets (mostly real estate) to pruning and upgrading its portfolio into  higher quality and easier to understand asset groups including real estate, infrastructure and private equity. As BAM’s success attracted third party capital, BAM wanted to transform into more a fee based business to generate returns while being less capital intensive. As a result, BAM began spinning off groups of its assets into Brookfield Infrastructure Partners (BIP), Brookfield Property Partners (BPY) and (the most recent one) Brookfield Business Partners (BBU).

Setup

As we know, spinoffs generally create pretty interesting dynamics because holders of the “parent” company typically: 1) receive a small position in the spinoff making the spinoff holding irrelevant, 2) do not bother analyzing the spinoff because of its small size and the amount of work required to understand it and 3) the lack of the spinoff’s independent operating history precludes some investors from being comfortable investing in the spinoff.

In BBU’s case, forced selling is likely exacerbated by: 1) BAM holders only getting 1 BBU unit per 50 shares of BAM, a tiny amount when compared to BAM’s other spinoffs, 2) the BBU spin being taxable so there is less incentive to hold onto the position to avoid triggering taxes, 3) the limited partnership structure which some mutual funds are simply not allowed to hold, 4) the lack of index inclusion and 5) the limited disclosure around the eclectic mix of assets (unlike BAM’s infrastructure and real estate spins).

Knowing there is non-fundamental selling pressure for BBU is nice, but why should one be interested in BBU now?

Pattern Recognition

With BAM having spun out both BIP and BPY over the past decade or so, it is interesting to see how BAM has managed the spinoffs in terms of setting a low(er) hurdle to generate incentive payments from a low fair value mark then marketing, getting sell-side coverage and increasing its distribution for the spinoff and even buying back units help the companies rerate higher over time.

Specifically, for BIP, BAM shareholders got 1 share of BIP for every 25 BAM shares and BIP took about 2 years to rerate that came as distributions were increased and as we exited the financial crisis.

For BPY, BAM shareholders got 1 BPY unit per 17.4 BAM shares and it took about a year to rerate. Interestingly for BPY, BAM likely wanted BPY to trade poorly because its incentive fee was calculated using the initial capital level calculated using the 30 day initial trading BPY VWAP. Over the course of a year, BPY was active in getting BPY back into indices, executing on leasing its properties, buying back units, getting sell-side coverage and raising the distribution.

See my previous writeup here: https://www.valueinvestorsclub.com/idea/BROOKFIELD_PROPERTY_PRTRS_LP/119185

So approximately 6 months after the BBU spin-off, why should it rerate faster than the previous BPY spin?

I think BBU will shake off the usual negative spin-off dynamics sooner than the previous BAM spins mostly because of one important detail in the BAM/BBU Master Service Agreement (page 132 in BBU prospectus). Basically BAM gets a 1.25% management fee on total capitalization (recourse debt + weighted average trading price of equity by quarter) and an incentive fee as follows:

As a result of holding Special LP Units, Brookfield will be entitled to receive from the Holding LP incentive distributions calculated as (a) 20% of the growth in the market value of our units quarter-over-quarter (but only after the market value exceeds the “Incentive Distribution Threshold” being initially $25.00 and adjusted at the beginning of each quarter to be equal to the greater of (i) our unit’s market value for the previous quarter and (ii) the Incentive Distribution Threshold at the end of the previous quarter) multiplied by (b) the number of units outstanding at the end of the quarter.

This is quite different from the BPY spinoff where BAM gets a flat management fee and incentive payment where BAM gets 1.25% of growth in total capitalization plus essentially IDR splits in distributions similar to MLPs in the US:

For purposes of calculating the equity enhancement distribution at each quarter-end, the initial total capitalization against which the quarter-end total capitalization is measured will always be the company’s total capitalization immediately following the spin-off. For purposes of calculating the initial total capitalization, securities will be valued based on their volume-weighted average trading price on the principal stock exchange (determined on the basis of trading volumes) for the 30 trading days commencing on the date of the spin-off; provided that if a security is not traded on a stock exchange, the fair market value of such security is determined by the BPY General Partner.

Put simply, in the BBU spinoff, BAM’s incentive is to: 1) set an equity value threshold low enough that they will certainly cross and generate 20% incentive distributions and 2) have BBU rerate quickly as there is no need to depress BBU unit price to set a low bar unlike BPY.

I cannot stress this enough but the difference in incentive structure is a significant nuance investors need to understand here. In BPY’s case, the incentive is to let BPY trade as poorly as possibly to have a low and non-resetting low bar set by the 30 day VWAP so BPY generates incentive fees on total capitalization growth over the initial 30 day VWAP (they have $12.5 mln base management fee). As well, there is less of a rush for BPY to rerate because the big incentive fees come from the distribution splits (like IDRs in MLPs). This is pure speculation on my part but perhaps from the BPY experience, BAM realized it did not like leaving the base total capitalization calculation to chance based on the 30 day post spin VWAP (i.e. BPY held up ok post spin and got worse as funds who could not hold LP units got extensions from their compliance department to dump it later).

My speculation is that this time around, BAM wants to set a bar conservative enough that they will generate good incentive fees going forward. BAM, knowing BBU’s assets best, would be incentivized to set as low a hurdle as possible to virtually guarantee incentive payments and not leave the determination of said hurdle to a post-spin VWAP unit price in case something wonky happens again. Perhaps with this in mind, BAM sets up a management fee structure at 1.25% of total capitalization (that fluctuates with the unit price) and a 20% incentive fee over a $25 BBU unit price. Again this is significant here, BAM has set a price where if BBU is below $25, it gets LESS of a management fee (instead of a flat $12.5 mln for BPY) AND gets no incentive payment. Whereas at $25 or above, BAM gets a FULL management fee AND an incentive payment. Again to put it gently, if I were BAM, I am setting the number at a price I know reflects a downside/worst case valuation scenario for BBU (but I am speculating here). Finally, as you can read in the prospectus, BBU does not intend to increase its distribution and there is no IDR splits like BPY – so all of BAM’s incentives are in compounding value in BBU over S25. There is no incentive to let BBU units trade poorly like BPY – in fact it is the opposite this time around.

Corroborating Evidence

Armed with an understanding of incentives, we can now review some actions BBU has taken to suggest BBU/BAM’s incentive for this new vehicle to trade well ASAP:

1. Less than 3 months post spin, BBU announces unit buyback program: https://bbu.brookfield.com/press-releases/2016/08-02-2016

2. ~ 4 months in, BBU is already hosting its investor day with a marketing presentation detailing valuation and the range of value BBU should be worth:

https://bbu.brookfield.com/events-and-presentations/events/09-28-2016

Valuation

The difficult part of this idea is coming up with a valuation range for BBU given the many different businesses under the BBU umbrella and limited disclosure in underlying business and KPI’s/unit economics. From the filings, BBU only really separates its business into 4 segments: 1) construction services, 2) other business services, 3) energy and 4) other industrial operations. Although segment “company FFO attributable to parent company” is provided, one can’t really do much valuation work other than slapping on FFO multiples on comparable businesses (which is hard to define) and guess how much BBU is worth. Using this method and really stealing from BBU guidance, you get $24-28.

Interestingly, there is another way. Because of most BBU’s underlying businesses were acquired around the great financial crisis and/or involved public companies, one could figure out what BBU essentially paid for these businesses around the financial crisis and also what company and sell-side projections or normalized earnings expectations were at the time. Generally speaking, I used the former as the downside case in valuation and the normalized earnings expectations in the upside case. Of course the valuation range is wide but I hope to demonstrate that by marking valuation to many years ago, one should be very comfortable with the downside case.  

Due to the lack of disclosure as to what businesses are in which BBU business segment, I identified the main businesses within each segment by reviewing the BBU presentations, filings and personal recollection. As well, there is no disclosure around what % of the business BBU owns, so I rely on this exhibit to make a guesstimate on BBU’s % ownership (page 86 of prospectus):

Here is how I built up BBU’s NAV:

Construction Services (100%): We know BBU’s construction services segment (at 100%) came from an acquisition of the Australian business called Multiplex Group in 2007. If we go back and dig up research back then, we see the sell-side attributed about A$650-$750 mln to the construction business:

Now before the bid, taking the most pessimistic sell-sider (who had a sell rating at the time), Deutsche Bank back then valuation its construction business at ~ A$540 mln. While analysts at the time thought Brookfield may have overpaid for the Multiplex acquisition, I feel these valuation parameters are sufficiently conservative as they represent stale figures 9 years ago.

To sum it up, I use the low and high case for the construction segment EV at US$425 mln and US$580 mln, and take out the 2Q reported segment debt to get an equity value range of US$400 mln to US$555 mln.

Other Business Services – Under this segment, BBU has a 30% interest in its” facilities management business” and 100% interest in its “residential real estate service business”. Using a similar approach as the construction segment, I pegged the facilities management piece at A$55 mln to A$120 mln, which at 30% interest works out to US$13 mln to US$28 mln. The tricky part here is the Residential Real Estate Service (and whatever is not captured in Facilities Management from the Multiplex deal). With this struggle, I ended up just using US$80 mln as the FFO to BBU (2015 figure was US$83 mln after non-controlling interest) and giving a wide multiple range of 9x to 12x. Backing out US$450 mln in segment debt, I get this segments equity value in the range of US$190 mln to US$510 mln.

I can go through comps etc. but the quick check here is on a recent VIC facilities management write-up here, it seems like the author had the company at a 17x 2015 EBITA multiple and a terminal multiple at 15x – so again using a 8-12x FFO should be conservative on the verge of being punitive.

https://www.valueinvestorsclub.com/idea/Coor_Service_Management_AB/138538

Energy – There is better disclosure in this segment in terms of KPI’s and reserve reports for both its Canadian and Australian operations. After slicing and dicing it many different ways, I figured the best way to frame the valuation range here is to take the net interest in boe/d production (page 77 in prospectus) and apply a wide range of netbacks ($5 to $8/boe) and a 10x multiple (not unlike the EV/DACF convention in the oil and gas space). With this, I got a range of $1.1 bln to $1.7 bln in enterprise value, minus 40% of the debt, I get $750 mln to $1.4 bln in equity value.

Now the energy experts may view my valuation method and range as being too crude. However, it is very interesting to see reports Brookfield is looking to IPO Ember Resources at > $1 bln valuation – which is said to produce 300 MMcf/d. This figure works out to ~ 50,000 boe/d which roughly compares to the 2015 Canada production of 48,600 boe/d (again page 77 of prospectus, net of interest due to others and net of royalties).

http://www.bloomberg.com/news/articles/2016-10-17/brookfield-said-to-weigh-ipo-of-methane-producer-ember-next-year

So again, I think we are conservative for the valuation range, especially on the low end, when we consider the $1 bln valuation floated does not consider BBU’s Australian energy assets and other small holdings we did not account for (i.e. CWC Energy Services).

Industrial – If disclosure was a bit lacking in the other segments, it is even more of an issue for the industrial businesses. From what I can gather, the main businesses in this segment are: Graftech (taken private by Brookfield), Maax, North American Palladium, Armtec Infrastructure and Hammerstone. In the prospectus, BBU ownership interest in these businesses are ~25-40% - so I conservatively just use 30% across the board.

Graftech – This name was taken private by Brookfield so there is some information. Feel free to read through the filings but the takeaway is, before the take-out, JP Morgan’s valuation work had enterprise value at around $1 bln. Looking at Jeffries research coverage, I understand the view is normalized EBITDA could be in the $200 mln and could trade at 8x EV/EBITDA, or $1.6 bln. At 30%, I have BBU’s Graftech ownership at $300 mln to $480 mln

https://www.sec.gov/Archives/edgar/data/931148/000119312515200349/d930745dex99cii.htm

Maax – This is a bathroom fixtures company Brookfield took out by just assuming the debt in the middle of 2008. I understand that “No dollar figure was announced for the sale but Brookfield will acquire Maax's assets for the amount owed under the senior security credit facility, revised in January to $225 million, plus a $50-million credit line. It will also assume its obligations to customers and suppliers.” So in the low end of the valuation range, I am using $275 mln enterprise value. On the high end, I am using $400 mln, which is a rough guess using 10x EV/EBITDA based on BBU’s investor day disclosure that Maax was expected to do $40 mln in EBITDA. At 30%, I have BBU’s Maax stake at $80 mln to $120 mln

http://www.cbc.ca/news/business/brookfield-fund-buys-bathroom-fixtures-company-1.759158

North American Palladium – This business is a little easier to put a valuation mark on. BBU basically owns 53.5 mln shares of the company and the latest traded price is almost C$5. I add that to the amount of debt BBU has funded them at ~ C$32 mln. I get $230 mln, at 30% = $70 mln for both the low and high end of my valuation range.

NAP’s parent company, Brookfield Business Partners LP (“BBU”), is a limited partnership publicly listed on the New York and Toronto stock exchanges whose general partner is a wholly-owned subsidiary of Brookfield Asset Management Inc. (“Brookfield”). An approximate 21% economic interest in BBU by way of limited partnership units was spun off to shareholders of Brookfield on June 20, 2016 as a special dividend, with Brookfield retaining the remaining limited partnership interest in BBU. BBU and Brookfield collectively hold approximately 53.5 million common shares, representing approximately 92% of the issued and outstanding common shares of the Company.  Prior to June 1, 2016  NAP’s parent company was Brookfield Capital Partners Ltd., a wholly-owned subsidiary of Brookfield.

. BBU and Brookfield collectively hold approximately 53.5 million common shares, representing approximately 92% of the issued and outstanding common shares of the Company. Prior to June 1, 2016  NAP’s parent company was Brookfield Capital Partners Ltd., a 100% wholly-owned subsidiary of Brookfield.

On January 26, 2016, the Company drew the first advance of US$10.0.  The loan is measured at amortized cost, net of transaction costs of US$0.3, and is being amortized at an effective interest rate of 12.8%.

On May 2, 2016, the Company drew the second advance of US$15.0.

On June 30, 2016, the Company entered into an amendment of its existing secured term loan with Brookfield to increase available funds by US$25 million. The additional funds are available immediately in up to four advances and available until December 31, 2016.

On July 5, 2016, subsequent to the end of the quarter, the Company drew the third advance of US$10.0.

http://www.napalladium.com/

Armtec Infrastructure – Another business Brookfield got involved when the business/capital structure was stressed. Brookfield ended up acquiring all the assets of Armtec (and wiping out the equity) for an undisclosed amount. With a little digging, however, we can see that Brookfield was a C$163 mln creditor. (do a ctrl f to find this in the following creditor report)

http://documentcentre.eycan.com/eycm_library/Armtec/English/CCAA%20Proceedings/List%20of%20creditors/Listofcreditors,asat28Apr15.1.pdf

So for my low case, I am using $125 mln and the high case 7x the average of 2013 and 2014 reported EBITDA ($27 mln) or $190 mln. At 30% estimated ownership, I get $38 mln to $44 mln.

Hammerstone – Yet another business Brookfield took over after the quarry company (originally Birch Mountain Resources) got in trouble during the financial crisis. I understand Brookfield paid $50 mln for the assets and I use this as the low end of valuation. On the high end I use $340 mln, I assume they can produce 1.9 mln tonnes at a normalized EBITDA margin of $30/tonne and give it a 6x EV/EBITDA multiple (can check the TD sell-rated initiation report that discusses quarry industry dynamics and what normalized margins could look like). At 30% estimated ownership, I get $12 mln to $80 mln.

http://www.marketwired.com/press-release/tricap-announces-launch-of-hammerstone-corporation-and-appointment-of-its-president-nyse-bam-970293.htm

Summing up Industrial Segment – Based on the above businesses and netting out 30% of segment debt, I get a range of $1.4 bln to $2.4 bln in equity value for this group.

NAV – Adding up all the segments, I finally made the following adjustments: 1) add back cash on the balance sheet, 2) apply a 15x multiple to management fee in the low case and management fee + incentive fee in the high case. I get a range of $23-$36. It is very interesting how BBU calculates its management fee, which is total capitalization excluding non-recourse debt:

Pursuant to our Master Services Agreement, we pay a quarterly base management fee to the Service

Providers equal to 0.3125% (1.25% annually) of the total capitalization of our company. For purposes of

calculating the base management fee, the total capitalization of our company is equal to the quarterly

volume-weighted average trading price of a unit on the principal stock exchange for our units (based on trading

volumes) multiplied by the number of units outstanding at the end of the quarter (assuming full conversion of

the Redemption-Exchange Units into units), plus the value of securities of the other Service Recipients that are

not held by us, plus all outstanding third party debt with recourse to a Service Recipient, less all cash held by

such entities. See ‘‘Management and Our Master Services Agreement’’ for further detail.

Other pro forma adjustments

(i) Management fees

Management fees are based on 1.25% of market value. The Unaudited Condensed Combined Carve-Out Pro Forma Statement of Operating Results reflect a charge of $20 million for the year ended December 31, 2015 with the associated tax effects of $5 million, representing an estimate of the annual management fee based on the pro forma carrying value of preferred shares, Redemption- Exchange Units and limited partnership units that would be paid by our company for services rendered in connection with the Master Services Agreement. The quarterly management fee will be based on the capitalization of our company and derived from our quarterly volume weighted trading price. A 10% decrease in our capitalization would result in a pre-tax annual decrease in management fees of approximately $3 million.

I am bringing this up because there is no disclosure by segment what the non-recourse debt amounts are and I have probably incorrectly included ALL debt by segment in calculating the NAV. This is extremely conservative as BBU itself calculates the proforma management fee to be $20 mln for 2015. At $25 per unit and 92 mln units at 1.25%, the management fee should be $29 mln. So the fact they proforma’ed it at $20 mln suggest BBU thinks there is a net cash position (i.e. very little recourse debt). Put another way, in my NAV I subtracted $1 bln in the proportionate debt BBU would economically be exposed to based on their disclosed ownership percentage. This figure should actually be a lot lower if we exclude the non-recourse debt.

Why Is This Interesting and What is your Edge?

I recognize there are probably many investment vehicles and conglomerates that trade at a discount to NAV and the fact that BBU hits my low end valuation range may not seem that interesting. However, it is important to recognize two things:

1. As discussed earlier in the writeup, BBU is facing a lot of the usual spinoff dynamics and the incentives are set up for BBU to rerate sooner than the previous BAM spinoffs.

2. BBU is highly likely to be a long-term compounder. This is supported by general historical evidence that BAM has compounded its opportunistic private equity investments (like BBU) at 23% for the past 15 years (how many funds charging 1.25%/20% with that track record and ability to operate at scale and are not closed to new investors?). More specifically, BBU’s business was built by acquiring assets when the former businesses’ equity was wiped out or cyclical industry fundamentals were challenging (Australian Apache assets, Hammerstone, Maax). As well, BBU is not subject to industry/category constraints (i.e. focused on real estate or infrastructure). I would argue BBU probably has a repeatable investment process and good capital allocation skills (already buying back units). Afterall, when talking about their 15-20% target returns, this line has got to sound familiar to most of us:

Such businesses generate minimal or even negative earnings at the outset but have the potential to generate substantial gains over the longer term. In essence, we are happier earning a bumpy 20% internal rate of return instead of a steady 15%.

https://bbu.brookfield.com/~/media/Files/B/Brookfield-BBU-IR/press-release/q2-2016-bbu-letter-to-unitholders.pdf

In terms of edge, I don’t think I have any complicated knowledge or trading strategy around BBU. It really comes down to the spinoff dynamics where there is an abundance of non-fundamentally driven sellers (funds who can’t own trust units, funds that don’t have time to bother, index considerations, etc.). The other part comes from just the sheer willingness to put in the work to analyze all the different businesses within BBU given the lack of disclosure here. Put another way, a non BBU Brookfield executive mentioned he is not aware of a single investor meeting where the investor has read through the relevant Brookfield entity’s prospectus that they were discussing at the time.

Disclaimer: The write-up is only intended for VIC members and not for dissemination (especially to the issuer).

 Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

Catalyst

Continued unit buyback

Additional disclosure

Opportunistic transactions

Negative spinoff dynamics abates