Brookfield Residential Properties (BRP) Long Recommendation

Brookfield Residential Properties is the newly formed combination of Brookfield Homes (formerly BHS) and Brookfield Office Properties (BPO) residential assets.  The merger between BHS and BPO Residential was completed in March of this year with BHS shareholders receiving 49.1% of BRP's equity and BPO receiving 50.7% (preferred shares captured the remaining 0.2%). 

To the new entity, BHS contributed its assets which consist of entitled residential developments in California and Washington DC - BPO Residential contributed entitled residential developments in Canada (primarily Calgary) and also in Texas and Colorado.

The combined Brookfield Residential has over $2.5 billion in assets, 55% of which are in the U.S. and 45% are in Canada. 

BRP is trading for just over 1x book value today, a significant discount to publicly traded homebuilders which trade at over 1.3x book.  There is another more important distinction between BRP and other publicly traded homebuilders, BRP actually makes money, a lot of money.  While the U.S. business is roughly breakeven, the Canadian assets are producing steady profits and cash flow. 

BRP represents an attractive absolute and relative valuation with a compelling near term catalyst and what amounts to a free option on a long term recovery in housing in the U.S.

Valuation:

                Current Price                        $10.20

                Base Case                            $13.00

                Best Case                            $20.00

                Low Case                             $8.00

Investment Positives:

                Complicated transaction obfuscates the idea creating a "hidden gem"

                Lack of clear financials masks the value created by the combination

                Compelling valuation with cash flow generation while you wait to monetize U.S. assets

                Smart owner with Brookfield Asset Management controlling over 2/3s of BRP

Investment Risks:

                BRP is highly levered with 58% debt to capital ($500m of which is owned by BPO)

                Severe downturn in new home starts in the U.S. would pressure profitability in Canada

                There isn't much public float with Brookfield Asset Management owning over 2/3s of BRP

Catalysts:

June 10^th, 2011 - Brookfield Office Properties shareholders received rights to purchase BRP stock at $10.00 per share (described in more detail below).  Those rights expire on the 10^th, which should remove an overhang on the trading of BRP.

Analyst coverage - BRP is the only $1 billion market cap homebuilder without any analyst coverage

Earnings releases - there is no quarterly data on the combined company yet as BPO Residential was private.  Through the end of the year, earnings power will become apparent and analysts will be able to screen for and easily understand BRP.

Below is a description of Brookfield Homes and BPO Residential with summary financials as well as the consolidated financials.  The document used to source the numbers is the BPO rights offering prospectus filed with the SEC on May 5, 2011.

Brookfield Homes

Brookfield Homes contributed 8,200 lots in Northern California, 4,700 lots in LA and 8,700 in San Diego and 4,700 lots in Washington D.C.  Historically, BHS built and sold upwards of 1,000 homes per year.  During the boom, BHS sold as many as 1,600 homes in a year.  Today they are selling approximately 600 homes per year.  To scale those volumes financially, on average BHS would make around $120 or $150 million in EBITDA selling about 1,000 homes.  In the boom, BHS was making upwards of $300 million in EBITDA.  During the bust, they were in a loss position of about $35 million.  Today, they hare operating basically at breakeven after having right sized the G&A structure of the business.

Financials are below:

Cash flows have been a different story.  During the boom, BHS spent all excess cash flow to buy and entitle new parcels.  As things began to fall apart in 2007, BHS pulled back on new land purchases and entitlements, and thus sales became completely cash generative and cash flows have been very positive.

Going forward, my understanding is that management intends repay debt as a first priority, then to selectively invest in entitlement projects which they believe have 20%+ IRRs over two to three years.  In the U.S., building homes is not the priority for cash.

BPO Residential

BPO Residential contributed 28,900 lots in Calgary, 17,900 lots in Edmonton, 9,500 lots in Toronto, 14,800 lots in Austin and 10,700 lots in Denver.  All of the Canadian sites have homebuilding operations - the markets in the U.S. are not actively building homes.  Currently, the primary source of income for BPO Residential is lot sales in Alberta.  BPO Residential does build homes, but the sales of entitled lots are more significant both in terms of top and bottom lines.  House closings in Alberta and Toronto have been steady over time but have averaged about 900 units.  In 2009 the company closed on just 650 units and lot sales declined by about 25% in Canada which pushed operating income down to $100 million versus $200 million the prior year.  In 2010 lot sales in Alberta picked back up and operating income increased to $170 million, which is about where management believes it should stay in the current environment for energy.

Demand in Alberta has been driven by trade up to mid-priced to higher-priced homes, which is a wealth creation affect from the current boom in the so called Oil Sands in Alberta.

Financials are below:

Cash flows from Canada have been positive, but have lagged operating income as the company has spent capital to buy and entitle land.  Going forward, I'm told that land purchases will not be a focus but that the company will continue to entitle parcels to meet demand and maintain earnings.  Net, Canada should be a major cash generator, which in turn will be used to pay down debt.

Brookfield Residential Properties Consolidated

Below are the combined financials from BHS and BPO Residential.  The numbers flow down to adjusted net income line which incorporates the new capital structure for BRP and backs out the capitalized interest expense running through the cost of goods line - that is meant to show the true "cash" flow through of sales, operating profits and cash interest in a given year.

Below are the cash flows for the business, which take into account the change in land and homes as either a use or source of cash.  Going forward I believe that land and homes will be a source of cash in Canada and a slight source of cash from the US, which implies free cash flow above net income.

Competitive Landscape and Valuations

Complexity of the Transaction

Beyond the lack of financial history for BRP, there is another complicating factor which I believe adds to the opportunity.  Brookfield Office Properties is distributing its shares of BRP equity to BPO shares through a rights offering at $10.  Brookfield Asset Management has agreed to backstop the rights offering at $10 (which is why BAM may end up owning more than 2/3s of the BRP common).

The BPO rights trade publicly as BPO/RT or BPO-R on Bloomberg.  I believe that many of the BPO shareholders who received these rights back in early May (rights began trading on the 9^th) have no interest in owning a homebuilder, much less writing a check to own one through a rights offering.  Selling pressure on those rights has, I believe, created downward pressure on the BRP shares as 10 rights exercise for 1 share of BRP at 10, so arbs keep the disparity between the two at a minimum.  I believe it's a case of the tail wagging the dog. 

Once the rights offering has expired, next Friday the 10^th at 4pm, the selling pressure will be over, and any BPO shareholder that doesn't want to own BRP will be out of the name.  At that point I believe that BRP will begin trading on its own and analysts will begin to follow the story, both of which I believe are positive catalysts.

Valuation

Steady state BRP does between 85c and $1.00 in earnings on $10.00 of book.  I value that in line with US homebuilders at 1.3x to arrive at $13.00 fair value. 

In the best case the US gets back to a normalized number for housing starts and begins producing $120 to $150 in EBITDA which is about $1.00 / share in earnings (more in cash flow as the US has as $70 million NOL that isn't on the balance sheet but lasts for 15 years).  Combined, the business does close to $2.00 which I'd argue is worth about 10x or $20.00 per share.

Your downside is Canada goes to 2009 levels and the US burns $30m pre tax per year.  In that scenario you'd still have $10 in book but earnings would fall to 25c to 35c per share.  I give that a 20% discount to book and peg fair value around $8.00

At the current price of $10 per share you're buying a 75c dollar with 10 points of upside and 2 points of downside (5 to 1 risk reward), a near term catalyst, a free option on any recovery in housing and lots of cash flow generation while you wait.  For those reasons I believe BRP represents a compelling long investment.

June 10th, 2011 - Brookfield Office Properties shareholders received rights to purchase BRP stock at $10.00 per share (described in more detail below).  Those rights expire on the 10th, which should remove an overhang on the trading of BRP.

Analyst coverage - BRP is the only $1 billion market cap homebuilder without any analyst coverage

Earnings releases - there is no quarterly data on the combined company yet as BPO Residential was private.  Through the end of the year, earnings power will become apparent and analysts will be able to screen for and easily understand BRP.