Although Brookfield Infrastructure Partners (BIP) has existed as a stand-alone entity for only about 5 years, it is already well-known to investors. Its dividend yield, which has ranged between 4.5% and 6% most of the time, is surely appealing in the current low interest rate environment. Although the stock does not sell for 50 cents on a dollar (and I doubt it ever will due to the quality of the company), I think the dividend is safe and will continue to nicely grow in the coming years. The aim of this article is to determine the current value of BIP, evaluate possible risks and look at growth opportunities.
The business of Brookfield Infrastructure has been described in various other articles, so I will not go into much detail here (see the company presentation for an overview). Briefly, BIP operates various infrastructure assets with very long lives and low maintenance expenditures: electricity transmission systems, railroads, ports, natural gas pipelines, toll roads. Some of those assets are unique and irreplaceable and replication of most of the other assets is not economically viable. For instance, the high-voltage lines in Chile are the backbone of the transmission system serving 98% of the population, and the Australian railroad is the only economically viable mode of transport connecting local mines to the ocean. Moreover, quality of the assets is very high, e.g. customers of the Australian coal terminal (which currently operates at full capacity) have an evergreen option to extend their allocated capacity for another 5 years, and not a single customer has passed such option in the 29-year history of the terminal. Infrastructure owned by BIP will be needed for many decades to come, and even though the traffic can decline in periods of economic turmoil, the world is too globalized and most of the people do not want it to be disentangled. Can you imagine consumers in Europe or the US to forgo all the cheap Asian imports?
The recent news is that all the timber assets have been sold at a reasonable price. Anyway, the timber assets constituted only a small part of the enterprise, so this is not a big change. What is more important, it displays the willingness of the management to dispose of assets if good price is available and either decrease the debt load or recycle the proceeds in businesses with more potential. (The net debt is 6.4B compared to 7.7B in 4Q2012; all the figures are in US dollars.)
The company boasts impressive compounded 5-year growth in both distributions and the stock price; however, precise numbers are not important because of the short history and low starting values, so I will ignore them in this analysis. The management plans to grow the distribution by 3 to 7 percent a year and succeeded to grow it by more than 10% in recent years. (Note that the management has presented the plan 5 years ago and sticks to it. Although they have beaten their estimates by a wide margin for four years in a row, they stay cool and keep future assumptions realistic.)
To illustrate the quality of the company, let us have a quick glance at its three operating platforms.
The regulated and contractual utility platform consists of 2B of invested partnership capital, which together with borrowings gives 4.6B rate base. The return on rate base is 11%, and so the return on invested capital, equal to 25%, is excellent. However, this does not take into account maintenance capex (which is less than 10% of FFO for this platform). After factoring in the maintenance and interest expense, the AFFO yield (that is, AFFO divided by invested capital) is 15%. Additional 430M are prepared to be committed to the rate base in a short future.
AFFO yields for the transport platform and energy operations are 15% and 5% respectively in 1H2013. The number 5% (which was 9% in 2012) is distorted by higher than average maintenance capex due to the timing of North American gas transmission operations.
Future possibilities for growth are promising. The company claims about 5B of organic growth projects under consideration (3.5B of this corresponds to an expansion of the Australian coal terminal); a nice example of such growth can be found in the Australian railroad: the recent expansion of the operation is the most important factor in the revenue increase in 2Q2013. Good acquisition targets can be found among assets which can be bought from industrial companies wanting to free tied-up capital; such assets are often vital to the companies and so offer a recurring revenue stream for a long time. In addition, the management has a good track record of exploiting the 2008/9 recession: they have merged with troubled Prime Infrastructure which enabled a hefty increase of distributions. Therefore, I believe that even periods of general distress might be beneficial to BIP in the long term. Overall, there is plenty of room to grow, either by issuing new units or just by reinvesting retained earnings.
The interesting part is that revenues are likely to grow even without any additional capital investments. About 70% of revenue is either indexed to inflation or the company has the pricing power to raise it along with consumer prices. Moreover, many assets have surplus capacity, mainly the toll roads, railroads, and ports. We will try to take these factors into valuation by assuming a 2% "inflationary" growth in addition to the growth obtained from reinvestment of retained earnings.
Brookfield Infrastructure defines two important metrics to evaluate the company: funds from operations (FFO), which is net income plus depreciation and amortization plus deferred taxes and a few other non-cash items (e.g. fair value adjustments); and adjusted funds from operations (AFFO), which is FFO minus maintenance capex.
AFFO is a measure very similar to owner earnings presumably used by W. Buffett. We will use it as a measure of distributable free cash flow. Since the 2012 numbers do not reflect recent acquisitions and the commissioned Australian railroad, we will use data from the first half of 2013 as a proxy for the second half. I expect the actual results for 2013 to be even slightly better since there are projects to be commissioned in 3Q2013 and the contribution of the Australian railroad is not reflected in 1Q2013 results. FFO of the sold timber segment was only 11M in 1Q2013, so its loss is more than offset by recent FFO gains in other segments.
The company recently distributes about 55% of FFO (about 62% of AFFO). The plan is to distribute about 60 to 70 percent of FFO. For our rough calculation, we will assume that two thirds of AFFO are distributed and one third is retained. Assume further that the retained part is reinvested with AFFO yield 12% (the lower bound of the management guidance; the current yield is 13%). This means that AFFO will grow by about 23M, that is, about 4%. After adding the above-mentioned "inflationary" increase of 2%, we get 6% growth of AFFO. Since we assume a constant payout ratio, the distributions will also grow by 6% (again in line with the management estimate of 3% to 7%). The current yearly dividend rate is $1.72. The resulting "fair" unit valuation is 45 at a 10% discount rate. Compared with the current price of 36.6, I see a nice 20% margin of safety.
Evaluation of risks
In the short term, 90% of revenues are protected by take-or-pay contracts and regulated contracts. In the long term, I believe that revenues are also safe because the infrastructure owned by BIP is essential to customers.
As a kind of sensitivity analysis, assume that revenues decline by 10% while the direct costs associated with revenues decline only by 5%. This would mean about 176M decline in cash from operations, thus FFO would stand at 504M. After deducting 114M of maintenance capex, we arrive at 390M of AFFO, which still covers 350M of distributions.
The main risks I see are the following:
1. Significant debt load. Total net debt stands at 6.4B; partnership capital is about 5B. The management has done a very good job of exploiting the recent period of low interest rates: the interest rate currently paid by BIP is between 6 and 7% and less than 10% of debt is payable within three years. Only 14% of debt is floating rate. Borrowings are non-recourse, so a default at one operation does not lead to a default of the company. The management is determined to keep bonds investment grade (currently BBB+, see the report). The company has 1.1B in cash and a credit facility of 1.4B ready at hand. Management also promises to keep a reasonable payout ratio (at most 70% FFO) and maintain sufficient liquidity. Interest expenses are covered 2.3 times, which I would be happy with as a bondholder, but as we have seen, a 20% decline in revenues can put the distribution in jeopardy.
Personally, I am willing to bear this risk and prefer BIP to an index fund at this price. There are two factors mitigating the risk of default. First, revenues are either obtained from distribution of necessary products like household electricity, or protected by long-term contracts, and so they can decline only if counterparties default. That is unlikely since most of the counterparties are governments or investment-grade companies; they usually default only under a really dire general conditions, and one would expect defaults and dividend cuts all across the board leading to large losses of market value in whatever stock I could have invested in. Second, although the services provided by BIP are essential to customers, they constitute only a minor expense, so they will be the last thing to cut.
2. The risk of management failure. First, the ownership structure of BIP is very complicated, essentially there is a small group of Brookfield Asset Management (BAM) stakeholders controlling BIP, and a conflict of interest between BIP and BAM may arise. Second, issuance of new units can dilute current unitholders (however, the 25% limit on incentive distribution rights is favourable compared to 50% used by various MLPs). Third, acquisitions can fail, but the management seems trustworthy and conservative in this area. In addition, the relationship with BAM which has a large network of business connections and significant capital at hand appears helpful with respect to acquisitions.
3. Political risks. There are two significant risks in this category: the risk of unfavourable changes in regulatory regimes (or some hostile actions of governments) and the possibility of losing the current tax status.
4. Significant dependence on China, particularly the dependence of Australian operations on the production of steel (railroads transporting mostly iron ore, the coal terminal used for 22% of world seaborne metallurgical coal).
5. Currency risks. These are small, however; about 70% of FFO is hedged to US dollar (more than enough to cover distributions).
A combination of multiple risks realizing at the same time can be particularly unpleasant, for instance, a very high inflation (and the corresponding increase of maintenance capex) combined with regulatory changes not permitting to increase prices. This is not out of consideration in many countries BIP operates in---both risks have manifested in Latin America not so long ago.
Finally, I would like to cheerfully note that the company is not exposed to a destruction by a single event. (I can invest in only a few individual companies, so oil producers, nuclear utilities, and single-factory companies are somewhat out of reach.)
I am a happy owner of BIP (more than 7% of my stock portfolio), and I find reasonable to buy more if funds are available. Markets have been rather volatile recently, so even a better opportunity may arise, but I would be content with buying at 36. BIP earnings and revenues are reasonably predictable for decades, and the current stock price indicates about 11% return. I consider this very attractive compared to the overall market with Shiller P/E above 24, indicating expected returns far below historical average. Also, compared to a 20-year bond with fixed 3.3% yield, carrying the risk of losing 20% or more in a short time if interest rates rise, BIP with rising 4.7% yield offers a better value.