A week ago, Brookfield Infrastructure Partners (NYSE:BIP) reported strong third quarter results and updated the guidance for future growth rates. I will use the new numbers to refine my valuation of the company which was based on 1H2013 results (see the analysis). I think that the units are slightly undervalued at $40 and anyone investing at this price will achieve satisfactory returns. In particular, I am looking forward to a 6 to 20% increase in the quarterly distribution in February 2014, which could lead to a similar increase in the unit price.
As I have written in a recent article, I am trying to avoid risky businesses. In particular, I prefer companies that carry little debt. Brookfield Infrastructure owns various infrastructure assets with very stable cash flows and so they can afford to borrow considerable sums of money against those assets to boost returns. Such borrowing is quite common among MLPs and electrical utilities (even Berkshire's MidAmerican does it, and Buffett is known to avoid debt as much as possible), but the looming end of quantitative easing and a possible increase in interest rates makes one think hard what would happen to his investments.
The third quarter letter to unitholders devotes much space to discuss how the risk of rising interest rates affects the business. I find the management's claims reasonable and comforting to the shareholders. The CEO Sam Pollock has the following to say: "We don't profess to know when or if interest rates will rise further, however, we can state that we have for the last several years, during this historically low interest rate environment, operated our business on the assumption that rates would return to more traditional levels. In addition, we do not believe that higher interest rates are bad for infrastructure assets, in fact, we believe the opposite, as higher rates will in all likelihood, be accompanied by higher inflation and economic growth which are generally beneficial for our business."
There are two important metrics used by the management. Funds from operations (FFO), which is essentially net income plus depreciation and some non-cash charges, and adjusted funds from operations (AFFO), which is FFO minus maintenance capital expenditures. I view AFFO as an equivalent of Buffett's owner earnings.
My analysis is based on the numbers reported for the third quarter which I will multiply by four to get a full year estimate. Numbers from the first and the second quarter are less meaningful because of the sale of timber assets in the second quarter and an increase in FFO mainly due to the commissioning of the Australian railroad. Apart from asset disposals and acquisitions, cash flows tend to be very stable over the year. I consider my approach conservative: FFO is likely to increase in the following quarters because of new capital investments and the interest expense and maintenance will remain more or less the same. The following table summarizes important financial data for the third quarter and my full year estimates (in millions of US dollars).
Full year estimate
Total net debt stands at 6.7B, while partnership equity is about 5B. BIP has capitalized on the historically low interest rates and increased the average maturity of its debt to about 10 years. Approximately 90% of the debt is fixed-rate. The interest cover of 2.7 times looks sufficient.
The payout ratio, which I define as distributions divided by AFFO, is 75%. Considering the stability of BIP's cash flows and the quality of their contracts (most are long-term or regulated), the distribution is safe. The management of BIP aims to distribute between 60 and 70 percent of FFO. My estimate is at least $3.2 of FFO per unit in the next year, so the distribution should fall between $1.92 and $2.24. However, this covers not only the net distributions to unitholders, but also incentive payments to the general partner Brookfield Asset Management. The most important part of the incentive payment is 25% of the portion of the distributions to unitholders in excess of $0.33/quarter. For the current quarterly distribution it means that about 3 cents go to BAM. For a full year, it is 12 cents, so the gross distribution is $1.72 plus $0.12 per unit, which is $1.84. Consequently, the dividend increase can be expected to be between 4% and 20%.
With units trading at $40, the dividend yield is 4.3%. There are several potential sources of growth:
- Reinvestment of retained earnings. There is 132M to be reinvested. The management expects to be able to reinvest cash flows at 12 to 15% returns, which leads to 3-4% growth. They have a proven track record, so we can use their numbers.
- Inflation. About 70% of revenue is indexed to inflation. The management expects long-term inflationary growth rate of 3 to 4%, which is consistent with historical data.
- Volume increases. There is surplus capacity at various assets which allows to increase revenue without meaningfully increasing costs (for instance, toll roads). The management estimates the growth potential at 1-2%.
However, the growth in FFO or AFFO cannot be directly translated to the distribution growth because of the incentive distribution rights. The precise formula would be too complicated; for an illustration, a 20% growth in FFO would translate to 17% growth in distributions to unitholders at the current level of distributions and only 15% growth in distributions if the distributions were already much larger than $0.43 per quarter.
I will consider three scenarios and estimate future growth rates in each of them.
First, deflationary scenario with zero inflationary growth and no volume increases. The only source of growth is the reinvestment of retained earnings. Consequently, one can expect total return of about 7% (obtained by summing yield and growth). I am perfectly OK with such performance in this pessimistic scenario.
Next, a realistic scenario: about 3% inflationary growth and 3% reinvestment growth plus 1% from volume increases. Together with yield we get 10-11% total return.
Finally, in an optimistic scenario, the management expects FFO per unit growth of 10% (see the company presentation). This leads to 12-13% total return. This scenario is not unrealistic: the 5-year CAGR of FFO/unit is 34% and the CAGR of distributions is 13%. Though I do not believe these trends will continue for many years to come, the numbers are certainly impressive. In addition, there is about 2.7B of corporate liquidity ready to fund new investments.
The management of BIP has increased their guidance for long-term distributions growth to 5 to 9%. A discounted cash flow calculation assuming 6% distribution growth and 10% discount rate gives the value of $45/unit. Thus there is at least 10% margin of safety. The margin would increase to 35% if we assumed 7% growth of distributions. I am not going to repeat my mistakes of buying too little of a great business available at a moderate price and will increase my position if I have cash available.