My 2 Favorite Infrastructure Businesses Are On Sale

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About: Brookfield Infrastructure Partners L.P. (BIP), MIC, Includes: SPY
by: Samuel Smith
Summary

BIP is the quintessential GARP play and is one of the most attractively valued SWANs on the market today.

MIC has higher operational and execution risk and weaker growth prospects, but its yield is nearly twice as BIP's and the distribution coverage is very strong.

Infrastructure has a very bright growth outlook for decades to come, and BIP and MIC are well positioned to capitalize. Their valuations make them very opportunistic in this environment.

In an attempt to bring relief to the heavily indebted balance sheets of many governments across the globe, the infrastructure industry is in the early stages of a large scale transfer of ownership from governments to private corporations. Furthermore, rapid economic growth in Asian giants like India and China, continued development in Brazil, and rapid population growth in the developing countries of Africa and Southeast Asia (not to mention the aging infrastructure in countries like the U.S.) are leading to a significant need for new and improved infrastructure across the globe. By some estimates, $94 trillion (yes, that's trillion with a T) in global infrastructure investment will be needed by 2040. This puts experienced infrastructure businesses in an ideal growth position as they should have limitless opportunities to put investor capital to work in accretive projects and drive strong returns for a long time to come. After the recent market sell-off, two infrastructure businesses look particularly enticing.

Brookfield Infrastructure Partners

Brookfield Infrastructure Partners (BIP) is one of the top growth-at-a-reasonable-price opportunities today, especially considering the fact that its business model is highly recession and inflation-resistant: 75% of its cash flows are inflation-indexed, 65% contain no volume risk, only 5% are subject to commodity price risk, and all of its assets are considered wide moat/high entry barrier/mission critical businesses. Further adding to its macroeconomic resilience is its considerable geographic and sectoral diversification: 25% of its cash flows come from North America, 25% come from Europe, 30% from South America, and 20% from Asia, Australia, and New Zealand. Additionally, its 35 assets include railroads, electricity and natural gas utilities, timberlands, toll roads, ports, and pipelines.

Bear Case

1. Foreign Exchange Risk: While its geographic diversification is a blessing in that it provides an abundance of attractive investment opportunities and macroeconomic diversification, the trade-off is that BIP's cash flows are exposed to foreign exchange impacts on earnings. It has a sizable negative impact during Q3 and is an item that is not going away, likely continuing to cause choppy performance on a quarter-to-quarter basis. Investors must decide for themselves if they agree with management's conviction that this averages out over time to have a negligible impact or if they believe that the U.S. Dollar will continue to strengthen relative to foreign currencies in BIP's target markets (especially Brazil, Canada, and India). If foreign currencies in which BIP does much of its business decline significantly against the Dollar for a prolonged period of time, BIP's returns will be significantly muted.

2. Interest Rate Risk: Another factor investors should keep an eye on is interest rates. Should they continue to rise, the bond-like nature of many of BIP's assets will likely decline in value, offsetting some of the growth in value from organic growth. Furthermore, if interest rates rise significantly and remain high for a considerable period of time, BIP's interest rate expense will also significantly increase as it comes due for refinancing, eating into returns and limiting their ability to finance growth.

Bull Case

1. Tremendous Growth Potential: This focus on stable, economic-backbone businesses alongside long-term contracts and significant geographic and sectoral diversification has enabled BIP to grow its distributions rapidly (11% CAGR since 2009 IPO) while still retaining sufficient cash flows to reinvest in further growth. In fact, even in a year in which significant dispositions and recycling of capital are taking place (thereby temporarily halting cash flow growth), BIP has still been able to grow its distribution by 8%.

Speaking of dispositions and capital recycling, the second aspect of BIP's business model that enables it to achieve such standout total returns and consistently raise capital to finance its growth without overleveraging the balance sheet is its ability to effect operational improvements into its assets to "mature" them and then sell them for significant capital gains. This strategy has worked remarkably well as BIP has averaged an IRR of ~25% on $3.8 billion of asset sales since its IPO about 10 years ago. After selling these assets at forward projected 6%-10% IRRs, it then recycles the capital into other opportunistic assets that it believes it can achieve 12%-15% IRRs on by utilizing Brookfield's operational expertise.

During the most recent quarter, BIP executed on this aspect of its business model by investing $210 million in growth CapEx, closing numerous acquisitions in key markets (India toll road, Western Canada Midstream business, Enercare, and a leading South American Data Center business), and adding $190 million to the investment backlog as part of an expected $2.3 billion in growth investments over the next several years. Between adding an impressive and diversified portfolio of new assets to the business and bolstering the growth runway, BIP looks primed to reaccelerate its FFO/unit growth in a meaningful way in the near future.

The emphasis on extensive capital recycling explains well the disconnect seen in BIP's Q3 report between underlying asset-level performance (8% constant currency organic growth) and the headline FFO/unit figure (declining 12%). In fact, going back to the beginning of the year, FFO/unit is still pretty much flat year over year ($2.31/unit in 2018 and $2.32/unit in 2017) and their annualized distribution payout ratio is not too far above the long-term target at 76%.

2. Significant Liquidity: The BBB+ rated balance sheet is also in strong shape: management reduced total net debt from $9.628 billion to $8.439 year over year and corporate borrowings from $1.944 billion to $1.664 billion year over year (the vast majority of their debt is asset level non-recourse leverage) in Q3. This leaves BIP sitting on $4.3 billion in liquidity at quarter end (of which $3.2 billion is at the corporate level, giving them significant acquisition flexibility as well as financial security), thanks to raising ~3/4 of a billion CAD during the quarter through preferred equity and debt (10 year length) issuance at an attractive blended annualized fixed cost of ~4.5%. This was a prudent move by management, enabling them to raise low-cost, long-term capital for investment in its significant growth runway. Additionally, the corporate debt to EBITDA and corporate interest coverage ratio are a very safe 1.1x and 25x respectively (all other debt and interest payments are at the asset level), making the business and its distribution very safe.

3. Compelling Risk-Reward: BIP is the quintessential growth-at-a-reasonable-price investment right now: sporting a strong 8%-13% growth outlook for the foreseeable future alongside its 5.3% dividend yield.

Chart BIP data by YCharts

Considering its stable business model, there is a high likelihood of double-digit total returns being achieved over the long term, barring drastic moves in interest and/or exchange rates. BIP clearly offers some of the best risk-reward in today's uncertain market and economic environment.

Macquarie Infrastructure Corp.

Macquarie Infrastructure Corp. (MIC) is a highly diversified company operating in the infrastructure segment which offers investors a compelling opportunity to access high-quality low-risk assets at a steep discount while locking in a well-covered double-digit yield. Shares declined sharply earlier in the year after management responded to weakness in its International-Matex Tank Terminals (IMTT) energy storage business (backwardation in relevant commodity markets resulted in a dramatic decrease in the demand for liquid fuels storage and ~15% excess capacity this year) by cutting the distribution by 30%. However, the dividend cut was a very conservative response to a mere 8%-10% expected decline in free cash flow from the storage business weakness, rendering the steep decline an overreaction and creating a significant gap between price and value.

Bear Case

1. Execution/Capital Allocation Risk: Given the large percentage of its total cash flows stemming from the IMTT business, management's ability to successfully and rapidly repurpose it for stabilized performance and eventually growth is crucial to the total return proposition in MIC shares. If management fails and this segment underperforms for several years, the shares could continue to languish or even decline further, while distribution growth will likely be put on hold indefinitely.

2. Recession Risk: Unlike BIP, some of MIC's business could be significantly negatively impacted by a recession. A significant slow-down in energy consumption (due to a slowing economy) could lead to further weakness in the energy business and its aviation business would also likely suffer from a downturn in global air traffic demand. This could result in a declining share price and postponed dividend growth.

3. Interest Rate Risk: Another factor investors should keep an eye on is interest rates. Should they continue to rise, the value of MIC's assets will likely decline in value. Furthermore, if interest rates rise significantly and remain high for a considerable period of time, MIC's interest rate expense will also significantly increase as it comes due for refinancing, eating into returns and limiting their ability to finance growth.

Bull Case

1. Improved Balance Sheet: Despite its recent challenges, MIC still has a recently reaffirmed investment grade credit rating. Thanks to their sale of the "Bayonne Energy Center" ('BEC'), MIC's balance sheet is even stronger than it was at the time of their reaffirmed credit rating and plan to have reduced total outstanding debt by nearly $1 billion by year-end. This should bring their debt to EBITDA ratio well within their 4x-4.5x target, down from 5x earlier this year. As a result, their interest costs will be greatly reduced and liquidity will be significantly improved, strengthening their distribution and potentially paving the way for renewed investment in growth projects.

2. Significant Insider Buying: While insider buying isn't the end-all-be-all of investing, it certainly helps to build conviction in an investment thesis. This is especially true when shares have been beaten down significantly in recent months. Over the past half year, MIC insiders purchased shares in significant amounts between $45 and $46. Today shares are trading at 16%-17% lower than insiders purchased them at, MIC has retained a significant amount of cash flows, the balance sheet has improved, and the IMTT is closer to being repurposed than it was when they purchased shares.

3. A Record of Outperformance: Despite the recent sell-off, MIC still has a record of vastly outperforming the S&P 500 (SPY):

Chart

MIC Total Return Price

data by YCharts

Its dividend also has a strong long-term growth average despite the recent 30% cut, growing by 128.7% over the past decade:

Chart

MIC Dividend Per Share

(TTM) data by YCharts

These numbers illustrate the strong long-term returns that its business model can generate, even when accounting for challenges like it is suffering at the present.

4. Well-Diversified Business Model: While the troubled IMTT business gets the most attention, fortunately, MIC is not a one-trick pony. In fact, roughly half of its EBITDA is generated outside of IMTT.

Its Atlantic Aviation business enjoys networking and economies of scale advantages as one of the largest of its kind in the U.S. and is currently providing MIC with much-needed stable cash flow generation and steady growth. Though it is somewhat recession-vulnerable due to the sensitivity of the airline industry to macroeconomic conditions, it does enjoy 20 year plus average remaining leases on its contracts. As a result, it should not experience a significant decline during an economic downturn. The Contracted Power business has shrunk considerably following the sale of the BEC facility but still provides MIC with an avenue for potential future growth. Finally, MIC Hawaii is a green energy-focused business which consists of Hawaii Gas and other businesses that are collectively engaged in enhancing the cost-to-performance ratio of energy in Hawaii. MIC Hawaii is a fairly stable cash-flowing business and also enjoys a growth tailwind from the pro-green energy sentiment on the islands.

5. Highly Compelling Valuation: In addition to the heavy insider buying, the cheap valuation appears obvious due to the 1.5x distribution coverage and the yield climbing to levels not previously seen (note the chart's yield is based on TTM rather than the forward yield of ~10.4%):

Chart

MIC Dividend Yield

(TTM) data by YCharts

While there is interest rate, recession, and execution risk present, MIC's balance sheet improvements and diversified stable businesses significantly mitigate the downside risk. Furthermore, the distribution coverage means that a lot of cash is being conserved to invest in restoring the IMTT business, further reducing interest rate, recession, and execution risk. MIC is clearly a deep value play that is higher risk than BIP, but the margin of safety is wide and the upside potential is enormous.

Investor Takeaway

Thanks to the recent market turmoil, there are now some very attractive opportunities in the infrastructure sector - a recession-resistant and wide moat industry with a very attractive growth profile for several decades to come. BIP offers investors an attractive growth-at-a-reasonable-price opportunity alongside an attractive 5.3% dividend yield. Furthermore, its business is fairly recession and inflation resistant, making it a great "Sleep-Well-At-Night" opportunity. MIC, on the other hand, presents investors with more of a deep value opportunity and an extremely attractive 10.4% yield. However, its business is at more recession risk (though still fairly stable) and the distribution does not share the same robust growth prospects as BIP. Unless you strongly favor income growth or current income (or have a strong preference between K-1s (issued by BIP) or 1099 (issued by MIC), a 50-50 split between the two might be ideal as it would make for a well-covered ~7.85% yield with strong recession-resistant distribution growth prospects (5%-7%) as well as significant potential for price appreciation.

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Disclosure: I am/we are long BIP, MIC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.