Cutting Through Complexity: Brookfield Asset Management Valuation

Summary

• BAM has been very successful with the unique team approach to the investment process as its competitive advantage.
• The method that BAM uses to value itself has significant flaws and cannot be used for intrinsic value determination.
• BAM value can be approximately calculated as 16-17 times its operating FFO.
• This method worked well for BAM prior to Oaktree acquisition and is likely to remain relevant once accounting includes operating results on post-acquisition basis.

Introduction

No doubt that Brookfield Asset Management (NYSE:BAM) has been truly successful since Bruce Flatt became its CEO in 2002. Born in 1965, he is likely to lead BAM for many more years which by itself makes shareholders optimistic. The company has developed its own strategy based on certain competitive advantages and did the utmost to sharpen these advantages. I have been a BAM investor for more than 7 years with market-beating results and my only regret is that I had not discovered it earlier. The company, being simultaneously powerful and nimble, causes certain fascination and you cannot stop admiring its tireless maneuvering that almost always produces added value.

In my opinion, the company's root competitive advantage is its ability to profitably invest in real assets for long term on value basis by a TEAM of outstanding investment managers. Typically, in investment companies (like Berkshire Hathaway (BRK.B) or Markel (MKL)), we can easily designate one or two outstanding investors who run the show. It is not so with BAM, which has developed a team approach to long-term investment. Members of this team speak a very similar language and implement similar investment ideas. Often BAM would appoint new managers for its investment vehicles or newly acquired subsidiaries out of its formidable lineup and they would manage up to the highest standard (for comparison, you may recall that Warren Buffett typically acquires companies with strong management in place and emphasizes Berkshire's inability to supply good management). Other competitive advantages, such as operational proficiency and global scope, were built on top of that. At first, the company made investments work well for its own capital and later succeeded in attracting under its management third-party capital of giant institutions.

There are plenty of reasons to own BAM, but this post is devoted to a more narrow topic of BAM valuation before the majority acquisition of Oaktree (OAK). Preliminary calculations show that this transaction is accretive in the present and even more promising in the future. The recent share price increase provides support for this thesis. However, I prefer to restrain from the detailed analysis until accounting is merged and synergies become palpable. It is quite likely that once post-acquisition operating results become available for the first full quarter (in Feb 2020), the proposed valuation method will become applicable and the results could be directly compared with the share price.

BAM Values Itself

At the end of each quarter, BAM presents the detailed Supplemental Information (available on the company's site) that accumulates all possible figures regarding the company's performance during the last quarter and the last twelve months (LTM). Few companies can match this treasure of numbers every quarter, but the challenge remains to extract the most meaningful data. And some important details remain opaque (as an exercise I suggest figuring out how BAM calculates its tax liabilities), or are published as footnotes in a fine font.

In terms of its structure, BAM is one of the most complicated companies. One can imagine it as a mothership (BAM itself) surrounded by 4 giant vessels (Brookfield Property Partners (BPY), Brookfield Infrastructure Partners (BIP), Brookfield Renewable Partners (BEP), Brookfield Business Partners (BBU) - for simplicity we will call them subsidiaries in this post even though it is not technically correct), further surrounded by other vessels - many different investment vehicles, big and small, public and private, subsidiaries of subsidiaries, significant investees, etc. Overall this flotilla consists of tens of significant ships with quite complicated relationships between them that include direct and partial ownerships, indirect ownerships, vertical and horizontal relationships, contractual relationships, multiple listings of same entities, common management, countless preferred issues in different currencies and so on. The mothership controls all other ships and benefits from their successes and in return supports them when needed and guarantees they stay afloat in a time of trouble.

To cope with this complexity, the company helps investors publishing in each Supplemental Information its own valuation. Until a few years ago this published figure was called "intrinsic value" but now is called "plan value".

BAM makes money primarily in 3 ways: returns on its own invested capital, earning various fees on managed capital entrusted to BAM stewardship by other institutions and retail investors (management fees, performance fees, IDRs, transaction fees) and carry, i.e., a certain type of performance fees that BAM assesses on managed capital once its returns exceed certain hurdles. So, the formula that BAM uses for valuing itself may seem straightforward at first glance: its own capital plus certain multiple of fee-related earnings (FRE, calculated as fees earned less direct costs such as compensation, taxes) plus certain multiple of targeted net carry (i.e. carry less expenses that are projected to be earned annually provided all performance hurdles are met). This approach has become quite popular and is often repeated in posts related to BAM, including those on this site. But if you are skeptical, numerous problems with this valuation method pop-up immediately:

1. Let us start with the company's own capital. It is primarily concentrated in BAM itself and its 4 big subsidiaries: BPY, BIP, BEP, BBU. All of these subsidiaries are traded publicly and you can directly calculate the fair value of the shares belonging to BAM. However, BPY trades significantly lower than its book value, while all other subsidiaries trade significantly higher than their book values. BAM has elected to use the highest number of the two and calls it "blended". Do not think the difference is small. Total BAM capital in Q3 2019 is $24.4B with the difference between book value and fair value of BPY of $4.6B ($10.6 B vs. $15.2B). Moreover, for BPY book value, BAM uses IFRS values that require periodic real estate revaluation instead of more conservative GAAP values that use historic transaction prices as depreciated. So even book figures are subject to further review (BPY IFRS figures seem realistic as in most cases they sell real estate for prices in excess of IFRS values but even this can be challenged: what if BPY sells only when the price of a building is higher than its IFRS value and does not sell otherwise?)

2. For FRE and target carry, BAM uses multiples that are quite arbitrary. Until recently it was 20 for FRE and 10 for the carry. But in Q3, 2019 these numbers were instantaneously changed to 25 and 10. Since FRE is arguably the most important part of earnings, the company immediately became significantly more valuable.

3. The use of any multiple for the target carry is doubtful. The target carry is something that the company is supposed to earn PROVIDED the investment hurdles are met. They may not be earned at all and/or if earned it will happen in the future, sometimes in the distant future as carry is typically back-loaded. Granted, so far BAM has been successful in meeting and beating its investment hurdles. But we want to value the company (in fact, any company) based on what it has done so far, not on projected and undiscounted results.

4. BAM approach to valuing itself includes double counting. FRE is calculated on total capital under management, including BAM's own capital. So, at first, BAM counts its own capital and then it adds management fees on its own capital at 25 multiple…

The arguments above should make one very suspicious accepting BAM calculations as something close to intrinsic value. That is, probably, why BAM changed the name for its method to "plan value". This name seems quite proper to measure the company's progress in different areas, but one should clearly distinguish between the hyped "plan value" and conservative intrinsic value.

How to Value BAM?

Is another way to value BAM possible? I think, yes, and it is pretty straightforward, but first of all I want to list methods that will not work:

• No detailed calculations for different segments of BAM are possible due to the complexity of the company's structure. Metrics should be simple and straightforward, valuing the company as a whole and bypassing numerous details.
• Book value that works reasonably well for other investment companies (Berkshire Hathaway, Markel and others) is not appropriate for BAM. FRE segment has no material book value at all, book values for BIP, BBU, and BEP are too low and for BPY is too high.
• Valuing BAM on SOP (sum of the parts) basis, in my opinion, is not relevant. One can effectively use SOP when a company under review consists of truly independent parts that are loosely tied to each other. This is not the case with BAM. Its main competitive advantage is its ability to creatively and profitably invest in real assets. This ability alone stands behind the growth of its own capital and assets under management. I will provide here a comparison that might be convincing for some and controversial for others: one cannot, in my opinion, value Apple based on different multiples for services and hardware sales, since both figures are dependent on iPhone installed base and every dollar earned in hardware sales is as good as a dollar earned in services.
• Considering the target carry directly should not be a part of the conservative valuation. The future target carry is indeed a source of significant upside potential for BAM, but it should be accounted for gradually while it is being earned or at least being accrued while still subject to clawbacks (BAM publishes this figure in each Supplemental Information)
• Net income cannot be used due to depreciation far exceeding maintenance capital expenses (I will not go into details here but some of BIP presentations show it very clearly) and accounting for deferred taxes which may never be paid.

In my opinion, the best logical metric to value BAM is its operating FFO (funds from operations, similar to REITs, it primarily adds depreciation to operating earnings after cash taxes). BAM recognizes its importance by publishing the FFO figures at the beginning of Supplemental Information and other investor materials. However, certain comments and adjustments are relevant when working with this metric:

• Operating FFO excludes some volatile and one-off figures such as capital gains and realized carry. They account only for some time-resilient business. When BAM extracts capital gains or realizes carry, it shortly invests them again and before long this investment starts generating incremental cash flows. That is why operating FFO, albeit indirectly and with some time lag, accounts for all added value including capital gains and realized carry.
• Operating FFO consists of 2 parts: earnings generated by long-term assets such as real estate, infrastructure, renewable energy (invested assets), and FRE. The metric is very convenient in the sense that it automatically prevents double-counting: management fees on BAM's own capital are deducted from invested assets FFO and added to FRE.
• Operating earnings should be adjusted for preferred dividends, and considered on a per-share basis for the last twelve months.
• Operating FFO is not an ideal metric. I would prefer AFFO (adjusted at least for maintenance Capex). However, this figure is not available across the BAM universe. BIP publishes AFFO adjusting not only for maintenance Capex but also for the return of capital (as opposed to the return on capital) but this is the only part of BAM that provides this number. For BBU, EBITDA is arguably a better metric than FFO, but BBU is relatively small and hopefully, we are not making a material mistake here.

In the table that follows I present the results of valuation based on calculating price to operating FFO ratio for end of period share prices.

Table 1: BAM valuations

Disclosure: I am/we are long BAM, BIP. 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.