Brookfield Corporation. Notes (I)

An introduction.

Earlier this month I asked in Twitter whether it would be of any interest that I share some thoughts or notes taken while diving into Brookfield. Following the result of the poll and given the size (and complexity) of Brookfield, I believe the compilation of these notes to be helpful for both the reader and myself by (a) providing details about Bruce Flatt’s insights and (b) showing how I approach the process of understanding an enterprise from scratch.
When looking at a business I tend to take an A-to-Z sort of approach which, while it can seem exhausting sometimes, it is the best technique I know of. For this reason I would like to apologize upfront if I jump from topic to topic randomly or thoughts are compiled in a somewhat chaotic way.
Having said this, I hope you find it interesting.

When analyzing Brookfield, two key aspects are -in my view- the pillars behind the process of truly understanding the mission of the company and the value proposition over the longer term. These are its management (more especifically Bruce Flatt) and the enterprise culture that has been achieved within Brookfield over the years.
As they put it in their investment principles:

Brookfield’s approach to investing is disciplined and straightforward. With a focus on value creation and capital preservation, we invest opportunistically in high quality, real assets within our areas of expertise, manage them proactively and finance conservatively to generate stable, predictable and growing cash flows for clients and shareholders. Our approach to investing is anchored by a set of core investment principles that guide our decisions and how we measure success:

• Invest where we possess competitive advantages.

• Acquire assets on a value basis with a goal of maximizing return on capital.

• Build sustainable cash flows to provide certainty, reduce risk and lower our cost of capital.

• Recognize that superior returns often require contrarian thinking.

So, what does Brookfield exactly do?

Brookfield Corporation focuses on acquiring real assets at prices below their replacement cost (a.k.a. when the owner goes through times of distress and becomes a forced seller). Furthermore, these assets are considered of high quality. This means they represent the backbone of the global economy, whether office space, residential and commercial properties, renewable power generation stations or key infrastructure (e.g. ports, railroads, etc.). Why is it so important that these assets are located at the spine of the economic activity? Because not only their cash flows will enjoy more visibility and resiliency (when problems arise), but their underlying fair value will appreciate at a higher pace.
Furthermore, visibility in cash flows makes them predictable, which in turn serves their owners well in reducing the cost of capital used for financing them.

When acquiring these assets, Brookfield’s approach is to only contribute with a minor portion of its own resources, with the remaining capital being financed on a long-term, investment-grade basis. Sometimes third-party capital also co-invests alongside Brookfield’s equity (to who Brookfield refers to as clients or co-investors), splitting the ownership of the underlying asset proportionately and thus the future cash flows. On the financed side (debt), the intrinsic predictability of the cash-flow generative nature of the assets helps Brookfield and its co-investors in getting favorable conditions. To provide an example on this, most of Brookfield’s debt is non-recourse, meaning that only the asset being financed acts as collateral so, shall the project go bankrupt, the rest of the assets within the corporation cannot be claimed by the lender.
Why would Brookfield accept sharing a portion of the pie with third parties? There are two main reasons: (a) Brookfield always operates these assets, charging management and performance fees to the portion of the asset which belongs to the non-controlling equity in case there are co-investors and (b) this “freely” increases Brookfield’s scale, easing the reach and discovery of future projects, as well as the financing terms moving forward.

The next step after acquiring these assets is their operations. Brookfield’s approach is to run them as efficiently as possible, avoiding frictional costs and enhancing cash flows.

Therefore, we have spotted the two main components which have made Brookfield Corporation compound its intrinsic value at annualized rates between 12.0% and 15.0% for the past decades: cash flows from operations (an adjusted version of these that serves as a key indicator within the business is called funds from operations or FFO) and the increase in fair value of the underlying assets over the years.

As they put it in the annual report from 2010:

We create value for shareholders in the following ways:

• As an owner-operator, we aim to increase the value of the assets within our platforms and the cash flows they produce.

• As an investor and capital allocator, we strive to invest at attractive valuations, particularly in distress situations that create opportunities for superior valuation gains and cash flow returns, or by monetizing assets at appropriate times to realize value.

• As an asset manager, by performing the foregoing activities not just with our own capital, but also with that of our clients.

Our primary financial objective is to increase the intrinsic value of Brookfield, on a per share basis, at a rate in excess of 12.0% when measured over the long term. Our intrinsic value has three main components:

• The net tangible asset value of our equity (NTAV). This is based on the appraised value of our net tangible assets as reported in our financial statements, with adjustments to eliminate deferred income taxes and revalue the assets which are not otherwise carried at fair value in our financial statements.

• The value of our asset management franchise. Asset management franchises are typically valued using multiples of fees or assets under management. […]

• The overall business franchise, which to us represent our ability to maximize values based on our extensive operating platforms and global presence, our execution capabilities and relationships which have been established over decades. This value has not been quantified and is not reflected in any of our estimations but may be the most valuable of them all.

Cash flow from operations (CFO) is another important metric for us, as it serves as an important benchmark for valuing many of our assetts and our operational efficiency.

[…]

We do not utilize net income on its own as a key metric in assessing the performance of our business because, in our view, it does not provide a consistent measure of the ongoing performance of the underlying operations. For example, net income includes fair value adjustments in respect of our commercial properties, timber and financial assets but not our renewable power, utility and development assets which currently represent approximately 50.0% of our invested capital.

It may sound easy, but avoiding overpaying for high-quality assets very well may require long periods of time where invested capital is reduced, meaning you have to sit on a pile of cash waiting for the opportunity. This, together with the continuous effort for cost control and efficient operations, is where Brookfield’s culture results most important.

Linking a Google Talk from Bruce Flatt that I consider a master piece:

As usual, any feedback is much appreciated.