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Meet the Brookfields, Meet Profit

Matthew DiLallo, The Motley Fool

Brookfield Asset Management (NYSE: BAM) is an under-the-radar company with big potential and a fantastic track record. In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Matt DiLallo dive into Brookfield itself, two of its subsidiary companies (Brookfield Property Partners (NASDAQ: BPY) and Brookfield Business Partners (NYSE: BBU)), and the Brookfield Property REIT (NASDAQ: BPR).

Tune in to find out how each of these businesses work, how they make money, what signs and metrics investors should track for each of them, what kind of return investors can expect in the long term, and what makes Brookfield such a unique and exciting opportunity. Be sure to tune in next week for a deep dive into Brookfield's infrastructure and renewable energy arms!

A full transcript follows the video.

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This video was recorded on Feb. 14, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Valentine's Day, and this is part one of a two-part discussion of the Brookfield Asset Management family of companies. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Matt DiLallo via Skype. How are you doing, Matt?

Matt DiLallo: Doing great! How are you? 

Sciple: I'm doing great! I'm excited for Valentine's Day tomorrow! Love is in the air and we're talking about a company that you really love today, Brookfield Asset Management and the whole family of companies. We were talking about before the show that this is your No. 1 holding when you net together all of the underlying businesses. Can you talk about, off the top of the show, what makes you like this business and this family of businesses so much?

DiLallo: I like them because they've really done well for me over the years. I think I've held Brookfield for maybe 15 years. I've learned so much through this holding. Their CEO, Bruce Flatt, is just so smart. He's like the Warren Buffett of Canada. His shareholder letters are right up there with Buffett's in my mind as something that should be read every quarter. It's been a great learning experience for me, as well as an enriching holding.

Sciple: Let's go ahead and talk about Brookfield Asset Management, that's the parent company of this family of Brookfield companies. Depending on how you count, there's four subsidiaries, but you can also count the REIT, and they also own a majority stake in TerraForm Power. This is a large number of companies.

Talking about Brookfield Asset Management first, this is a company that has over 100 years of history. I thought it was really interesting, reading about this company, that it started from, some Canadian financiers in 1899 bought some assets in Brazil. From there, they've grown over time. They just started taking outside investment dollars in 2001. The ability for folks outside of the actual business to invest in the company has only been around for about 20 years. 

Can you talk a little bit about -- the company has evolved over time, but what is Brookfield Asset Management's business today?

DiLallo: The name really sums it up, they're an asset manager. They own things that produce cash flow. As you mentioned, they have different subsidiaries. Each one focuses on a different aspect. We have property, infrastructure, private equity, and renewable energy. They manage assets in each one of those groups and they make money off of that business of managing these assets for not only themselves -- Brookfield has a huge stake in each of these companies -- but for private investors. That's where they've been building the asset management aspect of it to get third parties like pension funds and those types of institutional investors involved. 

Sciple: I saw that they have $330 billion under management. Of that, $30 billion is their own cash that's into the business, while the other $300 billion of that comes from various institutions. They have over 500 institutions invested in their various family of funds. 

What's really interesting about Brookfield to me is, they're countercyclical in the way that they invest. Typically they invest in out-of-favor assets and hold them for a long period of time, until those assets do come back into favor, and then they rinse and repeat over time.

Can you talk about what we've seen from Brookfield in the past year? How have they been performing? What are we seeing from the company in 2018?

DiLallo: They haven't reported results yet for the fourth quarter. But so far, it's been a good year for Brookfield overall. Each one of their subsidiaries has grown funds from operations, which is the way that REITs and those types of entities classify their earnings. It's been another growth year. They continue to launch new funds. They just had a huge real estate fund closing at $15 billion. It's been a very good year for them. They made a lot of acquisitions. 

It's also been a year where they started to sell things. That's a big driver of Brookfield. Not only do they buy low, but they sell high. They found that there's a huge disconnect between what public investors are paying for assets and what other private institutions are paying. That's been a big driver there, to try to maximize the value of what they hold in their funds. Once they've squeezed all the growth out, then they'll sell it to somebody else who isn't as focused on the growth.

Sciple: Sure. Let's talk a little bit about their balance sheet. It really reflects the way the business is structured in that they're an asset manager. Eighty-five percent of their balance sheet is invested in listed securities. Of that, most of it is Brookfield partnerships. They've been able to generate significant cash flow out of those securities and have been able to grow it over time. Can you talk a little bit about how the company has been able to do that and what their strategy entails? We maybe described that a little bit, but maybe an additional thread pull there?

DiLallo: Sure. They're different than like a BlackRock or those types of asset managers. Brookfield owns a huge chunk of these assets. What they've tried to do is separate that ownership into the asset management side. That's where we've gotten some of these separate listed entities. It's because Brookfield's found out that the value of the assets they own, the market isn't fully appreciating them, especially when you look at the amount of cash flow that they're pulling in from these fees for managing assets. They've shifted gears over the years to, "Let's put these into different entities that investors can understand, and let's focus on the cash flow we're getting to this asset management business," because investors tend to pay more for that type of cash flow. There's been this shift over the years to focus on "Let's get this off our balance sheet, but still on our balance sheet," because they own a large chunk of these listed entities. It's so that it draws your attention to this asset management businesses that's generating lots and lots of cash flow and will generate even more in the future as they start monetizing some of the assets in their funds. 

Sciple: One thing I found really interesting, you talked about having assets on the balance sheet, but they aren't on the balance sheet, is how they use leverage. When you take a look at Brookfield's balance sheet, particularly their debt load, if you weren't super familiar with the business, you might be really intimidated by it. They're about a $41 billion company, but they're carrying over $100 billion in net debt on the balance sheet. Just so investors can understand how to think about that in the context of Brookfield, how do you view their leverage as it relates to the way the business operates and how they structure their investments?

DiLallo: They do something different. If you're going to own a business, you'll have that debt on your balance sheet. It's between you and the bank or you and other investors. Brookfield does it on each business level. It's not on the corporate level, it's on the business level. For example, they own a pipeline in Brazil that their infrastructure group bought. When they bought it, there was no debt on that pipeline. But as interest rates in Brazil improved, they were able to layer in debt, but it was at the pipeline level, not at the Brookfield corporate level. So it reflects on the balance sheet that they have this debt, but it's all the way down at that pipeline level. They call it nonrecourse. If the pipeline goes bankrupt -- which is highly unlikely -- it's not going to impact Brookfield. They might have to take that entity into bankruptcy and restructure there, but it's not going to have any impact on Brookfield's balance sheet. That's their game plan all the way through. They'll structure each one of their businesses to an investment-grade credit -- it might be five times earnings for one business, it might be two times earnings for another business -- but it's each structured at those levels.

That makes it a little bit difficult when you're looking at Brookfield Asset Management. It's like, "Oh, my goodness, $100 billion in debt, this is overlevered." But once you dig into it, you see where the leverage is, how it impacts the company, and it's not as big of a deal as it might seem. 

Sciple: Sure. You talked about a lot of this debt being carried down at the subsidiary level. Let's talk a little bit about the relationship between the Brookfield Asset Management parent company and its relationship with the subsidiaries. First off, when you think about investing in Brookfield Asset Management vs. the subsidiaries, how should investors think about that? What are the pros and cons to each, when it comes to whether you want to own the full asset manager itself, or you want to target one of these smaller companies like, say, the renewable energy business or something like that? How does that relationship work out? How should investors think about that?

DiLallo: I would think of Brookfield Asset Management as almost a holding company. It has these four subsidiaries that you have the opportunity to participate in. It's almost like four business units. It's at corporate level, so you have this diversification across these four really interesting businesses. Then, you can almost look at the listed entities as like a pure-play. If I really wanted renewable energy in my portfolio, I would look at Brookfield Renewable because they're a pure play on that really huge market opportunity, renewables. Same thing with Brookfield Infrastructure Partners. There aren't that many infrastructure companies out there. Brookfield Infrastructure is one of the better ones. So that's an opportunity to have this focus. 

In addition to that focus, all of their listed entities other than the private equity, they pay really high-yielding distributions. If you're an income investor, that's a great way to get income. That's how I'd look at it. This is a great way to target and make income vs. Brookfield as the overarching play on real property and real assets.

Sciple: Sure. Another follow-up question when we're talking about the relationship between Brookfield Asset Management and its subsidiaries is how Brookfield makes its money is predominantly through management fees when it comes to operating these funds, as well as management fees that it charges to the subsidiaries. We got a question from one of our listeners, Noel Sayers, where he's concerned about how Brookfield Asset Management -- the fees that it charges down to the subsidiaries, it really looks like the fees that a hedge fund is going to charge. They have a base load fee that they'll charge a percentage of assets, as well as a performance-based fee depending on how the subsidiary performs. 

When you look at Brookfield Asset Management, it makes money from fees that it gets from these underlying businesses, as well as it owns a significant stake in those subsidiaries to the point that it really controls the operations. How do you view the potential conflicts? Do you think there are any potential conflicts between the fee structure that Brookfield Asset Management charges to its subsidiaries and the relationship between those entities?

DiLallo: Anytime you have a parent-child relationship with that, there's going to be a conflict of interest. They do a good job of eliminating as much as possible. The fee structure itself is patterned after that two and 20 that you see in hedge funds and private equity. However, it's more of a hybrid between that fee structure and the master limited partner, general partner that you see in the energy midstream, where you have these incentive distribution rights that the master limited partnerships pay to the general partner. It's a way that the parent company makes income off of their child aside from just owning it outright and getting the distributions.

But there's a reason for that. It's justified by the services they provide and the simple things like accounting, HR, and then the deal flow. A company like Brookfield Property Partners wouldn't be able to, on its own, get into some of these investments that we're seeing it able to make, where it's able to take out some really large real estate investment trusts. It bought General Growth, it bought Forest City. This deal flow that Brookfield is able to cultivate and leverage, because they're able to bring on all these institutional partners, and it's able to allow these entities to grow faster and acquire assets that they wouldn't likely have been able to on their own.

So yes, the fees are high compared to what they could be, but the incentives are aligned so that investors in both entities will profit. And Brookfield owns a big chunk. That's different than you find in a lot of hedge funds. Brookfield pours a lot of its own money into these funds. It pours a lot of its money into these entities. That helps align it with investors. 

Sciple: Yeah. You look at some of these things that the subsidiaries invest in, Brookfield Asset Management is putting some of their own money in as well. They're aligned, they have skin in the game when it comes to a lot of these projects, both on the asset management level as well as in the subsidiaries.

Let's transition and talk a little bit about these subsidiaries. We mentioned that Brookfield Asset Management, the parent company, a large portion of its revenues come from management fees that it's going to charge to its subsidiaries. When you think about the operations of Brookfield Asset Management, you're really going to want to look through to these smaller companies to understand, like you mentioned, the different operating segments of the business. 

The first segment we want to talk about is Brookfield Property Partners, ticker BPY. They launched in 2013. Brookfield claims that this entity has transacted in more properties over the last 25 years than any other business in the world. It has $87 billion in total assets. Matt, can you give us a brief overview of how Brookfield Property Partners invests its assets and what vehicles it's looking for to allocate its capital in the property arena?

DiLallo: Brookfield Property Partners has basically three segments. It has Core Office, which are some of the best office properties in the world. They'll own what are called Class A offices in cities like New York, London, Sydney. These attract top tenants like law firms, investment banks, those sorts of top-tier clients. These are premiere office properties. That's one part. Retail is another part. They own some of the best malls in the U.S. That was through their investment in General Growth Partners. It's not your typical mall. These are destination locations that still are driving a lot of traffic. The third part is, they invest in a bunch of funds that Brookfield has set up that are opportunistics. They'll invest in a whole range of things. They own hotels, car dealerships, student housing, manufactured housing, almost anything, they'll own in these funds. Those are designed to generate a return on investment. They'll try to buy low and sell high. Brookfield sees that as an opportunity to make more money for their investors by investing in these funds so that it can earn more of a capital gain than just the income it would earn from the Core properties.

Sciple: Matt, you mentioned this General Growth Properties acquisition. I want to dive into this one a little bit deeper. I think it's indicative of Brookfield's strategy and the way they look at how they want to manage assets. You mentioned, they acquired General Growth Properties in 2018 for $15 billion. It's the second-largest mall operator in the U.S. Talking about how Brookfield really is opportunistic in acquiring these businesses, they were the only bidder on General Growth Properties. Nobody really wanted to invest in this company. Malls are out of favor. Brookfield realized there's an opportunity. If I'm the only bidder on this property, I can really set the price point. It's indicative of Brookfield's strategy of going against the grain when it comes to investing their assets. What thoughts do you have about that strategy and the way Brookfield went about investing in this General Growth Properties REIT?

DiLallo: This story with General Growth is really interesting. It goes back to the financial crisis. Brookfield and a hedge fund helped get General Growth out of bankruptcy. They got around a 33% stake in the business, I forget exactly what it was. They owned that on their balance sheet for years. It had done pretty well. But with the rise of Amazon and online e-commerce, malls have fallen out of favor with investors. However, just because investors see the death of the mall doesn't mean it's coming. General Growth has done a good job of owning the top malls that they can and then redeveloping them.

One of the big concerns has been when companies like Sears and J. C. Penney are closing stores. They appear to be huge hits to a mall. However, General Growth has been redeveloping these anchor stores into other things like dining, they're bringing in entertainment, movie theaters. This redevelopment is really the key to bringing these malls forward. They're also adding things like hotels and apartment buildings. It's really been making these a destination, a live-work-play-type atmosphere where they're going to continue to grow revenue from these businesses. 

Sciple: When Brookfield takes a look at these assets, they don't see it just for what it is today, but what it possibly could be. They've talked about a densification strategy that they want to do across all of their retail assets, which is like what you mentioned, Matt, taking them all and then converting that asset into a more valuable form, whether it's adding residential or movie theaters or what have you. 

Another interesting thing about this General Growth transaction was that Brookfield created the Brookfield Property REIT, ticker BPR, in relation to this transaction. That's an entity that's set up to deliver the same economic interest that you would get from an investment in Brookfield Property Partners, however, through a REIT vehicle. Can you talk about, if you're thinking about investing in Brookfield Property Partners, how should you think about choosing whether to invest in the MLP, Brookfield Property Partners, or invest in the REIT, BPR? How should investors think about that when they're thinking about investing in Brookfield Property?

DiLallo: It really opens the door to more investors. A lot of them don't like the Schedule K-1s that you get with the MLPs. It makes doing your taxes a pain. Typically, you can't own those in a retirement account, although Brookfield, they're not traditional MLPs, so that's not so much an issue. However, more investors understand a REIT. That was a demand, almost, of the investors in General Growth Properties. They wanted to invest in a REIT. So Brookfield created this. If it's successful, I could see them eventually converting Brookfield Property Partners into a REIT. They'll go where investor demand is. If being an MLP or partnership is holding down the value of the company, but being a REIT wouldn't, then they'll go in that direction. It's almost like a test in that direction. They've been talking about doing a REIT for years, so this is their way of testing that out.

Sciple: Let's talk about something else that's going on with the business. Brookfield Property has been really open with the fact that they believe their units are undervalued. They believe they're worth around $30 per unit. However, as of this past week, they're trading in the $20 range. They bought $200 million in units back at the end of Q3. They just approved another $500 million repurchase between $19 and $21 per unit at the end of Q4. They're being really aggressive there. How do you think about that as an investor? Is that encouraging to you, seeing how aggressive they're being about buybacks and how open they are about how much they think their business is worth relative to what it's trading at today?

DiLallo: Absolutely. Brookfield knows value. They see value in themselves right now. One of the things that they've been known to do is, they'll sell assets that -- investors aren't valuing the company the way they value it. They'll sell 49%, for example, of a mall in Las Vegas. It'll show that, "Hey, this mall's worth a lot more than the market's giving us credit for." This is a way that they're trying to unlock the value. They say, "Our real estate assets are worth a lot more than the market's giving us credit for." They're doing everything in their power to prove that they really have some valuable assets and they're putting their money where their mouth is here.

Sciple: It's really encouraging to me to see when a business is open about saying, "Hey, we think our shares are worth this amount of dollars and we're going to buy until it gets to that price." Brookfield has been really aggressive there. 

Before we talk about Brookfield Business Partners, Matt, what should we be thinking about as investors when we look forward for the next few years at Brookfield Property? What opportunities do they have for growth over time? What kind of return might an investor be able to expect if they were to put capital to work today?

DiLallo: One of the reasons I really like the Brookfield companies is because they're very open about what they think they can do. In this case, they have a plan on how they can create value. They look out five years. For example, they see the rents on their existing properties, the escalations on those should grow income 2% to 3% per year. Then you layer in their ability to sell properties for higher values and then reinvest that money to buy properties at lower values. They believe they can grow earnings in a mid-single-digit range, and that should support distribution growth of about 5% to 8% per year. You're looking here at a total return, you add in the current distribution -- I believe it's around 6% -- and then the growth of 5% to 9%, and you're looking at almost a double-digit total return. And that's not even factoring in their ability to boost that unit value by $10 a unit. It has a potential for growth in income. 

To sum it up, it's an interesting way to play the global property market. There's some income along the way, and it's a value stock as well. It really hits on all three things that investors want to look at in the company. 

Sciple: Yeah, I think any of these Brookfield companies, Brookfield Property in particular, it's not going to be something that's going to blow your mind when it comes to equity appreciation over time; however, you have a very reliable return over time that you can depend on. You have management that you can really trust to allocate your capital in a way that you can trust. I really think it's really an attractive investment to generate a reasonable rate of return relative to the risk that you're taking. 

Let's transition into talking about Brookfield Business Partners, ticker BBU. This is the youngest of the Brookfield family of companies, entering the market in 2016. It operates in the private equity arena. Can you talk a little bit about how Brookfield Business Partners invests its capital?

DiLallo: It's a different one from the other three in that it really has a wide net. It'll invest in anywhere that it sees value. It owns Westinghouse, which supports nuclear power plants. It owns a stake in a company that supports offshore drilling. It really goes across the grain. They're looking for value. It's traditional private equity. They'll either take companies private or they'll do a recapitalization investment where they'll basically take over management, take over 50% or more of a stake in the company so they can control. Their aim is to actually induce change at the operating level, to cut costs, to get them growing the right way, to get them out of bad businesses. It's a true private equity. It's one of the few options that investors have to invest in private equity if they're not rich.

Sciple: [laughs] Right. We talked about, earlier, the way they use leverage at the asset management level, but I really thought, reading through one of their letters to unitholders, the way that Brookfield Business Partners uses their leverage is particularly interesting. Can you talk about that a little bit, the way that they structure their debt to minimize the risk that they're taking when investing in these private equity investments, but also putting themselves in a position to where, if the investment pays out, they can capture a lot of the upside?

DiLallo: Again, you're talking traditional private equity. We'll use the Westinghouse deal as an example. It was a $4 billion deal. I think they put in less than $1 billion in equity and they put in $3 billion in debt. That's pretty highly levered. However, that debt that they put in is nonrecourse, which means that if Westinghouse goes bankrupt again, it wouldn't impact Brookfield Business Partners. They would have to restructure Westinghouse, but not Brookfield. It really insulates them from a situation where a business holding they have goes bankrupt. However, because they have a good amount of leverage, then when that business performs, the amount of upside to have can be significant. They've had some really big upside closes in the past couple of years, where they've sold business for multiples of what they initially invested in them.

Sciple: Let's talk about this Westinghouse acquisition a little bit, just pull the thread for investors. Brookfield Business Partners, as you mentioned, invests in a wide variety of businesses, but I think the Westinghouse acquisition gives a good example of the way that they think about investing and the opportunities they look for. We mentioned earlier, when we talked about the REIT acquisition for Brookfield Property Partners, how they acquired that, they were the sole bidder and things like that. Similarly, this Westinghouse acquisition, as you mentioned, they grabbed this business out of bankruptcy. Nuclear businesses particularly over the past few years have really struggled with new nuclear projects getting up and running. Westinghouse went bankrupt as a result. But they really don't have any fear to go into these businesses where they see an attractive valuation, and that's exactly what they did here with Westinghouse. 

Can you talk about what the competitive position is of this Westinghouse business and why Brookfield found it a very attractive opportunity for them to invest in?

DiLallo: As you mentioned, the reason Westinghouse went bankrupt is because it was involved in building two nuclear power plant projects that went way over cost. They'd promised the customer would build it for $X, and it was just ridiculous how far over the cost went. So they had no choice but to declare bankruptcy. There was no way they could deliver on that. 

However, the core business, and what Brookfield saw, is that they help service nuclear power plants and other power plants in addition to that. It's under long-term contracts. They'll earn recurring cash flow by doing maintenance, supplying fuel. They saw this underlying business of servicing nuclear power plants as being a very lucrative, and if they could restructure it, they see a lot of upside just by cutting costs, getting out of building nuclear power plants and just focusing on how they can serve nuclear power plants well.

Sciple: They talk about how they want to invest in businesses that have high barriers to entry and wide moats. When you look at Westinghouse, they service 65% of global nuclear plants worldwide, so they really have a strong position. Also, the nuclear industry is not the type of industry that's going to see a lot of new entrants. If you see an attractive valuation here with Westinghouse today, it's likely that will continue out into the future. So, it was really attractive, both on the case of, they're out of bankruptcy, so you get an attractive price, as well as, they're operating in an industry that is really unlikely to see new entrants come, at least in the near term. 

Let's talk a little bit about how their results played out in 2018 and the way things are looking out into the future. Similarly to Brookfield Property Partners, Brookfield Business Partners has been very open that they see their units as undervalued and they're repurchasing shares. When we're looking out into the future, where are we seeing the growth opportunities for Brookfield Business Partners? Based on what we saw in 2018, how excited are you about those opportunities?

DiLallo: It's such an interesting company because opportunities are everywhere. They've shown that by where they've gone out and made acquisitions. You really don't know what that's going to do next other than, they're going to look for value. They're going to look for businesses that have problems right now, but through operational changes, maybe it's a new management, maybe it's just getting out from a lot of debt, whatever the case may be, they'll look for those opportunities where they can buy at the bottom of a business cycle and then ride it all the way up, and then they'll sell it as the business cycle tops out. They will look for those cyclical businesses. We've seen them with oil and gas, they bought a lot of oil and gas assets in the past several years as the market downturned. Then, as conditions have gotten better, they've been starting to sell those. You're not going to get the dividend that you will in some of the other entities. It's all about capital gains here. If they do well, investors should do well as the unit price rises. 

Sciple: Definitely an interesting business to be involved in it. As you mentioned, Matt, it's hard to get exposure to that as an individual investor. To get that exposure from a company like Brookfield, that as we mentioned and will continue to mention on part two of our discussion, is prudent in investing their capital, and really has a strong track record of doing that. 

Any last things you want to mention before we close out part one of our discussion on the Brookfield family of companies, Matt?

DiLallo: I just think that investors should take a look at these companies. They offer a unique opportunity to invest in things that you just don't see out in the market these days.

Sciple: All right folks, make sure to tune in next week, where we'll be talking about Brookfield Infrastructure Partners and Brookfield Renewable Partners. For now, we'll leave you a "Happy Valentine's Day." We hope everyone has a fun, happy, and romantic holiday! Thanks for coming on, Matt!

DiLallo: Thank you!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Rick Engdahl and Dan Boyd for their work behind the glass. For Matt DiLallo, I'm Nick Sciple. Thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew DiLallo owns shares of Amazon, Brookfield Asset Management, Brookfield Business Partners L.P. Limited Partnership Units, Brookfield Infrastructure Partners, Brookfield Property Partners, Brookfield Renewable Energy Partners, and TerraForm Power. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Brookfield Asset Management. The Motley Fool recommends Brookfield Infrastructure Partners. The Motley Fool has a disclosure policy.