Brookfield Asset Management Inc.

Please see disclaimer at bottom of this document

March 3, 2008  Third Ave Real Estate Value Fund (29.56)

Run by Michael Winer has reduced holdings of BAM by 371,225 as of January 31, 2008. This may or may not have been reported on the 12/31 Form 13F. (one could find this by comparing last 2 reports from the Winer and compare to 13F.) I'm going to guess that most of reduction was done in November and December 2007.  I could be wrong though.  During that period TAV reduced BAM by 307,352 shares, whereas TRAV reduced by 371,225 during Q ending  January 2008.

http://www.thirdavenuefunds.com/taf/documents/pdf/TAF_1Q_ShareholderLetters.pdf

Winer goes onto discuss his concerns with Commercial Property. He cites cap rates specifically. Also mentions availability of financing and a concern of CMBS via "conduit lenders" freezing the borrowers of the last 15 years. Talks about widening spreads.

Here are some key takeaways:

“Commercial property valuations – particularly in the United States and Europe – have declined as the result of uncertainties regarding availability of financing and how an economic slowdown may impact future rental growth."

"Property valuations are most often determined by applying a market-determined capitalization rate (cap rate) to net operating income. A cap rate converts income into value. Typically, a cap rate reflects the anticipated unleveraged yield for the succeeding year. The unleveraged yield is determined by dividing the net operating income (cash flow before debt service and capital expenditures) by the purchase price. A property expected to generate net operating income of $900,000 would be valued at $15 million using a 6% cap rate. Unfortunately, capitalizing first-year net operating income is not always an accurate measure of value. For example, a fully occupied office building leased to a single high-credit-quality tenant would seemingly warrant a lower cap rate than a similar building leased to multiple, lower-quality tenants. However, if the lease on the single-tenant building is set to expire in two years, and the contract rent exceeds current market rents in the area, then a higher cap rate (lower value) is warranted to compensate for the uncertainty of future cash flows. Similarly, if the contract rents on the multi-tenant building are substantially below current market rents, and there will be near-term opportunities to increase contract rents, then a lower cap rate (higher value) is warranted.”

“To determine an appropriate cap rate, several factors must be considered – including property specific and general market. Property specific factors include age, physical condition, location, credit quality of tenants, occupancy levels, in-place rents versus current market rents, lease expirations and local supply and demand. General market factors include interest rates, availability of long-term financing, unemployment rates, inflation and macro-economic conditions. Simply put, a cap rate (required yield) should indicate the “risk premium” over the “risk-free” return (e.g., U.S. government securities).”

“Each of the aforementioned factors must be taken into account when evaluating the risk premium. Cap rates are heavily affected by interest rates and the availability of long-term financing. A primary source of long-term financing for commercial properties over the  last fifteen years has been “conduit lenders” that underwrite and originate loans that ultimately get packaged into commercial mortgage-backed securities (“CMBS”). The recent global credit crunch has had minimal impact on interest rates, but a dramatic impact on availability of financing. Demand for CMBS has weakened globally since banks and institutional investors  began suffering mark-to-market losses on investmentgrade, subprime mortgage-backed securities. Despite  strong credit fundamentals, especially high up in the  CMBS capital structure, spreads on super senior CMBS  have widened over 150 basis points (1.5%) since last  summer. The decoupling of spreads and credit  fundamentals is apparently due to uncertainty about  potential economic fallout from the downturn in the  U.S. housing and mortgage markets. U.S. 10-year Treasury yields have declined from about 5% last July to  under 4% as of January 31st. Therefore, even though  spreads have widened, actual yields on AAA-rated CMBS  have not increased dramatically. (Note: the fact that the  “risk-free” returns are lower, while required yields are higher, illustrates investors’ demand for higher “risk  premium.”) The lack of liquidity and demand for CMBS has dramatically curtailed new loan originations by conduit lenders. This lack of financing has, in turn, resulted in a dramatic slowdown in commercial property transactions. Buyers and borrowers seeking refinancing have been forced to seek financing from “portfolio lenders” such as insurance companies and pension funds,  that tend to have more conservative underwriting standards. These more conservative standards generally  require more equity and more experienced and creditworthy borrowers.”

“Like any other investment, real estate must generate fair, risk-adjusted returns on equity to be attractive. If an investor can obtain 75% leverage at 6% interest on an  investment property that yields 7%, the investor’s firstyear  return on equity is 10%. (The equity return is higher  due to the positive spread between the 7% property yield and 6% cost of debt.) However, if the investor could only  obtain 60% leverage at 6% interest, the first-year return  on equity would be only 8.5%. In order to achieve a 10%  first-year return on equity, the investment property would  have to yield 7.6%. This example illustrates the effect  tighter credit has on cap rates (required yields) and, thus, commercial property values. Simply reducing the amount  of leverage from 75% to 60%  can force cap rates to increase (in this example, from 7% to 7.6%, or an 8.6% decrease in  property value). Tighter credit, coupled with economic uncertainty and  wider spreads (increased risk premiums) has resulted in downward revaluations for all property types.”

March 1, 2008 Ramblings, thesis, Brookfield Power (29.65)

We  have been short BAM at various increments, with an average cost of around $38ish. 

Our short thesis is based on the following concerns.

1.  We think they are over leveraged and that increased credit costs, costs of capital, lower loan to values, will start stressing BAM.

2.  We think potential for credit downgrades.

3.  Concerns with reliance on commercial paper markets for liquidity.

4.  Incestual sales and potentially unusual uses of related parties.

5.  Severe over-valuation of power division.  How do you get a book value of $349M, Free Cash flow of $10M, operating at a net loss, into a valuation of $6.5B?

6.  Slowdown in Alberta CN real estate. (BPO)

7.  High occupancy rates in metro areas, possibly deteriorating because of reliance on financial service industry as well as potentially unusually high.

8.  Recent exotic financings.  One would be 1 Liberty Plaza NYC.

9.  Credit tightness.

10. Recession potential and pain on levered companies.

11. Stock price fueled by blind following of value investing community, who bought the idea and didn’t dig deep into financials.  Perhaps that has ended and mass  liquidation could occur.  Are any covenants reliant on stock price?

12. Potential aggressive accounting procedures. Consideration that potential of over capitalization in past increased earnings, yet now they potentially use the crutch of depreciation on those previous capital expenditures not being considered in valuation.   

13.  $4B of debt coming due in 2008.  Can they manage to refinance.  Again, this is where excess leverage can become painful.

14. Reminds me of Enron with all their spin-offs and shuffling of assets.  Not so sure institutional investors will embrace for continuing investments.

15.  Integration concerns of multiplex.  CEO UK already left.

16.  Is BAM the glib helper and also a member of Buffett's Gotrocks family?

Brookfield Power Corp. reports annual financials:

www.sedar.com

1. Brookfield Power Inc restated Sept and June financials. I think a non-cash restatement of taxes due to currency translation. I think favorable to book value. Non-Cash working capital went up $27M.

2. Brookfield Power Corp reported its audited financials. (BPC is wholly owned by BPI and consolidated into BAM). Company is financing facility for BPI.

a. Shareholders deficit went up to $3.6B from $2.5B in 2006.

b. Long term debt went down $6M.

c. Changed accounting methods in 2007 for deferred financing fees.

d. $450M of debt coming due 12/09.

e. Credit facility expires 4/09, has $350M avail. Has letters of credit out of $135M.

f. Annual net loss was only $1.2B compared to last year of $2.5B

g. Will be combining with BPI 1Q08.

h. The total assets of $802M consist of notes receivable from BPI.

3. BPC issued Earnings Coverage Ratio was .96 in F07 and .92 in F07 (an improvement). Yet, excluding capital securities interest coverage was 1.30 in F07 and 1.98 in F06 (not an improvement).  We wonder how ratings agencies will work with this.

4. Note to myself... Restatement and accounting change.... in textbook forensic accounting, these are two warning signs of potentially aggressive accounting. We are not saying they are doing anything wrong. We are just saying we have two potential red flags. To put this into context, a heavy person who is a smoker who does not exercise has a higher risk of heart attack then does a person who eats healthy and exercises regularly. Yet, the heavy guy could live a lot longer. Just in the stats.

Brookfield Power Inc (operating company and consolidates great lake hydro):

1. Consider the potential of Book Value to be currently inflated because of potentially aggressive capex policies in prior years. This could be cause for rising depreciation as well.

2. Watch the bond ratings closely.

3. Review related party transactions.

4. Compare to last years annual. Look for prior debt discussions and compare.

5. Company has coml. paper, rated R-1 (low) by DBRS. Same last year1

6. $451M of debt coming due in 2009. I think I mentioned in my last Brookfield Power note.

7. Debt went up $1B.

8. Page 24 - new debt instrument to be issued, not yet known, this is based on the amalgamation of BPC.

9.  Shareholders equity is now $349M, from $409M in 2006.

10. Track the bonds of Power Operating Companies:

11. Capital Securities, being paid in cash or conversion shares?

12. On January 24, 2008 BAM INJECTED Power with $200M to provide liquidity. I kind of recall, and will have to look into my notes, the ratings agencies frowning on such, and would consider such a financial movement as a possible downgrade trigger.

Notes to Management Discussion &Analysis

13. Page 7 of MD&A describes the "Low environmental impact of Hydro." Verify this, as I thought there were environmental concerns with water flow, temperature, carbon factor and wildlife.

14. Company of course sold assets to BIP. Netted cash of $90M.

15. Page 10 discussed financing in December 2007. Find the terms and the actual note.

16. Company benefited by $12M for CDN to USD currency gains.

17. Derivative commodity loss of $79M. $16M of that loss is related party. The other $65M is from the LIPA contract.

18. Net loss of ($19M) includes a tax recovery of $21M; hence one could argue Adjusted Loss was closer to $40M

19. "We continue to maintain investment grade unsecured issuer ratings from DBRS (BBB High)), Standard and Poor’s (BBB) and Fitch (BBB-), which are influenced by a prudent level of low-cost asset financing and modest levels of corporate debt. The long-life nature of our assets allows us to finance with non-recourse debt and minimal near-term maturities, minimizing risks associated with liquidity and refinancing."

20. Hydrology levels at normal or above normal in January 2008.

The following is just one quick exercise on my first quick read.

Free Cash Flow off the cuff:

Net Income after adding back non-cash items was $150. Subtract capex of $140. You would have free cash flow of $10M. That does not take into account use of cash in investments, such as Brascan Brazil Ltd., debt repayments and those various related party transactions, which are not already included in income statement.

So you have FCF of say $10. Apply a multiple of 15X and you have a valuation of $150M.

In CSFB's 9/30/07 report, they assign a value to Brookfield Power of $6.5B. I am including $454M for Great Lakes Hydro.

How do you get a book value of $349M, Free Cash flow of $10M, operating at a net loss, into a valuation of $6.5B?

Beware the glib helper. 

Warren said in his 2007 Annual report, "Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."

He was referring to those that sell investors based on the hair brain idea that they will generate 10% or greater returns each year.

Brascan Properties SA achieves guidance    

Highlights – For the three months and twelve months ended December 31, 2007

• The Company achieved its 2007 Guidance regarding launches (R$900 million to R$1 billion)

And contracted sales (R$600 million to R$700 million).

• Developments launched in the fourth quarter amounted R$303.0 million, while the total

Amount for the year was R$1 billion. Respectively, these figures represent an increase of 68%

and 165% compared to the same periods of 2006.

• Contracted sales reached R$390.8 million in the fourth quarter and R$713.1 million in the

year, which is the equivalent to an increase of 151% and 96%, respectively.

• The PSV (Potential Sales Value) of the land bank under Brascan’s control increased from R$5.6 billion in the end of 2006 to R$10.4 billion in the end of 2007, representing an 85.7% growth.

• Gross profit amounted to R$85.9 million in the fourth quarter and R$221.5 million in 2007, the

equivalent of a 71% and 24% growth, respectively.

• EBITDA reached R$66.6 million in the fourth quarter and R$171.9 in the year, which

corresponds to a growth of 77% and 56% compared to the same periods of 2006 (adjusted for

IPO expenses and partnership sales).

• EBITDA margin in 2007 achieved 41.1%, an increase of 5.2 pp from the previous year

(adjusted for IPO expenses and partnership sales).

• Net earnings were R$76.8 million in the fourth quarter and R$154.6 million in 2007,

representing a 99% and 60% increase, respectively.

• Cash and cash equivalents as of December 31, 2007 totaled R$466.6 million.

• Year-end gross debt totaled R$238.2 million, compared to R$465.5 million in the same period

of the previous year.

BAM bonds showing some price deterioration     27-Feb-08 07:04 am

We always watch the bonds. We have mentioned previously that the BAM bonds have held up very well. This holding up is contrary to our thesis, and certainly a potential indicator that our short thesis is incorrect.

The bonds trade very infrequently, and have been priced at par or above.

BAM.GA 2017 5.80% have been priced at 100ish for quite a while. Most recent sale was at 87.791 yielding 7.678%, last trade 2/21/08. I have to look further, as this yield may be telling us that the bond although rated A- S&P is not trading as such.

BNN.GF 2012 7.125% have been priced at 105ish for quite a while. Most recent sale was at 98.5 yielding 7.535%, last trade 2/26/08.

BNN.GH hasn't traded since December 2007.

BNN.GA 2008 8.125% have been priced at 103ish for quite a while. Most recent sale was at 101.164 yielding 6.581%, last trade 2/25/08.

This is merely one thing we look at, long or short. The bond market maybe telling us something here. On the other hand, the bond market is acting funny lately, and recent trades could be the exception and nothing to concern oneself with. Something we watch though. Often in an issue that is trading at yields greater than their rating, means that the price of the bond has already priced in a ratings cut (or increase).

As a comparison average bond rates are as follows

2 year A yielding 3.16% on average

5 year A yielding 4.49% on average

10 year A yielding 5.61% on average 

BAM Cash Flow Multiple - Back of envelope 2006     26-Feb-08 09:33 pm

OR you can use

Need to see capital expenditures from other segments, required funding of other segments (such as Norbord and Fraser this year), preferred dividends, debt repayments required

Lets be generous and say that 2006 true free cash flow was $500M, then using a multiple of 15X would be a market cap of $7.5B.

market cap of $7.5B, using 584M shares o/s would be a share price of $12.84 per share.

If price adjusted to $12.84 a share, would Bam Split and Bam investments cause concern? Would financing be obtainable at a reasonable cost? Would financing even be available?

Don’t forget average sell side analyst is incestually tied to BAM via deals, rentals, sales of assets, buyings of assets, share of the pie and investment banking. So, "believe little of what you hear and less of what you see". (Springsteen 2007, Magic)

BAM - Notes to myself     26-Feb-08 08:51 pm

1. I have had difficulty figuring out what is committed capital, versus already funded capital. If there is committed, and not yet funded, is a receivable set up. I don't think so. It would be important to see that committed versus funded, so that one could figure out potential cash outlays.

2. On the same token, I wonder if co-ventures have had difficulty coming up with committed and required capital. In this environment, it would be expected that some funds (not BAM of course) might have liquidity concerns.

3. I wonder if BAM has been affected by the lock of Auction Market Preferreds and overnight commercial paper. Judging from BAM bond prices, I think all is cool, but something to think about.

4. I need to refresh. I could have sworn that Brookfield Power and Brookfield Homes have consolidated in the past. Yet, on page 40 of Supplemental Information FYE 12/31/07, BAM discusses that BPO is consolidated in the segment basis, whereas other operations are not. I gather on consolidated financials they are all consolidated, unless something has changed, or unless I have been mistaken.

5. Page 43 indicates debt schedules coming due. 2008 is a big year for refinancing. This is where the credit profile is crucial. It is unarguable that credit costs have increased, loan to values have gone down, which in turn spells more expensive credit for all. Not to mention that liquidity is no longer a plenty. Lets see what happens on the new financings. One thing to watch is BIP's discussion last week, and how they will refi $1ish Billion by end of March. Just a lot tougher nowadays. Looks like $4.3B is coming due in 2008, again if I didn't look at the schedule incorrectly. $4.3B is 58% of current stockholders equity.

6. Companies to review, if possible. Concert Industries and Western Forest Products. These are owned by Tricap.

7. BAM made $100M using derivatives and credit protection. What was the cost of such. Will be interesting to see that unwind in 2008. Future profits or losses? Any guesses? My guess is we will see costs or losses from this in First half of '08.

8. I look forward to really trying to determine free cash flows. BAM reduces free cash flow by sustainable capex. they don't reduce by other real costs of maintenance capex. yet, maint and sustaining shows up in Statement of Cash Flows (when issued). Hence, why would maint capex not be an integral part of Free Cash Flow?

9. When do warehouses and credit lines come due for renegotiation?

10. It will be interesting to dissect the balance sheet. We will find out for sure what the "Financial Assets" of $1.5B are, why Accounts Receivable increased by $2.0B, goodwill increased by $800M, and Accounts Payable Increasing $2.8B.

11. Interest expense has increased dramatically. It will be fun to run the interest coverage ratios.

More to write, looking forward to the financials

October 23, 2007            Questions for BAM

1.       Where is Great Lakes Hydro ownership reflected in BPI financials? According to BAM, they are consolidated.    BPI makes up most of BAM Power Generations. There are a few immaterial addbacks and so forth at consolidated level, but one could tear apart BPI and realize that probably greater than 90% of BAM power is BPI. I didnt realize that GLH.UN is consolidated into BPI.

Brascan Power is the new BPI. They were the old company. Brazil and Chile have nothing to do with BPI, nor are they reported under Power Operations with BAM.

I think one could look at BPI, project future cash flows, and try to determine various pricing metrics.

2.       What assets on BPI are marked to market?  None per BAM.

3.       Is Brascan Power still a subsidiary?  I don’t think so, but just checking. No, Brascan became BPI.

4.       Are there any potential operational or financial stresses that could be caused or relieved because of stock price changes?  Are any of the loans outstanding at all predicated by minimum BAM stock prices? No, per BAM.

5.       Why does BAM not indicate on page 19 of 2Q07 Interim Shareholder Report that BPI debt is ‘BBB-‘ as opposed to reported ‘BBB’?  They will get back to me.  They also offered to send me all ratings reports, giving full detail.   Interest on Capital securities is eliminated in consolidation. Nevertheless, I guess I would have to look into including it as a real expense for BPI, and maybe as real income for BAM. Remember, BPI has an IDR rating of  'BBB-' by Fitch.

As I mention Fitch, and ratings. I see that BAM debt on the 2017's are yielding around 6.01%. If you compare to like rated debt , you will see others (disney, Schering and Kraft), are yielding 5.40%. One could theorize that BAM debt is not trading like other S&P A- companies.

6.       BAM discusses in 2Q07 report  on page 4, “And as we discussed in our letter of February 10, 2006, we are generally inclined to hold assets indefinitely, preferring to monetize the accrued value by refinancing the asset, as opposed to an outright sale.”  What assets would qualify for being held a long time?  World Financial Centers have according to discussion, owned since early 1990’s.  North American timber, which was spun off to Acadian Timber has been owned for almost 40 years, some of the Power operations as well.

7.       BAM indicated to me that BPI has a deferred tax asset.  I asked where it was on the financials, and they mentioned they would get back to me.

8.       In BPI , what is “interest on capital securities?”  Interest paid to parent.

9.       Brookfield Properties, Brookfield Homes  and Great Lakes Hydro are all consolidated, per BAM into BAM.  They claim these are reduced via  “non –controlling interests.”  This is itemized on Page 43 or BAM AR 2006.

10.     Longview Fiber operations, I think with value of $300M  is listed as “financial asset – common shares section.”  Longview Fiber shows up in 2007.  BAM mentioned that they do not disclose components of these assets for competitive reasons.

11.      Pages 16 and 17 of AR, list Total AUM, net invested capital for total and BAM.  Committed Capital is listed in total, not for BAM.  BAM told me this is being shown effective 3Q07 filings.

12.     “We don’t concern ourselves with revenue.  We concern ourselves with the net cash flow of the businesses.”

13.     Maintaining capex is different than improvement and acquisition capex, according to BAM.  I could see this to a point, but a serial acquirer could have this backfire.  BAM claimed their sustaining basis capex is approximately $45M annually going forward.

14.     If you go to sedar, again select "brookfield Power corp", look at filing on April 23, 2007. called other and is the document with 29K of info.

It discusses interest coverage. I didnt fully understand. I spoke to several people at BAM, and they also were not familiar.

It is interesting how this document both includes and excludes interest on capital securities. Also, you can look at link on march 28, 2007, there is a "prospectus supplement." In that supplement they discuss interest coverage ratio as well.

My quick, back of the envelope analysis on BPI, has me thinking that "Brookfield Asset Management Power Operations" should carry a market cap between, $1B to $4B, and as far as I can see, I see no reasonable business explanation to a value of $6B. with all that, be reminded that I have been short GOOG since $450ish.

Thesis:


1. Assets to Equity is 6.7X. Leverage.

2. High occupancy rates, low current interest rates, priced for perfection.

3. sometimes, marks to market. Companies that mark to market, have been on my radar.

4. Will financing costs remain low? Is access to capital already hindered? I am hearing that capital markets have really siezed up.

Are investors still yearning for these types of investments? Are cash flows as predictable as claimed? What percentage of their market cap is related to an asset greater than 10 years? Could BAM be the "Gotrocks" Berkshire has referred to?

5. Certain assets have been given long lives, which limits depreciation. Gas Generation assets prior to 2006 were written off over 5 - 60 years. Now , it is 10 - 60 years.

 

15.              Some metrics below.