A High-Yield, Fast-Growing Utility

Utilities are one of the cornerstones of high-yield portfolios, and for good reason.

Their generally stable and predictable cash flows, often protected by regulated prices, result in most utilities achieving high Dividend Safety Scores.

Safe payouts can be a major asset for low-risk investors – especially retirees who depend on dividends for funding their living expenses.

Not all utilities require one to sacrifice growth for a safe, high yield however.

One global utility in particular, Brookfield Infrastructure Partners (BIP, Financial), appears to have a long runway for income growth.

Let’s take a closer look at Brookfield Infrastructure for consideration in our Conservative Retirees dividend portfolio.

Business overview

Brookfield Infrastructure is one of the fastest growing and most diversified utilities in the world.

In fact, the limited partnership (a corporate structure similar to that of a Master Limited Partnership or MLP) owns 32 infrastructure assets consisting of:

• 2.8 million natural gas and electricity connections
• 6,959 miles of electrical transmission lines
• 6,151 miles of railroads
• 2,236 miles of toll roads
• 36 global ports
• 9,320 miles of natural gas pipelines
• 600 billion cubic feet of natural gas storage
• 7,000 telecom towers
• 3,106.8 miles of fiber optic lines

As Brookfield points out, it essentially owns “critical and diverse infrastructure networks over which energy, water, goods, people and data flow or are stored.”

Source: Brookfield Infrastructure Partners Investor Presentation

Brookfield’s healthy diversification by business segment (no business unit is more than 20% of cash flow) and geography helps to ensure very stable cash flows to secure the safety and growth of its distribution (a tax deferred form of dividend).

This is especially true since 91% of the company’s cash flow is secured by either fixed rate, long-term contracts (with annual inflation adjustments) or is derived in regulated industries.

Brookfield Infrastructure’s global reach also provides it with one of the strongest growth runways of any utility.

Business analysis

The key to Brookfield Infrastructure’s success is its sponsor, general partner and manager, Brookfield Asset Management (BAM, Financial), which is the world’s premier utility, infrastructure and real estate asset manager.

In fact, with over 115 years of experience and $250 billion in assets under management, Brookfield Asset Management is the world’s most experienced, trusted and largest hard asset manager in the world.

Here is how it works.

Brookfield Asset Management’s 55,000 employees (operating in over 30 countries) scour the world for attractive investment opportunities in infrastructure and utilities. That includes undervalued, cash-rich assets located in troubled economies such as Latin America and Europe.

The two companies have a symbiotic relationship in which Brookfield Asset Management uses its world-class expertise in utilities and infrastructure to make highly profitable deals for Brookfield Infrastructure, which raises debt and equity capital from investors to pay for these high-quality, wide moat assets.

In exchange, Brookfield Asset Management gets a 1.25% annual base management fee as well as 25% of marginal funds from operations (from incentive distribution rights or IDRs), plus 30% of Brookfield Infrastucture’s fast-growing distribution (courtesy of its 30% equity stake in the LP).

Source: Brookfield Asset Management Investor Presentation

Brookfield Asset Management uses its enormous financial resources to acquire assets at attractive prices, resulting in very high cash yields for investors.

These assets are then sold (i.e. dropped down) to Brookfield Infrastructure Partners, which gains long-term, secured cash flows with which to grow its distribution at management’s long-term goal of 5% to 9%. It also helps the company pursue its target long-term total returns of 12% to 15% per year.

The result has been nothing less than spectacular for Brookfield Infrastructure unit holders, with the stock more than doubling the market’s total return since its initial public offering in 2008.

While past performance is no guarantee of future results, however, investors have numerous reasons to expect Brookfield Infrastructure to continue its strong growth.

For one thing, as Brookfield Infrastructure has continued to exceed management’s long-term growth guidance, the LP’s access to cheap debt and equity capital has only increased. This allowed it to make a record number of deals in 2016, totaling $850 million.

That allowed Brookfield Infrastructure to generate sensational (for a utility) top-line growth of 14% last year. But more importantly, its adjusted funds from operations, or AFFO per unit (equivalent of free cash flow), grew 11.5% and allowed management to hike the dividend twice while retaining a secure AFFO payout ratio of 78%.

Source: Earnings Release

Brookfield Infrastructure Partners plans to invest $1.4 billion over the next two years into its organic growth pipeline, which means expansion of assets it already owns.

In other words, even if new investment opportunities continue to dry up, Brookfield Infrastructure should still maintain steady growth in its AFFO, and thus its payout.

Even with continued recessions in certain key markets, especially Latin America (due to a commodity crash hurting the continent’s export dominated economies), Brookfield’s new acquisition pipeline remains as robust as ever.

In fact, management is currently working on $2.4 billion in new deals, which would make 2017 the largest growth year yet for Brookfield Infrastructure.

Of course, as we have seen with other fast-growing infrastructure companies such as Kinder Morgan (KMI, Financial), a large growth backlog means nothing if a company lacks the liquidity to execute on it.

Fortunately, that is not the case with Brookfield Infrastructure Partners, whose relationship with Brookfield Asset Management as well as its world-class track record for highly profitable deals and fast payout growth ensures strong access to growth capital.

In fact, Brookfield Infrastructure has $4 billion in current liquidity and its access to equity capital is even greater thanks to management’s solid track record for superior capital management.

Specifically, the company will periodically recycle capital, meaning selling assets when they become overvalued, in order to redeploy capital into more undervalued assets.

For example, in the last eight years, management has sold eight businesses for $2 billion and generated 25% internal rates of return.

It is currently planning $1.5 billion to $2 billion in asset sales to help fund its growth opportunities as it attempts to become ever more profitable over time.

Overall, Brookfield Infrastructure runs an attractive business that benefits from healthy customer, end market and geographical diversification, as well as ownership of hard-to-replicate assets. Replacing the company’s hard assets would be extremely costly, and many of them are further protected by regulatory and legislative operating permits. The non-discretionary nature of their services is also attractive, and only so many infrastructure assets are needed in any particular location, further raising barriers to entry.

Key risks

While Brookfield Infrastructure Partners shares elements with other great long-term income growth stocks, there are still several risk factors to keep in mind.

First, because it operates overseas, unlike most U.S. utilities, Brookfield has significant exposure to fluctuating currency risk. More specifically, the U.S. dollar is up 26% in the last two years and now sits at 15-year highs.

This means when Brookfield converts the local currencies in which its businesses operate into U.S. dollars (for accounting and distribution purposes), a stronger dollar can create significant growth headwinds.

To offset this risk, the company has hedged 75% of its funds from operations over the next two years. Regardless, that still leaves a significant portion of its cash flow exposed to the risks of a rising dollar. In fact, the utility’s results in 2016 were 4% stronger in constant currency terms.

Of course, currencies fluctuate over time and the U.S. dollar will not be this strong forever. Over the next few years, however, there is risk if it continues rising, crimping Brookfield’s reported cash flow and payout growth.

Next, be aware that like MLPs and Real Estate Investment Trusts (REITs), LPs like Brookfield Infrastructure are dependent on external growth capital.

That is because, in order to maintain their preferential tax status, these pass-through entities need to pay out the majority of their cash flow to investors as dividends or distributions.

As a result, the majority of Brookfield’s growth capital needs to be raised through additional debt and equity offerings (or periodic asset sales) because there is little internally generated cash remaining after distributions are paid.

Up to this point, Brookfield Infrastructure Partners has been able to raise very cheap equity capital, which combined with the highly profitable nature of its deals means that even though the company's unit count rises over time (units have increased 4.8% annually over the past five years), AFFO per unit continues to grow quickly.

Part of the reason Brookfield’s unit price has done so well is because record low interest rates have sent yield-starved income investors searching for safe bond alternatives.

Should higher U.S. interest rates send 10 and 30-year Treasury bond yields up to 4%, 5% or even 6%, then much of the demand for its units that has benefited Brookfield could reverse as some investors flock to less risky sources of yield.

To put it another way, while a low unit price is great for new investors, it can also make it harder for Brookfield to raise enough cheap equity growth capital to continue expanding its cash-rich asset base at such a torrid pace.

Speaking of asset expansion, we cannot forget many of the countries Brookfield operates in have far less stable politics and regulations than in developed markets.

For example, the largest deal Brookfield is currently working on has just been blocked by a Brazilian court. It was arranging to acquire 90% of Petrobras’ (PBR, Financial) Nova Transportadora do Sudeste S.A natural gas pipeline system for $5.2 billion (of which Brookfield would own 20%).Â

In other words, a major growth initiative may end up not happening unless Brookfield can convince the court to allow it to go through. This shows the political and regulatory risks inherent with operating in emerging markets, including Latin America where populist political parties have a nasty habit of occasionally nationalizing assets.

Another risk to keep in mind is that, unlike most utilities, which have very low volatility (as measured by beta), Brookfield Infrastructure Partners’ beta is 1.05, indicating shares have historically been slightly more volatile than the S&P 500.

That means investors who prize low volatility, such as retirees who must fund retirement via share sales, might want to avoid Brookfield due to its rare but periodic sharp corrections.

Finally, while this is not a risk per se, be aware Brookfield Infrastructure Partners is structured for tax purposes in such a way as to avoid something called UBTI (unrelated business taxable income) and also to avoid paying taxes at the corporate level.

Specifically, Brookfield is structured as an LP which does not directly own its assets. Rather, the businesses are themselves limited partnerships that pay distributions to the utility, which then pass that cash flow (and tax liabilities) onto unit holders.

Why implement such a convoluted tax structure?

By avoiding UBTI, Brookfield Infrastructure Partners is safe to own in tax-deferred accounts such as IRAs and 401Ks.

It also means investors in Brookfield Infrastructure Partners will get both a 1099 and K-1 form at tax time.

This creates added tax complexity due to the fact much of the company’s distribution is a return of capital, which lowers your cost basis and is thus a deferred tax liability until you sell.

Tax preparation software such as TurboTax can easily handle K-1s (which take about five minutes per LP/MLP), but require you to use the more expensive (and complex) Deluxe edition.

Dividend safety

We analyze at least 25 years of dividend data and over 10 years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with companies that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been and how to use them for your portfolio here.

Brookfield Infrastructure Partners’ has a Dividend Safety Score of 65, indicating the payout is both secure and dependable today.

That is not surprising given the utility’s track record, which includes strong payout growth, even during the 2008 to 2009 financial crisis.

Source: Simply Safe Dividends

The highly stable nature of the company’s cash flow supports its steady, growing distributions. Remember that 90% of Brookfield’s cash flow is either regulated or under long-term contract, 70% of which are indexed to inflation and 60% of which has no volume risk.

In other words, Brookfield Infrastructure is a highly diversified collection of tollbooth-like businesses, which generate very steady cash flow used pay the company’s fast-growing distribution.

Unlike some other MLPs in recent years, which tried to attract investors with unsustainable payout growth, management at Brookfield is highly disciplined, targeting a 60% to 70% FFO payout ratio.

The company’s AFFO (which takes into account maintenance capital needs) payout ratios are always below 80%.

For a utility, especially one that is structured as a pass-through entity, that is a very safe payout ratio. Even when unexpected events arise, such as a rising dollar or even some asset nationalization, Brookfield’s distribution should likely be safe from a cut (though growth would be affected, impacting the stock’s price).

The other thing protecting Brookfield Infrastructure Partners’ payout is the company’s strong balance sheet.

As you can see, compared to most other MLPs, Brookfield’s leverage ratios are far lower and its current ratio is much stronger.

Sources: Morningstar, FastGraphs, Investor Presentation

That explains the strong investment grade credit rating, which allows the utility to borrow cheaply and will continue to be a competitive advantage in a rising interest rate environment.

In other words, unlike many MLPs, management’s conservative approach to debt means Brookfield Infrastructure Partners is not likely to have to choose between growing its business and sustaining or growing its payout.

Dividend growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score, but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good and 25 or lower is considered weak.

Brookfield Infrastructure’s Dividend Growth Score of 59 indicates investors can expect higher than average distribution growth relative to the S&P 500’s 20-year median dividend growth rate of 5.9%.

That is not surprising given the utility’s impressive long-term track record of 12% annual payout growth over the last five years and management’s long-term distribution growth target of 5% to 9% per year.

Source: Simply Safe Dividends

Given the strong growth runway ahead of Brookfield in the coming years as infrastructure investments continue around the world, income investors could likely even expect long-term distribution growth at the higher end of management’s target range.

Valuation

Not surprisingly, Brookfield Infrastructure’s impressive growth over the past year has sent the unit price up sharply. The stock has gained 38% over the last year, roughly doubling the S&P 500’s 19% gain.

Brookfield’s stock trades at a forward price-AFFO (P/AFFO) multiple of 11.4 and offers a dividend yield of 4.8%, which is slightly higher than the stock’s five-year average yield of 4.6%.

If Brookfield Infrastructure Partners grows its distribution in line with management’s guidance, the stock appears to offer potential annual total returns between 9.8% and 13.8% (4.8% dividend yield plus 5% to 9% annual distribution growth).

Compare that to the market’s historical 9.1% CAGR total return since 1871, and Brookfield Infrastructure could represent a decent long-term growth investment trading at a reasonable price.

Concluding thoughts

The LP nature of Brookfield Infrastructure Partners imparts special risks compared to regular utilities.

Should capital become harder to access or meaningfully more expensive (driven by an inability to sell assets at favorable prices, a lower unit price or higher interest rates), the company’s growth outlook could deteriorate, adversely affecting the stock and its distribution growth.

For investors willing to accept these risks, which are common with most MLPs, Brookfield Infrastructure Partners’ growth opportunities and proven management team make the company one of the more interesting high-yield investments in today’s market.

Very conservative income investors, however, are likely best served by sticking with pure-play regulated utilities that operate primarily in the U.S., such as Duke Energy (DUK, Financial) or Southern Co. (SO, Financial).

Disclosure: As of the time of writing, the author had no position in any of the stocks mentioned.

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