Brookfield 2Q18 Letter: Real Assets Market Environment, Renewables, NGPL Case Study

Smart Money
  • In the last few months, we have advanced or completed a number of large transactions – including the acquisition of the balance of GGP for $15 billion, a large midstream natural gas gathering system in western Canada for $3.3 billion, the closing of the acquisition of Westinghouse Electric Company for a total purchase price of $4 billion, the commitment to acquire Forest City Realty Trust and Enercare for $6.8 billion and $2.5 billion, respectively, and the acquisition of a number of solar and wind facilities in Spain for $1.2 billion

Market Environment

  • Global equity markets have stabilized compared to the volatility seen earlier this year, on the back of strong corporate earnings and consistent growth in the overall economy
  • Growth is also supported by favorable global lending conditions. Bank liquidity is very strong and the capital markets remain open, with credit spreads having stabilized following volatility earlier in the year
  • We are still in a period of historically low global interest rates, despite the narrative of a “rising interest rate environment and increasing inflation”
  • Owning real assets means that we are primarily focused on longer term rates which have remained low, particularly outside the US. Specifically, the 2, 10, and 30-year Japanese bonds are essentially zero. Similarly, the 2, 10, and 30-year German bonds are trading at -0.59%, 0.41%, and 1.1%, respectively. The 10-year UK bond is at 1.33% and the 10-year Canadian bond is at 2.37%
    • In each of these economies, low interest rates are expected to persist for the foreseeable future. Not only do these rates keep borrowing costs low in these regions, but in today’s global capital markets with investors seeking yield, they also keep US rates lower
  • Growth in the US continues to be strong and interest rates are increasing faster than any other country, yet the 10-year bond continues to trade below 3%
  • Outlook continues to reflect steady, modest rate rises and we expect the 10-year bond to level out in the range of 3.5% by the end of 2019. The slope of the yield curve continues to flatten, with the spread between 2 and 10-year US treasuries at 30bps, implying very limited expectations of interest rate increases
  • With 50% of our assets in the US, we are well positioned to benefit in this environment
    • Our revenues for real assets typically outpace incremental interest costs in an inflationary period – either because of contractual rights, or our ability to either make operational improvements or expand the operation
    • Our debt is locked in at long-term fixed rates, so for the most part we have “hedged” the cost side of the equation
    • Increase in revenue should more than offset adjustments to discount rates in our asset valuations

The Sun is Getting Brighter

  • We’re in the midst of a 50-year long transformation of the global power grid, from 100% fossil fuels to a good portion being renewables. We are still in early stages – we estimate that replacing a meaningful part of the non-renewable capacity in our core markets with wind and solar will require over $10 trillion of investment
  • Shift from new technology to established infrastructure has occurred at a rapid pace due to a combination of environmental regulation, subsidies, and more recently, cost declines which in the last five years have made some traditional forms of thermal generation obsolete, and therefore created widespread adoption of renewables
  • Over $1 trillion of capital has been invested into renewables in the last 5 years, and over 1 million MW of new renewables have been added to the global power markets. This is equivalent to the entire US electrical supply being replaced by renewables in the last 5 years. Despite this, renewables still account for less than 30% of global power supply, of which wind and solar account for less than 8%
    • Even if the world maintains its current $200-300bn of annual investment into renewables, the level of penetration will remain modest for years
  • The numerous subsidies offered by governments, combined with low interest rates and sustainability initiatives have attracted all forms of investors
  • We believe the prospects for growth are better than they have ever been. Furthermore, subsidies were never a sustainable way to build a power grid, but over the long term as they are eliminated, opportunities will favor those with operational expertise

Long-term Value Creation Requires Hard Work

  • We initially acquired a 27% position in NGPL through Brookfield Infrastructure Partners as part of a larger recapitalization transaction that we completed at the height of the global financial crisis in 2009
  • While many of the other investments acquired in this transaction performed exceptionally well following the financial crisis, this business faced a number of headwinds – including a regulatory review that reduced the rates it could charge to customers, and a natural gas market that had fundamentally shifted to a position of oversupply, adding further pressure to pricing. By 2014, revenue had declined substantially and with its debt ratings downgraded, NGPL was faced with a challenging environment to refinance its $2bn of near-term debt maturities
  • Despite its poor financial performance after we acquired the stake, we viewed NGPL as a high-quality asset strategically located and positioned to benefit from the changing dynamics of the North American natural gas market
  • To this end, we acquired 100% of NGPL and created a 50/50 joint venture with a multi-year strategy to unlock value
  • Together we recapitalized the business with $1bn of new equity, then refinanced the company’s debt. We re-aligned management with a plan that focused on generating value over the long term and established a simple governance framework that allowed for efficient decision making on key business matters
  • We came up with an operational plan that included various capital projects that expanded capacity and reversed flow on several sections of the pipeline to facilitate new demand from customers to flow gas north to south
  • The culmination of these efforts is that NGPL has turned around and cash flows have increased 20% in the last few years to almost $400 million. We also put in place longer duration capacity contracts to reduce our risk to volume fluctuations. This all led to a recapitalization plan last year that concluded with a successful $1.4bn long-term bond issuance. With this issuance, NGPL’s debt rating increased nine notches, recently receiving an investment grade rating, and the annual interest costs declined by $130 million due to the lower rates and reduced leverage
  • All in all, we expect annual EBITDA of approximately $500 million within the next few years, which represents a 50% increase since we started our re-work of the asset
  • By doubling down on a good business and by putting our operational and financial skills to work, together with an aligned and high-quality partner, we turned around performance and set the foundation for a great future at NGPL

Brookfield Asset Management 2Q18 Letter, August 9, 2018

Image Source: EIA, Kinder Morgan