{"id":6643,"date":"2023-10-29T07:29:46","date_gmt":"2023-10-29T07:29:46","guid":{"rendered":"https:\/\/infundpros.com\/news\/brookfield-mind-the-interest-rate-rating-downgrade-nysebn\/"},"modified":"2023-10-29T07:29:47","modified_gmt":"2023-10-29T07:29:47","slug":"brookfield-mind-the-interest-rate-rating-downgrade-nysebn","status":"publish","type":"post","link":"https:\/\/infundpros.com\/?p=6643","title":{"rendered":"Brookfield: Mind The Interest Rate (Rating Downgrade) (NYSE:BN)"},"content":{"rendered":"
\n

<\/picture>
\n

Magnifying glass, calculator and charts on newspaper<\/p>\n<\/figcaption><\/figure>\n<\/p>\n

Brookfield<\/strong> (NYSE:BN<\/span>)(TSX:BN:CA<\/span>) stock is one of those rare names that has a following among value investors and growth investors alike. The stock trades at low multiples, yet it also has very strong growth in some of its subsidiaries. For example, its insurance subsidiary grew its earnings 245% in the most recent quarter. Its mix of <\/span>value and growth characteristics has made Brookfield stock appealing to a great many investors.<\/span><\/p>\n

However, BN stock is also subject to many risk factors, the most dangerous of which is rising interest rates.<\/p>\n

Brookfield currently has $13.6 billion in corporate borrowings and $206 billion in borrowings at its managed entities. The ‘managed entities’ category includes both partially owned and wholly-owned subsidiaries. It is well known that Brookfield subsidiaries have been defaulting on some of their debts. Brookfield Property Partners risks having its credit rating <\/span>downgraded to \u2018junk\u2019 because of these defaults. It\u2019s true that Brookfield today enjoys an <\/span>A- credit rating from Fitch, but its subsidiaries affect their parent\u2019s earnings, and their ratings affect Brookfield\u2019s cost of capital.<\/span><\/p>\n

More to the point, Brookfield\u2019s large amount of debt incurs significant interest expenses that are eating into the company\u2019s earnings. In the most recent quarter, Brookfield delivered $1.5 billion in net income, down from $2.9 billion\u2013an 85% decline. A major contributor to the decline in GAAP earnings was a large jump in interest expense, which increased $1.4 billion, from $2.1 billion to $3.5 billion. Some of the jump in interest expense came from new borrowings to finance deals, but the biggest single category responsible for the jump was rising interest rates on existing variable rate debt. We would expect that debt to take a bite out of earnings when Brookfield reports on November 9.<\/p>\n

When I last covered Brookfield, I rated the stock a \u2018strong buy\u2019 on the grounds that it had high quality assets, was cheap, and enjoyed significant protection from the effects of interest on its non-recourse debt. Today, I still consider Brookfield stock a buy, but with somewhat less conviction than before.<\/p>\n

After an extensive review of the company\u2019s debt, I\u2019ve come to the conclusion that Brookfield is not totally shielded from risk, chiefly the possibility of higher rates on variable rate debt. While it is true that only a small proportion of Brookfield\u2019s lenders have recourse to the company\u2019s assets, a significant percentage of the company\u2019s debt is made up of corporate borrowings at Brookfield subsidiaries. In other words, it\u2019s not all \u201cproperty specific.\u201d If S&P Global<\/strong> (SPGI) downgrades Brookfield Property Partners\u2019 debt because of its defaults, then Brookfield as a whole will face higher costs of capital when doing real estate deals, compared to the costs it incurred in the past. So, Brookfield\u2019s debt is a non-negligible risk factor for the company. On the other hand, BN stock is cheap enough at this point that a significant amount of the potential damage is already baked into its price. Factoring in both the risks and the valuation, I still consider BN a buy today.<\/p>\n

How Much Does Brookfield Owe?<\/h2>\n

The reason why Brookfield\u2019s debt situation is tough to wrap one\u2019s head around is because the company\u2019s corporate debt is separate from the debt held by its subsidiaries, as well as that tied to specific properties. The company often touts the fact that it has only a small amount of corporate debt, and that only the corporate debt holders have recourse to the corporation\u2019s total assets. This is technically true, but some of Brookfield\u2019s \u201cnon-corporate\u201d debt is the debt owed by subsidiaries\u2013some of them wholly owned\u2013and therefore has recourse to the subsidiary\u2019s assets. By my estimate this type of debt makes up around 8% of Brookfield\u2019s total debt. In the ensuing paragraphs I\u2019ll explain how that breaks down.<\/p>\n

To begin, let\u2019s look at Brookfield Corp\u2019s financial statements. These list three categories of debt-like liabilities:<\/p>\n

    \n
  1. \n

    Corporate debt<\/strong> – $13.6 billion at 4.2% interest.<\/p>\n<\/li>\n

  2. \n

    Preferred shares:<\/strong> $4.3 billion at 4.6% interest.<\/p>\n<\/li>\n

  3. \n

    Non-recourse borrowings of managed entities:<\/strong> $206 billion, variable interest rates.<\/p>\n<\/li>\n<\/ol>\n

    \n

    \"Brookfield<\/span>
    \n

    Brookfield Balance Sheet (Brookfield)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

    If we lump all of Brookfield\u2019s different types of debt together and subtract the total from assets (along with non-controlling interests), we still get $41 billion in common equity, or $40 billion if we count the preferred stock as a liability. The debt to equity ratio resulting from this exercise is 5.25, which is extremely high. However, if we use total equity in place of common equity, we get a 1.4 debt\/equity ratio, which is only moderately high. As I\u2019ll show shortly, it\u2019s not Brookfield\u2019s debt\/equity ratio that is the real problem, but the potential for interest on the company\u2019s debt to increase\u2013with or without additional borrowings.<\/p>\n

    Brookfield\u2019s Interest Expenses<\/h2>\n

    Knowing the structure of Brookfield\u2019s debt obligations, we can now proceed to a discussion of how the debt will affect the company\u2019s future profits. I\u2019ll start by looking at the effects of the interest rates, and then proceed to examine what percentage of the debt could become a burden to Brookfield at a corporate level.<\/p>\n

    The interest expense resulting from all of Brookfield\u2019s combined debts was $3.75 billion last quarter, or 188% of EBIT (calculated as $1.512 billion in net income plus $409 million in income tax). According to Brookfield, 76% of its debt is fixed rate.<\/p>\n

    \n

    \"Brookfield<\/span>
    \n

    Brookfield Q2 earnings (Brookfield)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

    As shown previously, Brookfield\u2019s interest expenses increased $1.4 billion last quarter. $879 million of that increase\u2013the majority of it\u2013was due to higher rates on variable rate debt. This would imply that another two quarters with increases in variable rate interest expense comparable to the one seen in Q2, would turn Brookfield\u2019s net income from a positive figure into a loss. Not only that, but only $81 million of the $1.512 billion in Q2 net income was attributable to common shareholders. So, it looks like Brookfield\u2019s variable rate debt has the potential to reduce its profitability significantly. Granted, the company\u2019s distributable income\u2013the type of income that determines how much it can pay out in dividends\u2013is much higher than its GAAP net income. That figure was $1 billion\u2013higher than net income to shareholders, but lower than net income to the firm. Again, two more quarters of $879 million cost increases would more than cause all of that profit to disappear.<\/p>\n

    Now, I don\u2019t find it likely that Brookfield\u2019s variable rate interest expense will increase by $879 million once more. Remember, corporate financial statements compare the current period to the same period a year before\u2013so Brookfield gained $879 million in interest expenses through the entire 2022\/early 2023 period of aggressive rate hiking, not from Q1 to Q2. Interest expenses may rise, but not by $879 million per quarter.<\/p>\n

    The \u2018Non-Recourse\u2019 Topic<\/h2>\n

    Having discussed the matter of Brookfield\u2019s interest expense, we can now explore how exposed Brookfield itself is to all of this debt. Brookfield\u2019s executives like to point out that the company\u2019s debt is mostly non-recourse and property specific. It is true that only a small $13.6 billion sliver of Brookfield\u2019s total debt is at the level of Brookfield the company, but not all of the remainder is tied to specific properties. Some of it is subsidiary-level corporate borrowing.<\/p>\n

    According to Brookfield\u2019s Q2 earnings release, about $16 billion of the \u201cnon-corporate borrowing\u201d is subsidiary borrowings. $4.7 billion of that is corporate level Brookfield Property Partners debt\u2013the remainder of that company\u2019s debt (everything with \u201cBrookfield Property Retail Holding\u201d attached to its name) is likely property specific. In the table below, you can see two bonds\/LOCs that are corporate-level Brookfield Property Partners<\/strong> (BPY) borrowings, and $67 billion in total BPY debt. Apart from the $4.7 billion in subsidiary-level debt at BPY, there is also $11.3 billion from other Brookfield entities. Brookfield Asset Management<\/strong> (BAM) has only $930 million in total liabilities, and is not part of Brookfield\u2019s debt problems, as it hasn\u2019t defaulted on anything.<\/p>\n

    \n

    \"Brookfield<\/span>
    \n

    Brookfield Property Partners borrowings (Brookfield Property Partners)<\/span><\/p>\n<\/figcaption><\/figure>\n<\/p>\n

    S&P Global recently put Brookfield Property partners under credit review. The company\u2019s debt is already at the lowest investment grade rating, and could be downgraded to junk. This is a wholly owned Brookfield subsidiary, so every penny of its debt is also Brookfield\u2019s debt. That means that $67.5 billion out of Brookfield\u2019s $223.6 billion in total debt could face higher costs when it has to be refinanced.<\/p>\n

    So we have two potential sources of increased interest expense at Brookfield: the 26% of its debt that is variable rate, and the 30% attributable to BPY that will be financed at higher rates if BPY\u2019s rating is downgraded to junk. True, the vast majority of BPY\u2019s debt is non-recourse, but $4.7 billion of it is corporate-level (i.e. owed by a corporation that is a Brookfield subsidiary), and $16 billion out of Brookfield Corp\u2019s $210 billion in \u201cnon-corporate non-recourse debt\u201d is in fact corporate borrowings at various subsidiaries. So we have between 30% and 56% of Brookfield\u2019s debt that could see its interest expense rise either from variable rate increases or refinancings (the exact percentage depends on the overlap between BPY debt and Brookfield Corp\u2019s variable rate debt), and another $16 billion that has recourse to assets beyond just individual properties. So a significant percentage of Brookfield\u2019s debt could cause problems for the company in one form or another.<\/p>\n

    Valuation<\/h2>\n

    As we\u2019ve seen, Brookfield Corp\u2019s debt has the potential to cause serious problems for the company. Namely, it has the potential to increase the company\u2019s interest expenses, and cause a credit rating downgrade for BPY. This is a serious risk; in my opinion, a more serious risk than Bruce Flatt\u2019s public statements would have you believe. Nevertheless, I still consider the company\u2019s stock a buy at today\u2019s prices.<\/p>\n

    The reason is that Brookfield owns many good assets, and its rock-bottom valuation now \u2018prices in\u2019 a significant amount of trouble.<\/p>\n

    At today\u2019s prices, Brookfield trades at:<\/p>\n