Q2 2022 Transcript

Brookfield Business Partners - Q2 2022 Results Conference Call & Webcast

August 5, 2022

Corporate Speakers:

• Alan Fleming; Brookfield Business Partners L.P.; SVP, Investor Relations
• Cyrus Madon; Brookfield Business Partners L.P.; CEO
• Denis Turcotte; Brookfield Business Partners L.P.; COO
• Jaspreet Dehl; Brookfield Business Partners L.P.; CFO
• Stuart Levings; Sagen MI Canada; CEO

Participants:

• Geoffrey Kwan; RBC Capital Markets; Research Division; Analyst
• Devin Dodge; BMO Capital Markets; Equity Research; Analyst
• Nikolaus Priebe; CIBC Capital Markets; Equity Research; Analyst
• Jaeme Gloyn; National Bank Financial, Inc.; Research Division; Analyst
• Gary Ho; Desjardins Securities Inc.; Research Division; Analyst

PRESENTATION

Operator^ Welcome to the Brookfield Business Partners' Second Quarter 2022 Results Conference Call and Webcast. The conference is being recorded. (Operator Instructions) Now I'd like to tuthe conference over to Alan Fleming, Senior Vice President of Investor Relations. Please go ahead, Mr. Fleming.

Alan Fleming^ Thank you, operator, and good morning. Before we begin, I'd like to remind you that in responding to questions and talking about our growth initiatives and our financial and operating performance, we may make forward-looking statements. These statements are subject to known and unknown risks, and future results may differ materially. For further information on known risk factors, I encourage you to review our filings with the securities regulators in Canada and the U.S., which are available on our website.

On the call with me today is Cyrus Madon, Chief Executive Officer; Denis Turcotte, Chief Operating Officer; and Jaspreet Dehl, Chief Financial Officer. We're also joined today by Stuart Levings, Chief Executive Officer of Sagen, our Canadian residential mortgage insurer. I'll tuthe call over first to Cyrus to provide an update on our business and then Stuart will talk about recent developments at Sagen. Jaspreet will finish with a discussion on our financial results. We'll then all be available to take your questions. And with that, I'll pass the call over to Cyrus.

Cyrus Madon^ Thanks, Alan. Good morning, everyone. Thanks for joining us today. We had a great quarter. We generated over $540 million of Adjusted EBITDA and continue to be very pleased with the resilience of our operations. We're well positioned heading into the second half of the year and we're progressing initiatives to crystallize significant value.

I thought I would start with a few comments on the operating environment before turning to an update on our initiatives. Like most, we're facing headwinds around inflation and supply chain challenges across our businesses - but the durability of our earnings has been a significant advantage for us. With a few exceptions, volumes are holding up well across our operations. We continue to make progress to either pass through higher costs or increase prices to support margins. In fact, on a same-store basis, our EBITDA is up 10% over last year. It's too soon to predict when these inflation headwinds will ease and some may not for a while, but we continue to work with our management teams to take appropriate action to support performance if the environment worsens.

Since our last update, we have closed three of our recently announced acquisitions, including the $8.5 billion acquisition of CDK Global, our technology services and software solutions provider to the automotive dealer industry. This is a high-quality business with recurring contracted revenues, low ongoing capital requirements and high margin potential. Even with the recent widening of credit spreads, we were able to finance the transaction at favorable rates. We're now implementing our value creation plans to grow margins and cash flows. We also completed the acquisition of an Australian residential mortgage lender and a slate roofing products provider.

Apart from growth, we've turned our attention to initiatives that should generate significant proceeds and crystalize value for our business. In May, we launched a process to sell Westinghouse, our nuclear technology services operation, which generated good interest from prospective buyers. Diligence is ongoing and we're optimistic this will result in us reaching an agreement to sell the business. In the interim, we were able to complete a dividend recapitalization from this business that generated about $800 million in proceeds of which BBU's share was $315 million. We look forward to providing you an update as the sales process unfolds.

There are other businesses we own today that could be candidates for monetization. The timing of any sale will depend on many factors, including market conditions. Our water and wastewater operation in Brazil is one example. Since our acquisition five years ago, we've made significant progress to build value in the business. We're now exploring options to monetize our investment.

Like many of you, we're disappointed in the trading price of our units and shares. We're confident though that as we execute on our plans and continue to build long-term value in our business, the trading discount will close over time. We've continued to repurchase our units given that they trade at levels materially below our view of intrinsic value.

With that, I'm going to tuit over to Stuart but I first wanted to express our thanks to Stuart and his team at Sagen who have done a wonderful job for us. I hope you take this opportunity to ask Stuart any questions you might have about the business he's running. Thank you, Stuart.

Stuart Levings^ Thank you, Cyrus, and good morning, everybody. Sagen had another strong quarter as it continues to produce solid operating results in a favorable economic environment. While interest rates are rising and housing markets are slowing, our proven business model, disciplined risk management and high-quality insurance portfolio position us well to manage through economic headwinds over the coming months.

Sagen is a market leader operating in a concentrated, highly regulated industry with natural barriers to entry. We provide insurance to mortgage lenders against homeowner default in exchange for an upfront non-refundable premium. Our business model produces an attractive financial profile, generating strong margins, earnings and cash flows that have proven to be resilient through prior housing and economic cycles.

In Canada, mortgage insurance is mandatory for home purchases with a down payment of less than 20%. Our product is limited to owner-occupied homes under CAD $1 million with a maximum loan-to-value of 95% and amortization of 25 years. We insure predominantly first-time homebuyers with strong income and credit profiles, who tend to purchase entry-level homes with an average price of approximately CAD $420,000. These buyers are often double income families, 25 to 45 years old with growing household incomes. Our portfolio includes mortgages originated across the country concentrated around large urban areas, leading to a regionally diversified mortgage insurance book which limits exposure to correlated economic risks.

Our business has performed exceptionally well over the last few years, benefiting from record levels of new underwriting activity, strong home price appreciation and low mortgage default rates. Today, we have around CAD $2.8 billion of unearned premium reserves, representing cash premiums already collected but not yet recognized into earnings. These premiums will be amortized into earnings over the next five years, providing the business with predictable revenue and the ability to absorb higher default rates as the housing market and economy slow.

Over the past two and a half years, we have worked together with the Brookfield team to execute on our value creation plan including growing our market share, improving our expense ratio, enhancing the yield on our investment portfolio and optimizing our balance sheet and capital efficiency. These enhancements have improved our retuon equity to 20%, allowing the business to provide meaningful distributions to shareholders, including BBU.

Looking ahead, we expect to see a more challenging environment with reduced levels of housing sales and some price softening. Rising interest rates, high consumer inflation and the expectation of slowing economic activity have led to a growing consensus for home prices in Canada to fall by 10% to 15% from their peak in the first quarter of 2022. This represents a modest pull back from the approximately 50% gain in home prices seen through the pandemic and we believe that several factors, including continued undersupply of housing and positive immigration trends, including the target to welcome over 400,000 new immigrants per year to Canada, will act as a floor to home prices.

The quality of our insurance portfolio is the strongest it has ever been. Increasingly stringent underwriting criteria have contributed to higher quality borrowers at an average credit score in excess of 750 across the portfolio. Approximately 80% of the insurance portfolio is backed by fixed rate mortgages, providing borrowers with payment stability in a rising mortgage rate environment. The majority of the remaining variable rate mortgages have constant payments, where only the mix between principal and interest is impacted by fluctuations in rates, thereby providing a similar degree of payment stability.

In addition to the quality of our insurance portfolio, strong oversight and regulation including mandatory loan amortization, full borrower recourse and debt service stress test for all insured borrowers serve to mitigate the risk of borrower default. For example, all insured borrowers in Canada are subject to a stress test that builds in a cushion for affordability in a rising rate environment. Borrowers must qualify for mortgage at a minimum qualifying rate, which is the higher of the benchmark rate, currently 5.25%, or the rate offered by their lender plus 200 basis points. This means that all insured mortgages over the past few years have been qualified and approved at an interest rate of at least 5%. Furthermore, insured borrowers facing financial hardship as a result of significantly higher payments at mortgage renewal can extend their amortizations under our loan modification program. Consequently, rising rates are not typically a driver of mortgage delinquencies.

Unemployment, which sits at historical lows with the consensus forecast for moderate increases over the next few years, typically has a more pronounced impact on mortgage delinquencies. While unemployment drives the frequency of delinquencies, changes in house prices influence the likelihood of claims and degree of loss given default. That said, due to the significant level of house price appreciation over the past few years, our portfolio has an average loan-to-value of 60% which means many borrowers today have significant embedded equity in their homes. This enables them to absorb a material correction in home prices and still sell their property without suffering a loss in the event of default. For example, even in house prices declined by 40% and unemployment reached 10%, both of which would be well beyond current consensus forecast, the business will continue to generate positive net operating income and cash flows.

With that, I will hand it over to Jaspreet.

Jaspreet Dehl^ Thanks, Stuart, and good morning, everyone. As Cyrus mentioned, we had an excellent second quarter, generating Adjusted EBITDA of $543 million compared to $381 million last year with stronger results across all three operating segments.

In Infrastructure Services, we generated Adjusted EBITDA of $205 million compared to $125 million last year. Adjusted EFO increased to $124 million.

Our nuclear technology services operations had a good quarter. Adjusted EBITDA of $58 million was in line with expected seasonality. The business is managing through disruption caused by the conflict in Ukraine and remains on track to generate strong full- year results. In May, the business completed the acquisition of BHI Energy to enhance its

outage and maintenance services capabilities. It funded the transaction with a combination of committed debt financing and existing liquidity on hand.

In April, we completed the acquisition of our lottery services and technology operations, which contributed $25 million to Adjusted EBITDA during the quarter. The business is benefiting from resilient demand despite some impacts from higher input costs and supply chain delays. We've also secured a few new customer wins since closing our acquisition, including a 10-year contract to provide products and services to the operator of the U.K. National Lottery.

Modular building leasing services contributed Adjusted EBITDA of $41 million. The overall demand environment remains stable and we're continuing to benefit from high utilization levels on existing units on rent. We're also making progress on increasing the penetration of value added products and services which is helping to enhance margins.

Moving on to our Industrials segment. Second quarter Adjusted EBITDA increased to $204 million and Adjusted EFO was $101 million compared to $216 million in the prior year. Adjusted EFO in the prior period included a $148 million after-tax gain on the partial sale of our investment in common shares of our graphite electrode operations.

Advanced energy storage operations generated Adjusted EBITDA of $105 million. Pricing and a favorable mix of increased higher margin on advanced battery sales contributed to results despite the impact of higher labor, commodity and transportation costs. Overall battery volumes continue to be impacted by the ongoing production challenges at auto manufacturers. Just as a reminder, prior year results benefited from very strong aftermarket demand as global lockdowns and travel restrictions had eased.

Our engineering components manufacturer generated Adjusted EBITDA of $44 million. Strong performance was driven by commercial pricing actions and contributions from recent acquisitions. We're working closely with the management team on taking appropriate pricing and cost actions to support volumes and margins through the balance of the year.

And finally, our Business Services segment generated second quarter Adjusted EBITDA of $166 million compared to $145 million last year and Adjusted EFO of $151 million for the current quarter.

While Australian healthcare services generated improved Adjusted EBITDA of $21 million this quarter, the operating environment remains challenging. Elevated labor cost and high COVID-19 infection rates of patients and staff are resulting in cancellations of planned surgical procedures which are having an impact on overall performance. We are hopeful that activity levels in the business will improve as COVID-19 infection rates in Australia decline.

Lastly, our Brazilian fleet management operations continue to perform well and in June, agreed to acquire Unidas, a leading full-servicerent-a-car platform in Brazil. This