2023-03-17 00:37:57 ET
Summary
- FRU's royalty model can result in positive netbacks and free cash flow in almost any environment.
- 2022 FYE showed record high FFO as a result of commodity prices and U.S. acquisitions.
- Even if lower commodity prices persist, I project a minimum 9% FFO yield and a well covered ~7% dividend yield.
Please note that since the company is based in Canada and trades on the TSX, any company-related figures, such as FFO, FCF, or dividends, are stated in Canadian dollars. All commodity prices such as oil and natural gas are quoted in U.S. dollars unless otherwise indicated.
Introduction
I have written on Freehold Royalties ( FRU:CA ) numerous times with the most recent being in August 2022. My conclusion was as follows:
Despite operating in a cyclical industry, FRU should benefit greatly in the current inflationary environment and provide stable returns to shareholders. Investors can enjoy a safe minimum 8% yield in the near term as commodity prices remain at record highs and should benefit from multiple expansion. Therefore, double-digit returns are not unreasonable to expect. FRU's operators are all reputable companies, most of which are considered "investment grade" and like FRU have made tremendous efforts to deleverage as a result of excess cash flows in the current commodity price environment.
Source: Freehold Royalties: Still Steady As She Goes In The O&G Sector
The stock had done quite well up until January 2023 delivering total returns of over 50% and blew its peers out of the water. However, the recent fall in oil prices has been a low tide that has brought down all energy related stocks and has made those recent gains evaporate. Still FRU has outperformed its peers since August 2022 when last discussed.
Oil had rallied early in 2023 as a result of increased economic activity in China after the end of COVID-19 lockdown measures ended. U.S. crude stockpiles have risen by 1.6 Million barrels in the week to March 10 to 480.1 Million barrels according to CNBC . In addition, the recent failure of the Silicon Valley Bank (SIVB) and Signature Bank ( SBNY ) sparked some panic in the markets about an impending financial crisis that could weigh on fuel demand. The combination of these events brought WTI prices to their lowest levels in over a year at $68/bbl USD as of today's date.
Whether the lower oil prices will persist I cannot say but FRU manages one of the largest non-government portfolios of oil and natural gas royalties in Canada with a sizeable land base in the U.S., which positions it as a leading North American energy royalty company. As a royalty interest owner, FRU does not pay any of the capital costs to drill, complete, and maintain, or abandon the wells it owns. All of these costs are paid by the royalty payors. Freehold receives royalty income from gross production revenue (revenue before any royalty expenses and operating costs are deducted). This operating model can result in positive netbacks and free cash flow in almost any environment which is exactly what I run to in periods of uncertainty.
Investment Thesis
2022 FYE results were nothing short of a record breaking year.
Spring 2023 Investor Presentation (Freehold Royalties)
Royalty and other revenue totalled $98.5 Million in Q4-2022, up 31% from the same period in 2021. This increase in revenue was driven by growth of record production and a strong commodity price environment. 1,057 gross wells were drilled on FRU's royalty lands in 2022, a 61% increase YoY. These increases were a result of acquisition activity completed over the year and increased third-party drilling and completion activities on FRU’s lands. 2022 FYE results reflect a full year of production from royalty income properties acquired throughout 2021 which included the Eagle Ford and Midland basins in the US.
Spring 2023 Investor Presentation (Freehold Royalties)
G&A costs increased 40% YoY as a result of additional skill sets required to manage Freehold’s expanding North American asset base, overall inflationary pressures, and a weakening Canadian dollar increasing the reported cost of FRU’s U.S. dollar denominated software applications and a newly created diversified royalties team. The breakeven cost to produce a barrel of oil is still only $5.19/boe USD while the average realized price was $75/boe USD. That led to a netback of ~$68/boe USD which was far and away the best netback of any oil and gas company in 2022. FFO in 2022 totalled $316.5MM or $2.10 per share, up 67% from 2021 and greatly exceeded guidance of $250MM.
The monthly dividend was raised to $0.09/share for Q3 2022, up 59% versus the same period in 2021 for a respectable 7% dividend yield while the payout ratio is only 51%.
Freehold completed $191 Million in North American royalty acquisitions and related expenditures in 2022 which included adding royalty assets in the Permian and Eagle Ford in the U.S. and the Clearwater in Canada. CAPEX was funded through a combination of funds from operations and the existing credit facility. Proved and probable oil and natural gas reserves totalled 54.5 MMboe as at December 31, 2022, up from 49.8 MMboe at December 31, 2021. That is enough inventory to last almost 10 years if 15,500 boe/d is drilled.
This increased acreage has led to increased production guidance on behalf of management by at least 3% for 2023. Management already took into account that commodity prices could potentially be lower this year with WTI prices breaking $100/bbl USD and AECO prices being over $3.00/mcf CDN in 2022. Management therefore guided for lower FFO based on $80/bbl USD WTI prices and AECO prices of $3.00/mcf CDN. Even assuming the lower end of guidance at $250 Million FFO for 2022, this would still imply a respectable 12% FFO yield.
2022 Annual Report (Freehold Royalties)
Although leverage ratios were in line with the previous year at 0.4x net debt-to-FFO, net debt increased 26% YoY from $101MM to $128MM as a result of utilizing its credit facility to fund acquisition activity completed in 2022, but did repay amounts thereunder with FFO. Even at the lower end of guidance FRU could fund its dividend and repay 71% of its debt in 2023 assuming it doesn't do any more acquisitions. If commodity prices remain this volatile in 2023, I don't expect any dividend increases as debt repayment would be the more prudent use of free cash flow. Management has indicated the dividend is sustainable at WTI prices greater than $50/bbl USD so the likelihood of a cut is very low in the near term.
Spring 2023 Investor Presentation (Freehold Royalties)
The 2022 Annual Information Form has valued FRU's 1P reserves at $1,025MM and 2P reserves at $1,828MM using a 10% discount rate. The prices used in the inputs might look a tad aggressive as they would have been based on the prevailing futures curve in December 2022 and we the WTI has not been at $80/bbl USD and AECO has not been over $4/MMbtu since early in the year. The company does trade at a slight premium to its book value with its market cap being at ~$2 Billion and would be well advised to issue shares for future acquisitions.
Investor Presentation 2023 (Freehold Royalties)
2022 Annual Information Form (Freehold Royalties)
Conclusion
You may recall commodity prices today were about the same level in Q2 2021 even a little lower and FRU still produced $0.31/share in the quarter ($2.20 annualized) and with production being ~80% of what it is today. That would imply a conservative ~9% FFO yield if these lower commodity prices persist. This provides a good proxy on downside protection. Despite the royalty trading at a premium to book value, this royalty stock is one of the safest income plays in the energy space as a result of its low cost and leverage structure.
Q2 2021 Financial Reports (Freehold Royalties)
For further details see:
Freehold Royalties: A Safe Haven In The O&G Sector