Funtay
Around this time of the year, I like to go over every name in my portfolio, especially those that I have set on autopilot and have not reviewed in a few months. Freehold Royalties (TSX:FRU:CA, OTCPK:FRHLF) is a name that I have held for many years and mostly recently wrote about in January. My thesis on Freehold is that it is a defensive way to gain energy exposure and the stock paid an attractive dividend yield that is safe down to US$40 WTI.
Unfortunately, 2023 has not been kind to energy producers and Freehold has delivered -10% total returns since my last update, significantly underperforming the equity markets (Figure 1).
Figure 1 – FRU has underperformed markets (Seeking Alpha)
With the benefit of some hindsight analysis, let us review Freehold’s performance so far and whether the stock still deserves a buy recommendation heading into 2024.
(Author’s note, financial figures in this article are quoted in C$ unless otherwise noted)
Brief Company Overview
Freehold Royalties is a Canadian energy royalty company with assets in Canada and the US. Although Freehold has a U.S. OTC ticker (“FRHLF”), most of the volume on the stock goes through the main TSX ticker (“FRU”).
Freehold’s assets are balanced between Canada and the U.S., with 63% of corporate production coming from Canadian assets which drives 57% of revenues (Figure 2).
Figure 2 – FRU portfolio overview (FRU investor presentation)
Dividend Sustainable Down To US$50 / BBL WTI
The beauty of Freehold’s business model is that it has very low ‘cash costs’ of production. Essentially, it takes $30 million a year to run Freehold’s business (corporate G&A plus interest expense). This allows the company to fund a generous $0.09 / month dividend that is sustainable down to ~US$50 / bbl WTI (Figure 3). Freehold is currently yielding 7.9%.
Figure 3 – FRU’s dividend is sustainable down to $50 WTI (FRU investor presentation)
Investors should note that historically, Freehold had shown dividend sustainability down to US$40 / bbl WTI in its presentations (Figure 4). However, with increased interest rates and cost inflation, the breakeven rate has been increased to US$50.
Figure 4 – Historically, FRU had claimed dividend sustainability down to $40 WTI (FRU investor presentation)
While this is a deterioration in the business fundamentals, short of a prolonged recession or an irrational price war (Saudi Arabia and Russia famously engaged in a price war in 2020 just as global oil demand collapsed due to COVID, causing spot oil prices to briefly dip into negative territory), I do not expect oil prices will trade down to those levels.
Steady Production Marred By Weak Commodity Prices
In terms of Freehold’s financial performance, 2023 has been characterized as steady operating performance marred by choppy commodity prices that were outside of the company’s control.
For the 9 months ended September 30, 2023, Freehold produced 14,664 boe/d, with oil and NGL accounting for 62% of corporate production. This is a 6% increase from 2022, when the company produced 13,784 boe/d (Figure 5).
Figure 5 – FRU financial overview (FRU Q3 Financial Report)
Compared to the company’s initial guidance provided in March, production is right inline at 14,664 compared to the 14,500-15,500 range (Figure 6). However, the run-rate of funds from operations (“FFO”) is light, at just $236 million ($177 million for YTD 2023 annualized) compared to the $250-280 range.
Figure 6 – FRU initial 2023 guidance (FRU 2022 Annual Report)
Unless we see a surge in commodity prices in the final days of 2023, Freehold will most likely miss on its FFO guidance for the year, especially since WTI prices have been in virtual freefall since the end of September (Figure 7).
Figure 7 – WTI prices have been in freefall since end of September (stockcharts.com)
With WTI averaging $82.18 so far in Q4 compared to $82.25 in Q3, Freehold’s financial performance for the upcoming Q4 will most likely resemble the most recent quarter, with FFO of ~$65 million. This should bring total 2023 FFO to approximately $242 million or $1.60 / share.
M&A Heating Up, Will Freehold Follow?
With M&A heating up in recent months in the oil patch (Exxon buying Pioneer; Chevron buying Hess, plus a host of smaller deals), Freehold has been surprisingly quiet on the acquisition front. Freehold’s most recent transaction was conducted in July 2022, just after I wrote my initiation article.
Perhaps the recent streak of industry M&A transactions have pushed up the price of transactions for Freehold, beyond what the company is comfortable paying. Historically, Freehold is known as a disciplined acquiror, having paid $1.66 billion in total for 12,235 boe/d of production or $136,000 / flowing boe of production (Figure 8).
Figure 8 – Freehold is known as a disciplined acquiror (FRU investor presentation)
However, by some measures, the most recent transaction from last July has underperformed, as Freehold paid $159 million for 1,000 boe of 2023 production (initial announcement was $155 million for 1,100 boe of production, but after adjustments, the final tally was $4 million higher for less production).
So while opportunistic transactions made in 2020 and 2021 have delivered strong ROIs (the 2020 acquisition has almost paid for itself after 3 years and the September 2021 acquisition has returned over 60% in revenues over 2 years), the July 2022 acquisition has only generated 21% in revenue after more than a year (Figure 9).
Figure 9 – Opportunistic acquisitions have generated strong cash returns (FRU investor presentation)
Commodity prices also had an impact, as the older transactions were made before the bonanza prices of 2022, while the July 2022 transaction was made right after Russia’s invasion of Ukraine when commodity prices spiked.
Free Cash Flow Should Build Up Over Coming Years
Looking forward, at between US$60 to $80 / bbl WTI, Freehold should generate $200-500 million in free cash flow (“FCF”) above the dividend that can be returned to shareholders or used to make additional accretive acquisitions (Figure 10).
Figure 10 – FRU should generate lots of FCF in coming years (FRU investor presentation)
Hopefully, with oil prices stagnating below US$80 WTI, sellers will become more eager to sell and Freehold can strike accretive deals in the coming quarters and years.
Valuation Remains Fair And Risks Are Well-Balanced
At a current market cap of $2.07 billion compared to my 2023E FFO estimate of $242 million, Freehold is currently trading at 8.5x P/FFO. I believe this is a fair valuation for Freehold’s shares.
On the upside, if energy prices were to rally, Freehold should have a lot of torque in its business model as costs are essentially fixed at $30 million per year and additional revenues fall to the bottom line.
On the downside, if oil prices continue to languish, investors will still be able to collect an attractive dividend yield, currently set at 7.9%. This dividend should be safe unless the bottom falls out from the energy markets and oil prices tumble below US$50 / bbl.
Supporting commodity prices is OPEC+, which recently announced it would be deepening and extending its voluntary production cuts to March 2024. With North American producers now focused on capital returns and OPEC+ supportive, it is hard to see oil prices falling below US$50 / bbl for an extended period of time.
Conclusion
Given weak commodity prices and an uncertain economic outlook, investors should look to high grade their portfolios. I believe Freehold Royalties is one of the most defensive ways to gain energy exposure and is currently my only energy producer holding. Freehold’s 7.9% dividend yield should be sustainable down to US$50 WTI. I continue to hold my shares and recommend investors switch out of their more aggressive holdings and into Freehold or similar royalty companies. I rate FRU a buy.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
