Buy Freehold for low-risk growth and income

Despite a challenging outlook, Freehold Royalties Ltd.’s royalty structure bodes well for long-term cash flow.

Canadian oil and gas producers had a challenging year in 2018. A deterioration in the global economy put downward pressure on energy prices.

Buy Freehold for low-risk growth and income

Freehold Royalties should keep its oil, gas and cash flowing.

But the challenges for Canadian oil and gas companies were made worse by an inability to get supplies to international markets due to infrastructure constraints, particularly a lack of pipeline capacity. This caused an increase in the discount of Canadian oil and gas prices to global benchmarks such as West Texas Intermediate oil and NYMEX natural gas.

Given these headwinds, it’s understandable that many Canadian oil and gas companies began to suffer from weak cash generation as the year progressed. Freehold Royalties Ltd. (TSX—FRU) was no exception. Unlike conventional oil and gas companies that hold working interests in their operations, Freehold is a Canadian royalty company that receives revenues from 300 industry operators that extract oil and gas from its mineral and royalty properties.

Lower prices and volumes hit cash flow

Due to lower gas prices and reduced production volumes, Freehold’s cash flow declined 2.0 per cent in the year ended Dec. 31, 2018, to $121.3 million from $123.8 million a year earlier. Cash flow per share fell 1.9 per cent to $1.03 from $1.05.

Total production for the year averaged 11,410 barrels of oil equivalent per day (boe/d), down 7.6 per cent from 12,350 boe/d in 2017. The decrease was caused by significant dispositions within Freehold’s working interest portfolio, as it sought to become a pure-play royalty company. Its royalty production averaged 10,718 boe/d for the year, representing 94 per cent of total volumes and over 99 per cent of operating income.

With uncertainty around commodity prices and Canada’s economy, Freehold has decided to maintain its monthly dividend at $0.525 a share. The current adjusted dividend-to-cash flow payout ratio sits at 64 per cent, comfortably within the company’s targeted range of 60 to 80 per cent. But management forecasts a higher ratio of 76 per cent for 2019, suggesting cash flow per share will fall to about $0.83 a share.

Lower production in 2019 may rebound in 2020

That decrease will partly reflect lower production. Freehold forecasts royalty production to average from 9,900 to 10,000 boe/d in 2019. Production and cash flow are expected to rebound in 2020.

Though the high volatility of its share price may not suggest it, Freehold is a lower risk oil and gas investment. That’s because it doesn’t incur the production risks of a working-interest company and it has a strong balance sheet.

Freehold should earn $0.83 a share in cash flow in 2019, and it trades at 10.4 times that estimate, which is reasonable for a royalty company. Its annual dividend of $0.63 a share yields 7.3 per cent. Freehold Royalties is a buy for growth and income.

This is an edited version of an article that was originally published for subscribers in the April 5, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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