Concession companies remain one of the easiest ways to gain exposure to the oil sector. Since this type of company gets a percentage of top line revenue, its financial performance should roughly line up with how Trade oil prices (minus overhead and normal business expenses). I bought freehold rights (TSX: FRU: CA) (OTCPK: FRHLF) in 2021 and the share price has doubled since then. With the influx of liquidity, the freehold acquired more assets and increased the monthly dividend several times.
The third quarter was again strong, and cash flow continues to be strong
During the third quarter, the average attributed oil production rate was 14,219 barrels of oil equivalent per day. Almost 30% of production now comes from the US as the freehold has focused on increasing its exposure to US assets through acquisitions. Interestingly, about half of oil equivalent production is actually oil. Natural gas liquids make up more than 10% while natural gas production accounts for about 38% of oil equivalent production.
During the quarter, the company reported an average realized oil price of just over CAD 110/bbl while its average realized natural gas price was CAD 5.51, resulting in an average realized price of just over CAD 74/bbl. This represents an increase of approximately 51% compared to the third quarter of last year, thanks to the 68% increase in the average achieved natural gas price.
This resulted in total revenues of just over CAD 98 million and as you can see below, total operating expenses were CAD 18 million only thanks to gains of CAD 18 million. The final freehold realtor shows a net income of CAD 63 million, for an EPS of CAD 0.42.
Of course there is more than meets the eye here, and equity firms should be evaluated based on a cash flow perspective. The CAD 18 million in FX is a non-cash gain but on the other hand, the CAD 27 million in depreciation and depreciation charges and CAD 2.2 million in stock-based compensation is not a cash expense either.
So while the third quarter EPS of C$0.42 and 9 million 2022 EPS of C$1.12 look attractive, it’s also important to pull the cash flow statement. As you can see below, Freehold reported C$81 million in funds from operations. This is also the free cash flow (after deducting CAD 48,000 in lease payments) since the equity firm does not have to contribute a single dollar to the current capital expenditure on an oil asset. Freehold is buying a property, paying cash up front and that’s it. This means that depreciation and depreciation expenses are just an accounting item.
Of course, no oil field will produce forever, but the operators will obviously do their best to extract as many barrels of oil and as many cubic feet of natural gas as possible from the assets. The freehold can use the incoming cash flow to capture new royalties on other assets.
Dividends are well covered, even if the price of oil drops
The freehold recently increased its monthly dividend to C$0.09 per share per month. With fewer than 151 million shares outstanding, the dividend costs about C$13.5 million per month. Given that EPS was C$0.42 in the third quarter, the dividend of C$0.27 could easily be covered.
The coverage ratio improves when compared to free cash flow. Our third quarter free cash flow result was just over C$80 million which means that the dividend payment of C$40 million in current dividend yield is well covered. The remaining cash will be used to boost the balance sheet. As of the end of September, the net freehold equity position was just under C$160 million although the calculation method used by management is somewhat unorthodox.
Rather than deducting the cash position from the total debt position, the freehold assumes that the working capital elements are “as good as cash”. This is original and not necessarily wrong, but keep in mind that the official net debt position is based on an unconventional method of calculation.
As the freehold is able to hold a significant amount of cash, net debt and gross debt should decrease which will also have a positive impact on interest expense in the long run.
Even though I’ve recently reduced my exposure to freehold returns (basically taking my initial investment off the table) I’m still a shareholder. The dividend is well covered with a payout ratio of about 50% based on Q3 cash flow which means that even when the price of oil and natural gas drops, the dividend will still be covered.
In general, the current dividend remains fully covered up to a 40% decrease in realized prices compared to realized prices in the third quarter. This is the theory. Free equity uses a 60% payout ratio as a dividend policy, and if we get into a prolonged period of oil prices between $60 and $70 a barrel, the dividend obviously will be lowered to a level in line with the payout ratio. But as management mentioned on the conference call, existing monthly earnings will be held based on a long term oil price of $75 oil, I don’t expect to see any changes anytime soon.
Editor’s note: This article discusses one or more securities that are not traded on a major US stock exchange. Please be aware of the risks associated with these stocks.