We've upgraded Freehold Royalties Ltd. (TSX?"EURFRU) to a buy from a hold. That's because we believe its recent acquisition of royalty assets from Penn West Petroleum Ltd. strengthens its oil and gas royalties asset base and greatly expands it production and cash-flow growth potential.
Freehold Royalties' oil and gas royalty interests are a major contributor to its operating and financial performance and are not subject to expenses such as operating and capital costs. The company's assets generate income from crude oil, natural gas, natural gas liquids, and potash. Growth is achieved through ongoing development activity on its extensive land base, which spans about three million gross acres, and through acquisitions.
Freehold has agreed with Penn West Petroleum to acquire two royalty packages that total an expected 1,400 barrels of oil equivalent per day of 2015 average net production, with expected annualized operating income of C$29 million in 2015. This assumes prices of US$60 a barrel for West Texas intermediate oil and C$3 for 1,000 cubic feet of Alberta energy clearing organization natural gas. It also assumes an exchange rate of C$0.80 to the U.S. dollar. Freehold's operating income in 2014 was $175.2 million.
The purchase price for the oil and gas royalty packages is C$321 million and has been funded by a $297-million equity financing, or public offering, and a $33-million private placement.
The first royalty package is an 8.5 per cent gross overriding royalty covering 45,000 acres in Penn West's Dodsland area of Saskatchewan, which has prospective holdings in the area's prolific Viking formation. The second package is existing royalties and mineral title lands across a variety of plays within the Western Canadian Sedimentary Basin.
The acquisitions are in line with Freehold's ongoing strategy to acquire attractive oil and gas royalty interests that will add to its bottom line. The company expects the transactions to bolster its free cash flow and strengthen the sustainability of its high dividend yield by lowering its debt-to-cash flow ratios and basic payout ratios.
Using the commodity-price assumptions noted above, Freehold expects the transactions to add about six per cent to its 2015 annualized operating income, and to also strengthen operating income in future years.
The stock trades at about 16.3 times Freehold's depressed projected 2015 cash flow of $1.10 a share. But we expect 2016 cash flow to rebound strongly on the back of higher commodity prices, giving these shares strong appreciation potential. Meanwhile, the current annual dividend of $1.08 a share yields an attractive 6.0 per cent.
Freehold Royalties is a buy for growth and income.
The MoneyLetter, MPL Communications Inc.133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846