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Royalty companies are still one of the easiest ways to gain exposure to the oil sector. Since this type of business gets a percentage of revenue, its financial performance should be roughly in line with how oil price trading (minus normal overhead and professional fees). I purchased Freehold Royalties (TSX:FRU:CA) (OTCPK: FRHLF) in 2021 and the share price has since doubled. As the money poured in, Freehold acquired more assets and increased its monthly dividend several times.

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The third quarter was again strong and cash flow remains strong

During the third quarter, the average attributable oil production rate was 14,219 barrels of oil equivalent per day. Around 30% of production now comes from the US, as Freehold has focused on increasing its exposure to US assets through acquisitions. Interestingly, only about half of oil equivalent production is oil. Natural gas liquids account for more than 10% while natural gas production accounts for approximately 38% of oil equivalent production.

Manufacturing result

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During the quarter, the company recorded an average oil price of just over C$110 per barrel, while the average realized natural gas price was C$5.51, resulting in an average realized by just over C$74 per barrel of oil equivalent. This is an increase of approximately 51% over the third quarter of last year, thanks to the 68% increase in the average realized price of natural gas.

Realized Prices

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This resulted in total revenue of just over C$98 million and, as you can see below, total operating expenses came to just C$18 million thanks to a foreign exchange gain. of 18 million Canadian dollars. Freehold’s net income showed net profit of CA$63 million, for EPS of CA$0.42.

income statement

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Of course, there’s more than meets the eye here, and royalty companies should be valued on cash flow. The C$18 million foreign exchange gain is a non-cash gain, but on the other hand, the C$27 million depreciation and depletion expense and the C$2.2 million compensation equity basis are also not cash expenses.

So while Q3 EPS of C$0.42 and 9M 2022 EPS of C$1.12 look attractive, it’s also very important to show the cash flow statement. As you can see below, Freehold reported an operating fund of C$81 million. It is also free cash flow (after deducting C$48,000 in lease payments) because a royalty company does not have to contribute a single dollar of ongoing capital expenditure on an oil asset. Freehold buys a royalty, pays cash upfront, and that’s it. This means that depletion and depreciation expense is only one accounting item.

Cash flow statement

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Of course, no oil field will produce forever, but operators will obviously do their best to extract as many barrels of oil and as many cubic feet of natural gas from the assets. And Freehold can use the incoming cash flow to acquire new royalties on other assets.

The dividend is well covered, even if the price of oil falls

Freehold recently increased its monthly dividend to C$0.09 per share per month. Since there are just under 151 million shares outstanding, the dividend costs Freehold about C$13.5 million per month. Considering EPS was C$0.42 in Q3, the C$0.27 in dividends going forward would be easily covered.

The coverage ratio improves when compared to free cash flow. The third quarter free cash flow result was just over C$80 million, meaning the C$40 million of dividend payouts at the current rate of return are well covered. The rest of the cash will be used to strengthen the balance sheet. At the end of September, Freehold Royalties had net debt of just under C$160 million, although the method of calculation used by management was a bit unconventional.

Calculation of net debt

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Rather than deducting the cash position from the gross debt position, Freehold assumes that working capital items are “as good as cash”. It’s original and not necessarily wrong, but keep in mind that the official net debt position is based on an unconventional calculation method.

As Freehold is able to retain a good amount of cash, net debt and gross debt are expected to decrease, which will also have a positive impact on long-term interest expense.

Investment thesis

Although I recently reduced my exposure to Freehold Royalties (essentially took my initial investment off the table), I am still a shareholder. The dividend is well covered with a payout ratio of around 50% based on third quarter cash flow, which means that even when the price of oil and natural gas prices decline, the dividend will still be covered.

Generally speaking, the current dividend remains fully hedged up to a 40% drop in realized prices compared to prices realized in Q3. That’s the theory. Freehold Royalties uses a 60% payout ratio as its dividend policy and if we enter an extended period of oil prices between $60 and $70/barrel, the dividend will obviously be reduced to a level in line with the payout ratio. But as management mentioned on the conference call, the current monthly dividend will be maintained based on a longer term oil price of $75, I don’t expect to see any changes any time soon. .

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