Freehold Royalties Ltd (OTCPK:FRHLF) Q3 2020 Earnings Conference Call November 10, 2020 6:00 PM ET

Company Participants

David Spyker – Interim President & CEO

David Hendry – VP, Finance & CFO

Robert King – VP, Business Development

Conference Call Participants

Jeremy McCrea – Raymond James Ltd.

Luke Davis – RBC Capital Markets

Operator

Good afternoon, ladies and gentlemen. Welcome to the third quarter results conference call. I would now like to turn the meeting over to David Spyker. Please go ahead.

David Spyker

Good afternoon, everyone, and thank you for joining us. With me on the call from Freehold are David Hendry, our CFO; Rob King, our Vice President, Business Development; and Matt Donohue, our Manager of Investor Relations and Capital Markets.

Before we get into the highlights for the quarter – and it was a really good quarter for us, we wanted to note that alongside government and public health officials, we are actively monitoring COVID-19 updates and following the latest guidance. We prioritize the health and safety of our workforce by directing all employees to work from home initially. Now the Alberta public health measures relaxed in June, our return-to-office task force worked diligently to develop office safety protocols in alignment with government and public health guidelines. We were able to reopen our office in July with a reduced staff complement, and we’ll continue to monitor COVID-19 updates and follow the latest guidance to move to our next phase of return to office. We sincerely appreciate the continued efforts of our staff during this time, and we want to thank our shareholders for their ongoing support.

So despite these ongoing concerns associated with COVID-19 and the prevailing commodity price environment, Freehold continued to deliver strong returns to its shareholders over the quarter. We remain focused on the sustainability of our dividend and providing a consistent income source for our shareholders while reducing the overall risk profile by reducing leverage and positioning our royalty lands ahead of the drill bit. We continue to highlight that during these periods of weaknesses, our strong margin and simple business model stands the test of time.

Operationally, production on our royalty lands averaged 9,096 BOE a day, essentially flat versus the previous quarter and down approximately 10% versus the same period last year. Shut-in production on our royalty lands averaged about 5% during Q3, an improvement from 9% in the previous quarter, and we exited the quarter with only about 3% shut-ins. Through the remainder of the year and into 2021, we see volumes stabilizing in our core plays like the Viking, Clearwater, Southeast and Southwest Saskatchewan and North Dakota. This is driven by volumes coming back online and the resumption of third-party drilling on our royalty lands.

We were encouraged with the level of drilling on our royalty lands during the third quarter with 32 wells drilled. Recall the previous quarter had no drilling activity, after excluding adjustments, as producers responded to weaker crude oil prices. For the first 9 months of 2020, we had 261 wells drilled on our royalty lands, slightly higher than our initial expectations. What we’re seeing is activity continue to be focused on our core Viking play Dodsland, but we also saw increased drilling in core plays in Southeast Saskatchewan, Western Saskatchewan heavy oil, Cardium oil in West Central Alberta, and then liquids-rich natural gas in the Deep Basin. We believe that with the lower volatility within the crude oil price environment and the stronger natural gas pricing due to winter months, producers will continue to remain active on our royalty lands in the breakup of 2021.

Given the backdrop for shut-in volumes and uncertainty around the pace of third-party drilling, Freehold announced early in Q2 its previously released 2020 guidance was no longer applicable. We’re continuing to suspend 2020 guidance at this time with the expectation that we will resume 2021 guidance as more information is unveiled on spending levels associated with some of our top drillers. We expect to provide the next update to investors as part of our Q4 2020 results, which will be released in March 2021.

As part of our Q3 results, we are increasing our monthly dividend by 33% from $0.015 to $0.02 per share, starting in January 2021 for shareholders on record as of December 31, 2020. At the revised monthly dividend level, Freehold’s funds from operations are forecast to be at the low end of the annual payout range of 60% to 80%. With 2 months remaining in the year, it’s our expectation that dividend levels will be at the low end of our payout range for 2020 as well. While increasing the dividend, we continue to maintain the strength of our balance sheet, and we’ll continue to pursue value-enhancing acquisitions. At current commodity prices and the revised dividend levels, we expect to pay down approximately $2 million to $2.5 million in debt per month with leverage remaining below 1.5 net debt to funds from operations.

I’ll now pass the call to Dave Hendry to walk through some of the financial highlights.

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David Hendry

Thanks, Dave, and good afternoon, everyone. Financially, as crude oil prices stabilized and natural gas prices improved, Freehold continued to deliver on the core aspects of its return proposition: a meaningful dividend while providing investors with a lower risk investment, differentiating itself from traditional oil and gas E&P companies.

In the third quarter, Freehold generated $23.1 million in royalty and other revenue, up 56% versus Q2 2020, reflecting improved liquids and natural gas pricing, lower cash costs and stable production volumes. Our royalty portfolio generated an operating netback of $27.20 per BOE during the third quarter, up 61% when compared to Q2 2020. Funds from operations for Q3 2020 totaled $19.9 million or $0.17 per share, up 87% and 89%, respectively, versus Q2 2020.

Our payout on a dividend paid basis was 27% in the third quarter of 2020, down from 92% during Q2 2020. We target Freehold payout to remain at the lower end of our outlined range of 60% to 80% for 2020 with our year-to-date payout at 67%. As previously mentioned, we increased our monthly dividend for 2021 from $0.015 per share to $0.02 per share, reflecting an improved and less volatile crude oil price environment and positive momentum associated with third-party capital on our royalty lands while still remaining cautious and measured.

Cash costs for the quarter totaled $3.70 per BOE, an all-time low for Freehold. This was down notably from $4.79 per BOE in Q2 2020. The decrease versus Q2 reflects both lower operating and financing charges. The reduction in cash costs was most materially impacted by the disposition of working interest production during the previous quarter with the forecasted impact on operating costs expected to be approximately $0.35 per BOE.

Freehold closed the quarter with $14.4 million reduction in net debt from Q2 2020. Net debt totaled $81.7 million at September 30, 2020, representing a 1x net debt to funds from operations. The decrease in net debt quarter-over-quarter reflects stronger funds from operations. With oil prices likely to remain range-bound for the remainder of 2020 and into the first half of 2021, we expect our long-term debt to EBITDA ratio to comfortably remain covenant compliant, Freehold’s prudent strategy of maintaining long-term debt to cash flow below 1.5x and a dividend payout range of 60% to 80% of funds from operations, providing cushion for a potential volatility that may pick up in commodities.

Updating our Canada Revenue Agency reassessments, amounts are consistent with those reported last quarter. Freehold’s corporate income tax filings for 2015, 2018 and 2019 were reassessed by the CRA in 2021. Pursuant to these reassessments, deductions of $92.6 million of noncapital losses by Freehold were denied, resulting in reassessed taxes, interest and penalties totaling $29.3 million in addition to a denial of $129.9 million of carried forward noncapital losses. Freehold has filed its objection of the reassessment, which required deposits totaling $14.7 million to have been paid to the CRA during the third quarter. Freehold has received legal advice that it should be entitled to deduct the noncapital losses, and as such, management remains of the opinion that all tax filings to date were filed correctly and that it expects to be successful in its objection to these reassessments and, therefore, the deposits paid to CRA should be refunded with interest. Freehold anticipates the proceedings through the CRA will take approximately 1 year to resolve. Furthermore, the payments of these deposits does not impact Freehold’s earnings or funds from operations or net debt.

Now back to Dave for his final remarks.

David Spyker

Thanks, Dave. So looking forward, we expect the next 3 to 6 months to remain challenging for the industry although improving sharply from the oil price lows of Q2. Setting ourselves apart, Freehold provides investors relative stability as royalties represent a higher-margin business. We continue to maintain flexibility in our balance sheet while maintaining sustainability in our dividend. At current share price levels, we feel the return proposition is an attractive entry point for investors. With today’s increase to our 2021 monthly dividend, we highlight how the royalty model is sustainable through all commodity cycles, as we have demonstrated since we went public in 1996, nearly 25 years ago. We continue to execute on the core aspects of our strategy moving forward with the goal of maximizing returns for our shareholders.

In addition, we would also like to encourage all people to take a moment tomorrow to remember some of the sacrifices made by our Canadian heroes through Remembrance Day ceremonies. While many of us may not be able to attend in person given some of the restrictions associated with COVID-19, we think it is important for people to take a moment to recognize some of the tremendous sacrifices Canadian soldiers have made to provide us with the incredible freedom and quality of life we maintain in Canada today.

We would now entertain any questions that you may have.

Question-and-Answer Session

Operator

[Operator Instructions]. The first question is from Jeremy McCrea.

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Jeremy McCrea

Can you give me an indication of how many new leases – lease agreements you’ve signed here for the quarter or looking to sign? And just have you noticed any increase in activity on some of your gas-weighted lands here? I’m thinking maybe Edson or in some of those other areas there.

Robert King

Yes. Thanks, Jeremy. It’s Rob speaking here. I mean I’ll answer your first question first – or the second question first. In terms of gas-oriented drilling, we’ve seen a little bit of activity in the Deep Basin with a couple of the producers that we’re close with. I think that’s – I’d say it’s probably not been the key focus of our activity. It’s really continued to be in the Viking, in the Cardium, in the Southeast Saskatchewan, and we’re beginning to see more activity in Clearwater. Those are certainly the – I would say the big 4 that continue to be the most dominant in the portfolio. But some of those Cardium locations are obviously – have a fair amount of gas in them as well. So whether it’s gas economics or the liquids economics that are driving it, unclear, but they are being – important thing is they are being drilled.

And as related to new leases, let me get that number to you. I don’t have it handy here. It was a modest amount in terms of what we were able to secure in terms of new leases, certainly from a dollar amount, which is a lease bonus revenue.

Jeremy McCrea

Yes. It was just more just trying to see how much activity has really started to pick up. Have guys started to come approach you and say, “We’re getting comfortable with drilling again. Let’s look to sign these new leases or these lands over here?” But just generally, how that’s changed.

Robert King

Sure. Maybe I’ll answer in a bit of a different way in terms of actual drilling because where we’ve seen activity pick up in Q4 here, we’re now on pace halfway through Q4. We have about 50% more drilling on our lands relative to Q3. Same areas are still the dominant areas of activity. Viking, Sparky, Cardium are kind of the big 3 followed by Southeast Saskatchewan. We’ve talked to a number of our Clearwater players where there are 2, in particular, talked about 10 to 15 wells in the winter drilling program here. So I think we certainly are seeing signs of activity picking up in terms of drilling.

Operator

[Operator Instructions]. The next question is from [indiscernible].

Unidentified Analyst

Great quarter. Just wondering, why not institute an NCIB just given Prairie Sky has been doing something similar, and it seems like there’s not many acquisitions going on.

David Spyker

Yes. I think our perspective on the NCIB is that our preferred method of returning value to shareholders is through the dividend. So that’s a first priority. Want to continue to manage our balance sheet is second priority. And I think that we’re actually seeing quite a good number of opportunities that are out there right now. And so we do think that there are opportunities to further enhance our portfolio with select acquisitions. And we’re taking a long-term view that we think by allocating some capital to making our portfolio even more resilient and durable than it is right now by key acquisitions, and we think that’s a better allocation of capital than NCIB at this point in time. Certainly, every opportunity that we look at, we compare it to an NCIB. But right now, we think that there’s opportunities to do business out there that would make our company better.

Unidentified Analyst

Totally understood. Just wondering, as we get past OPEC and you have more line on – of sight on COVID, would you be targeting a 60% to 80% payout ratio on the dividend? Is – the $0.02 increase was good, but just thinking about it longer term.

David Spyker

Yes, definitely. Our strategy is still that 60% to 80% payout. What we’re looking at here is more of a measured dividend increase. We still have a conservative view on commodity prices. We’re not 100% sure how COVID is going to play out despite some of the optimism this week with the Pfizer announcement. And so we really need to see how that plays out. We need to see how our quarter plays out. And we’re going to reevaluate in Q1 once we have a little more confidence that the environment ahead of us is stabilized and is sustainable. So the target is still there, 60% to 80%. How we ramp up to that through a measured approach is how we’re going to handle that. So…

Operator

The next question is from Luke Davis.

Luke Davis

Just a few quick ones for me related to the last caller. How are you thinking about setting the dividend just from a modeling perspective? Are you typically kind of targeting the lower end at 60% and then thinking about the balance, the 80%, is kind of a volatility cushion? Or how should we be thinking about that going forward?

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David Spyker

I think that’s a fair comment, Luke. Definitely, for now, we’ve given the rapidly evolving business environment that we’re a little bit more comfortable operating at that bottom end, low end of the payout range, provides ourselves a little bit of cushion in case we do see retreatment of commodity prices again. But also, we think that there’s a good opportunity to make some smaller dividends that – I mean smaller acquisitions that enhance our portfolio. So I want to just to be a little bit of room there as well. So it’s a balance of – it’s a number of factors that are driving us initially to sit in that lower end as we just watch how the environment unfolds.

Luke Davis

Right. Makes sense. And then I guess to follow on that, any change in terms of how you’re thinking about hedging just particularly as we see commodity pricing that sort of appears more constructive and, I would say, more so on the gas side?

David Spyker

Yes. We have not historically hedged, and it’s not an area of focus right now. I think that the prices are still volatile enough in either direction that we don’t think that hedging is the right thing for us right now. And by the nature of our conservative business model and the high netback that we achieved, hedging is not a key part of our portfolio that would be safe for a traditional E&P producer where – who’ve got a really good, stable production base. It doesn’t have an operating cost component to it and doesn’t have a capital draw associated with it. So broad hedging is not a priority right now.

Luke Davis

Right. Makes sense. And then I guess final one from me. Just can you maybe frame out what you’ve seen in the acquisition markets to date? Any kind of changes in recent months? And can you kind of frame about how we should be thinking about that going forward?

David Spyker

Let me just turn that over to Rob. He’s got – his team have been really looking at a lot of opportunities in the last little bit here and maybe just give some color on what you’re seeing.

Robert King

In terms of – since our last update in August, we’ve certainly seen an uptick on both sides of the border as it relates to potential transactions. These are both marketed processes but also proactive conversations that we’ve been having. In the – on the Canadian side, a lot more, as you guess, on the other manufactured or opportunities and probably a lot more receptivity as it relates to proactive conversations with a number of counterparties particularly on the private side, so a fair amount of dialogue. I think there’s still fair bid-ask spread that’s definitely out there, but with every month, we’re optimistic that, that spread will narrow. In the U.S. side, a lot of opportunities are coming across our desks and, say, more of the packages that are also looking fairly attractive, that have a pretty interesting mix of near-term production, tangible upside and future upside. And that’s not just a Bakken comment. We’ve really been expanding our efforts and our capabilities if you’re looking outside of North Dakota and have been doing – looking at a number of opportunities that are in other basins that are seeing capital being actively allocated in this current commodity price environment. So that’s providing some encouraging opportunities that we’re actually looking at.

Luke Davis

All right. Makes sense. And then I guess final one. I can appreciate this might be a little bit more sensitive, but when you speak to spreads, can you maybe provide some broader ranges in terms of where the market is sitting and around where you’d like to execute transactions at?

Robert King

Yes. Maybe I’ll just kind of talk more from a – one of the key tenets, as Dave talked about, that when we’re looking at acquisitions, it really has to be accretive to our free cash flow yield. And so if I kind of use our free cash flow yield and they have 15-ish percent range, plus or minus, depending on the day, it has to be superior to that. And so I think that’s – it’s a bit of a data point to kind of point in terms of where we need to see acquisitions to be attractive and be competitive for us, and they’re probably a little bit inside that right now.

Operator

Thank you. There are no further questions registered at this time. I’ll turn the meeting back over to Mr. Spyker.

David Spyker

Okay. Well, thanks, everyone, for attending the call this afternoon, and thank you for your interest in our story, interest in our company and for the value proposition that we offer. So we had a good quarter, and we look forward to talking, guys, again throughout the coming weeks. Thank you, and goodbye.

Operator

Thank you. Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.



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