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Edited Transcript of FRU.TO earnings conference call or presentation 2-Aug-19 1:00pm GMT

Q2 2019 Freehold Royalties Ltd Earnings Call

CALGARY Aug 3, 2019 (Thomson StreetEvents) -- Edited Transcript of Freehold Royalties Ltd earnings conference call or presentation Friday, August 2, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan G. Withey

Freehold Royalties Ltd. - Interim VP of Finance & CFO

* Thomas J. Mullane

Freehold Royalties Ltd. - President, CEO & Director

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Conference Call Participants

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* Amir Arif

Cormark Securities Inc., Research Division - Analyst of Institutional Equity Research

* Dennis Fong

Canaccord Genuity Corp., Research Division - Exploration and Production Analyst

* Jeremy McCrea

Raymond James Ltd., Research Division - Energy Analyst

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to the Freehold Royalties Ltd. Second Quarter 2019 Conference Call. Please be advised that certain statements on this call constitute forward-looking information. These statements relate to future events or are expectations for future performance. All statements other than those of historical facts may be forward-looking, and we caution the listener.

I will now pass the call over to Tom Mullane, Chief Executive Officer. Please go ahead.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [2]

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Thank you, and good morning. Thanks for joining us. With me from Freehold are Alan Withey, our Chief Financial Officer; Matt Donohue, our Manager of Investor Relations and Capital Markets; and myself.

We will summarize our second quarter results, and then we'll be happy to answer questions.

Some quarterly highlights we wanted to expand upon include, on the operations front, Q2 2019 royalty production averaged 10,311 BOEs a day, up 2% versus the previous quarter. The increase in royalty volumes quarter-over-quarter was driven by strong activity levels during the first half of the year, particularly within the Alberta and Saskatchewan Viking and our liquids-rich portfolio. Royalty interest accounted for 97% of production and 100% of operating income in Q2, reflecting acquisition activity, which we will detail. We have increased our 2019 royalty production forecast from a range of 9,900 to 10,300 BOEs a day to 10,000 to 10,500 BOEs a day. We remain cautiously optimistic concerning activity levels through the remainder of the year. With the expectation our royalty portfolio will continue to outperform the Western Canadian Sedimentary Basin activity levels.

Utilizing our free cash flow and the flexibility within our balance sheet, Freehold closed a $30 million acquisition of gross overwriting royalty during the quarter. The transaction comes with drilling commitment on the part of the vendor on certain light and medium oil reservoirs in Central and Northern Alberta and Southwest Saskatchewan. At the time of closing, the royalty was producing 215 BOEs a day, with 94% of production being liquids. Funds from operations in 2019 under actual and strip pricing associated with the acquired assets is estimated at $3.8 million.

Subsequent to quarter end, Freehold closed a $9.8 million acquisition of certain royalty assets located in North Dakota, United States. As part of the transaction, a USD 0.5 million acquisition deposit was paid in June 2019. Production and funds from operations in 2020 associated with the acquired assets is forecast to be approximately 200 BOEs a day and $2.3 million, respectively. This represents our first royalty acquisition outside of Canada. Freehold has been looking at royalty opportunities in the United States for several years. And in the past 2 years, we have significantly improved our U.S. knowledge base and developed our U.S. entry strategy. We will initially focus on royalty opportunities in the Williston Basin, which is an extension of the Bakken/Three Forks plays found in our existing royalty acreage in Southeast Saskatchewan.

Our ability to understand the geology and play types make for a comfortable transition as we continue to build our expertise in doing business in the United States. Within Canada, Freehold saw a continued strength in activity on our royalty lands during the first half of 2019. In total, we had 274 wells, 10.2 net wells drilled on our royalty lands during the period. Of these, 127 or 2.9 net wells were drilled in the second quarter of 2019. This represents a 34% improvement on a net measure and a 15% decrease on a gross measure over the same period in 2018. Typically, the second quarter represents a period of slower drilling activity. However, activity on our royalty lands outpaced expectations, particularly when compared to the same period in 2018. Together, Saskatchewan and Manitoba drilled -- drilling represented approximately 51% of our gross drilling on the -- in the first half of 2019. Alberta activity has again been concentrated in the Viking in East Central Alberta as well as the Cardium in West Alberta. Moderate activity continues for Mannville oil plays throughout the basin. We continue to see activity emerging in the Duvernay and Clearwater, with 12 gross wells drilled between these 2 plays in the first half of 2019. Also our top payers continue to represent some of the most well-capitalized upstream companies in Canada. We are currently forecasting 20 net wells as part of our 2019 guidance. And while we are well ahead of our forecast year-to-date, we would like to see activity levels through the third quarter before making any revisions to this estimate.

Both the Canadian Association of Oilwell Drilling Contractors and the Petroleum Services Association of Canada are forecasting material reductions in drilling activity in 2019, greater than a 25% drop in drilling year-over-year. We are not seeing that on our lands. Dividends represented 62% of funds from operations for the quarter. This compares to 64% during the previous period and 101% during the Q4 2018. We will continue to elevate our dividend -- evaluate our dividend quarterly, but given the volatility associated with the Canadian energy industry, particularly activity levels and the outlook for light heavy differentials, we have chose to maintain our dividend at current levels.

Through 2019, we are forecasting a period of approximately 60% to 65% versus our previous guidance of 60%, reflecting a weakened outlook for crude oil. We have set a dividend payout range of between 60% and 80% of funds from operations for 2019, so we remain at the low end of this range.

I will now pass the call to Alan to walk through the financials.

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Alan G. Withey, Freehold Royalties Ltd. - Interim VP of Finance & CFO [3]

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Thank you, Tom. Good morning, everyone. This quarter, we continued to demonstrate strong financial flexibility at Freehold. During the second quarter of 2019, Freehold generated funds from operations of $30.1 million or $0.25 per share. Revenue from oil and NGL production increased to 93% of total revenue in Q2 2019. A retreat in natural gas prices during the quarter, along with the focus towards more activity within oil plays, impacted this weighting, a weighting that has become more valuable over the past 2 years. Continuing a multiyear trend, Freehold's royalty production amounted to 97% of total production and 100% of operating income in the second quarter, that's up from 95% of total production and 99% of operating income in Q1 2019. Freehold declared dividends of $18.7 million or $0.1575 per share in Q2 2019, implying a 62% payout ratio within the targeted payout range Tom mentioned earlier.

In conjunction with our Q2 2019 results, we updated our WTI and Edmonton oil price assumptions for the full year of 2019 along with the 60% to 65% payout ratio expectation at the low end of our targeted payout range. Freehold closed the quarter with net debt of just over $98 million, representing 0.9x net debt to funds from operations. The net debt figure increased just over $20 million versus the prior quarter, reflecting acquisition activity closed late in the quarter partially offset by free cash flow generated in excess of dividends paid during the period. For year-end 2019, based on our forecast, and including the United States expansion closed subsequent to the quarter end, we forecast net debt to funds from operations of approximately 0.8x. Net income for Freehold in the second quarter was $3.4 million or $0.03 per share. As discussed in our call last quarter, Freehold received a proposal letter from Canada Revenue Agency or CRA, where CRA stated that it intends to reassess and deny Freehold's deduction of certain noncapital losses claimed and carried forward in the tax return filed for the year-end December 31, 2015. Freehold is and will continue to vigorously defend its tax filing position, however, it anticipates the proceedings with CRA could take considerable time to resolve. We firmly believe Freehold will be successful defending its position, and therefore, any amounts paid to CRA should be refunded plus interest. No provisions have been made in the financial statements relating to the proposal letter.

Now I'll turn it back to Tom for his final remarks.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [4]

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Thanks, Alan. In closing, we executed on our strategy in Q2 2019. We were able to grow our royalty production organically quarter-over-quarter. We provided a sustainable dividend to our unitholders. We executed on our acquisition strategy, utilizing free cash flow while unveiling our first U.S. royalty transaction. We reiterate to our shareholders that the move to the U.S. will be measured with the goal of improving the quality of a royalty portfolio. We see the Williston Basin is providing a strong near-term opportunity set for our shareholders.

Looking forward, we will continue to strive to maximize value for our shareholders by investing our free cash flow in the form of dividends, value-enhancing acquisitions and/or paying down our debt. Overall, Freehold offers investors a lower risk oil and gas investment vehicle with upside oil prices, and we feel we have furthered this during the quarter.

I'll now pass it over to the moderator for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Dennis Fong with Canaccord Genuity.

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Dennis Fong, Canaccord Genuity Corp., Research Division - Exploration and Production Analyst [2]

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The first one that I have is on the U.S. royalty acquisition and kind of your view therein. How do you guys see the build-up of essentially your U.S. business now that you've kind of done your first forays into the North Dakota Bakken. And how should we think about the pace of acquisition growth, especially if you're able to complete transactions at a 3.5 to 4.5x cash flow rate and show that an -- on assets that show production growth over time?

That's my follow-up.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [3]

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Dennis, this is Tom. Thank you for the questions. First of all, when you look at our U.S. royalty acquisition strategy, we're just looking to add assets that improve the quality of our existing portfolio, we look in Canada and in the U.S. to find those. We do believe right now that there is plenty of opportunity on both sides of the border. But we are -- we have been looking at the U.S. for some time, and we'll continue to look in the Williston Basin area primarily on our -- in our first go in the U.S. As far as the pace, I mean, we just use excess free cash flow, as you know, Dennis, to buy acquisitions and we've used a little bit of our balance sheet as well. And don't expect every deal that we have is 3.5 to 4.5x cash. It all depends on the upside and the pace of drilling on lands as you know. So that cash flow range can range as low as this to double this as well for quality assets, which have a larger drilling opportunity. As far as -- so we've just allocated a cash to the best opportunities that we see coming. Some could be in Williston Basin and some could be in Canada.

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Dennis Fong, Canaccord Genuity Corp., Research Division - Exploration and Production Analyst [4]

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Okay. Perfect. And just quickly as a follow-up in terms of -- using a little bit of your balance sheet to potentially fund transactions. I'm wondering kind of -- if you wouldn't mind reminding us as to what kind of the debt target that you would like to stay within to kind of potentially pursue some of these potential acquisition.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [5]

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Yes. Our debt, as you know, again, is our -- debt target is to be less than 1.5x debt to cash flow. We won't push it right to that limit. We'll stay comfortably underneath that as we have done in the past.

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Dennis Fong, Canaccord Genuity Corp., Research Division - Exploration and Production Analyst [6]

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Okay. Perfect. And then last one here is just in terms of looking at the activity levels in Canada. I was just curious as to how the initiatives that you were indicating and that you're pursuing to drive more committed wells and capital on your line, how is that kind of faring along?

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [7]

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Yes. I mean, this is a long-term process for us, Dennis, to energize our land. We're working with producers. If producers can commit to drilling wells, we might offer a small break in the royalties to encourage development.

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Operator [8]

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Our next question is from Amir Arif with Cormark Security.

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Amir Arif, Cormark Securities Inc., Research Division - Analyst of Institutional Equity Research [9]

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Just a quick question for you, Tom. Can you just give us a little more color about the opportunities you do see in the Williston Basin, just in terms of like the fragmented nature of any royalty opportunities? Are there splits between mineral versus cores that you see in just the maturity of the play in general? Just as you contrast that to what you've seen in the Canadian side.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [10]

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Yes. Thanks, Amir, for that question. In Canada, there is more Crown land than there is free mineral title land, Freehold land, about -- probably 80-20, it's flipped in the U.S. So as far as opportunities, most of the opportunities in the Williston Basin are mineral title. As far as fragmentation of land, usually, we look at land that's already been kind of got through drilling spacing and it's in order and stuff like that. So usually, there's already a lot of the hard work that's done. And we kind of come in just before the drilling starts.

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Amir Arif, Cormark Securities Inc., Research Division - Analyst of Institutional Equity Research [11]

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Okay. And then for this specific acquisition. Is that -- is the royalty for all the zones or is it just the Bakken versus the Three Forks? Is there any split on...

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [12]

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Yes. It would be all zones, but the target here is Three Forks/Bakken.

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Amir Arif, Cormark Securities Inc., Research Division - Analyst of Institutional Equity Research [13]

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Okay. And then just a final question on that Canadian acquisition, the $30 million acquisition with its own commitments? Did those growing commitments -- based on your projections, does that hold production or annual cash flow flat as you move out a year?

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [14]

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Yes. This -- it grows or -- slightly or is flat in the near term.

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Amir Arif, Cormark Securities Inc., Research Division - Analyst of Institutional Equity Research [15]

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Okay. Okay. And the reserve life to that production?

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [16]

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Many, many, many years. I actually do not know that, but the Reserve Life Index would be over 10 years, for sure.

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Operator [17]

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(Operator Instructions) Our next question is from Jeremy McCrea with Raymond James.

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Jeremy McCrea, Raymond James Ltd., Research Division - Energy Analyst [18]

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A couple of questions on these acquisitions here as well too. The first question is just more of a high level, like what are you guys -- and how do you guys push acquisitions in today's market versus what you guys would have done a couple of years ago when you looked at acquisitions like has your hurdle rate for acquisitions changed? Like what exactly are -- is -- or do you think there's different more important things with acquisitions nowadays? And maybe if you can just kind of go around those lines.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [19]

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Yes. Thanks, Jeremy, for the question. I mean, as far as -- when we look at acquisitions, we try -- with every acquisition, we want to improve the quality of our assets. So that's number one. Number two is the -- where we've traded down there, things traded down, so we have to -- everything has to be accretive. So we do demand a higher rate of return for our assets. I think we -- I'd say, a couple of years ago, we'd say high single digits, low double digits. Today, it's a low double-digit rate of return after tax, is what we look for.

Also a quality counterparties as well. We've always wanted quality counterparties, but we're just more attuned to that in this day and age.

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Jeremy McCrea, Raymond James Ltd., Research Division - Energy Analyst [20]

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Okay. Is there something -- are you more inclined to have royalties on future inventory or more inclined to have near-term cash flow? And just a quick follow-up, are you able to give any kind of indication of how many locations these royalty rates may apply to that aren't kind of producing now?

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [21]

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Okay. I guess when we look at -- we've done several deals where it's mostly raw land, and we -- and they're usually typically small deals. But usually, they have drilling activity forecast for the near term, not like 4 or 5 years down the road. So it's something that has near-term cash flow projected. Some of the assets we have bought that has -- I mean, these ones in the States, it's good cash flow today because that's why we have such a low multiple on the deal. So it's a balance. It's all driven by net asset value and the quality of the asset.

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Jeremy McCrea, Raymond James Ltd., Research Division - Energy Analyst [22]

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Okay. And are you able to provide any kind of future location that you see on these acquisitions?

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [23]

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Yes. There's always -- yes, well, I mean, I guess, we -- when we do a bottoms-up analysis, there's always (inaudible) locations that we on put on the acquisitions. As far as the CAD 30 million royalty we just put in, we do have a 100-well commitment, and if that isn't met, then the royalty percentage goes from 1.7% to 2.7%. So that's how you incur -- well, if you don't drill 100 wells, it's a good deal for us. If they do drill 100 wells, it's a good deal for us, too.

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Operator [24]

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Thank you. There are no further questions registered at this time. I would like to turn the meeting back over to Mr. Mullane.

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Thomas J. Mullane, Freehold Royalties Ltd. - President, CEO & Director [25]

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Yes. Well, thank you very much. It is -- thank you, everybody, for joining us on the call. We're excited about our acquisitions that we did in Q2. We generated increase in production on a per share basis. Our organic growth quarter-over-quarter, we're pretty excited about that in this environment. Thanks for the call. And everybody, have a great weekend.

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Operator [26]

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