Barclays PLC Says Freehold Royalties Ltd. Will Rise 40%

Freehold Royalties Ltd. (TSX:FRU) has been lauded by Wall Street. Is the big upside for real?

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Freehold Royalties Ltd. (TSX:FRU) operates a fairly straightforward business. Its primary focus is acquiring and managing oil and natural gas royalties in western Canada. The company has amassed a diversified portfolio with over 200 operators, reducing its exposure to major downturns in drilling activity. Its largest royalty interest only constitutes 7% of total royalty income.

Analysts have grown consistently optimistic over the summer.

Royal Bank of Canada lifted its price target in May from $15.00 to $16.00. Toronto-Dominion Bank reaffirmed its “buy” rating and issued a $15.50 price target in June. In July Bank of Montreal upped its price objective from $14.00 to $16.00.
Recently, Barclays PLC (NYSE:BCS) jumped on the bandwagon, raising its target price from $15.00 to $16.00. Still, shares languish around $11.00 apiece. Could there really be 40% upside to go?
An impressive business
Freehold doesn’t have much trouble generating a profit. Because most of its revenues are royalty based, it’s typically not responsible for supporting what otherwise would be a capital-intensive business. Last quarter it generated 91% of its operating income from royalties.
Despite being a $1.3 billion company, it spent only $753,000 on capital expenditures last quarter. With ample cash flow, Freehold has been able to deploy its spending towards acquisitions, becoming a big buyer of assets at a time when most of the competition is desperately trying to shed assets (often at fire-sale prices).
For example, on April 14, 2014, Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) struck a deal with Freehold to sell its royalty interest in some western Canadian oil fields. Penn West was pressured to make the sale to meet the $650 million the company had promised to pay the holders of its senior notes.

The deal involves Penn West’s 8.5% royalty from production in part of the Viking oil field in Saskatchewan as well as royalty payments in Alberta, Saskatchewan, and Manitoba. The acquired interests, totaling 280,000 acres of royalty and mineral-title lands, are already near Freehold’s current properties and should add $14.2 million to its operating income this year.

As with most of its business, Freehold is not responsible for any of the capital costs to drill and equip the wells for production and will not incur any costs to operate and maintain the wells.

A business model worth betting on

What better way to bet on rising oil prices than with a company that directly gains from rising prices? With very limited capital expenditure needs, Freehold is a solid bet with limited insolvency risk.

The need for additional financing has forced many operators other than Penn West to sell royalties to Freehold at attractive prices. Freehold completed $200 million in acquisitions last year, representing the second-busiest year in company history.

With a strong balance sheet and one of the lowest leverage ratios in the industry, expect Freehold to continue to capitalize with value-creating deals. Wall Street’s rosy expectations might actually be warranted.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Ryan Vanzo has no position in any stocks mentioned.

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