Sprague Resources LP (NYSE:SRLP) Q2 2016 Earnings Conference Call August 5, 2016 1:00 PM ET
David Glendon - President and CEO
Gary Rinaldi - COO and CFO
Justin Jenkins - Raymond James
Mike Gyure - Janney
Lin Chen - Height
Good day, ladies and gentlemen, and welcome to the Sprague Resources' Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call is being recorded.
I would like to introduce your host for today’s conference, David Glendon, President and CEO. Please go ahead.
Thank you, Ashley. Good afternoon, everyone, and welcome to Sprague Resources' second quarter conference call. Joining me today are Gary Rinaldi, our Chief Operating Officer and Chief Financial Officer; John Moore, our Vice President and Chief Accounting Officer; and Paul Scoff, our Vice President and General Counsel.
First, some of today's call will include forward-looking statements. While Sprague believes these statements to be reasonable as of today's date, future results are subject to many risks and uncertainties that are difficult to predict and outside of management's control. Any forward-looking statements we make are qualified by the Risk Factors in our most recently filed SEC Form 10-K and future filings with the SEC. Sprague Resources LP undertakes no obligation to publicly update or revise any forward-looking statements as a result of new information, future events or otherwise.
Second, Gary and I will be referencing the non-GAAP measures we have consistently used to manage and report on the business and their most directly comparable GAAP equivalents. Because our business requires maintaining physical inventories and transportation assets and we hedge them appropriately, these hedges produce unrealized derivative gains and losses, which are required to be reflected in our GAAP financials, without the accompanying offset for the corresponding physical positions.
Therefore, our reported net income will often experience large swings in a given quarter. Similarly, our hedge portfolio’s gains and losses are part of EBITDA and we adjust our results for the unrealized portion of the derivative hedges to focus on adjusted EBITDA and adjusted gross margin. The inability to predict future commodity price movements also prevents Sprague from budgeting and forecasting future unrealized gains and losses on our hedge portfolio and therefore providing net income guidance.
You can find a discussion of our use of these non-GAAP measures as well as reconciliations between these measures and their most comparable GAAP figures in our earnings press release on Form 8-K with the SEC as well as additional disclosures and reconciliations in the Investor Relations section of our website.
While Sprague reported a net loss for the quarter of $9.7 million, this includes $12.3 million of unrealized hedging losses. Had market prices not rallied higher in the quarter, our resultant hedging losses would have been lower and Sprague would have reported higher net income for the quarter. Sprague’s second quarter performance was stronger than last year.
Adjusted gross margin increased $8.1 million, adjusted EBITDA was $9.9 million higher and we generated $11.8 million more distributable cash flow than we did in 2015. Higher volumes and increased unit margins in natural gas as well as increased revenues in materials handling drove the 20% improvement in adjusted gross margin.
Each business segment is contributing to the successful execution of our growth strategy. In natural gas, our teams have completed the integration of Santa Buckley's natural gas business. So far, the results have been better than initially anticipated, with both volumes and unit margins exceeding our valuation forecast, implying an even lower effective purchase multiple.
Materials handling, the continued evolution of Kildair's business model witnessed increased demand for heavy oil storage services. In the US, we saw an early jump on infrastructure projects that drove our dry and liquid bulk categories higher, due to the mild winter and project funding, stemming from the 2015 passage of the federal transportation bill. Work has also commenced on our upgrade of the Portsmouth facility dock, which will allow us to offer a wider variety of services to our customers.
Finally, in refined products, I’m pleased to report that we have completed the project to convert 420,000 barrels of heavy fuel oil tankage at Kildair to distillate service. We’ve obtained the necessary permits to begin operations and we’re now ramping up our marketing activities. The $5.5 million project is another excellent example of our asset optimization strategy and action and our ability to identify meaningful organic expansion CapEx projects at compelling economics.
As a reflection of Sprague’s performance, and in line with our previously issued guidance, on July 27th, we raised our declared distribution to 54.75 cents per unit, a 2.8% increase over the distribution paid in the first quarter and 12% above a year ago, recognizing our strong financial position and demonstrated ability to achieve our growth objectives. Today, we’re announcing our intent to continue the current pace of distribution growth through 2018. We expect to deliver this growth, while simultaneously maintaining permanent leverage within our long term target range of 2.5 to 3.5 times. We remain steadfast in our belief to consistent distribution growth overtime in combination with conservative balance sheet management, will ultimately deliver the highest value for our unit holders.
Finally, we continue to pursue growth opportunities and have active dialogs for non-option transactions in each of our business segments. While the specific timing of each opportunity is dependent on many factors outside of our control, we still believe one or two meaningful transactions a year is an appropriate expectation.
Now, I’ll turn the call over to Gary for a more detailed review of our results.
Thank you, David and good afternoon, everybody. Sprague’s total adjusted gross margin for the second quarter was $48.7 million, an increase of $8.1 million or 20% over last year, as stronger natural gas and material handling results more than offset modestly weaker refined products results. Adjusted EBITDA increased $9.9 million to $13.9 million, as continued year-over-year reductions in operating expenses and SG&A costs added to the adjusted gross margin outperformance.
Sprague’s operating expenses decreased $1.1 million or 6% to $16.5 million during the second quarter. Reduced boiler fuel expenses, lower variable employee related costs and repairs and maintenance expenses across our terminal system accounted for the majority of the decline. We continue to expect our full year 2016 operating expenses to total between $65 million and $70 million, assuming no new terminal acquisitions are made.
Sprague’s SG&A costs decreased $700,000 or 4% to $18.2 million in the second quarter, compared to a year ago. Lower M&A related expenses and professional fees associated with our three late 2014 acquisitions more than offset higher incentive compensation expense tied to the quarter’s higher earnings. We continue to forecast full year 2016 SG&A expenses to total between $85 million and $90 million, partially driven by personnel and M&A expense synergies from our recent acquisitions as well as the continued focus on cost management throughout the company.
Sprague generated $7.7 million of distributable cash flow in the second quarter, $11.8 million more than last year. Our distribution coverage ratio for the quarter was 0.6 times, but I’ll remind listeners that due to the seasonal nature of our business, we expect to see coverage ratios lower than 1 times in the second and third quarters. For the first half of 2016, Sprague produced distributable cash flow of $45.5 million, generating distribution coverage of 1.9 times.
Assuming continuation of our distribution growth, Sprague’s first and second quarter distributable cash flow by itself represents over 90% coverage for the full year. On a trailing 12-month basis, Sprague’s distribution coverage is 1.8 times.
Sprague’s cash interest expense declined 3% compared to a year ago, driven by the additional paydown of acquisition debt with excess cash flow and less working capital requirements resulting from lower commodity prices and volumes. If energy commodity prices remain near current levels, we believe our full year cash interest expense will range between $22 million and $26 million. Maintenance CapEx also declined $1.1 million compared to last year due to the timing of certain capital projects. We are still managing full year 2016 maintenance CapEx between $8 million and $11 million, while full year 2016 expansion CapEx is expected to total between $5 million and $8 million.
Now, on to a topic that we spent considerable time discussing last quarter, Sprague’s balance sheet strength positions us well for the future. Sprague’s liquidity and its working capital facility was $154 million as of June 30 and $286 million was available on our acquisition facility. While we certainly manage our working capital requirements tightly, we manage our business and our credit facility by focusing to leverage discussion on permanent debt, which relates to the acquisition facility. This is due to the fact that our working capital requirements fluctuates seasonally, are impacted by energy price levels and are collateralized with self-liquidating current assets.
I’m pleased to report that our permanent leverage ratio of 2.4 times is now slightly below the low end of our long term target range of 2.5 to 3.5 times and we intend to reduce our permanent debt further with excess distributable cash flow later this year, providing additional liquidity to finance growth opportunities.
Now, turning to the business segments. Refined products sales volumes decreased 26 million gallons or 9% compared to the second quarter of 2015. Net sales decreased 32% to $391 million as a result of lower volumes and commodity prices year-over-year. The volume decline was primarily driven by a decrease in heavy fuel oil exports from Kildair and the loss of some high volume low unit margin bid contracts. While we continue to see a difficult unbranded gasoline marketing environment, given the high level of supply available on pad 1, our heating oil sales volumes were unchanged relative to last year.
Refined products adjusted gross margin decreased $2.2 million or 9% to $23.7 million in the second quarter as a result of the volume declines as well as lower asphalt margins at Kildair. Overall, refined products unit margins were unchanged at $0.09 per gallon compared to a year ago, thanks to an improved market structure for distillates and new customer additions which replaced the lower margin bid volumes. And as David mentioned earlier, the $5.5 million expansion capital project to bring 420,000 barrels of tank capacity in to distillate service at Kildair has been completed and permitted with marketing activities underway.
In natural gas, our sales volumes increased 1.9 billion cubic feet or 16% compared to the second quarter of 2015 due to the acquisition of Santa Buckley’s natural gas assets earlier this year. Our teams have completed the integration of these accounts into our back office systems and Sprague is now supplying more delivery service locations than it ever has before, a more than three-fold increase in just two years.
Natural gas exceeded our expectations in the second quarter, as the business generated $9.8 million of adjusted gross margin compared to $1.3 million last year. This was driven by a combination of strong results from our recent acquisition of Santa Buckley’s natural gas assets as well as an uplift in the value of forward sales contracts. In addition, there was a positive quarter-over-quarter ASC 820 fair value accounting adjustment, due to valuation changes in narrowing credit spreads on forward derivative positions. Overall, we are proud of our recent natural gas expansion driven by the Metromedia and Santa acquisitions. The number of accounts supplied by Sprague as well as adjusted unit margins are both increasing and we expect our full year 2016 performance to reflect the successful execution of our growth strategy.
Finally, materials handling adjusted gross margin increased $1.4 million or 12% to $13.1 million in the second quarter. Increased heavy oil storage and handling revenues at Kildair as well as increased drive bulk handling activities and asphalt demand were the largest positive drivers for the quarter. This was partially offset by timing differences for handling windmill components and lower stock volumes following the mild winter. For the first-half of 2016, materials handling adjusted gross margin is 12% higher compared to last year. Sprague’s second quarter results positioned us well to deliver on the guidance we shared with listeners in March. And we still expect our full-year 2016 adjusted EBITDA results to range between $105 million and $120 million. As David mentioned we have clarified our distribution growth guidance of $0.150 per unit per quarter through 2018, while still maintaining our permanent leverage within our stated target range and above-average distribution coverage.
Please note that this guidance is based on assumptions of normal weather and market structure conditions and does not include any contribution from possible acquisitions. We continue to believe Sprague’s performance provides one of the more compelling investment propositions in the MLP sector regardless of the valuation metric chosen. Sprague has delivered nine consecutive quarters of consistent distribution growth yet still yields above many small and mid-cap MLPs. Additionally, we have maintained above-average coverage and reduced our acquisition debt but as you heard on this call in May, the seasonal nature of our working capital requirements makes leverage and EV to EBITDA metrics highly dependent on the time period chosen for the calculation.
And finally, we have noticed increased attention on free cash flow yields and believes Sprague also fares well under this valuation approach. Before closing, I'm proud to spend a moment highlighting a few significant safety accomplishments achieved by our colleagues during the second quarter. In June, we recognized several individual employees that have demonstrated an outstanding commitment to safe work that doesn't just stand years but decades, in particular Joe Kane in Providence and Allen Daken in Searsport have completed 25 years of safe work. In addition, our entire Oswego terminal crew past 5,000 days, almost 14 years without a recordable injury. David and I applaud each of these significant accomplishments and thank everyone for exemplifying this core value of ours.
This concludes my remarks, and I’ll let David wrap up before we take questions. David?
Thank you Gary, thank you for joining us today and thanks to every Sprague employee for their contribution, making the first half of 2016 a success. Let's open the call for questions.
[Operator Instructions] Our first comes from Justin Jenkins of Raymond James. Your line is open.
Great, thanks and good afternoon, guys. I guess I will start with maybe a more strategic question. It's definitely great to see the distribution growth guidance extended into 2018, but I guess I'm just curious how you think about the medium term? We are running pretty high annual distribution coverage ratios, pretty low relative leverage and with the bolt on M&A typically coming in at pretty low multiples, feels like there could be quite a bit of runway for these type of growth rates if everything seems to go to plan. I guess I'm just curious on how you guys see the medium term evolving on capital allocation and maybe what type of long-term target you might have for an annualized coverage ratio?
I think a few embedded questions in there Justin; I’ll try and address them but very good questions certainly. So I think you saw the guidance extended out to 2018 which is a little bit more clarity than we’ve provided in the past, I think which is, I'm sure welcomed from you folks. You’ll also note that in that guidance, it does not reflect any possible contribution from additional acquisitions. So that's 2018 timeframe is taken just the kind of core business as it exists today. So I think as we are successful in acquisitions, I think the expectations - we continue to grow distribution at a healthy pace. So, obviously that’s a board discussion but that’s the way I would encourage you to think about that at the current time.
And with that I think we expect as we shared our leverage to remain very low in the range or in that certainly in that target of 2.5 to 3.5 times and we anticipate and recognize that our coverage ratio should be north of the absolute lows that others run at given the inherent volatility that does exist in our business. So, as we have said in the past we are uncomfortable going below 1, 2 or so, and I think that also holds with respect to the guidance that we are providing on distribution growth.
That's great, David and apology for the long-winded question. I learned from the best here. And then turning over to operations I guess looking at the natural gas segment results seemed pretty strong and Gary you mentioned that some of this was a function of the move we've seen in price and the success of Santa Buckley. Could you maybe walk through maybe more details on what the drivers are for solid results?
Sure Justin, the comment on the forward sales contract, this isn't really anything new and it's something we've talked about in the past in different ways but it’s essentially basis gains and losses, basis gain, we have a fully hedged book and it’s a portfolio hedge, so there is locational basis, there is time differences and there is, you know, creates with price moves basis gains and losses. In the second quarter, it was a gain. Second quarter is kind of a low point of the year, so on a relative basis the optics makes it more material, so we thought we would comment on it. And it’s not material on an manual basis.
With regard to ASC [ph] 820 fair value accounting adjustment this relates to forward derivative positions and there is a few things in play here, one is with changing commodity prices, volume et cetera, a derivative - assets derivatives and liabilities change and it was a positive change in the second quarter. Number two is with the Santa energy transactions on a relative basis we have a higher relative amount of investment grade customers versus C rated customers which is a positive change. And number three, as I mentioned the narrowing credit spreads on C rated customers was also a positive chain. So the combination of the three, it was material enough to warrant a comment for the quarter results.
Hey Justin, it’s David, there is just one thing I could add to that is, as we've talked in the past, we’d encourage you to, you know, if you look at our unit margins or adjusted unit margins and natural gas on a quarter to quarter basis it can look a little bit funky, so we continue to encourage an annual view of that dynamic and we believe that that annual view will continue to show the strong trajectory that we've been talking about.
Okay. Appreciate that color guys and last one for me if I could maybe just thinking about the Kildair tank conversions, how would you frame maybe the ramp and contribution to the model from those assets, and I'll leave it there? Thanks.
We’ve been talking about the excess storage capacity at Kildair for the last 18 months and that we are going to bring that capacity into service which you just heard that we completed the project to convert tanks into distillate service. And with the next couple of weeks, we’re going to take our first delivery and then shortly thereafter, the revenue should start improving. We don't really give guidance on specific expansion capital projects but as you heard us talk about in the past, this should be a good low effective multiple and we are happy about with the expected returns are going to be on the cash flow related to this project.
[Operator Instructions] Our next question comes from Mike Gyure of Janney. Your line is open.
Great, thanks. Thanks for taking the call here. On Kildair you guys talked about kind of where you're at the rest of the year. Is there any sense you can give us to what you're looking at maybe in 2017 as far as maybe additional expansion opportunities up there or what you're thinking maybe long-term in Kildair?
Hi Mike, this is Gary, as we’ve talked about a lot there has been - in David’s comments, there has been an evolution of Kildair's business model to be more in line with Sprague’s overall business model which is an integrated materials handling business within a refined products terminal. And we've been pretty successful over the last couple of years executing on that strategy and we will be continuing to look for growth opportunities particularly in the materials handling segment for instance dry bulk activities which we don't have any at this point, but it’s part of the future strategy. So the evolution of Kildair's business model is well underway and will continue and basically the business model has been derisked over the last few years.
The only thing I’d would add to that Mike, too, is that, so the types of opportunities we are talking about the expansion of dry bulk or other activities those tend to have a very long sales cycle, so I wouldn't necessarily assume that any incremental projects there are contributing necessarily in 2017 timeframe, they tend to be sales cycle measured in many months.
Thank you. Our next question comes from Lin Chen of Height. Your line is open.
Good afternoon, thanks for taking my call. When I look at the refined product and the volumes down 9% and the margin also down. I think you mentioned in the Press Release because reduced heavy fuel input, and also you have some low-margin contract [indiscernible] to renew the base. So for the segment should I think that probably the volume is going to be stabilized like here or maybe there is a trend that you will continue to trim the low margin volume?
We have no expectation of further declines in volumes, I’d say, Lin, two things, the heavy fuel oil exports out of Kildair can contribute significantly to volume noise quarter over quarter but generally are not a huge margin contributor. So, the way we are able to leverage that facility and again, it makes the volume numbers move around potentially more than gross margins. And the specific contracts we are referring to are contracts that we assume through an acquisition and we’re at relatively low margins and it wasn't a margin level we are comfortable continuing those contracts. So, you always have some contracts you’re winning, some bids you’re losing, our expectations are not for continued volume declines in the refined products business.
Thank you. I'm not showing any further questions in queue at this time, I would like to turn the call back over to management for any further remarks.
Thank you very much, Ashley, no further remarks, I appreciate everybody jumping on the call today and the questions that we got and enjoy the nice weekend.
Ladies and gentlemen, thank you for participating in today's conference, this concludes today's program, you may all disconnect. Everyone have a wonderful day.
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