Sprague Resources LP (NYSE:SRLP) Q3 2018 Earnings Conference Call November 7, 2018 1:00 PM ET
David Glendon - President and CEO
Gary Rinaldi - COO and CFO
Jeremy Tonet - J.P. Morgan
Mike Gyure - Janney
Anthony Olivieri - Wells Fargo
Good day, ladies gentlemen, and welcome to the Sprague Resources LP Third Quarter 2018 Earnings Conference Call. [Operator Instructions] As a reminder, this call may be recorded.
I would now like to introduce your host for today’s conference, Mr. David Glendon, President and CEO. You may begin.
Thank you, Catherine. Good afternoon, everyone, and welcome to the Sprague Resources Third Quarter 2018 Conference Call. Joining me today are Gary Rinaldi, our Chief Operating Officer and Chief Financial Officer; Paul Scoff, our Vice President and General Counsel; and Kory Arthur, our Vice President and Chief Accounting Officer.
As a reminder, some of today's call will include statements regarding Sprague's future plans and prospects. These statements are based on our current expectations, which we believe to be reasonable as of today's date and Sprague does not undertake any obligation to update any forward-looking statements to reflect new information or future events. Actual results may differ significantly because of risk and uncertainties that are difficult to predict. Please refer to our 10-K for an extensive list of risk factors, which could cause our actual results to differ from anticipated results and review our 10-Q current reports and other filings with the SEC.
We also describe our business using certain non-GAAP financial measures. Reconciliations of those measures to comparable GAAP are available in our non-GAAP quarterly supplement and our third quarter earnings press release, which are posted to the Investor Relations section of our website.
While Sprague’s third quarter results were generally in line with our expectations, recent dynamics have caused us to temper our expectations for full year results. Specifically, we're lowering our adjusted EBITDA guidance range to $110 million to $120 million and our anticipated coverage ratio slightly below one times for the full year 2018. I'd like to share some perspective on the drivers of the changes and more importantly, the steps we're taking to ensure that coverage returns to healthier levels in 2019 and beyond.
This view has also been reflected in our board's October decision to maintain our third quarter distribution at second quarter levels, as we believe, it's prudent to moderate our longstanding distribution growth trajectory in the current market environment. The primary driver of our lower expectations for 2018 is weakness in our refined products business where market conditions have limited our opportunity set relative to previous years.
Specifically, the convergence of sulfur specifications to an ultra-low sulfur standard across northeast heating oil markets has largely eliminated our ability to blend products and achieve associated beta schemes as in prior years. Additionally, a less attractive NYMEX market structure has curtailed storage opportunities. At the same time, the continued absence of a biofuel blenders credit has weakened the economics of bioheat and biodiesel sales.
To be clear, while blending activities are likely to be limited to biofuels going forward, we do expect to see future [indiscernible] and other contained oil opportunities as the NYMEX contract aligns with the product dynamics. While current conditions clearly generate some near term headwinds, they also create prospects for tankage consolidation and associated cost savings as well as further conversion to additional materials handling services.
We've also recently seen weaker demand at our Coen subsidiary in what we believe to be a temporary downdraft in fracking services activity that we continue to see solid prospects for expanding our offerings in this region. Finally, the combination of higher commodity prices and rising interest rates has resulted in an increase in interest cost, which have not yet been accompanied by a corresponding higher margin realization at the rack. Our experience has been that there is a decided lag effect before increased working capital costs are reflected in market pricing.
Turning to our efforts to mitigate these challenges, in the immediate term, note that our revised guidance includes a significant reduction in SG&A costs. As we limit discretionary spending and realize uplift from the design of our unitholder friendly incentive compensation program where bonuses only accrue after we meet distributable cash flow targets. Longer term initiatives include investments and customer facing assets to stimulate additional organic growth, including development of the next generation of the Sprague real time platform in our refined products business and the anticipated rollout of our natural gas pricing tool.
Recent surveys of our customer base have verified strong levels of satisfaction and superior net promoter scores versus B2B benchmarks and we intend to continue leveraging our investments in the customer experience to drive growth, fulfilling our mission of delivering simple solutions to complex energy and logistics challenges. We also continue to move toward our goal of increasing our participation in alternative energy offerings and have been pleased with the results of our trial of thin film solar on a petroleum tank. We're moving forward with plans to expand our participation in this area.
Finally, we're pursuing a number of exciting growth projects at the Lawrence terminal acquired from Carbo last year. From RAC enhancements to ethanol expansion to butane blending, we're seeing meaningful growth in EBITDA, relative to our valuation case. I'm also pleased to report that we're getting significant interest in storage capacity at Kildair for the period following the expiration of our initial 5-year crude handling agreement in June of 2019.
Now, I'd like to turn the call over to Gary for a review of our third quarter results. Gary?
Thank you, David. Good afternoon, everyone. As David mentioned, the third quarter was generally in line with our expectations [indiscernible]. Third quarter adjusted gross margin of $46.1 million declined by $2.5 million or 5% from 2017 levels. Segment results were mixed with materials handling posting strong results, natural gas was unchanged, the refined products experienced a decrease in adjusted gross margin for the quarter.
Third quarter adjusted EBITDA of $8.6 million reflects a $6.2 million decrease from 2017 levels, primarily driven by an increase in operating expenses related to the recent acquisitions and to a lesser extent stockpile expenses associated with an increase in materials handling activity. SG&A expenses decreased compared to last year, with the primary drivers being reduced M&A expenses and employee related costs, including incentive comp, partially offset by higher professional fees and expenses associated with Coen.
As stated on prior calls, we continue to focus on cost management and expect 2018 SG&A expenses to be between $81 million and $86 million, down from a range of $88 million to $93 million. And as David mentioned, given the third quarter results and our expectations for the remainder of the year, 2018 adjusted EBITDA is expected to be between $110 million and $120 million.
Below the EBITDA line, third quarter cash interest of $7.6 million increased by $2.3 million over the prior year. The increase was driven by higher borrowing rates, increased debt levels related to last year's acquisitions and an increase in working capital requirements from higher commodity price. This was partially offset by hedges on the fixed portion of our floating rate debt. We expect cash interest to be at the high end of the $28 million to $33 million range for 2018.
In the quarter, cash taxes were consistent with 2017 levels and we continue to forecast cash taxes to be approximately $5 million for the year. Maintenance CapEx for the quarter was $1.7 million lower the 2017. As such, we reduced our 2018 maintenance CapEx guidance by approximately $2 million, down from the previously issued guidance of $13 million to $16 million.
Distributable cash flow was negative $3.2 million for the quarter. This was primarily driven by lower adjusted gross margin combined with increased operating costs and higher cash interest expense.
Now for a discussion of our business segments. In the third quarter, refined products sales volumes decreased by 2% versus the prior year as higher demand for crystals in gasoline and volumes associated with our Coen acquisition were offset by the transition of Kildair’s asphalt marketing business to a materials handling contract as well as decline in fee volume and marine bunker volumes.
The modest decline in volumes combined with lower adjusted unit margins resulted in $26.6 million in adjusted gross margin for refined products, a decrease of 17% from the third quarter last year. In natural gas, sales volumes were down 2%, resulting in a modest $200,000 reduction in adjusted gross margin for the quarter.
And finally, our materials handling business had a strong third quarter as adjusted gross margin improved 29% or $3.3 million compared to last year. Primary contributors included Kildair’s new asphalt handling contract as well as increased heavy fuel oil and vacuum gas oil fees. The segment also benefited from additional asphalt handling activity of our Providence and Newington terminals related to last year's expansion capital projects as well as increased structural steel heavy lift activity at Searsport and the replenishment of soft stockpiles at multiple terminals.
These gains were partially offset by lower demand for pulp and china clay as well as reduced heavy lift activity related to windmill components. David?
Thank you, Gary. Before we open the call for questions, given his pending retirement on December 31, I would like to congratulate and thank Gary for his distinguished 15-year career at Sprague. As Chief Financial Officer and Chief Operating Officer, Gary has been an exceptional partner and role model. We joined the company together and I benefited from his collegial style, wise counsel and integrity, as we’ve set the vision and work together towards Sprague’s success. It's been a pleasure to work with Gary every step of the way and I'm delighted for he and Vicki to enjoy this next phase in their lives. It is much deserved.
Thank you, David. Appreciate your kind words, a wonderful support and friendship over the 15 years we’ve been together. I also want to thank the investors and analysts who participate on our calls, thank you for your interest in Sprague and for the analysts, your professionalism in covering the company. It's been a pleasure working with you guys. Thank you.
With that, we're happy to open the call for any questions.
[Operator Instructions] Our first question comes from Jeremy Tonet with J.P. Morgan.
Congratulations on retirement there. Wish you all the best.
Thank you, Jeremy. Appreciated.
Just want to start off with the Irving refinery. I think there might have been some downtime recently there and we’re just wondering if you could elaborate on what if any implications that has for your business or opportunities that could materialize from it.
Jeremy, that's a great question. Unfortunately, it's an unfortunate development for Irving. We do expect, as a result of that though to see a little bit of incremental tightness in the distillate markets, particularly in the northern part of the system. Irving's a both a supplier and a competitor to us and a customer of ours. And we do expect that at least as far as we can tell, they're going to be relatively short in ultra-low sulfur products for the upcoming period. So given that short, we do expect to see some incremental tightness in the marketplace, which would be a positive development for Sprague.
And so is that factored into your 2018 guide as it stands or anything kind of beyond that?
Fair question, Jeremy. I'd say it's a little bit too new to tell. I mean, the refinery went down a couple of weeks ago and we haven't really seen the big winter demand pick up yet. We're starting to see some pickup on the heating demand, but it'll really manifest itself in the colder months. So as of now, we're not reflecting anything in our 2018 guidance for that development.
And then just want to build on I guess IMO a bit more here and how you see that impacting your business over the course of ’19, how do you think the pros and cons line up for you guys.
Yeah. It's a good question. There's a lot of speculation about what's going to go on there and I think you've seen some revisions to anticipated conversion of scrubbers or potentially even use of LNG. I would say everybody, at least every one I've talked to or read from does believe that there will be tightness in the distillate markets as a result of the transition, which again tends to create positive dynamics for Sprague, given our extensive distillate participation. So while we don't have an enormous bunkers business today, although we do have some bunkers participation, we do anticipate that structural tightness in distillates will create opportunities for companies like Sprague.
And materials handing keeps kind of ticking up here, is this kind of a good run rate or do you still see kind of more opportunities to build that business here?
Hi, Jeremy. It’s Gary. So materials handling, as you see, has had another strong quarter in the third quarter and we expect the nine month run rate to continue into the fourth quarter. The more significant drivers relate to the conversion of Kildair’s asphalt marketing business. The increases in asphalt volumes at our River Road and Providence terminals related to last year's expansion capital projects as well as some positive contributions from other products like the structural steel and [indiscernible] as I mention on multiple terminals and Kildair’s heavy fuel oil storage contracts. So we expect the trend to continue and -- into fourth quarter and beyond.
And just one thing I’d add to that Jeremy is, as I mentioned briefly on the call, the convergence of sulfur specifications in the Northeast will create some incremental tankage that we could deploy into materials handling services. Now, that's more of a long term dynamic than an immediate opportunity, but we do expect to see additional opportunities for conversion to alternative liquids.
It’s consistent with what we've done over a number of years, particularly with heavy fuel oil tankage.
Our next question comes from David Rothschild [ph]. He's a private investor.
Thank you for taking my questions. A lot of companies don't take private investor questions. I'll look on your guidance announcement on the dividend back on October 26th and maybe I'm reading too much into it, but it sounds like you guys are contemplating at least looking at maybe reducing the dividend, so is it prudent to re-evaluate the best use of capital in the current market environment? Am I reading too much into that or what?
So, a fair question. I would answer yes. You're reading too much into that candidly. I think the -- from our perspective, a flattening of the distribution was appropriate in light of the market conditions and I think we had specific language in our earnings release this morning about our intention to maintain the current distribution rate.
Okay. That's comforting to hear.
Our next question comes from Mike Gyure with Janney.
Can you guys talk a little bit about, I guess, the Coen commentary? You touched on a little bit I guess what was happening in that business, but maybe a little more color on specifically what happened here in the third quarter and I guess what you’re thinking in to the fourth quarter and going forward?
Michael, it’s Gary. First as a reminder, Coen has three business segments, the commercial fuels business, the small residential fuels business and energy field service business. The commercial fuels and residential fuels segments are performing on forecast and on evaluation model. The energy field services segment, natural gas productivity has been first both up and then down recently. After a ramp up in the first nine months since the acquisition, the last three months have seen a drop in demand and frac activity and I've been close in this business depending on the mix of variables. So, we remain bullish for the near to medium term and it's, as you know, it's a strategic acquisition for us with the geographic stuff out, platform for growth. But there's been a drop in demand more recently after a ramp up.
And then maybe if you guys could touch on, within your guidance, what kind of weather assumptions you're assuming here for the fourth quarter and if that changed at all with the adjustment on the guidance?
Yeah. So we always assume normal weather conditions whenever we're forecasting and I think last time you may have noted in our Q, we've adapted normal to be the 10-year average as opposed to the previous 30-year average, given the trends there. But it's generally, as we've seen our business in the past, if we get some cold can create upside opportunity. If we are warmer than normal conditions, it could create some downside risk, although that’s anticipated in the range of guidance that we provide currently, Michael, the prospects of weather being slightly better or worse. Usually, if you're going to see a big change in weather to the upside, it would be Jan, Feb, more so than November, December.
And then maybe lastly on the Lawrence terminal commentary, can you talk about potentially how much capital you're talking about investing there or -- for the expansion project?
Sure. So we’ve seen some capital investment this year already on the order of about $1 million or so in growth capital investment more into a project we’re contemplating and likely to pursue for next year, it’s about a $3 million capital project.
[Operator Instructions] Our next question comes from Anthony Olivieri with Wells Fargo.
My investors often see your reports and they show a loss of say $0.90, but then we’re distributing 66 and three quarter cents and their question is are you actually generating enough cash from operations to pay those distributions or are you borrowing, getting that from other sources?
Yes. Good question. We’ve often gotten that question in the past. It has to do with vagaries of GAAP accounting where as an example, let's say, commodity prices are rising, okay, we have a fully hedged book, we don't take commodity price risk. So the hedges are losing money. We can't write up the value of the inventory so we adjust for that, okay, in our financials and that's why you see adjusted EBITDA and adjusted gross margin and it gets back to a truer cash basis. And for prior years, we've had excess cash flow, so we haven't been borrowing to pay any of the distributions and this year, we're trailing 12 months right about at 1 times coverage. So the answer to your question is, no, we're not borrowing to make the distributions.
Is it possible to report something like a cash flow per share figure that could make more sense to investors?
I mean we certainly could take a look at that and we’d be happy to review it and get back to you with what our thoughts are. Fundamental [indiscernible] is that metric, so distributable cash flow and you can do it on a per unit basis.
[Operator Instructions] There are no further questions in the queue. That does end the call for today. Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. Everyone, have a great day.