Earnings Call Transcript - SPH Q2 2023

Davin D'Ambrosio, VP and Treasurer

Thanks, Chad. This morning for our fiscal 2023 Second Quarter Earnings Conference Call. With me this morning are Mike Stivala, our President and Chief Executive Officer; Mike Kuglin, Chief Financial Officer and Chief Accounting Officer; and Steve Boyd, our Chief Operating Officer. This morning, we will review our second quarter financial results, along with our current outlook for the business. Once we've concluded our prepared remarks, we will open the session to questions. Our conference call contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, relating to the partnership's future business expectations, predictions, financial condition, and results of operations. These forward-looking statements involve certain risks and uncertainties. We've listed some of the important factors that could cause actual results to differ materially from those discussed in such forward-looking statements, which are referred to as cautionary statements in our earnings press release, which can be viewed on our website at suburbanpropane.com. While subsequent written and oral forward-looking statements attributable to the partnership or persons acting on its behalf are expressly qualified in their entirety by such cautionary statements. Our annual report on Form 10-K for the fiscal year ended September 24, 2022, and Form 10-Q for the period ended March 25, 2023, which will be filed by the end of business today, contain additional disclosure regarding forward-looking statements and risk factors. Copies may be obtained by contacting the partnership or the SEC. Certain non-GAAP measures will be discussed on this call. We have provided a description of those measures as well as a discussion of why we believe this information to be useful in our Form 8-K, which was furnished to the SEC this morning. The Form 8-K will be available through a link in the Investor Relations section of our website. At this point, I will turn the call over to Mike Stivala for some opening comments. Mike?

Michael Stivala, CEO

Thanks, Davin. Good morning. Thank you all for joining us today. The fiscal 2023 second quarter was dominated by near-record warm temperatures throughout much of the quarter, particularly in the eastern half of the United States, which limited customer demand for heating purposes. In fact, during January and February, the most critical months for heat-related demand, average temperatures were 16% warmer than normal. And that 2-month stretch was reported as one of the warmest on record. Our West Coast operations experienced colder-than-normal temperatures, coupled with historic levels of snowfall and precipitation in certain areas. Customer demand in those territories responded well, which helped to offset some of the volume shortfall in our Eastern operating territories. The second quarter ended with a late burst of cooler temperatures at the end of March, which has created some momentum for customer demand into the early part of the fiscal third quarter. Therefore, when you look at the 2022, 2023 heating season in its entirety, aside from colder-than-normal temperatures in the latter half of December 2022 and cooler temperatures at the end of March, the majority of the heating season was unseasonably warm, and in many areas of our footprint near-record warm. However, our operating personnel have managed through these warmer weather scenarios before and do an excellent job managing the things they can control, providing outstanding service, managing selling prices, and controlling expenses. And with the success of our customer base growth and retention initiatives over the past several years, we have stabilized our customer base, which helps support our overall volume performance. As a result of overall softness in demand, volumes in the quarter were 9.4% below the prior year second quarter, and adjusted EBITDA was down 13.6%. Despite the challenging second quarter as a result of the weather, the strength of our first-quarter performance, which was up $3.5 million compared to the prior year, coupled with cooler-than-normal temperatures to start the third quarter, will help mitigate some of the earnings shortfall experienced in the second quarter. On the strategic front, as mentioned in detail during our first-quarter earnings announcement, at the beginning of the second quarter, we expanded our renewable energy platform with the acquisition of renewable natural gas or RNG-producing assets in Stanfield, Arizona, and Columbus, Ohio, for $190 million. These assets, when combined with the previously announced RNG facility to be constructed at Adirondack Farms in Upstate New York, creates a platform that is expected to produce a run-rate capacity of approximately 850,000 MMBtus per year, once expansion and upgrade plans are completed over the next 18 months or so. Since closing the acquisition at the end of December, we have been focused on integrating certain functions into the suburban platform, including back-office activities such as cash management, accounting, and financial reporting and certain operational management functions. Equilibrium Capital, the seller, has agreed to provide ongoing operational management and transitional support to Suburban under a management services agreement that extends through December 2025. This allows Suburban to continue to benefit from the deep knowledge and expertise of the Equilibrium management team and operate these assets during the transition. At the Stanfield facility, we have substantially completed the capital expansion efforts that were ongoing at the time of the acquisition. Since the beginning of March, we have exceeded our expectations for daily pipeline injection. The Stanfield facility generates revenues from a combination of RNG sales, LCFS credits in California, D3 and D5 RINs, tipping fees, and fertilizer sales. The Columbus facility is one of the main sources for receiving and processing municipal waste as well as food waste from several large food and beverage providers in the Columbus area. The facility earns tipping fees for accepting and processing approximately 100,000 tons of waste into biogas and fertilizer. We will be deploying additional capital to install gas upgrading equipment at the facility in order to upgrade the biogas into pipeline-quality RNG, at which time we will be able to earn additional revenue from sales of RNG, D5 RINs, LCFS credits, and fertilizer sales. We expect to reach run-rate earnings capacity for the Columbus facility around the third quarter of fiscal 2024. Therefore, while there will be an immediate contribution to EBITDA in our fiscal 2023, the acquired facilities are expected to achieve run-rate EBITDA once gas upgrade equipment is installed at the Columbus facility, with potential upside as earnings from both facilities benefit from efficiency gains, incremental production capacity, potential increases in LCFS and RIN credit values as well as additional incentives from the Inflation Reduction Act. In addition to the acquired facilities, Suburban Renewable Energy and Equilibrium have formed a partnership to serve as a long-term growth platform for the identification, development, and operation of additional RNG projects. Under the joint venture agreement, the parties have agreed to invest up to $155 million over the next 3 years or so, of which Suburban will fund $120 million and Equilibrium will fund $35 million. Suburban Renewable will own approximately 70% of the joint venture once capital has been fully committed and deployed. We have a number of additional RNG projects and opportunities in varying stages of analysis under this joint venture partnership. In a moment, I'll come back for some closing remarks and provide additional color on our strategic initiatives. However, at this point, I'll turn it over to Mike Kuglin to discuss the second quarter in more detail. Mike?

Michael Kuglin, CFO

Thanks, Mike, and good morning, everyone. To be consistent with previous reporting, as I discuss our second quarter results, I'm excluding the impact of unrealized mark-to-market adjustments on our commodity hedges, which resulted in an unrealized loss of $4.5 million for the second quarter compared to an unrealized gain of $33 million in the prior year. Excluding these items as well as the noncash equity and earnings of our unconsolidated subsidiaries accounted for under the equity method and acquisition-related transaction costs, net income for the second quarter was $112.8 million or $1.76 per common unit compared to net income of $142.8 million or $2.26 per common unit in the prior year. Adjusted EBITDA for the second quarter was $149 million compared to $172.5 million in the prior year. As Mike mentioned, our earnings for the quarter were impacted by lower heat-related demand, resulting from extremely warm weather during the most critical months of the quarter as well as the continued impact of inflationary pressures on our expenses. Although those headwinds presented operating challenges, our earnings for the quarter benefited from organic growth in our customer base, continued solid margin management, and contribution from the RNG facilities acquired at the beginning of the quarter. Retail propane gallons sold in the second quarter were 144.1 million gallons, which was 9.4% lower than the prior year, primarily due to warmer weather, partially offset by favorable customer base trends. With respect to the weather, average temperatures as measured in heating degree days were 12% warmer than normal and 5% warmer than the prior year second quarter. Although we experienced an overall decrease in heating degree days compared to the prior year, our operations were most negatively impacted by extremely warm temperatures during the critical months of January and February and were most pronounced in our East and Midwest operating territories, while our operations in the West generally experienced normal to cooler-than-normal temperatures. For the month of January and February, average temperatures were 16% warmer than normal and 11% warmer than the same period last year and were on par for the warmest on record for that 2-month period. From a commodity perspective, propane inventory levels in the U.S. remained elevated during the second quarter and contributed to declines in wholesale prices compared to the prior year second quarter. According to the Energy Information Administration, U.S. propane inventories at the end of March 2023 were at 56 million barrels, which was 67% higher than March 2022 levels and 20% higher than historical averages for that time of the year. As a result of the increase in inventories and other factors, average wholesale prices for the second quarter of $0.82 per gallon as basis Mont Belvieu decreased 37% compared to the prior year second quarter. Excluding the impact of the mark-to-market adjustments, our commodity hedges that I mentioned earlier, total gross margin of $299.4 million for the second quarter decreased $16.7 million or 5.3% compared to the prior year, primarily due to lower volumes sold, offset to an extent by higher propane unit margins and margin contribution from the RNG assets. Excluding the impact of the unrealized mark-to-market adjustments, propane unit margins for the second quarter increased $0.04 or 2.3% per gallon compared to the prior year, primarily due to effective selling price management during a period of declining commodity prices that helped to offset the impact of inflationary pressures on our delivery costs and other expenses. With respect to our expenses, combined operating and G&A expenses of $153.1 million for the second quarter increased $10.1 million or 7.1% compared to the prior year, primarily due to continued inflationary pressures across most areas of the business, including higher payroll and benefit-related expenses and higher vehicle lease and fuel costs. The comparison of our expenses to the prior year was also impacted by the costs associated with the acquisition and operations of the RNG assets. Included within G&A expenses for the second quarter were acquisition-related costs of $3.4 million, which were excluded from adjusted EBITDA. Although inflationary pressures persist, they have been gradually moderating over the last few months. Nevertheless, we will remain focused on leveraging our investments in technology and our flexible operating model to drive efficiencies while continuing to provide superior customer service. Net interest expense of $19.9 million for the second quarter was $4.6 million or 30.3% higher than our prior year due to higher level of average outstanding borrowings under our revolving credit facility resulting from the financing for the RNG acquisition, coupled with higher benchmark interest rates for borrowings under the revolver as well as the impact of the $80.6 million in green bonds assumed in the RNG acquisition. The green bonds are long-dated and carry an attractive fixed interest rate of 5.5%. Total capital spending for the quarter of $13.2 million was $1.6 million higher than the prior year primarily due to growth capital associated with the expansion and upgrade of the RNG production facility in Stanford, Arizona. Although construction at the Stanford facility is substantially complete, we expect our growth capital spending in the near term to be higher than historical levels as we install the RNG upgrade equipment at the Columbus facility and construct the RNG facility at Adirondack Farms, which is expected to take about 18 months to complete. Turning to our balance sheet. During the second quarter, we utilized cash flows from operating activities and borrowings under the revolver to purchase the RNG production assets and to make additional investments in overall fuels, all in support of our long-term strategic goal of building out a renewable energy platform. As a result of the increase in total debt resulting from the RNG acquisition, which included the assumption of the green bonds, along with the impact of warmer weather on earnings during the second quarter, our consolidated leverage ratio for the trailing 12-month period ended March 2023 increased to 4.43x. Although the leverage metric is elevated relative to historical levels and our target level of 3.5x, we remain well within our debt requirement of 5.75x. We have now moved through our historically high period of seasonal working capital needs and into the fiscal quarters, we expect to generate excess cash flows. We will continue to remain focused on utilizing the excess cash flows to strengthen the balance sheet and, as opportunities arise, to fund strategic growth, including the growth capital for our RNG platform. We have more than ample borrowing capacity under our revolver to support our capital expansion plans and ongoing strategic growth initiatives. While the recent debt-funded acquisition will temporarily add to our leverage profile, we expect our leverage metrics will improve over time as the earnings from the acquired assets reach their run-rate potential. As I stated last quarter, we have a long and proven track record of being great stewards of our balance sheet. We have long believed that conservative balance sheet management provides added protection for the potential short-term earnings impact of weather-driven demand softness but also provides a dry powder for opportunistic investments and the execution of our long-term strategic initiatives. Over the course of the last 3 fiscal years, we have reduced our total debt by nearly $150 million all while continuing to invest in the growth of the business. As we continue to focus on the execution of our long-term strategic goals, we will also stay focused on maintaining a strong balance sheet.

Michael Stivala, CEO

Thanks, Mike. As announced on April 20, our Board of Supervisors declared our quarterly distribution of $0.325 per common unit in respect of our second quarter of fiscal 2023. That equates to an annualized rate of $1.30 per common unit. Our quarterly distribution will be paid on May 9 to our unitholders of record as of May 2. Our distribution coverage continues to remain healthy at 2.26x for the trailing 12-month period despite lower earnings in the quarter and higher capital expenditures and interest associated with our RNG platform. So just a few more thoughts on our strategic initiatives and the build-out of our renewable energy platform under Suburban Renewable Energy. In addition to the expansion of our RNG platform during the quarter, we continued to advance our efforts to commercialize the new low-carbon alternative called Propane + rDME. Through our 38% ownership stake in Oberon Fuels, the producer of renewable DME, Suburban Propane is the only distributor in the United States to offer this new blended product that combines the low carbon benefits of traditional propane with renewable DME to further reduce the carbon intensity of propane in order to meet aggressive carbon reduction standards in California and beyond. We began our pilot program in April of 2022. And given the favorable results to date, we have begun to offer the blended product to all of our forklift customers in certain markets in Southern California, with expansion plans for other parts of California and ultimately, other parts of the country. We have also started third-party testing of the blended product at higher blend levels in order to evaluate engine performance and emissions profiles. Once testing results have been analyzed, we expect to be able to increase the blend level from current ratios, which will have an even greater impact on carbon reduction. As for our 25% investment in Independence Hydrogen, the team in Independence Hydrogen has been working hard to commission their first clean hydrogen production facility in Virginia, which is expected to come online this month. Under their business model, Independence Hydrogen produces clean hydrogen locally and distributes it in gas form to local markets, initially for materials handling equipment. Since making our investment in March 2022, Suburban Propane has worked closely with the team at Independence Hydrogen to provide support across a number of functional areas, particularly given the similarity of our business model relative to their business model. In conclusion, we have long been known for our best-in-class operating model within a highly competitive and mature propane industry. Our operating personnel have done an excellent job managing our core propane operations even in the face of many challenges in the economy over the past several years. We will continue to foster the growth of our core propane business while focusing on the execution of our long-term strategic growth plan for the continued build-out of our renewable energy platform under our newly created subsidiary, Suburban Renewable Energy. As society transitions to renewable energy solutions and low-carbon alternatives across many sectors of the economy, we are making strategic investments, leveraging our 95-year legacy as trusted local distributors of energy to position Suburban Propane for long-term growth and sustainability, creating long-term value for you, our valued unitholders. And finally, I want to take this opportunity to thank the more than 3,200 employees at Suburban Propane for their hard work and unwavering focus on the safety and comfort of our customers and the communities we serve during the last quarter. I'm extremely proud of all of their efforts. As always, we appreciate your support and attention and would now like to open the call up for questions. And Chad, if you wouldn't mind helping us with that?

Operator, Operator

First question will be from Gabe Moreen from Mizuho.

Gabriel Moreen, Analyst

A multipart question on the RNG opportunity set. Just wondering now with the Arizona facility up and running, what the approach, I guess, is going to be to hedging or not hedging, some of the different revenue streams kind of coming out of that facility. And then I also wanted to know about the reference to CapEx being higher going forward. Just kind of wondered if you could give us a good sense for kind of the trajectory around the Ohio facility, how much of the spend might be this year? How much might be next, and kind of relative amounts?

Michael Stivala, CEO

Sure. Regarding hedging, we currently have a long-term agreement with a major customer who is taking all the gas we inject into the pipeline, allowing us to benefit from our LCFS and RIN credits. As I mentioned on our last call, when we assessed the acquisition opportunity, we observed a decline in LCFS markets and RIN values, which helped us evaluate the earnings potential of this business in what we see as a typical environmental attribute market. While there is some downside risk, there is also upside potential as more states consider LCFS programs. At this time, we don’t feel the need to hedge and are on track to achieve the results we anticipated, especially from the Stanfield facility. We’re pleased to see that since fully deploying our capital and starting daily pipeline injections, our daily injection rates have surpassed our expectations, which is encouraging. Additionally, we are looking into further opportunities to sell fertilizer produced in the process, enhancing our efficiency and sales prospects. In the current credit environment, we are satisfied with the values we are seeing and believe there is room for improvement. Regarding capital expenditures, the Columbus facility will require about $12 million for equipment upgrades, mostly in fiscal 2024, with a small amount possibly this year. We also have the construction of RNG assets in Upstate New York, which will need another $12 million to $15 million in 2024, along with approximately $15 million this year. This outlines our growth CapEx trajectory for these major projects, and I hope this clarifies where we stand.

Gabriel Moreen, Analyst

Mike, that was very helpful. I wanted to share some reassurance regarding the balance sheet now that everything is finalized. With winter behind us, I recall your comment last quarter about possibly speeding up deleveraging. This quarter, it seems you're comfortable allowing it to happen more organically over time. I'm curious if there has been a shift in your perspective and what your current thoughts are on this matter.

Michael Stivala, CEO

Yes, I think we're in a good position, Gabe. When these assets achieve full run-rate capacity in 2024, it will naturally reduce our leverage. Another interesting point is that we have generated a significant amount of excess free cash flow in recent years, allowing us to reduce debt and make investments. If you compare our total debt at the end of March to the end of September, which was somewhat of a low point, we've only increased our debt by about $170 million despite investing around $200 million in the RNG assets alone. The strength of our balance sheet and the cash flow generated by the propane business have provided us the opportunity to invest in higher growth ventures like the RNG platform and our other investments in Hydrogen and DME.

Operator, Operator

And the next question will be from Ned Baramov from Wells Fargo.

Ned Baramov, Analyst

Mike, in your remarks, you indicated a number of other RNG opportunities under evaluation. Could you maybe provide more details on your funnel? Are you looking at new builds or operating facilities, the approximate size of these investments, and maybe if you can also give us a sense of how competitive is the RNG space today? And who do you typically run into?

Michael Stivala, CEO

Yes, it's quite varied, Ned. To frame the potential, with our joint venture with Equilibrium, we anticipate deploying around $155 million in capital over the next three years, with Suburban's share around $120 million. This outlines our potential. Currently, we have several opportunities, primarily focused on existing facilities that might require additional investment to reach certain capacities or upgrade to renewable natural gas, similar to what we're doing in Columbus. We also have small investments in larger platforms that need added capital without us taking on full ownership, as well as opportunities for new construction like our Adirondack Farms project in Upstate New York. Importantly, we are actively engaged with Equilibrium and our Construction and Maintenance teams in New York, giving us strong support and helping us identify further opportunities. While there’s nothing immediate, our pipeline is solid, and we’re committed to a patient and disciplined approach in choosing the best opportunities for capital deployment.

Ned Baramov, Analyst

Got it. And then how do you think about propane acquisitions while the RNG assets are ramping up? Is this on hold? Or would you still look at kind of smaller tuck-in transactions if they make sense for you?

Michael Stivala, CEO

We're going to continue to feed the propane business. The propane business is still our bread and butter; it is the source of cash flow that allows us to invest in higher growth opportunities such as renewable energy. So we're going to continue to look for ways to enhance that platform. We do have also a funnel of opportunities that are in active analysis right now. There's a couple that are very promising, relatively small tuck-ins, but fitting into our strategic view of highly attractive markets where we either have a very strong presence or we have identified population growth where the market can benefit from a Suburban presence that is not big enough today. So those are the kind of opportunities that we're seeing. And this is, as you know, the time of the year where more and more of the smaller companies contemplate putting their business up for sale once the heating season is behind us. So the funnel and the propane M&A market is also starting to build nicely.

Ned Baramov, Analyst

Great. One housekeeping item, if I may. Going forward, will you break out the contributions from your Suburban Renewable Energy subsidiary as a separate segment?

Michael Stivala, CEO

As the earnings of the newly acquired RNG platform get to run rate, I would expect sometime probably at the tail end of 2024 is when I would expect to see us do that, Ned.

Operator, Operator

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Mike Stivala for any closing remarks.

Michael Stivala, CEO

Great, Chad. Thank you all again for your attention today and your support. We hope that you enjoy the coming summer season, and we look forward to talking to you again after the end of our fiscal third quarter. Thank you.

Operator, Operator

And thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.