Sunoco LP Q1 FY2022 Earnings Call

Greetings and welcome to Sunoco LP's First Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Scott Grischow, Vice President of Investor Relations. Thank you, Scott. You may begin.

Thank you and good morning, everyone. On the call with me this morning are Joe Kim, Sunoco LP's President and Chief Executive Officer; Karl Fails, Chief Operations Officer; Dylan Bramhall, Chief Financial Officer; and other members of the management team. Today's call will contain forward-looking statements that are subject to various risks and uncertainties. These statements include expectations and assumptions regarding the partnership's future operations and financial performance, including expectations and assumptions related to the impact of the COVID-19 pandemic. Actual results could differ materially and the partnership undertakes no obligation to update these statements based on subsequent events. Please refer to our earnings release as well as our filings with the SEC for a list of these factors. During today's call, we will also discuss certain non-GAAP financial measures, including adjusted EBITDA and distributable cash flow as adjusted. Please refer to the Sunoco LP's website for a reconciliation of each financial measure. I will now turn the call over to Dylan to discuss first quarter results and our outlook for the remainder of 2022.

Thanks, Scott. Before I walk through our first quarter results and accomplishments, I'd like to start by thanking our employees for their efforts in delivering excellent financial results this quarter against one of the most difficult macro backdrops in recent history. The team did an outstanding job of executing on our strategies in the face of a rapid increase in oil and gas prices which resulted in the partnership reporting one of its strongest first quarters on record. Moving on to M&A. We closed on our third acquisition in the past six months with the addition of the Gladieux Energy assets to the Sunoco portfolio on March 31, 2022. This acquisition demonstrates our continued commitment to expand our midstream asset base with low-risk, solid return capital deployment. As a reminder, we expect a sub 7x EBITDA multiple on this investment which, combined with our ability to finance with a mix of low-cost revolver borrowing and cash from operations, results in very strong accretion to our unitholders. Regarding guidance, the 2022 adjusted EBITDA of between $770 million and $810 million provided in early December excluded the impact of the Gladieux energy acquisition and we remain confident in that range for the legacy Sunoco business. We are adding $25 million to this range to reflect the acquisition which results in updated guidance of $795 million to $835 million. Now shifting over to our first quarter 2022 results. The partnership recorded net income of $216 million. Adjusted EBITDA was $191 million compared to $157 million in the first quarter of 2021. Volumes were approximately 1.8 billion gallons, an increase of 1% versus the first quarter of 2021. Fuel margin was $0.124 per gallon versus $0.103 per gallon in the first quarter of 2021. Fuel margin results include the benefit of the 7-Eleven makeup payment of $13 million. Total operating expenses in the first quarter were $124 million, up from $100 million in Q1 of last year and essentially flat to Q4. This increase was primarily driven by the NuStar terminal acquisitions and some additional costs that we reinstituted over 2021 that had been temporarily cut during the onset of the COVID pandemic. First quarter distributable cash flow as adjusted was $142 million, yielding a current quarter coverage ratio of 1.63x and a trailing 12-month coverage ratio of 1.66x. On April 26, we declared an $0.8255 per unit distribution, consistent with last quarter. We continue to maintain a stable and secure distribution for our unitholders which remains the number one pillar behind our capital allocation strategy. Leverage at the end of the quarter was 4.3x which includes a significant increase in working capital associated with higher commodity prices for our fuel inventory. We expect leverage to trend down toward our target throughout the year and could see an acceleration of this deleveraging if commodity prices decline from current levels. In early April, we closed on an amended and restated $1.5 billion credit facility. The maturity date was extended out five years to April 2027 and under substantially similar terms as the previous facility. First quarter's strong results, the recently closed acquisitions and the successful extension of our revolving credit facility, demonstrate our commitment to maintaining Sunoco's solid financial foundation and to increasing value to our stakeholders through a strategy of disciplined capital investment and balance sheet management. With that, I will now turn the call over to Karl to walk through some additional thoughts on the first quarter performance and recent growth initiatives.

Thanks, Dylan. Good morning, everyone. We delivered another strong quarter, supported by continued strength in margins and expense discipline. As Dylan mentioned, commodity prices in the first quarter were highly volatile. In addition, the dramatic rise in prices created significant headwinds for the first quarter. To put it in perspective, both gasoline and diesel futures reached all-time highs during the quarter and hovered around prices not seen since 2008. From beginning to end, gasoline futures were up $0.96 a gallon and diesel futures were up $1.36 a gallon. Despite these challenging market conditions, the first quarter again showed the resiliency of our business model. Volumes for the quarter were up about 1% versus the first quarter of last year. As I mentioned in our last earnings call, there was some Omicron-related weakness in January with volumes returning in February. We saw some volume weakness in March but are starting to see early signs of seasonal pickup in demand in April. Looking at margins. In the first quarter, we delivered strong margins of $0.124 per gallon, even in the face of the record price increases across the quarter that I already shared. There are a few key contributing factors worth mentioning. The first is the 7-Eleven makeup payment that occurs annually in the first quarter; second, industry breakeven margins continue to stay elevated, especially in the face of rising inflation; finally, our gross profit optimization strategy continues to be part of our day-to-day business which particularly helps us in volatile market conditions. A few years ago, we introduced the hypothesis that our business model exhibited asymmetric risk to market movements. While we are not immune to market dynamics, this quarter continues to show that our optimization strategies can counteract some of the effects of challenging market conditions like rising prices. And then when the market provides favorable conditions with falling prices, we are able to capitalize and deliver to the upside. I also want to add a few thoughts on expenses. As we have discussed many times, efficient operation and expense control are part of our DNA. This year, we faced headwinds on expenses with the impact of higher fuel prices and overall inflation. Much of this impact was contemplated in our guidance given in December, some was not. The most important thing to keep in mind is that higher costs are generally passed through and contribute to higher breakeven margins. As we use our size and scale to remain efficient, this can even be an advantage for us relative to other players in our space. Moving on to Brownsville. We are excited to share that our terminals operational and commercial sales commenced in late March. There will be a natural ramp in operations over the next 24 months or so. We're excited to bring this organically developed asset into service with our strong domestic demand as well as the export opportunities from this strategic location. We are also pleased with the closing of our Gladieux acquisition at the end of the quarter. The integration is going well and although we are early in the process, the business is performing as expected. This is another meaningful expansion to our midstream portfolio. As a reminder, the acquired assets consist primarily of the largest transmix processing facility in North America located in Huntington, Indiana as well as the associated refined product terminal. We also acquired a long-term operating lease in which we will operate Buckeye Partner's Indianola transmix facility outside of Pittsburgh. As with all our midstream acquisitions, while we like the stand-alone business, we are most excited about the combination of these assets with our fuel distribution portfolio and are looking forward to growing our presence in the Indiana market. Before turning over to Joe, I will reiterate the strength of our underlying business. We are off to a strong start to the year and we'll continue to focus on delivering results for our stakeholders through our proven recipe of gross profit optimization, tight expense control, solid efficient operations, and growing our core business.

Thanks, Karl. Good morning, everyone. We delivered a strong first quarter. Dylan and Karl have walked you through the key details. However, there are a few items that I would like to further highlight. On the volume side, every quarter presents a unique set of challenges but this quarter had more than most. The volume recovery that we saw last year subsided at the beginning of the quarter due to a massive increase in COVID cases. As cases started to go down and volumes started to recover, a rapid and material increase in fuel prices became evident at every street corner. The short and long-term impact of higher prices is still to be determined. The pace of continued volume recovery will center around a few key questions: first, how long will higher prices remain; second, how is the overall economy performing; and finally, how many more workers will return to a more traditional pre-COVID commuter schedule. Even with all these questions, we do expect fuel volume to increase as the year progresses as a result of typical seasonality and we expect margins to remain healthy given higher industry breakeven. The key to Sunoco's earning power has been our ability to optimize fuel gross profit and control costs. This has allowed us to minimize the downside and also allows us to capture the upside when the commodity market supports it. Quarter after quarter, we have proven the durability of our business. And looking forward, we expect 2022 to be another strong year. Moving on to growth. We continue to strengthen our business by growing our midstream assets. With the addition of Gladieux and the start-up of the Brownsville terminal, we continue to vertically integrate and provide a more enhanced platform for fuel distribution growth. We'll continue to look for attractively valued midstream assets with material synergy opportunities. On the field distribution side, we will continue to grow organically and also look for attractively valued acquisition opportunities. Let me close by stating that our current and future growth plans will build on our history of maintaining financial discipline which means protecting the security of our distribution, while also protecting our balance sheet.

Our first question comes from Theresa Chen with Barclays.

I wanted to ask about the near-term margin outlook. You had strong results in the first quarter despite rising wholesale gasoline prices for most of that time. As we enter the second quarter, with a more normalized pattern of volatility and some fluctuations depending on the day, do you expect the margin to be better than in the first quarter? How should we approach that?

Theresa, this is Karl. I mentioned in my prepared remarks a few different factors that really contributed to our first quarter margin. The first is the payment makeup from 7-Eleven. The second is our base gross profit optimization strategy across the entire fuel supply chain. As we've discussed before, our size and scale allow us to leverage market volatility effectively, which is generally advantageous. The third factor is the higher breakeven margins. Looking forward to the year, some of these elements will remain relevant, while others may not be as impactful. We won't benefit from a makeup payment from 7-Eleven in the second or third quarter. The trend in breakeven margins is likely to continue due to inflation and other influencing factors. While it will be challenging to replicate the volatility we experienced in March, April had its own volatility, and we are beginning May with some fluctuations. My ability to predict market conditions is not flawless, but I believe our system and capacity to capitalize on these conditions will persist. I'm uncertain which factors will have a greater impact on margins, but our focus is on how to leverage them throughout the year. As we've stated previously, we provide annual guidance on margins. There will be quarters that outperform others, but we believe the overall strength of our business will prevail.

Got it. And I'm sorry if I missed this but what would the cent per gallon have been without the 7-Eleven payment in first quarter?

I don't have the math. I don't know, Scott, if you have it. I think it's probably around 60 or 70 points.

Got it. And just looking at the volume side of things, clearly, the demand picture has remained resilient, absent the impact of COVID per Joe's prepared comments. But going forward, as we're seeing the escalation in gasoline prices, are you seeing any softening as far as the demand response to higher prices? When do you think we'll kind of reach that inflection point of demand elasticity? And then similarly, are you seeing any substitution along the octane curve as a result?

As far as the second question, it's been about 30 days since prices started reaching record levels. That's still a relatively short timeframe. Looking back, during 2008, gas prices were around $3.50 to $4. We saw demand decrease notably when prices went above $4 back then, with some customers opting for regular unleaded instead of premium. If we consider that period for future trends, it's relevant. Adjusting for inflation, those 2008 prices are closer to $5.25 today. Also, factoring in inflation and the improvement in vehicle efficiency since 2008, we're currently at about the average price per mile for Americans over the last 20 years. Another crucial aspect is the state of the economy; in 2008, high prices coincided with a recession, which significantly impacted volume. While it's early to draw definitive conclusions about the current effects of high prices, economic conditions, and commuting patterns, I believe our volume will increase throughout the year. Recent data shows a rise in volume from mid-April to now, which is a positive sign.

Our next question comes from Spiro Dounis with Credit Suisse.

First question is on M&A, actually. Just thinking about funding future deals for the rest of the year. If you look at your liquidity, I think you guys are fine there, no issues. But leverage has been ticking up kind of after these last few deals. And Dylan, I know you mentioned sort of a natural path of delevering as the year goes on. But just curious, is your expectation that you would prefer to sort of delever first before getting more active again? Or is that not necessarily a gating item yet?

Yes, I think it's more the latter at this point. I would say you're absolutely right. In the prepared remarks, I mentioned that we expect some deleveraging through the year. If you look at our guidance and what happens with commodity prices, that could provide a bit of a tailwind as well. We also expect to lower inventory levels slightly from where they are today. All of this will contribute to lower leverage. When we look at M&A right now, we're likely to be a bit more critical and selective in our analysis. However, for the right deal, I don’t believe our current leverage or liquidity will prevent us from being active in the market.

Got it. Okay. That's helpful. Second question, just looking for an update on J.C. Nolan and how that's running. It sounds like demand has kind of been moving higher in that basin but we're also seeing more competition to move fuel there as well. So just curious how you're thinking about the performance of that pipeline and the competitive dynamics going forward?

Yes, I've previously mentioned that our West Texas operations and diesel demand have been slower to recover compared to the rest of the country. However, in the past three to four months, we've seen some improvement, which is expected with the rise in oil prices. There has been an increase in drilling and fracking activity, and this is reflected in the pipeline volume. While we aren't fully back to the levels we had when the pipeline first started up at the end of 2019—when it was just beginning to ramp up and operating at full capacity in early 2020, just before the impact of COVID—there have been a few days where we've approached those volumes, and we anticipate reaching them. Overall, the situation looks promising.

Our next question comes from Gabe Moreen with Mizuho.

I know this didn't really have much of a bottom line impact but just curious what sort of the income tax stuff flowing through the DCF line was? It seems like it was related to a prior transaction.

Yes, this is Dylan. Absolutely. It's related to the 2018 return that included the sale of the retail asset to 7-Eleven. In the first quarter, we filed amended federal and state income tax returns for that year. With these updated returns, we saw an increase in tax basis, resulting in approximately a $40 million refund. What you're seeing in the DCF reconciliation is that cash tax refund, but since it pertains to the merger and acquisition transaction, that's why you see that specific line item that is typically absent, which backs out of the DCF. We're not taking credit for that in the DCF. The only other place that shows up is on the balance sheet, contributing to the increase in the current asset line, and we also have a receivable for that, expecting to receive that cash later this year.

Got it. If I could ask a broader question about industry breakevens. Karl mentioned that costs are increasing; some were anticipated and some were not. Can you discuss what you expected and what took you by surprise? Are there any unexpected pressures, whether they can be passed through or not? Additionally, relative to smaller wholesalers, Sunoco clearly has a lower cost of capital, but are you observing any pressure on others due to high commodity prices? Could this drive up industry breakevens if gasoline prices remain at their current levels?

Yes, Gabe, I'll provide an example of the cost pressures we anticipated, such as wage increases and some service partner costs. We included these in our assumptions and have not encountered any unexpected issues there. However, we did not account for credit card fees in our original guidance. We incur these fees for processing credit cards, which are partially passed through to our wholesale customers, but we cover the costs for the 70 to 80 locations we operate on the New Jersey Turnpike and in Hawaii. While these fees generally come out of margins, they are usually based on the total price of fuel, since they are calculated as a percentage. We did not foresee the retail prices reaching their current levels this year, and ideally, we would prefer lower prices. This is an expense we did not anticipate in our guidance, but it will be passed through and will increase breakeven margins. Regarding your second question, we believe our size and scale give us an advantage in weathering inflationary pressures or periods of tight capital. The working capital needs created by higher prices are greater, and we can manage that, while some smaller competitors may struggle, which may lead to upward pressure on breakeven margins.

Our next question comes from John Royall with JPMorgan.

Regarding the operational expenses, looking at your guidance for the first quarter, it appears to represent about a quarter of the upper limit of the range. I understand there’s variability with volumes increasing throughout the year, and you've raised the EBITDA guidance due to the acquisition without adjusting the operational expenses. Considering the pressures you mentioned, am I correct in interpreting that the operational expenses guidance may be optimistic, but could potentially be balanced out by margins? I want to clarify this interpretation since you maintained the EBITDA guidance without any changes.

Yes, you're correct. We did not make any changes aside from updating the EBITDA guidance, so the OpEx guidance is no longer current. That said, as we assess the situation, there will be some OpEx associated with Gladieux. You also mentioned some of the seasonality issues. We have addressed some of the seasonality in OpEx to a certain extent. We've implemented changes in how we account for certain items to reduce that variability. Additionally, there's the aspect you pointed out regarding pass-through costs that affect margins, such as credit card fees that Karl mentioned. So, while we're not adjusting our guidance, I hope this provides you with more clarity on our outlook for OpEx moving forward.

Yes, I understand. I was curious about the 7-Eleven makeup payment. This year's payment seems to be smaller than last year's. Some volumes are trending in the right direction, and we all hope it continues that way. So my question is, although I know you can't provide too much detail due to the contract, I wonder how much growth we would need to see for that contract to no longer affect these payments. Are we getting close to that point, or do we still have a bit more to work on?

Yes. Here's how I think about it. I'm not going to provide a clear answer. It's really at 7-Eleven's discretion on how they manage that. Overall, our relationship with 7-Eleven is as strong as ever, and we value the contract. One benefit we gained from that contract is a guaranteed gross profit annually. In return, 7-Eleven received some flexibility to manage their volume in a way that suits their business. Therefore, some of that makeup payment is influenced by their decisions. I wouldn't necessarily interpret this as a reflection of industry-wide volumes. I would expect our situation will remain in a similar to slightly smaller range. However, I don't want to constrain their flexibility or provide too much guidance on their plans.

Understood. If I may ask a third question, you are a significant player in gasoline. What is your perspective on the waiver of the E15 summertime ban? Do you anticipate it will have any significant impact on your business, or is it not as influential as some suggest?

E15 is a product that is expected to see continued growth in demand, although it starts from a very low base. The 1-pound waiver is mostly available in the conventional gasoline market, which limits its geography. Some retailers and wholesalers have had success offering E15, while others have not seen it gain much traction. Additionally, with current prices, E15 is an appealing option because it remains cheaper despite its lower BTU content, yet we still haven't observed a significant increase in demand. From our perspective, it is uncertain whether the profit margins on E15 will be better or worse than those for E10. We are exploring ways to sell and offer more E15 to our customers, and as demand grows, it will become a larger component of our sales, though it is not significant at this time.

Our next question comes from Ned Baramov with Wells Fargo.

You reaffirmed growth CapEx guidance for 2022 and this is after a fairly light Q1 spending budget. So maybe if you could just talk about the cadence of CapEx for the remainder of the year? And go over some of the larger items that could bring CapEx above the $150 million threshold?

Yes, Ned, I wouldn't focus on anything specific. The first quarter has historically been a lighter capital quarter for us for several reasons. We remain comfortable with the $50 million allocated for maintenance and $150 million for growth capital. If you look at the larger projects, we're completing the latter part of the Brownsville project, which is part of that growth capital expenditure. The majority of our growth will come from signing new field distribution customers.

There are no further questions at this time. I would like to turn the floor back over to Scott Grischow for any closing comments.

Well, thanks, everyone, for joining us on the call this morning. As always, feel free to reach out to me with any follow-up questions. We'll see everyone soon.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.