Greetings, and welcome to Sunoco LP's 2Q 2019 earnings call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Scott Grischow, Vice President of Investor Relations and Treasury.
Thank you. Good morning, everyone. On the call with me this morning are Joe Kim, Sunoco LP's President and Chief Executive Officer; Tom Miller, Chief Financial Officer; Karl Fails, Chief Operations Officer; and other members of the management team. A reminder that today's call will contain forward-looking statements subject to risks, uncertainties, and other factors that could cause actual results to differ materially. 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 website for a reconciliation of each financial measure. Before I turn the call over to Tom, I will provide an update on the J.C.
Nolan Diesel Pipeline joint venture with Energy Transfer that we announced on our first quarter earnings call. We signed final agreements on July 1st, successfully commissioned the pipeline in August, and completed our first deliveries to customers this week. As a reminder, Energy Transfer operates the pipeline for the joint venture, which transports diesel fuel from Hebert, Texas, to a terminal in the Midland, Texas, area. The joint venture splits the profits from midstream operations. Both parties benefit through a sharing agreement on the marketing side, capitalizing on the West Texas to Gulf Coast differentials. Sunoco LP's cash investment is approximately $50 million. $5 million of that is growth capital, with the balance comprised of line fill and working capital. I will now turn the call over to Tom, who will cover this quarter's financial and operating results. Tom?
Thanks, Scott, good morning, everyone. Again, this quarter, we delivered quality results. For the quarter, the partnership recorded net income of $55 million. Second quarter 2019 adjusted EBITDA was $152 million compared to second quarter 2018 of $140 million. Our second quarter leverage of 4.2 times was lower than last year's second quarter leverage of 4.5 times. Second quarter DCF as adjusted was $101 million, yielding a second quarter coverage ratio of 1.17 and a trailing 12-month coverage ratio of 1.35. As noted in the earnings release, these results include a one-time expense of $8 million related to a reserve for an open contractual dispute from prior periods. If you remove this one-timer, adjusted EBITDA would've been $160 million. DCF as adjusted, $108 million. Second quarter coverage would've been 1.26. Trailing 12-month coverage of 1.37 and leverage of 4.16 times.
Another solid quarter, no matter how you looked at it. On July 25th, we declared an $0.8255 per unit distribution, the same as last quarter. Looking at our operational performance, fuel volume in the second quarter totaled a record high of over 2 billion gallons. That's up 4% from a year ago. It was driven by contribution from 2018 acquisitions, organic growth, and gross profit optimization efforts. Fuel margin was $0.091 per gallon, which was impacted by the aforementioned one-time expense, as well as the mid-June Philadelphia Energy Solutions refinery fire. Spot gasoline prices ran up in the response, pressuring margins in the back half of June and into early July. PES is one of our largest suppliers on the East Coast. Given our size, we have multiple other options with good longstanding suppliers.
All told, without the one-time contractual dispute and the margin impact from PES, we would've been toward the lower end of our $0.095-$0.105 per gallon annual guidance. On a run rate basis, our second quarter and first half numbers suggest full-year operating expense below our $540 million annual guidance. While we expect quarter-to-quarter fluctuations, total 2019 operating expense will be below our annual guidance, primarily due to the sale of Fulton Ethanol plant. That said, the Fulton Ethanol sale will also result in lower gross profit by essentially the same amount. Moving to capital, we invested $31 million in the second quarter, $25 million on growth capital and $6 million on maintenance capital. We now expect 2019 maintenance capital to be around $40 million, up from last year's $31 million. Last year, we spent $71 million in growth capital.
Our current growth capital projection is now up to $100 million, which includes $5 million towards the J.C. Nolan JV.
As we've discussed in the past, we have strengthened our sales team and developed a strong pipeline of organic fuel distribution projects. We would be comfortable exceeding $100 million in growth capital by investing in additional organic projects that deliver high returns with short paybacks. Looking at the second quarter, our underlying business performed well. We continue to maintain a financially disciplined strategy, focusing on things we control. Expenses, gross profit optimization, and investing wisely. We believe this strategy will allow us to remain within our 4.5-4.75 times leverage target and our 1.2 coverage ratio target. We believe the 2019 adjusted EBITDA guidance remains very reasonable. I will now turn the call over to Joe for some closing thoughts. Joe?
Thanks, Tom. Good morning, everyone. Quarter after quarter, we continue to deliver quality results. Our second quarter performance is a good example of the resilience of our business. We faced an upward commodity price environment in both April and June. We were also negatively impacted by the PES refinery issues. Furthermore, we had a one-time $8 million expense that Tom mentioned earlier. Even with these headwinds, we delivered another solid quarter. Our underlying business remains strong, and we expect it to continue into the foreseeable future. We're building a business model to withstand various headwinds. Yet at the same time, our business model can also take advantage of select tailwinds, like we saw in the fourth quarter of last year. Looking forward, the third quarter is off to a good start, and more importantly, we expect to deliver on our annual guidance. Moving on to growth, the J.C.
Nolan pipeline was placed into service this month. Although the dollar amount is not exceedingly large, this is a prime example of our ability to create accretive growth outside of fuel distribution. Since last year, we have shifted personnel and dollar resources to build our midstream business. It's paid off with the acquisition of two terminals in December of last year and the completion of the J.C. Nolan project. We have temporarily slowed our fuel distribution acquisitions. However, our pipeline remains strong. When the right opportunity comes at the right price, we'll act on it. To balance the short-term decrease in acquisitions, we have increased our organic growth as Tom detailed earlier. Let me close by stating we continue to establish a track record of delivering on our targets. We remain confident that we will continue to deliver in 2019 and beyond. Operator, that concludes our prepared remarks.
You may open the line for questions.
Thank you. At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from the line of Shneur Gershuni with UBS. Please proceed with your question.
Hi, good morning, guys. Maybe we can start off with your outlook for margins for the back half of this year as we think about your full-year guidance. RBOB is moving in the right direction this quarter. Any color around your expectations for margins for three Q and fourth Q?
Hi, Shneur. This is Karl. As you mentioned, the fall in RBOB prices definitely provides a tailwind like we saw in Q4 of last year. That's very constructive for us. I think in general, as we've talked over the last number of quarters, we don't look at margins and volumes separately. We look at them together as gross profit. I think our gross profit optimization efforts have yielded results in Q2. It was a little more towards the volume side than the CPG margin side. We're very comfortable with our guidance as Tom and Joe mentioned on our prepared remarks, and Q3 is shaping up nicely.
Okay.
Shneur, this is Joe. Let me add a little bit to that. I think if you look at 2018 and look at what's happened in 2019, there's some similarities. If you look at 2018 on the first half of the year, I think our average margin was somewhere just north of $0.098. If you look at this year, even with the $8 million in the refinery issue, we're averaging somewhere around $0.095 for the first half of the year. I think the important thing that Karl mentioned is that our volume's going to be up. We're still going to do gross profit optimization. With the RBOB drop, I think we're in very good shape for the back half of this year.
That makes great sense, guys. I was wondering, given the success that you've had with optimizations, I was wondering if you can give a sense to us, what inning you're in. Are we in the fifth inning? Are we in the ninth inning? Just considering how long it's taken place. I was also wondering, as part of that, if you can talk about the PES closure, whether that actually presents an opportunity to enhance your optimization opportunities as well.
This is Karl. I'll take the PES piece first, then I think Joe might be able to comment on the other. As far as PES goes, as we mentioned earlier, they were one of our larger suppliers on the East Coast. I think we saw the market very quickly find alternate supply coming into the Philadelphia area. It's very well supplied. I think what we saw is that there was some impact. We estimate probably in the $5 million-$10 million range. Split between Q2 and Q23 as the logistics costs of getting that supply where it needs to get, needed to rebalance. That's still working through. From our standpoint, it was enough to notice, but not enough to be material. We're one of the largest shorts in that part of the country, and we were before, we're still going to have a large demand for fuel.
Yeah, as you stated, I think it creates opportunities for us going forward.
Shneur, as far as the question about price optimization, I think on the last conference call, I mentioned that, as far as our base business, we're pretty deep into it. I think the real opportunity for us is really when it comes to organic growth and optimizing the gross profit on those opportunities that we're ramping up, and also on future acquisitions. Our ability to price optimize, we believe with our scale and our brand, we bring that to the table. As far as our base business, it's a continuous process. Do I think that we have other opportunities internally to do it? Yeah, we have some, but using a baseball analogy, we're probably deeper into the latter innings when it comes to our internal base.
Just to paraphrase the first comment, essentially, 2Q earnings could have actually been higher had it not been for PES because of that higher expense. Is that what you were saying as part of the first part to your answer?
Yes. I think as we've stated, we look at our business as a whole. We think overall, that's not a forecast, but we don't think that we're going to hit our overall guidance for the year on both EBITDA and coverage. It's just a statement that that was a headwind for us in Q2 and probably a little bit in Q3. Right now, there are other tailwinds in Q3 that should overcome that.
Okay.
Go ahead, Shneur.
No, please finish.
I think to add a little bit more depth to the PES issue. If you want to try to do an analysis internally as kind of keep all variables equal, what did PES impact us in the second quarter and what did impact us in the third quarter? We think it's somewhere between $5 million-$10 million that kind of lapped over both the second and third quarter in combination. If you want to just call it right down the middle, somewhere between $2.5 million-$5 million each quarter. It did have an impact on the second quarter. As far as the third quarter, it had a little bit of leftover impact, but I think all of that has pretty much been worked out through the system. Our optimism on the back half of this year factors that in.
As you mentioned earlier, the drop in RBOB prices has definitely trumped over that variable.
Okay, one final question. Do you see an opportunity to take some capacity on Mariner East 2X when it starts up as a potential solution to filling supply into the former PES market?
I think as we look at Philadelphia, the East Coast has always been supplied by pipe, primarily from the Gulf Coast. It's been supplied by refineries in the area, and it's supplied with imports from Europe or other parts of the world. That's going to continue to be the case. I'd say we're always interested in looking at pipeline opportunities into certain markets. Depending on how that shapes out, that's definitely something we'll look at.
Perfect. Thank you very much, guys. Really appreciate the call.
Thank you.
As a reminder, if you would like to ask a question, please press star one on your telephone keypad. Once again, if you would like to ask a question, please press star one on your telephone keypad. One moment, please, while we pull from more questions. Our next question comes from the line of Ethan Bellamy with Baird. Please proceed with your question.
Hey, guys. Good morning. With respect to the joint venture line in West Texas, could you give us some context on how big that market is? If you think that pipe will impact the spread from the Gulf Coast. Then potentially, if we see a big downturn in oil and gas development out there, does that put volumes at risk on the line?
This is Karl. I'll be happy to take that. I think as we look at the diesel demand in that area of Texas, there's definitely been diesel that's come in by truck and by rail, pipeline economics should beat that every day of the week. We're comfortable that the market can absorb the capacity of the 30,000 barrels a day of the J.C. Nolan line. Obviously, as more supply comes in the market, that can impact differentials, but we bake that into as we looked at the JV with Energy Transfer, those economics. We're comfortable with how that looks. To the downturn in the Permian, as we look at that market and how it impacts our business, we think there's a lot of upside.
It's never going to be smooth quarter to quarter as things happen, as takeaway capacity comes on, as crude prices move around, we think there's a lot of runway in that market. As far as downside from our EBITDA perspective, we operated, if you recall, the West Texas stores that we now have a large commission agent operate as a commission agent with a large customer. We operated those as company-operated stores during the downturn in 2015, 2016. We know what that looks like from an EBITDA perspective. We see a potential slowdown in the Permian more as limiting our upside, not as a significant downside to us as a company.
Got it. That's very helpful. Should we view this as a template for future transactions or operability in concert with Energy Transfer? Is this more of a one-off?
Hey, Ethan, this is Joe. I'll kind of play off of Shneur's comment earlier by kind of using a baseball analogy. I would say that as far as looking at midstream, traditional midstream, organic growth projects, we're definitely in the first or second inning. The J.C. Nolan was kind of our first deal. We're looking at vast opportunities that are out there, either with Energy Transfer or without Energy Transfer. The way that we're looking at it is we have an 8 billion gallon plus fuel distribution business. Working further upstream is going to create some synergy opportunities for us. We feel confident that we're going to find other opportunities. The question for us is how many. I would say early stages. We think there is definitely some opportunities for us to move further upstream.
Okay. Last question. Since the last quarter, we've seen yet another IDR elimination from one of your partnership peers. Just got to ask the question, when you see that, does it make that more of a pressing concern?
Right. Ethan, I think what I've said in the past is that there's no efforts being spent by Energy Transfer or Sunoco on IDR elimination. We have a plan that we're executing, we think that we can create value. As for currently, we don't see IDRs as a prohibitor for us growing, given our excess coverage and our ability to stay within our targeted leverage. I think right now we're hovering somewhere around 4.2. Right now, we don't see this as a prohibitor.
All right. Thanks a lot, Joe. Keep up the good work. We appreciate it.
Thanks, Ethan.
Our next question comes from the line of Jeremy Tonet with J.P. Morgan. Please proceed with your question.
Good morning. This is Charles on for Jeremy. First one was, just wanted to see if you had any color on the potential reinstatement of the biodiesel blenders tax credit. Just been hearing some rumblings in the news on that. I'm curious if you had any color there and really how much of an impact that would be for Sun?
Yeah. This is Karl. I would say our guess on what Congress is going to do there is probably as good as yours. We obviously follow that and look at that. I would not say it's material, either way that goes for us.
Okay. Just wanted to follow up on West Texas here. I just wanted to make sure I understand. On the demand side, I guess your expectations there for the balance of this year and then maybe thinking more in 2020, as the differentials come in and there might be maybe less pull from on the trucking side, I guess it doesn't sound like it's maybe as much of a negative to you, at least in the near term?
Yeah, that's right. I think backing out truck and rail diesel into West Texas is going to be beneficial to us and beneficial to the joint venture project we've entered into with Energy Transfer. As you look at the production growth in the area, for every frac or rig that is in operation, you need diesel to run that. We're very comfortable and excited about the forward projections as it relates to diesel and our business in West Texas.
I'll add a little bit of commentary to Karl's comments. I think in my prepared remarks, I said our investment is not exceedingly large. It's about $50 million. I think the way to look at it from a Sunoco perspective is we were paying pipeline tariffs to begin with. Now we're part of a joint venture. Now at least we are paying ourselves or picking up half of that. The other half, there is some marketing exposure, but we had that marketing exposure to begin with because we have the 207 stores and the commission agent, and we have other diesel distribution in that market. From our standpoint, we flipped over some of our revenues into a more ratable pipeline revenue for ourselves.
Okay, great. Thank you.
Our next question comes from the line of Sharon Lui with Wells Fargo. Please proceed with your question.
Hi, good morning. Just wanted to touch on, I guess, your guidance for growth CapEx. It looks like the opportunity set is a little bit more robust. Maybe if you talk about some of the opportunities that you guys are exploring?
Sure. Hi, Sharon. This is Karl. I'd say we mentioned that part of that increase in the growth CapEx related to about $5 million towards our contribution to J.C. Nolan. The other portions of our contribution to J.C. Nolan really come as investment in working capital. As far as the other growth in our growth capital, it's in the same areas that we've talked about before. I think on our fuel distribution side, our sales organization is really ramping up, and so a lot of those projects are in signing up new customers or renewing other customers and expanding their business. As Joe mentioned before, we are spending time and money to increase our opportunity set in the midstream world. We don't have the next project to announce, but we're definitely working on that, and that's a component of our growth capital going forward.
Okay, great. Just a question on that one-time charge. Is the impact potentially just isolated to this particular quarter? Maybe you can give some color on that contract dispute.
Well, pardon me, this is Tom. We really can't provide any additional color. It is an open contractual dispute, as you said. We spent a lot of time looking at this, and we feel we're appropriately reserved on this.
Thank you.
Ladies and gentlemen, we have reached the end of the question and answer session. I would like to turn the call back to Scott for closing remarks.
Well, thanks again for joining us on the call this morning. Feel free to reach out to me with any questions. Have a great day, this concludes today's call.