Welcome to the Sunoco Third Quarter 2018 earnings call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star 0 from your telephone keypad. As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Scott Grischow, Senior Director of Investor Relations and Treasury. Please go ahead.
Thank you. Before we begin our prepared remarks, I have a few of the usual items to cover. A reminder that today's call will contain forward-looking statements. These statements are based on management's beliefs, expectations, and assumptions. They may include comments regarding the company's objectives, targets, plans, strategies, costs, and anticipated capital expenditures. They are subject to the risks and uncertainties that could cause the actual results to differ materially, as described more fully in the company's filings with the SEC. 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 this quarter's news release for a reconciliation of each financial measure. A reminder that the information reported on this call speaks only to the company's view as of today, November 8, 2018.
Time-sensitive information may no longer be accurate at the time of any replay. You will find information on the replay in this quarter's earnings release. 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 Commercial Officer, and other members of the management team. Before I turn the call over to Tom, I would like to review some of the partnership's accomplishments and activities that took place during this very strong third quarter. First, we completed the Sanford Oil acquisition on August 1, which included a 115 million gallon a year fuel distribution business to exploration, drilling, and oil field service customers, primarily in Texas and Oklahoma.
On October 16, we completed the acquisition of BRENCO Marketing Corporation's fuel distribution business, which distributes approximately 95 million gallons of fuel per year across a network of dealer, commission agent, and commercial account locations in Central and East Texas. Both acquisitions bring commercial and G&A synergies resulting in post-synergy multiples in the mid-single digits. We funded both of these acquisitions with cash on hand and amounts available on our credit facility. We expect both acquisitions to be accretive to our unit holders in the first year. These acquisitions, along with the Superior acquisition in the second quarter, are examples of the types of opportunities we continue to see in a fragmented industry. We maintain a robust pipeline of potential acquisition targets, and we'll only pursue the most attractive opportunities that allow us to capitalize on our scale and to meet our financial goals.
Moving on to an update on the tax impact of the divestiture of our retail operations to 7-Eleven earlier this year. Through the end of the third quarter, Sunoco LP made a total of approximately $370 million in tax payments related to the 7-Eleven sale. Our estimate for the total 2018 tax impact remains at $480 million, with the final payment due in mid-December. Finally, I would like to wrap up my comments by addressing a news story that came out last week regarding the Federal Circuit Court of Appeals ruling about Sunoco, Inc. The Sunoco, Inc. entity is a wholly-owned subsidiary of Energy Transfer Operating, L.P. As such, the court ruling is unrelated to and has no impact on Sunoco LP. I will now turn the call over to Thomas Miller.
Good morning, everyone. As Scott Grischow mentioned, last night we reported strong third quarter results building on a solid second quarter. In the two quarters since our exit from operating 1,200 retail sites, we delivered financial and operational results demonstrating our ability to execute our strategy. We've controlled costs, made three roll-up acquisitions, captured strong margins, and surpassed our leverage and coverage targets. For the quarter, the partnership recorded net income of $112 million and adjusted EBITDA of $208 million, which includes $2 million of transaction-related expenses and a one-time cash benefit of $25 million from a settlement with the fuel supplier. Even without this one-time cash benefit, the business performed extremely well this quarter with strong fundamentals, including healthy fuel margins and flat sequential operating expenses.
These results drove leverage as defined by our credit agreement down to 4.27 times. This is down from last year's third quarter result of 5.59 times. Distributable cash flow as adjusted was $149 million, yielding a third quarter coverage ratio of 1.73 times, and 1.24 times on a trailing twelve-month basis. Last year at this time, our trailing twelve-month coverage ratio was 1.04. If you remove the one-time cash benefit of $25 million, our coverage for the quarter would have been 1.44 times, and leverage would have been 4.44 times, an outstanding quarter no matter how you look at it.
On October 26th, we declared an $0.8255 per unit distribution, the same as last quarter. We are confident in the sustainability of our distribution at this level. Over time, we will manage leverage within the target range of 4.5 times to 4.75 times and a distribution coverage ratio of at least 1.1 times. Our liquidity continues to be robust with $1 billion available on our 5-year revolving credit facility, which we extended in July. Looking at our operational performance, total fuel in the third quarter was a little over 2 billion gallons, a 1.4% increase over the second quarter. For the third quarter, fuel margin inclusive of the $25 million adjustment was $0.127 per gallon. Removing the one-time $25 million, our margin would have been approximately $0.114 per gallon, which is a very solid margin on its own.
I would like to provide some context for how we view and manage fuel margin. First, as we have mentioned in the past, we manage the business for long-term gross profit dollars, not margin and volume separately. We have added resources to optimize our gross margin, and we are very pleased with the results so far. Second, we had an excellent quarter in all our channels. We employ a multi-channel strategy that balances highly ratable income, such as our 7-Eleven take-or-pay and our $140 million per year of rental income, with channels and geographies that give us the opportunity to capture robust margins. West Texas, Hawaii, and East Coast markets have had strong margins, which we expect to continue. Finally, our acquisitions of Superior Plus Energy Services and Sandford Energy had a positive contribution to our fuel margin. Moving on to expenses.
Last December, we provided run rate estimates for several key modeling inputs. We have focused on controlling spending throughout the year. We expect to be within our December expense guidance, even with the addition of the three bolt-on acquisitions. During the third quarter, G&A expense was $34 million, in line with our $140 million annual guidance and flat to the second quarter. Rent expense totaled $20 million, also flat to the second quarter and within our annual guidance at $75 million. Third quarter other operating expense was $86 million. Annualized, this number is above our $325 million run rate discussed last December. The nature and timing of certain expenses within the category will always result in quarter-to-quarter fluctuation. That said, we are very confident in our annual run rate of $325 million.
As I mentioned on last quarter's call, in the first half of the year, we revamped our capital allocation process, and this resulted in lower capital spend in the first two quarters. In the third quarter, we invested $30 million, $19 million of growth capital, and $11 million of maintenance capital. We expect annual capital spend to be approximately $30 million for maintenance capital and approximately $65 million for growth capital. In December, we intend to provide updates of the key financial modeling inputs for 2019. I will now turn the call over to Joe for closing thoughts. Joe?
Thanks, Tom. Good morning, everyone. The third quarter has historically been our most profitable time period, and our results this quarter reinforced our earnings power. The underlying business is strong, and we expect it to continue. Our October results were very encouraging, and looking forward, we expect the fourth quarter to be another solid quarter. Last year, we outlined a plan, and this year, we're delivering on that plan. For 2018, we're either meeting or exceeding our guidance for gross profit, expenses and maintenance capital. As a result, our coverage is materially above 1.1 times, and our leverage is below 4.5 times. We remain confident in our ability to sustain our distributions while still having excess cash that can be used for growth opportunities. And most importantly, we expect this to continue into the foreseeable future. We're also delivering on our growth plan, completing three accretive acquisitions since April.
Our pipeline remains robust. We will continue to deliver on additional accretive acquisitions. Let me close by stating that we are very optimistic about our future and our ability to deliver on our financial goals. 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 one from your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press star two 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. One moment please while we poll for questions. Thank you. Our first question comes from the line of Theresa Chen with Barclays. Please proceed with your question.
Good morning. Great to see the very strong CPG in third quarter, even ex the one-time effect. Joe, just following up on your comment about expecting a solid fourth quarter. When we look at the current period and the precipitous decline in wholesale product prices, can you talk about what you are seeing in terms of margin trends currently? Should we expect the fourth quarter of CPG to be even stronger than third quarter?
Hey, Theresa. Good question. First of all, as I mentioned in my prepared remarks, the third quarter has historically been the best quarter for fuel distribution companies and for retail-centric companies. With that said, I think the way to look at it is look at our business on an annual basis, where typically the third quarter is the best, the second quarter is the second best, and the fourth quarter is the third best, then the first quarter is just typically the lowest margin period. If you look at that in totality, and you look back at kind of a recast base of our business over the last four years, what you will find is. What I mean by recast is take the 7-Eleven agreement and push it back retroactive four years.
What you'll find is that our annual average over four years has been slightly above $0.095. If you look back over the last two years, our business has actually yielded more towards $0.10. If you look at 2018, we're actually slightly above 2017 on a margin basis. I think the key point is this is partially a very solid industry fundamentals, but there's also some proactive steps that we've taken. We did those three bolt-on acquisitions. The blended margin of these acquisitions is actually higher than our base business. You're going to see an uptick on that. Secondly, as Tom mentioned in his prepared remarks, we've gone through this volume margin optimization. As I stated previously, as Tom stated, the early results have been very encouraging, giving us a gross profit increase.
Finally, you think back to December when we announced our West Texas deal, we stated that we selectively picked out key markets that we want to have the ability to capture the full margin. West Texas, Hawaii, and the New Jersey Turnpike are three very robust margin areas, and we proactively, strategically picked these out. These are niche markets, really strong, and we expect that to continue. You put that into totality, I think you'll see why our margins were so strong in the third quarter. I wouldn't get overly caught up into quarter to quarter. What I would really focus on is over a course of the year, we've delivered over the last four years, over $0.095, and I think this year's result makes a very compelling case that it's going to be above that number.
Got it. Related to the settlement with the fuel supplier, can you just provide some history and context of how that came about?
Sure, Theresa, this is Karl. The settlement really relates to fuel purchases from one of our major suppliers. As you think about our business, we've told the market that one of our strategic advantages is our scale and the fuel purchasing power that provides us. We do a lot of things day to day to continue to ensure that we capture that purchasing power with our fuel suppliers. That settlement is related to this year, we resolved an open issue with one of our suppliers on fuel purchasing price, and that settlement was finalized in the third quarter. If you retroactively applied that settlement across the last few years on our volumes, that would have increased our average margin by about $0.001 per gallon.
The last thought I'd say is I'd reiterate again what Tom said in his prepared remarks, that even without this settlement, we had a very solid quarter.
Understood. Given just very healthy coverage year-to-date, can you talk about what your plans are for the excess cash? Are you looking at potentially growing the distribution again, or do you think the cash would be better spent reinvested in the business?
Theresa, it's Joe. If you look at our excess cash, first of all, our solid results are going to give us, I think we targeted 1.1, but if you look at market sentiment, I think the market is more leaning towards higher coverage versus an increase in distribution. If we did increase our distribution, I don't think it necessarily gives us a lower yield, resulting in a lower cost of capital. As of right now, I think the opportunity for us is to take this excess cash and apply it to growth or to our balance sheet.
Great. Thank you very much.
Our next question comes from the line of Jeremy Tonet with JP Morgan. Please proceed with your question.
Hi, good morning. This is Charlie in for Jeremy. One quick one for me is, just thinking about Energy Transfer family and kind of everything is simplified there with no IDRs. Is Sun going to request an IDR elimination? I understand that you're going to say that you talked to Energy Transfer about that. I'm trying to understand from your perspective if that's something that you're proactively pursuing.
Hey, Jeremy. First of all, I think no effort is being spent by neither Sun or Energy Transfer on IDR elimination. I think the second thing that you have to take into consideration is that we put together an executable strategy to grow the company and to create value for both our LP and for our GP. I think you look back since the 7-Eleven transaction, I think we have definitely had two quarters, the second and third quarters, showing that we can deliver on that. As I said in my prepared remarks, I expect another solid fourth quarter, and I stated I'm very optimistic about the future. The fact that we're delivering, we did three acquisitions since April, even with a very, I would say, a yield that I think we're justifying should be lower, and yet we still did three accretive acquisitions.
I mentioned that we have a robust pipeline. I think what we're showing is that even with the high yield and with the IDRs, we're growing and delivering on our plan.
Great, thank you. One more from me. On expense savings, you've done a good job there. Thinking about in context of the recent acquisitions, is there any foreseeable savings that you could capture, maybe, looking forward into 2019?
Let me answer that two ways. We feel comfortable with the guidance we've given you for the remainder of the calendar year. As for 2019, we're in the process of pulling together our budget, we'll be sharing that with you in December. Just one final point on that is when we make the acquisitions, we would normally expect to be able to have some synergy.
Great. Congrats on the quarter again.
Appreciate it.
The next question comes from the line of Patrick Wang with Robert W. Baird. Please proceed with your question.
Hi. Good morning. Great to see these numbers. If we could look broadly at your M&A framework, what type of cost equity do you assume when assessing potential transactions under that 50-50 equity framework? At what distribution yield would you believe you could achieve accretive M&A through equity rather than entirely on the revolver?
First of all, I want to reiterate that we don't see a need for 2018 equity. As we look forward to 2019, we're committed to maintaining the leverage targets of 4.5-4.75 over a long period. As we look at attractive acquisitions, we do look at it on a 50-50 capital basis, given right now where our yield is, we would probably be looking at a preferred to help fund the acquisition. We feel like it's just a better use of capital right now.
Okay. That makes sense. Thanks for that detail. Staying on this topic, is there a certain deal, let's say, something larger in the terminals area? Is there anything sizable and surprising that may require some equity or some preferred equity alongside debt, let's say, in 2020?
Yeah. Patrick, it's Joe. I think the way to look at our M&A is that it's kind of two parts. One part is the fuel distribution. I think we're starting to build a good resume of delivering on attractive multiples, accretive acquisitions. On the midstream side, we're definitely looking at midstream assets. As far as giving specific color on a specific target, I think it's way too early on that one. I think what you can take away is that we're looking. When we find the right assets at the right financial fit, we'll go after those assets.
All right. That's great to hear. Thank you very much.
Thank you. As a reminder, to ask a question, you may press star one from your telephone keypad. The next question is from the line of Mike Geyer with Janney. Please proceed with your question.
Yeah, good morning, guys. Can you talk a little bit about, I guess, working capital requirements and, I guess, in general sort of your conversion to the full wholesale model. Do you think there's any benefits that you can sort of wring out of the working capital within the network, or, I guess, how are you feeling about the working capital in general?
The good thing about the wholesale side of the business is it has a much more rapid cycle where things are paid quickly. It is an area that we're looking at, but we haven't been looking at it in great detail. We'll be advancing that over the next couple quarters. It's not real high on the priority list.
Okay. On the operating front, can you tell me if you had any, I guess, benefit or headwind from the hurricanes in any of your regions or markets this quarter?
Yeah, this is Karl. I would say there's no material impact, either positive or negative from the storms this quarter.
Great. Thank you.
The next question comes from the line of George Wang with Citigroup. Please proceed with your question.
Hey, guys. Congrats on the strong quarter.
Thank you.
Just want to hone in on the future roll-up acquisitions. Is this Post Energy mid-single digit sort of multiple still a firm guidance on the target you guys are looking at? I'm sure you guys are looking at different targets. Are you guys still seeing a bunch of attractively valued acquisition targets you guys can roll up?
George, this is Joe. Obviously, if we can continue to find assets that are synergized and mid-single digits, obviously those are attractive to us. As I've said, we've built up a good pipeline of these type of fuel distribution targets, and what we'll do is we'll pick the best out of the ones that presented to us. Secondly, I think this is a very important point. Our goal long term is to become more diversified and become a larger, stronger MLP. That means that we're going to also balance that out with some other traditional midstream targets that might trade at a slightly higher multiple. The good news is that the same type of synergies that we bring to the table for fuel distribution, that's also applicable to some midstream assets, such as product terminals.
The goal, obviously, is to purchase assets at a very low multiple, depending upon the quality of the assets and how that enhances our overall portfolio, I think we'll be looking at the whole range.
Got you. That makes sense. Are you guys still looking at four to five deals a year? I don't know if you guys are still sticking to this quantity of guidance. Since you guys have done three deals so far, is that to assume you guys may still announce one to two deals this year?
I don't think the four deals will be guidance might not be the right word, I think if you put together a good pipeline, you build the capabilities. I think, although M&A is not ratable, I think we put together a program where we've really yielded three since April, which is, I think, a strong accomplishment. When the pipeline continues, our approach is really evolving away from necessarily building up the pipeline. We have a pipeline. Our path forward is making sure we pick the best of our pipeline and also enhance our fuel distribution business with other businesses that can balance out our portfolio.
Got you. Understood. My last question, you guys talk about post-synergy. I am not sure if you can give more color just on how soon do you think you guys can achieve this 5 to 6x multiple after deal conclusion?
Yeah, this is Karl Fails. I'd say obviously it depends a little bit on the individual acquisition, but in general, a good rule of thumb is that in year one we will capture 50% of the synergy, and by year two, we will be at run rate. You think about the deals we have done so far this year. Superior has been in our portfolio about six months, and I'd say we are tracking maybe even a little ahead of that on our synergy. Sanford and BRENCO are both pretty recent, I'd say it is too early, but those integrations are on plan. The other thing I'd add is, as we do these, we get better at them as well. I'd expect, if anything, that our ability to capture those synergies and integrate them will accelerate.
Cool. Sounds good. Thanks a lot.
The next question comes from the line of Ben Brownlow with Raymond James. Please proceed with your question.
Hi, good morning. I appreciate all the color around. You provided a lot of detail around the drivers on the fuel margin, and you made one comment around one element of that driver was the added resources to optimize fuel margin. Can you give any specifics of that driver or what that entails?
Sure. Yes, this is Karl. I can provide a little more guidance. The basic idea behind our price optimization, the resources we've put on it is, you look at both margin and volume impacts when you set the price, not just one of those two. I'll give you an example. In a lot of our locations where we set prices at an individual site, we've developed individual location by location elasticity curves, so that when we set a price on a daily basis, we're taking into account what the anticipated volume impact of that is, and so we can look at the overall gross profit. I guess the other color I'd say is we're adding more data analytics around choosing competitors and how we make that choice in local markets.
The underlying principle is really putting more data, more analytics with real business responses to drive those decisions.
Great. That's very helpful. Just one more from me, a minor modeling question. Within the wholesale segment, can you give some color on the "other category?" That was around $7 million gross profit. It's a small contributor relative to the fuel category, but it still fell off relative to sequentially from second quarter. Just trying to understand some of the movement there.
Right. Well, first of all, what's in other income?
Yeah, the other income.
Yeah, the other income, that tends to be credit card, merchandise, food service, lottery, things like that, things from running the stores. We think that you probably should use this quarter as a run rate going forward as opposed to last quarter, which had some adjustments.
Okay, great. Thank you.
Our next question comes from the line of Sharon Lee with Wells Fargo. Please proceed with your question.
Hi. Good morning. I was just wondering if you could maybe provide some color on volume trends. Q3 was up about 1% sequentially, I thought it might have been higher given the acquisitions of Superior and Sandford. Maybe if you could just talk about, I guess, volumes this quarter and where you see volumes trending next quarter.
Sure. Hi, Sharon. This is Karl. You pointed out our Q3 volumes did rise seasonally from Q2 and from our acquisitions. I'd say that's in the area of our expectation. A few points that give color on that. One, remember that our volumes with 7-Eleven, really that's protected by our take-or-pay on an annual gross profit arrangement with them. We've also stated in prepared remarks and even in our Q&A, this gross profit optimization strategy where there are some trade-offs between margin volume. You should think about that. The last point I'd make is really our strategy is to continue to grow gross profit and to get a bigger piece of the pie, right? Whether that pie is shrinking, growing, whether it's staying the same.
I think really our gross profit delivery is really the focus and that's what we did this quarter and that's what you should look at going forward.
Okay. Then just housekeeping item. The income tax expense was a little higher this quarter, I think because of this continued ops. What is a good run rate number for cash taxes going forward?
Right. We've talked about $12 million in the past. We think that's a good run rate. If you recall last quarter it was negative taxes. A couple things this quarter, when you make money in your C corporation, which we did, and we had a good quarter there, you pay more tax and we also sold where we had a gain, we sold one of our non-core assets.
Great. Thank you.
That Yep.
Thank you. Ladies and gentlemen, we've reached the end of the question and answer session and I would like to turn the call back to Scott Grischow for closing remarks.
Well, thanks everyone for joining us this morning. Please feel free to reach out to me if you have any follow-up questions. This concludes today's call.
Thank you. Today's conference has concluded. You may now disconnect your lines at this time. Thank you for your participation.