Phillips 66 (PSX) — Q2 2019 Earnings Call Transcript

Good afternoon, and welcome to the Phillips 66 Partners Second Quarter Earnings Conference Call. Participants on today's call will include Kevin Mitchell, Vice President and CFO; Tim Roberts, Vice President Operations; and Rosy Zuklic, Vice President and Chief Operating Officer. The presentation materials we will be using during the call can be found on the Events section of the Phillips 66 Partners website, along with supplemental financial and operating information. Slide 2 contains our safe harbor statement. It is a reminder that we will be making forward-looking statements during the presentation and our Q&A session. Actual results may differ materially from what we present today. Factors that could cause actual results to differ are included here as well as in our SEC filings. With that, I'll turn it over to Kevin Mitchell.

Thank you, Jeff, and good afternoon, everyone. This morning, we announced an agreement to eliminate our general partner's incentive distribution rights. This transaction further reinforces PSXP as a premier MLP with a lower cost of capital and a simplified structure. PSXP is well positioned with a strong balance sheet and a robust portfolio of growth opportunities. I will cover the transaction in more detail later in the presentation. Our Board of Directors recently approved a second quarter distribution of $0.855 per common unit, an increase of $0.01 from the previous quarter, and 14% higher than the second quarter 2018 cash distribution. We have increased the distribution every quarter since the July 2013 IPO. We remain committed to delivering a competitive and growing distribution while maintaining strong coverage and leverage ratios. Moving on to Slide 4 to discuss financial results. The partnership reported second quarter earnings of $233 million. Adjusted EBITDA during the quarter was a record $319 million, an increase of $38 million from the first quarter. The improvement reflects higher volumes on the Explorer, Bakken, and Bayou Bridge joint venture pipelines. In addition, volumes on our wholly owned pipeline and terminals increased due to high utilization at refineries operated by Phillips 66. Second quarter distributable cash flow was $254 million, an increase of $28 million from the prior quarter, primarily due to higher earnings. Slide 5 highlights our financial flexibility and liquidity. We ended the second quarter with $130 million of cash and $749 million available under our revolving credit facility. The debt-to-EBITDA ratio on the revolver covenant basis was 2.8x. Our distribution coverage ratio was 1.44x. Long term, we're targeting leverage of up to 3.5x and distribution coverage over 1.2x. The partnership continues to advance its major projects. In the second quarter, organic growth capital was $102 million. This included spend for the Clemens Caverns expansion, a new isomerization unit at the Phillips 66 Lake Charles Refinery, and the Clemens to Gregory ethane pipeline. During the quarter, the Gray Oak JV secured $1.3 billion of project financing for the pipeline construction. Starting with the second quarter, capital spend for this project will be largely funded through this secured financing. Switching topics now to discuss the IDR elimination transaction, which starts on Slide 6. The elimination of IDRs improves our cost of capital and simplifies our structure. The transaction further aligns the LP and Phillips 66's economic interests. Given the partnership's robust growth profile, high distribution coverage, and solid financial position, we believe the transactions are attractive for both our LP unitholders and our general partner. The lower cost of capital enhances PSXP's ability to grow through organic projects, drop-downs, and third-party acquisitions. Looking ahead, the partnership maintains strong fundamentals and our commitment to unitholders is unchanged. Slide 7 provides the details of the IDR transaction. When the transaction closes, PSXP will issue $101 million of common units to Phillips 66 in exchange for the elimination of the IDRs and the GP economic interest. Phillips 66 will own approximately 75% of PSXP's outstanding common units. This transaction value is approximately $5.4 billion and represents a 16.7x multiple of forecasted 2020 GP distributions. The transaction is accretive to DCF on a per unit basis by the fourth quarter of 2020. The transaction is expected to close on August 1, 2019. I'll now turn it over to Rosy to provide an update on our growth projects.

Thanks, Kevin, and hello, everyone. Slide 8 lists the projects we have ongoing, I'll only touch on a few updates. We're continuing to construct the Gray Oak Pipeline. We have received all major permits and acquired 100% of right-of-way. Approximately, 80% of the pipe has been installed and all 17 tanks are at cell height. The project remains on track to start up in the fourth quarter of this year. New to the slide this quarter is the C2G Pipeline, which is a 16-inch ethane pipeline that will run from the Clemens Caverns in Sweeney, Texas, to Gregory, Texas. The C2G Pipeline will serve petrochemical customers in the Corpus Christi area. The pipeline will have 240,000 barrels per day of capacity and is expected to be completed in mid-2021. During the quarter, we completed the construction of the Lake Charles product pipeline that connects storage at the Phillips 66 Lake Charles Refinery to the Clifton Ridge Marine Terminal. The connection to the terminal will provide the refinery with an outlet to competitively place its product in the market. The terminal will have up to 50,000 barrels per day of product export capacity. This last week, Phillips 66 exported its first high sulfur diesel cargo from this facility. We have a long-term agreement with Phillips 66 that includes minimum volume commitments for the pipeline and marine dock. Earlier this month, the Lake Charles isomerization unit reached mechanical completion and is expected to ramp up to full production in the third quarter. The project was completed on schedule and below budget. This concludes our prepared remarks. We will now open the line for questions.

I bet you're glad this is probably the last quarter you'll get the IDR questions. So just starting with that, can you walk through the rationale for the structure of the IDR elimination, specifically, given the multiple paid on the GP cash flows? Absent drop-down, we can't get to accretive in Q4 2020, or really any time beyond that. So my question is really why not do a drop-down acquisition in conjunction with the IDR elimination?

Elvira, this is Kevin. As we modeled this transaction, we did consider doing a drop-down in conjunction with it. Actually, on our model, we couldn't get to the sort of big bang combination transaction as really providing any incremental benefit over the simplicity and transparency of doing a straightforward IDR conversion as we've done. Now, what's important to remember is the MLP continues to have a significant growth profile ahead of it in terms of the organic projects that are underway. So there's a pretty clear line of sight to EBITDA growth through 2020 and into 2021. Additionally, think about what's going on at the PSX level in the Midstream business with the assets that are there today and the ongoing investment and projects taking place at the PSX level. There's still a long runway of potential growth beyond just the organic projects; there's significant growth coming. Regarding the ongoing investment at the PSX level, there's a lot of sight to potential growth that will come to the PSXP.

So can you just maybe walk us through how you get to accretive for Q2020? Just what are the different things we need to consider to get to this?

Yes. As you think about what's going to drive some of that, we look at Q2020, so you've got the underlying growth in the MLP, right? In simple EBITDA terms, taking this quarter annualized, we've got a $1.3 billion EBITDA rate; we've got new projects coming on this quarter, third quarter, fourth quarter, and more in 2020, including the newly announced C2G Pipeline. So you've got significant growth at the MLP level, then think about the different drivers as you look at that calculation concerning distribution growth, issuance of units, which can come in many forms; drop-down assumptions could drive unit issuance, ATM, the potential for equity market issuance, though we don't have plans to go do anything like that, but all of these will impact the calculation.

Okay. And then just the last one from me is, now that you've eliminated the IDRs here at PSXP, what's the strategic view on developing Midstream projects at the PSX level versus the PSXP level? Like, Red Oak and Liberty for instance?

Yes. Our views on that haven't changed. As you step back and think about it, we've consistently been doing as much as we can reasonably absorb at the MLP from an organic capital standpoint while keeping the balance sheet in a comfortable place, the way we like it, and not being dependent on having to go to equity markets that aren't available and not over-leveraging the balance sheet. There's no reason to assume that will change. So while it's a decision of the sponsor where projects like Red Oak and Liberty come into the MLP, the decision criteria around that will be the same as they were previously.

Okay. Sorry, just one last from me and then I'll hop off. But now that post IDR elimination, PSX is going to own 75% of PSXP units outstanding, if you were to do a drop-down, and if the MLP equity markets aren't amenable, would you issue even more units to PSX and theoretically push that ownership up even higher?

Yes. In theory, you could. The nice thing is there's still plenty of debt capacity available at the MLP. Typically, in a drop-down transaction, there's always going to be a minimum number of units that are issued back to PSX; however, since any issuance impacts both the numerator and denominator at 75%, you would have to do a lot to really move that percentage by much. It's not something we're concerned with at this point.

Sticking with the IDRs here and with them basically behind you at this point, just curious where you stand on the potential to check the box at some point and go 1099 potentially, opening up the investor pool here, especially if you're going into a stronger position here. We can maybe grow a little bit faster and get enhanced returns, so if that's something that's of interest to you now?

Yes, Spiro, it's Kevin again. It's something we would consider, but for the time being, as we've looked at it, to date, there hasn't been a compelling reason for us to go down that path. The nice thing is, for as long as we haven't done it, it's an option that's out there for us. So it's something we can consider, but it hasn't been a priority so far.

Okay. That's fair. And then just thinking about financing some of this growth going forward, forgetting about equity issuances and things like that. Obviously, there's public-private arbitrage that's still pretty wide here, and you guys have pretty interesting projects, most of which you still wholly own. Just curious if there's any appetite or interest you're seeing to maybe joint venture some of these projects that you have there like C2G?

You could, but it really depends on what your joint venture partner would bring to the table on a project like that. We don't want to just give up economic value for the sake of selling down our ownership interest; there needs to be more to it than that. We need to consider overall win for PSXP in a transaction like that.

Okay. Fair enough. Last one is a cleanup one. I know you're not providing any sort of specific distribution guidance here, but just following the IDR removal, any reason to expect maybe a change in the quarterly increase pace or slow down or speed up for the remainder of 2019?

Well, you're right. We're not giving distribution guidance other than to expect to remain competitive at the top quartile level, but one comment I would make is with IDRs out of the way, once you get to mid-to-late 2020, PSXP has the ability to increase the distribution at a faster pace than it could with IDRs in place. Once you get past a year or so, you have the potential to do that. Whether we choose to do that or not is another matter, and there will be a lot of factors that go into that, but we're very well positioned for continued distribution growth.

I guess just a couple of quick operational ones from me. Thinking through here with the Lake Charles isomerization unit being completed here in July. Any ramp in terms of the contract nature of the cash flow there? Is that all pretty much coming in day one for PSXP?

Justin, this is Rosy. From a modeling perspective, you are unlikely to see anything until the third quarter for the isomerization unit.

Perfect. And then thinking through, I guess a similar line of questions for Bayou Bridge...

Oh, I'm sorry, I was right the first time, it is the fourth quarter. I was thinking about the Lake Charles pipeline. Yes, sorry.

Got it. And same type of question here, I guess on Bayou Bridge, thinking through probably only a month or two of earnings flowing through in 2Q, should we think of the same type of ramp profile for the Bayou Bridge expansion?

Right. The Phase 2 Bayou Bridge, we only saw two months in the second quarter, that's right, so you would see an improvement in the third quarter.

Is there a comfort level that PSX has in terms of the percentage of the LP ownership and willingness to hold at this point? I mean 75% is relatively high. Any plans there?

Barrett, it's Kevin. That question really is a PSX question and it came up this morning on the PSX call. The answer is that our decision-making is not driven around a targeted ownership percentage; it's really about how PSX executes on its growth strategy in Midstream, and the PSXP is an integral part of that. There are various factors that will determine where that unit percentage ownership sits. But there's no target level specifically around that.

Okay. And then just one other thing is I'm looking at the multiple on the elimination, it was 15.8x, $5.2 billion value, so that gets me to about $330 million as an assumed cash flow to GP in 2020. Would that imply that you would have a faster rate of distribution growth in that year based on those numbers, pre-transaction?

Yes. What I would say is, yes, take you back to those comments I made earlier. Several factors determine what the IDR distribution would be. Distribution growth is one of those factors and a significant one. However, also consider the other things that can happen around the LP units. An ATM program, any drop-down would take back units or any other form of unit issuance will also impact that. Several moving parts will affect the final number.

If we're to look at PSXP, assuming the IDRs weren't restructured and we look at this new PSXP, are you assuming this new PSXP could do more projects and spend more money than if you hadn't done this transaction? Now that your cost of capital is lower?

I think that's a reasonable assumption, Christine. One key advantage of having the IDRs out of the picture is that your cost of equity no longer has that drag from an LP holder standpoint, so that makes the MLP better positioned to execute on projects.

Okay. And then if we're to look at the assumptions for this, the timing of this accretion mass as well. It sounds like if the growth assumptions are different then the equity assumptions should also theoretically also be different in the two scenarios?

Yes, in theory, yes.

I wanted to discuss the results, which exceeded our expectations on the JV equity earnings line that performed quite well. Can you elaborate on the factors contributing to this performance and whether this is a sustainable rate or if there's potential for additional capacity? How should we consider this, especially since we anticipated Bayou Bridge would soon be operational?

Sure, Jeremy, this is Rosy. We had three JVs that really contributed to the earnings this quarter, probably the strongest contributor actually came from Explorer. Seasonally, the second quarter and the third quarter tend to be stronger quarters for Explorer, as products move up to the Midwest during the second quarter specifically. There was more pull from Explorer as more products got pulled up due to some refinery outages in the area. Bayou Bridge was the second most contributor simply from the fact that you saw Phase 2 coming online, and when comparing it to the first quarter, Bayou Bridge had Phase 2 come online. The Bakken pipeline also had stronger performance relative to the first quarter, though not anything that was astronomically different; it ran 559,000 barrels per day compared to 543,000 barrels per day in the first quarter. All three of those pipelines ran really well. From a ratability perspective, Explorer usually sees stronger results in the second and third quarters. Bayou Bridge may improve in the third quarter due to Phase 2 being at full production, while Bakken continues to operate well at its capacity now at 570,000 barrels per day, probably running somewhere in the 540 to 550 range.

That's helpful. And just thinking about how you sit with the balance sheet now with all the projects you have on hand, you have good organic growth there, you were generating a good amount of DCF. Just wondering your thoughts on the need for equity or ATM at this point? And does that factor into the IDR elimination process?

Yes, Jeremy, you're right. Our balance sheet is in great shape, and we have debt capacity. As you look forward with IDRs behind us, would we issue under the ATM or equity? We may consider it depending on market conditions. The nice thing is now we are in a position where we don't have to issue and take a hefty discount on any issuance. This gives the MLP greater flexibility in its funding structure going forward.

Got you. Just a quick housekeeping one. Gray Oak, could you see that landfill had started there? Or not yet? Because it's not all or when do you expect to start if it's 80% complete at this point?

No, it has not started. We just have about 700 miles of the pipeline installed at this point. The lines wouldn't start sometime probably in the fourth quarter.

Great. And just one last one if I could. Clearly, there's been a lot of investor requests to have IDRs eliminated, which has been a big part of the MLP evolution here. I'm just wondering if you've thought about other steps that investors have talked about regarding compensation moving from PSX to PSXP, or any other thoughts there regarding the MLP evolution?

Yes, Jeremy. With PSXP, we acknowledge that we are a sponsored vehicle, so some of those other governance matters that you've seen changes on with MLPs will be more challenging and perhaps less likely to occur in a sponsored structure like ours. The overall nature of PSXP is not going to change.

Can you comment on your appetite for strategic third-party acquisitions in light of the IDR restructuring and pro forma financial outlook?

Yes. As we've discussed, we have a lot of growth ahead of us, both organic at the MLP and a lot of activity is going on at the PSX level. Because of that, we don't need to explore third-party M&A actions at this point. However, with IDRs behind us, we do have more flexibility, and if the right opportunities come along, we could consider them. As always, any third-party opportunities must compete with organic growth, so we evaluate them based on the overall competitive nature of those opportunities, including the return standpoint and strategic fit within the PSXP and greater PSX portfolio. The reality is that this recent change gives us a bit more flexibility to consider third-party acquisitions than we had before, but it's not something we're compelled to pursue.

Kevin, I want to circle back to the earlier questions about the accretion characterization. It's helpful to understand your baseline thought process, particularly since we've seen so many of these transactions where each one claims accretion but often uses different assumptions. You mentioned various items that drive IDR cash flow: coverage, growth rate, unit issuance, and price conversion. If I compare this with what you guided us on the last quarter call regarding 1.2x coverage and leverage under 3.5x—certainly you're running well south of that—there's no immediate plan for a drop-down. We've seen only a penny per quarter distribution growth and on Slide 7; you still haven't assumed that equity conversion. Given this, we struggle to get to accretion. Can you clarify if one of those assumptions was meaningfully different from what we understood?

No, not really. All of those items drive the IDR cash flows next year in that structure. When we provide guidance on both coverage and leverage, we are giving minimums; we aren't providing specific numbers. Coverage of 1.2x is a number we'd expect to be north of. I wouldn't hardwire that into your calculations. We've continued to issue—we've been in the ATM market during blackout periods for several weeks each quarter, but we have been active in the ATM markets. We have our own assumptions about what we will do on drop-downs; we've never provided guidance on those types of transactions, and I think part of what you're struggling with is that we haven't given a lot of specific guidance beyond the previous distribution growth guidance and EBITDA target. So those moving parts are indeed in our calculations, but there's no clear line of sight on our assumptions. All the factors drive it.

Thank you, Julie. I would like to remind everyone of the November 6 Analyst and Investor Day, and hope to see you there. In the meantime, Brent and I will be available for any follow-up questions. Thank you.