Delek US Holdings, Inc. (DK) Q2 2017 Earnings Report, Transcript and Summary

Good morning. My name is Pasha and I will be your conference operator today. At this time, I would like to welcome everyone to the Delek US Holdings Q2 2017 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you. I would now like to turn the conference over to Mr. Keith Johnson. Please go ahead, sir.

Thank you, Pasha. Good morning. I would like to thank everyone for joining us on today's conference call and webcast to discuss Delek US Holdings second quarter 2017 financial results. Joining me on today's call is Uzi Yemin, our Chairman, President and CEO; Kevin Kremke, CFO; and other members of our management team. As a reminder, this conference call may contain forward-looking statements as that term is defined under federal securities laws. For this purpose, any statements made during this call that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words believes, anticipates, plans, expects and similar expressions are intended to identify forward-looking statements. You're cautioned that these statements may be affected by important factors set forth in our filings with Securities and Exchange Commission and in our latest earnings release. As a result, actual operations or results may differ materially from results discussed in the forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. On today's call, Kevin will begin with a review of the financial performance for the quarter. Then he'll turn it over to Uzi for a few closing strategic comments. With that, I'll turn the call over to Kevin.

Thank, Keith. For the second quarter of 2017, Delek US reported a net loss of $37.9 million or $0.61 per basic share compared to a net loss of $7 million or $0.11 per basic share in the second quarter of last year. On an adjusted basis for the second quarter of 2017, Delek US reported an adjusted net loss of $25 million or $0.40 per share compared to an adjusted net loss of $5.1 million or $0.08 per basic share in the prior-year period. A reconciliation of reported results to adjusted results is included in the financial tables of our press release. Both reported and adjusted results in the second quarter of 2017 included a hedging loss of $31.7 million or $0.31 per share after-tax related to a realized loss on a crude oil inventory hedging strategy associated with the J. Aron supply and offtake agreement at El Dorado. The hedges were entered into in late 2014 in anticipation of the expiration of the supply and offtake agreement in the second quarter of this year. However, we elected to extend the maturity of that agreement until April of 2020. The primary driver that changed on a year-over-year basis was reduced performance in our refining segment, which I will discuss in more detail in a few minutes. We completed the acquisition of the remaining outstanding common stock of Alon that we did not already own in an all-stock transaction on July 1. For the second quarter of 2017, our 47% investment in Alon USA resulted in a pretax income of $400,000 compared to a loss of $10.4 million in the prior-year period. Delek's equity investment income from Alon was reduced by approximately $1.1 million for transaction costs that Alon incurred during second quarter 2017. Due to the timing of the completion of the acquisition on July 1, Alon will not file a quarterly report on Form 10-Q or issue a press release to announce quarterly results. I would like to point out that Delek US provided supplemental financial data for Alon's second quarter performance on our Form 8-K filed August 2, 2017. Our operating expenses increased by $4.3 million compared to the second quarter of last year, driven primarily by increased outside and contract services. General and administrative expenses increased $3.9 million on a year-over-year basis, mostly due to transaction-related costs. Finally, our income tax rate, excluding the non-controlling interest income associated with Delek Logistics of $5.7 million was 41.6% in the second quarter 2017. Turning now to capital spending, our CapEx during the period was approximately $15 million compared to $7.1 million in the second quarter last year. During this second quarter, we spent $11.2 million on our refining segment, $2.1 million in our logistics segment and $1.7 million at corporate. Our 2017 capital expenditures are forecast to be $95 million, which compares to $46.3 million in 2016. This amount includes $63 million in our refining segment, $21.1 million in our logistics segment and $10.9 million at the corporate level. This compares to our previous estimate of $89.2 million for Delek US prior to the Alon transaction. In addition, during the second half of 2017, we expect to spend approximately $75 million related to the Alon operations acquired on July 1. This equates to a 2017 forecast capital spending of approximately $170 million total. We ended the second quarter with approximately $572 million of cash on a consolidated basis and $250.2 million of net debt. Excluding net debt at Delek Logistics of $392 million, we had net cash of approximately $142 million at June 30, 2017, and Alon had approximately $250 million of cash and $564.8 million of total debt. On a combined basis at June 30, the company would have had a projected capitalization of approximately $790 million of cash and a net debt position of approximately $600 million. If the net debt at DKL is excluded from the combined capitalization, the net debt position would be $208 million. Now, I would like to discuss our results by segment. In our refining segment, we reported a contribution margin of negative $14 million compared to contribution margin of $40 million in the second quarter of last year. Market conditions improved on a year-over-year basis as the Gulf Coast 5-3-2 crack spread increased to $10.86 per barrel for the second quarter 2017 compared to $9.80 per barrel for the same period last year. Also, RINs expenses declined to $5.5 million in the refining segment from $12.3 million a year ago. These improvements were offset by a combination of factors. First, there was an inventory charge of $14 million in the second quarter of this year compared to a benefit of $12.9 million in the prior-year period. Second, this quarter included a net hedging loss of $29.5 million compared to a $17.4 million hedging loss in the prior year period. As I described earlier, this hedging loss includes the approximately $31.7 million realized loss on hedges associated with the J. Aron agreement that reduced performance of the El Dorado refinery. Third, lower margins on residual products, including asphalt, contributed to reduced margins at El Dorado. The combined contango in Midland-Cushing differential benefit declined by approximately $0.24 per barrel on a year-over-year basis. This consists of a favorable differential between Midland and Cushing that averaged $0.83 per barrel discount in the second quarter of 2017 compared to a discount of $0.18 per barrel in the prior-year period and contango in the crude oil futures market that was $0.54 per barrel in the second quarter of 2017 compared to contango of $1.43 per barrel last year. Now, I'd like to review our logistics segment, which is comprised of the results from Delek Logistics Partners. Our logistics segment contribution margin was $31.7 million in the second quarter of this year compared to $30 million in the prior-year period. On a year-over-year basis, improved performance in the West Texas wholesale business offset lower performance from the Paline Pipeline and SALA Gathering System. I will now turn the call over to Uzi for his closing remarks.

Thank you, Kevin. First, I would like to thank the employees of both Delek and Alon for their efforts to close the transaction on July 1. We are very excited about the future of the combined company and look forward to working with both organizations as we integrate the operation. We're on track to create approximately $95 million of synergies in 2018 and integration is moving forward with the efforts underway to apply best practices of both companies to the combined organization. In addition, our teams are focused on unlocking the value of approximately $78 million of logistics EBITDA through future potential drop downs to DKL. We believe that our company is well-positioned in the Permian Basin with approximately 200,000 barrels per day of access or approximately 75 million barrels a year. By partnering with DKL, we can utilize our logistic system to support this large operation through crude oil and large product initiatives in the future. Based on June 30, the combined Delek and Alon cash balance was approximately $790 million. This financial flexibility should support our effort as we move forward with the integration and evaluation of potential growth opportunities, while remaining focused on creating long-term value for our shareholders. With that, Pasha, would you please open the call for questions?

Pasha?

[Operator Instructions]. And your first question is from the line of Roger Read.

Sorry, I had to get the mute off there. I guess, I'd like to get into what exactly we should think about the performance of El Dorado. Kind of a tough quarter here. I know you called out the non-clean products, but would have expected a light crude refiner to have done a little bit better in that region this quarter. Just curious if there was anything else that went on there.

That's a great question, Roger. Good morning. We didn't want to go on the press release with the noise that we had in El Dorado this quarter. But all over, in El Dorado, we had $12 million, if you will, of charges and stock that usually doesn't happen. So, let me call these three components. The first one, we had a true-up of some benzene credit that we bought three years ago or a couple of years ago. And the market on benzene credit went down. And we bought two years ago with much higher price. We still have the credit, but we marked it down. That's a non-cash event. That's around $4 million. Also, we had Colonial impacting us and the netback along the Colonial which since then improved by $4 million. And we did say the asphalt impact, we could quantify for you guys, it's around $5 million. So, altogether, we're talking about $12 million, $13 million. We round it down to $12 million. So, if you take that $12 million and you apply it by barrel, you'll get the difference then why there was so much noise in this quarter that shouldn't exist in other quarters.

Okay. So, yeah, it looks transitory for the most part.

That is correct. When Keith will talk to you guys and other investors, he will explain that we didn't want to go into much details in the press release or in the conference around that. But that $12 million are certainly missing in El Dorado for the quarter. Obviously, we don't expect them to continue in the future. For sure, the markdowns of benzene credit shouldn't happen anymore. Actually, it's a benefit of these credits and they went down.

Okay, great. I know you're probably a little early in the integration process to give us a whole lot to think about different than what's been laid out with the Alon acquisition. But from a cash standpoint, and like you called out, Kevin, earlier on the call, really strong balance sheet here. Uzi, where do you think you are in terms of changes to shareholder returns, whether it's a higher dividend, share repurchase. What's kind of the way to think about that process?

Obviously, we are early – Roger, and you know that we're early in this process. We've said very strongly in our comments, our prepared comments, that the synergies that we see, we don't feel that we're coming short of these synergies. Actually, we are very encouraged with what we see and we expect to start seeing some benefits in the near future. With that being said, the third quarter started pretty nicely. Prices are good. The synergies are going our way. Fourth quarter is doing fine with Midland being 150 under. So, if this continues, then we will need to consider very carefully if we want to start being more aggressive via our buyback program, which we have. We need to be a little more patient with that, but we are pretty optimistic about it.

Okay, great. Thank you.

Your next question comes from the line of Phil Gresh.

Yes. Hi, good morning.

Good morning.

First question, I just want to clarify the capital spending numbers that you gave. I think you said $75 million for the ALJ asset in the second half. Is that correct?

That is correct.

Okay. And I think – obviously, things change. Standalone ALJ was $80 million for the full year previously. So, maybe you could just elaborate on what types of things you're spending money on in the second half of the year for ALJ?

Well, as you probably saw, the Big Spring refinery is about to sign a consent decree. So, that will require some projects in Big Spring. Also, as we are looking forward on the – and that's more important, on the Krotz situation, we know it needs attention. So, we haven't decided to do everything, but we are looking at it very carefully. We have a program that will try to improve Krotz significantly. And we wanted to come to the market and say that there's a possibility that we'll start spending money on this facility.

Sure, okay. The second question is just with the potential drop-down to the second half of the year. Is there expectation at the DK level that it would be 100% cash proceeds? And how are you thinking about debt equity mix and is there any circumstance where you would take units?

As DK as it is today, probably not.

Okay, 100% cash. Okay.

Now, everything can change. The market can go up or down. But as we see it today, probably not.

Okay. So, I guess – I know Roger kind of asked this, but maybe a slightly different way to ask, it would be, how do you think about leverage, pro forma leverage moving forward and where you'd be comfortable having it? I know there are some balls in the air here, ALDW and maybe additional spend across and other things.

Yeah, that's a great question. Excluding DKL, we never want to be more than one time.

Okay, got it. Okay, that’s it for me. Thanks.

Thank you.

Your next question comes from the line of Paul Cheng.

Hey, guys. Good morning.

Mr. Cheng, good morning.

Maybe it's way too early, is there a timeline that you would put for the resolution for ALDW?

It's too early to discuss it. We're, obviously, looking at that. We said all along it doesn't make sense to have three public companies. Or actually, it used to be four; now, it's three. But also, it depends on the returns. And if the ALDW doesn't make sense, we already proved to market that we can be patient. And it makes sense, obviously, to consolidate that thing, but it needs to make sense also from economic standpoint.

Sure. Why at this moment that you do not have any definitive timeline that you will be able to share?

Well, we are doing the work that we can pull the trigger. But the trigger, it depends on the market condition. So, it's not that we are sitting on our butts and doing nothing. We are doing the work. But we are, obviously, not going to overpay for ALDW. So, we need to be patient.

And somewhat question then. In terms of the timeline for your evaluation for Krotz Springs, that has always been probably the weakest offset. You are talking about that you may want to spend some money. But what kind of metrics you're going to measure them against? And how much time you're going to give that authority [ph] before you may decide that whether that – it should be a continued operation?

That' a great question, Paul. As we told the market and I told you privately in the past, there are three components to Krotz. First, the cost to bring the barrels to Krotz. Not the barrels themselves, because some of them are actually Midland. The problem is the cost to bring it over. Second is the operation itself, which requires capital, as you know. And third, the sale of the product that needs attention as well. We have a full team already sitting and thinking about these three components. We meet on a regular basis and we need to see if we can come to a resolution that we can find a way to improve it. Right now, I am more optimistic about it than I was in the past. But I don't want to declare any victory or to be ahead of myself in that area.

Because I think you're probably well aware that the IMO 2020 is probably going to make it very challenging [indiscernible] with the current configuration of Krotz Springs [indiscernible] you're going to make the investment there to trying to [indiscernible] high sulfur product more that – maybe that is to really consider shutting that down.

Well, I wouldn't jump into conclusions that we need to do a high sulfur or a ultra-low-sulfur diesel in Krotz. If you remember – or maybe let me refresh your memory, we have access capacity both in Tyler, in El Dorado. And we already have a project that is working, we just now started that we're selling in Tyler ultra-low-sulfur diesel barrels to Mexico. And the netbacks are pretty healthy over there. So, I wouldn't jump into conclusions that we need to put that investment in place. And I am very well aware of the 2020.

And on retail, is that going to be viewed as internally a core part of your long-term portfolio or would that – you will be looking to monetize, given the continued very strong valuation on the market for asset being changed hands? So, how should we look at the retail inside your portfolio?

Well, as you know, we weren't afraid to monetize our Delek's retail a few months ago. But the Alon retail, it will need attention. Again, it will need some capital with megastore, the building megastores that are planned today. We'll start building megastores and then put ourselves – because the market over there is very, very strong because of the Permian activity. And then, down the road, maybe we'll look at it. But it's not on the table and not for sale for the next year or two.

Okay. Two final quick one. One is a simple accounting question. Given for the full year, your average ownership for ALJ will be way over 50%. Is that at some point you need to restate the first half result there to combine to the fully consolidated operation, and so a possible consolidation using equity accounting in the first half? And final one, as the company become bigger, will you relook at your hedging strategy and whether that you should continue to do hedging? I think we have seen many of your peers, especially the bigger one, they have tried and have been quite unsuccessful in their hedging strategy. And ultimately, they just abandoned and not doing hedging.

Let me take the second one because it's a business question and not an accounting. And then Danny or Kevin will take the first one. The hedging program was very successful for us. I realize that we have a charge here of $0.31 because of our protection of inventory with J1 [ph]. But let's be clear, if we want to get out of these agreements, we really don't want prices to go up because then we will need to pay tremendous amount of money for that inventory. That was the idea behind that. Do I like to lose $0.31? Absolutely not. But at the same time, do I want crude oil to go back to $80 and need to pay somebody $200 million against that? That's probably extra. That's probably something I don't want to do either. So, let's just put that in context. From a big picture standpoint, yes, of course, there's noise again. And there, of course, again, that it goes with you. In the last few quarters, because of all this J1 [ph] situation, it went against us. But at the same time, it was very successful for us and we will be the – and we will need to evaluate that every quarter. But that's another tool in our toolbox. In regards to the accounting question, Danny, I don't know if you want to take that one.

Sure. Paul, it's Danny. So, as you're aware, the investment that we had in Alon prior to July 1 was treated for accounting purposes as an equity investment. July 1 forward, we will be consolidating those Alon assets into Delek US and be fair valuing that balance sheet and bringing that into the consolidated Delek US. Does that answer your question or do you have a further question based on that?

When you report the 10-K on a full year basis, since you have more than – way more than 50% equity ownership average for the year, do you need to – in the 10-K report it as a fully consolidated operation?

We're still looking at that, Paul. But, right now, our thought is that we will just report the last six months of the year under fully consolidated and then the 47% we had prior to that stay in equity income. But that's still under review, not fully decided, but that's where we're at at the moment.

Thank you.

Your next question comes from the line of Neil Mehta.

Hey, good morning, team.

Hey, Neil.

Good morning, Neil.

I'm sorry. Neil's question was withdrawn. We do have Chi Chow online.

Chi, are you on?

Yeah. Yeah, yeah.

Go on. Sorry, Chi. Good morning.

Good morning. I’m not quite sure what happened there. Okay, yeah. Just a couple of questions here. On the upcoming midstream drop, do have the EBITDA associated with the asphalt terminal?

We didn't disclose that just yet. We do have the EBITDA. But let us work on that a little more and then talking about dropping it down.

Okay. Any thoughts on the pace of the remaining drop going forward?

I'm sorry. What is the question?

The pace of the remaining midstream drop?

Yes. 18 to 24 months.

Okay. Okay, great. Then I guess another question back on El Dorado. The benzene credit...

Chi, just one thing. Let me have a correction here. We have it public. So, let me give you the asphalt terminal. It's $11 million to $13 million.

Sure.

My apologies. Yes.

Okay. Thanks for that. And then back on El Dorado, this benzene credit mark-to-market issue, is that truly one-time or is this going to float around every quarter?

I need to explain it again because – and again, it's technical. El Dorado is short benzene credit. So, we went ahead two years ago and bought bunch of them. Then price of benzene credit went down. So, we took the hit this quarter for all of that benzene credit inventory. It's a non-cash event. It used to be a $1; now it's $0.20. If the market goes to $0.10, then you'll have another charge, but nothing to this magnitude.

Okay. But technically, it does – it's going to float every quarter?

Maybe $200,000, but not $4 million.

Okay. Okay. And then you mentioned – I think it came up, this IMO bunker fuel set change, how are you thinking about that impact longer-term on the asphalt market? You have a high yield of asphalt at El Dorado. You've got the asphalt terminals. Any concerns on that part of the business once the IMO…?

Well, first, let's talk about the high yield of it. It's roughly 10%. We out of total production of all companies – and we have in Big Spring 3,000 or 4,000 of – we're talking about 10,000 barrels out of 300,000. We're looking at that. We think this is an opportunity because the demand for asphalt is growing. Hopefully, the bill will pass finally. But that's, of course, an area that we're looking at.

And your next question comes from the line of Neil Mehta.

Hey, good morning, team. Can you hear me?

Hey, Neil. Good morning.

Morning. I want to just start off talking a little bit about the $95 million of synergy. I know it's early. We're going to get a little bit more color later this year. Anything that you're seeing that will lead you to think that you can't achieve the $95 million of synergies run rate or that there could be potential areas for upside? And can you talk about where those potential value drivers can be?

It's too early to talk about upside, but we see no reason to believe that $95 million won't be achieved.

Okay. Got it. All right. And then ALDW, I know there's – there's an element of not wanting to broadcast the strategy here. But can you just talk about how you think about ultimately bringing that into the fault

Absolutely. As I've said, it doesn't make sense to have ALDW as a different public company. At the same time, it needs to make sense financially. And we're doing the work. We'll be already if the market is right. And if not, we'll wait. Similar to what happened with ALJ.

Got it. All right. And then on WTI Midland, I know we haven't talked about it a lot on this call. There have been some pipes that have been announced. Not a lot of them have been contracted out. But what are your thoughts in terms of the differential from here? And let's break it up into two parts, kind of more of a near-term look and then – and a longer-term look for the spreads?

Near-term, I think that $1 to $1.50 – we actually see the forward curve at $1.50 for the fourth quarter. Next year, I would say anywhere between – or let's call it, over the next two years, $1 to $2. And after that, I think it's $1.50.

Perfect. Okay, last one, Uzi, is just – we've talked a lot about the Mid-Con and the need for consolidation. You're doing a good job of starting that process, obviously. Tesoro is as well with Western, but there's still a lot of little players out there. How do you think about the role of Delek in terms of consolidation and incremental M&A in the Mid-Con area?

Well, I didn't change my mind, Neil, that consolidation needs to continue. And not only in the Mid-Continent, several more companies, us included, will – as the time goes by, we'll consolidate with each other. Do I know of anything specific for Delek? Absolutely not. But Delek will be a player. Delek is not afraid to be active in the M&A market. And we believe with the synergies of Alon and the – and again, it's early to say, but we're very optimistic with the things that we see. Now that needs to still be played out in order to see how it's being translated to the M&A market.

All right, great. Thanks, Uzi. Appreciate the color.

Appreciate you, Neil. Thanks.

And your next question comes from the line of Kalei Akamine.

Hi, guys. Good morning.

Good morning.

Hey. Just a couple of housekeeping questions from me on the drop-downs. So, as it relates to ALDW, does the entity need to be consolidated into DK or you can execute on those planned drop-downs of the Big Spring assets into DKL?

We prefer that. Hey, guys. I hear myself twice. So, we do prefer that, but it's not that much. We can work around it and we're doing the work both ways.

Got it. I understand. Separately. So, ALJ currently reports asphalt as a stand-alone segment. And you guys are talking about stripping off the terminals in drop-downs. This essentially exasperates those already pretty volatile earnings. Are you going to continue to report this segment as a stand-alone going forward?

We haven't decide that, but probably not.

All right. Thanks for the answers.

Thank you.

[Operator Instructions]. At this time, there are no further questions.

Thank you, Pasha. First, I would like to thank my colleagues around the table for their hard work that they're putting into this company. I'd like to thank you guys on the phone and other investors and analysts for your interest in our company. And lastly, I'd like to thank our employees for the great work that they're doing for this company. Thanks. And we'll talk to you soon.

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.