Good morning, ladies and gentlemen. Welcome to the Spark Energy, Inc. Third Quarter 2018 Earnings Conference Call. My name is Ashley, and I will be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time.

[Operator Instructions] As a reminder, this conference is being recorded for replay purposes, and this call will be posted on Spark Energy, Inc's website. I would now like to turn this conference over to Mr. Christian Hettick with Spark Energy, Inc. Please go ahead..

Thank you, Ashley. Good morning, and welcome to Spark Energy, Inc.'s third quarter 2018 earnings call. This morning's call is being broadcast live and also via webcast, which you can find on the events and presentations in the Investor Relations section of our website at sparkenergy.com.

With us today from management is our President and CEO, Nathan Kroeker; and our Vice President and CFO, Robert Lane. Please note that today's discussion contains a number forward-looking statements which are based on assumptions that we believe to be accurate and reasonable as of this date.

Management may make forward-looking statements concerning future expectations, operating projections, economic performance and regarding our financial conditions. These statements are subject to risks and uncertainties, and actual results may differ materially from these statements.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we give no assurance that such expectations will be realized. We urge everyone to review the Safe Harbor statement provided in yesterday's earnings release as well as the risk factors contained in our SEC filings.

We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. During this morning's call, we will refer to both GAAP and non-GAAP financial measures of the company's operating and financial results.

For additional information regarding our non-GAAP financial measures and reconciliations to the most directly comparable GAAP measures, please refer to yesterday's earnings release. We would also like to invite you to check our website regularly as we use it to disclose material information and to comply with our obligations under Regulation FD.

That web address is ir.sparkenergy.com. With that, I'll turn the call over to Nathan Kroeker, our President and Chief Executive Officer..

Thank you, Christian. I want to welcome our shareholders and analysts to today's earnings call. I'll begin by providing a summary of our results for the third quarter. After that, our CFO, Robert Lane, will provide more details on the financials, and then we'll close with some brief remarks before opening the line for any questions from our analysts.

In the third quarter, we reported adjusted EBITDA of $18.6 million and retail gross margin of $45.8 million, this compared to $19.6 million and $50.6 million, respectively, in the third quarter of last year. Taking a closer look, there are 2 drivers that contributed to the lower retail gross margin performance in 2018.

Earlier this year, we purchased additional power to provide insurance against adverse weather events in Texas over the summer.

In addition, as we have mentioned on other calls this year, we are still experiencing the residual effects of the hedges we put in place in the first quarter to mitigate last winter's extreme cold weather, along with the increased capacity costs in New England.

As these hedges roll off and as our customer mix shifts towards more mass-market customers, we see unit margins returning to historical levels.

Absent a onetime reduction from the revaluation of one of our contingent liabilities, our G&A for the third quarter actually improved by 21% year-over-year and adjusted EBITDA for 2018 would have been 32% higher without that item.

Looking forward, we expect the impacts from last winter's hedges to roll off by the end of this fiscal year, and the impact of the low-margin C&I contracts to decrease by the spring as we continue to manage that portion of our customer portfolio. Our team has done an excellent job driving costs out of the business, but we're not done.

We were very pleased to announce in yesterday's release that we expect to exceed our targeted range of G&A cost savings. We now expect to generate between $22 million and $23 million of run rate savings by year-end 2019.

As we've discussed on prior calls, we believe the best way to deliver long-term value to our shareholders is to continue streamlining our operations and focusing on our core mass-market customer book, utilizing organic sales channels, complemented by opportunistic acquisitions. That concludes my prepared remarks.

And with that, I will now turn the call over to Rob for his financial review..

Thank you, Nathan. Good morning. In the third quarter, we achieved $18.6 million in adjusted EBITDA compared to last year's third quarter of $19.6 million. Total retail gross margin for the quarter was $45.8 million compared with $50.6 million last year.

In our retail electricity segment, gross margin was $40.3 million, a decrease of $4.2 million from $44.5 million in the third quarter last year.

Volumes were higher than last year, but margins were lower as a result of the commercial segment increasing as a proportion of our overall book as well as the market movements and hedging strategies that we mentioned earlier. In our retail natural gas segment, gross margin was $5.5 million versus $6.1 million in the third quarter last year.

This slight decrease was a result of lower volumes, partially offset by increased unit margins. G&A expenses of $25.7 million were relatively flat as compared to the prior year quarter. Again, last year's third quarter G&A expenses included a $6.9 million credit, absent of which, G&A actually declined year-over-year by 21%.

As Nathan discussed, we have made excellent progress this year to reduce G&A expenses and expect to exceed $20 million in annualized cost savings. Total RCE count in the third quarter was 979,000 RCEs, up 1.7% compared to the prior year as a result of commercial growth and acquisitions, and down 6.7% from the second quarter.

Our attrition was 4%, up slightly from 3.7% a year ago as a result of our brand consolidations. Interest expense for the quarter was roughly flat compared to last year at $2.9 million. Income tax expense for the quarter increased to $3.8 million as compared to $2.5 million in the prior year, primarily due to the increase in taxable income.

Our net income for the quarter was $18.8 million or $0.27 per fully diluted share compared to net income of $12.9 million or $0.11 per fully diluted share the prior year. The increase in net income is primarily driven by non-cash mark-to-market accounting associated with the hedges we put in place to lock in margins on our retail contracts.

We had a mark-to-market gain of $18.9 million compared to $4.9 million a year ago. As we've reminded investors in the past, the non-cash mark-to-market movements do not affect the actual cash we expect to receive on our fixed-price contracts. On September 13, we paid a quarterly dividend on our Class A common stock.

And on October 15, we paid a quarterly dividend on our Series A preferred stock. As previously announced, we will pay our common stock dividend of $0.18125 per share on December 14, and preferred stock dividend of $0.54688 per share on January 15.

As we've stated in the past, we expect to continue to pay these quarterly dividends on a go-forward basis. That's all I have. Back to you, Nathan..

Thanks, Rob. One quick note on our winter strategy before we turn the call over for questions. We are approaching this winter much like we approached last summer, buying additional length to provide downside protection in the event of an extreme cold snap like we experienced last year.

Our goal is to keep the book fully hedged with this added safety net just in case. We're confident that we're implementing the right strategies is to maximize value for shareholders, and we're looking forward to delivering year-over-year growth in adjusted EBITDA next year. With that, I will now open up the line for questions.

Operator?.

Thank you. [Operator Instructions] And our first question comes from the line of Carter Driscoll with B. Riley FBR. Your line is now open. .

First one is, in the context of your proactive approach to ward off the potentially severe weather effects that you had earlier this year on a go-forward basis, could you talk about or maybe quantify the economic impact of implementing those hedges in the context of your operational savings targets? I mean, could you have achieved a higher one? Or was that achievement of the 20% that you anticipate end of this year, already baked into your plans to fully hedge your book? Just trying to get a sense of the different moving parts and trying to really drill down into the operational cost savings on a go-forward basis as well..

Yes. Carter, good question. I think it's a 2 separate line items. The G&A cost savings that we're talking about are all in our G&A line item. The cost of the incremental hedges, and in this case, it's actually some out of the money call options, so option premiums, is all in gross margin..

Got it. Okay. So none of it will be overlapping. You had a nice book pickup, I think should begin to impact 4Q '18.

Can you talk about the valuation of other books or other types of M&A? Are there similar types of books available? Are they smaller in size? Are people's expectations coming down from where they were in the first part of '17 or latter part of '16? That seem to be less accretive than they had been in the past.

Trying to get a sense of those opportunities to grow, again, inorganically, first..

So couple of thoughts. We're seeing a number of different M&A opportunities, upwards of half a dozen that we've seen in the last few months, all kind of similar size to the deal we did.

And I would say, from our perspective, most everything that we see, we need to look at as a book purchase, meaning it doesn't bring us a lot, other than the value of the customers. So we look at it in value on a per-customer basis.

And if we can buy that book for significantly less than what the discounted cash flow model is telling us it's to produce, we're looking at doing acquisitions like that. On this particular deal, if I had a blank sheet of paper and could just map out the perfect acquisition for us, I think it checks all the boxes.

It's in the right markets, it's a mature customer base, it's got a good mix of fixed and variable and we bought it as a significant discount to what the DCF model's telling us it's going to produce over the next several years..

And just remind me, is the rough electric/natural gas split of that book?.

It's virtually all electricity..

All electricity. Okay. Are there plans to, I mean, you do get better unit margins on the natural gas side. Are there plans to add to that side of the book? Your most recent acquisitions are really leveraging more to the electricity side than natural gas.

Is it a conscious decision to move in that direction? And any thoughts of trying to balance it more with natural gas?.

Yes. We would like to see gas become a larger portion of our customer book again. In the past, it's been as high as 40%. But with some of the recent acquisitions, that's obviously a lot lower now.

I will tell you that organically, we're actively marketing both in gas-only utilities as well as in all of our dual-fuel markets, and we believe that will result in gas becoming 25% of the overall portfolio again going forward..

Okay. There's a couple of clarifications. Maybe so you talked about the effects of the hedges for Texas rolling off, if I heard you correctly, by year end, but maybe some of the book issues from the past, not till spring of next year.

Is that correct? And if so, is there any way to quantify the magnitude of either or both?.

So let me clarify first. The hedges we did in Texas were July, August, September of '18, that's all behind us. And so we basically bought additional length to protect from price spikes. Didn't have a lot of price spikes, so ended up selling those hedges back and taking a small loss on it. That's all in the rearview mirror.

The piece that ends at December 31 is the carryover effect from the calendar strip hedges that we put on back in January in order to mitigate some of the collateral exposure in New England. Piece that's still in here through third and fourth quarter, but those all end at December of '18.

The piece that you're referencing that carries into '19 is the continued shift of our customer portfolio where we're not renewing a lot of those less profitable C&I customers. And you're going to continue to see us have a higher concentration of mass-market customers going into '19..

Okay. Excellent. That's helpful. And then is there any plans, I mean, you have very consciously focused on reinvigorating organic growth, you talked about going after some gas-only markets, but you have had some forays and some success in the Japanese market.

Any update there? I mean, I realize it's a fairly glacial-moving market, but it is a very large opportunity as well. Is it, are you still kind of on a holding pattern? Trying to see if it deregulates more fully. Seems to be the one promising market internationally for you right now..

Yes, I mean, our business continues to grow over there. We're upwards of 120,000 customers today. We're currently working with our partner over there to develop new products. The challenge in that market right now is there's just no forward market.

So we've got bilateral supply, but anything in addition to our bilateral supply agreements, we're exposed to the day-ahead market. So we're trying to make sure that we focus on new product development and can pass some of those costs through before we double down on that market.

But that's not really any different than where North America was in its early stages. So I'm very encouraged by it, but I think we need to figure out how to we get a robust forward market and more diverse product selection on retail side..

And then maybe just going back, one last one for me is, when you think about buying a book versus a brand, can you talk about what you'd be willing to pay up if you think the brand has value? I mean, is it a 1-turn or a 2-turn difference between just acquiring a book versus a brand? Just trying to get a sense of the magnitude of what you'd be willing to pay in particular if you think the brand had value..

Yes. If you look at what we've bought historically, we've been buying new markets or new products or new sales channels. Any of that justifies a kind of EBITDA multiple purchase price. And I think if you look at all the deals we've done, they've all been definitely below 4 turns before synergies, probably concentrated around 3 turns.

When we buy books, we really don't look at it on an EBITDA multiple basis. I'm just buying a book of customers and I'll pay something less than the DCF for those customers. So I'm not thinking of that in the same way..

And our next question comes from the line of Mike Gyure with Janney. Your line is now open. .

Yes, can you guys talk a little bit about, I guess, customer acquisition costs, how much you spent this quarter? And I guess, maybe your expectation going forward? It looks like you're more focused on acquisitions versus developing customers, but can you talk a little bit about that?.

Yes. We, I mean, as you know, early in the year, when we run into the challenges last winter, one of the things that we needed to do in order to conserve cash and manage through that was to cut back on CAC dollars for a period of time. We did that. It takes a while to ramp these channels back up.

If you see the third quarter, we spent $2.7 million in the third quarter, but that was all heavily weighted toward the back-end of the third quarter as we're ramping up those channels.

And our expectation is that we continue to ramp up our organic sales channels over the next couple of quarters to the point where we're maintaining and growing that mass-market book going forward..

And then maybe on financing and liquidity. I think I saw somewhere that your financing the book of 60,000 customers with debt.

But can you talk about, I guess, how you feel kind of into the winter, your liquidity this year versus last year? And kind of what your expectation is for financing acquisition?.

So that, we just paid for that book out of our, out of cash we had on the balance sheet. We didn't take any additional debt down for that deal. But then in terms of next winter, we've taken several steps to mitigate the effects that we saw last year.

One, as I said earlier, we've got, we're fully hedged, plus we have the additional insurance in the form of the out-of-the-money call option. We've taken steps to shift from being primarily financial hedges to having a balanced portfolio of financial and physical.

The physical, obviously, doesn't have the collateral implications that the financial does. And we have a much stronger balance sheet going in than we did a year ago just because we've done the preferred raise earlier this year. So I feel like it's significantly better than how we were positioned in December of last year..

Great. And then maybe lastly on the attrition. I think it sounds like you're sort of intentionally okay with increasing some of the attrition rate as you sort of move from residential to some of the mass-market products.

But can you talk a little bit about that and your expectation for the attrition rate going forward?.

Yes, our long-term view continues to be around 4%. We believe 4% is where we maximize lifetime value of the customer relationships. It's a trade-off between unit margins and returns and attrition. And that number is going to fluctuate a little bit.

We tend to have slightly higher attrition when we're on more organic sales activity, that number comes down if we pull back on sales activity. But our long-term view is in the low 4s..

Thank you. Ladies and gentlemen, this concludes today's Q&A session. I would now like to turn the call back over to Nathan Kroeker for any closing remarks..

I just want to say thanks to everybody for participating in today's call, and we look forward to talking to you soon..