ADNOC Distribution (ADD) reported 3Q18 results, with headline earnings +55% Y-o-Y, driven by better margins partly on inventory gains and some cost efficiencies. The solid earnings growth comes despite AED29mn in additional net finance costs due to the USD1.5bn facility from Nov 2017. Excluding inventory gains, net income would be up 33% Y-o-Y. We do not have quarterly estimates due to the lack of historical quarterly financials. Revenue grew 24%, mostly on higher fuel prices (pump prices are reset monthly). Total fuel volumes fell 5% Y-o-Y (partly affected by longer public holidays; 9M18 volumes -2%). Gross profit rose 26% Y-o-Y, with gross margin widening c40bps Y-o-Y to 21.4% as a result of the new refined products supply agreement with ADNOC Group (effective 1 Oct 2017), in addition to the positive impact on inventory from rising oil prices (AED79mn in 3Q18, AED293mn in 9M18). EBITDA margin rose a greater c1.5pp Y-o-Y to 12.0%, with EBITDA +42% Y-o-Y (+26% excluding inventory gains) on cost efficiencies with distribution and administration (D&A) expenses up only 4% Y-o-Y. Adjusted for depreciation (increased largely because of the transfer of some refining assets), the impact of the civil aviation supply carve-out (including relevant expenses from 1 Oct 2017) and non-recurring restructuring costs (AED37mn in 3Q18), D&A expenses would have been 10% lower Y-o-Y.
 
Segment details and other info:  
        Total retail revenue (c67% of 3Q18 top-line) +21% Y-o-Y, mostly due to the increase in fuel prices (on higher oil prices), which was partly offset by a 6% dip in volumes (-3% in 2Q18). Throughput per station (in litres) declined 7% Y-o-Y, while the no. of fuel transactions was almost unchanged (+2% Y-o-Y). 
        Meanwhile, non-fuel segment (mainly convenience stores) generated higher revenues as average basket size rose 22% to AED18.4, offsetting a 16% decline in number of non-fuel transactions, which were down due to the introduction of excise tax on tobacco and sugar tax on soft drinks in Oct 2017 and the VAT in UAE in Jan 2018. 
        ADNOC Flex (premium and self-service refueling) was introduced in Jun 2018 and is launched across all stations from Oct 2018, with average uptake of 20%.
        The company added four new petrol stations in 3Q18 (5 YTD) to reach 364 locations and six c-stores (241 total). It is looking to open 13 new stations (3 to open in Dubai) and 13 new c-stores in 2018. 
        Total retail segment (fuel + non-fuel) gross profit +34% on higher fuel margins (due to new supply agreement with the parent, effective 1 Oct 2017) and the positive impact of higher oil prices on inventory, with fuel retail gross profit rising 38%, while segment EBITDA almost doubled (+98% Y-o-Y). 
        Commercial segment revenue (c23%) +33%, mainly due to higher average selling prices. Volumes sold were flat Y-o-Y (all products rose, except for diesel). Gross profit +9% Y-o-Y, mainly on higher fuel margins post new agreement with ADNOC Group and inventory gains. EBITDA, however, dropped 2% Y-o-Y. 
        Aviation revenue (c9%) rose 32% Y-o-Y because of inclusion of revenue derived from refueling services for airlines and higher selling prices that offset a 16% decline in volume (lower sales to strategic clients). Aviation gross profit +35%, EBITDA -22% (due to lower volumes and the inclusion of recoverable operating cost related to civil aviation fueling services). 
        Capex in 9M18 fell 61% to AED527mn. The company’s guidance for 2018 capex is less than AED700mn, with c10% reduction in new service station construction costs achieved. 
 
While we are positive on the cost initiatives, we are wary of the declining volumes and inventory gains that will reverse as oil prices drop. Initial off-take of ADNOC Flex (c20%; introduced in Jun 2018 and rolled out across the network in October) is also low, but penetration of the service is likely to improve over time. We have a Buy rating on the name as we continue to like its: i) best-in-class profitability (LT net margin c10%, ROAE c40%+); ii) high site throughputs; iii) strong parent support; and iv) potential from boosting high-margin, non-fuel revenue that should drive 2018-19e earnings CAGR of 17%. 

Hatem Alaa, Nada Amin, Mirna Maher
 
ADNOC Distribution (AD): AED2.38 as of 15 Nov. 2018, Rating: Buy, TP: AED3.20/share, MCap: USD8,106mn, ADNOCDIS UH/ADNO.AD