Otter Tail Corporation: Currently Benefiting From Unsustainable Trends (NASDAQ:OTTR)

pedrosala Otter Tail Corporation (NASDAQ:OTTR) is a very unique electric utility that operates primarily in the U.S. states of Minnesota, North Dakota, and South Dakota. The company’s operations do not include any of the major cities in this area, however, so its customer count is much lower than might be expected given the 5.74 million population of Minnesota. After all, a relatively large proportion of that state’s population resides in the Twin Cities region, while the rest of the state remains rather rural. The same is true of both Dakotas, as neither state has a particularly high population. This rural service territory does not prevent the company from running a profitable electric utility on behalf of its investors, however. The company’s unique nature comes primarily from the fact that it also owns a manufacturing arm that focuses on the production of various types of plastics. This is very different from any other utility, as the majority of them do not possess any exposure to such a non-conventional operation. Indeed, the only other utility that I can think of that also has exposure to a non-utility sector is Hawaiian Electric Industries (HE), which owns a bank instead of a manufacturing operation. The fact that Otter Tail Corporation has non-utility operations provides it with a greater growth potential than the utility company alone could provide. Otter Tail Corporation does boast a few growth figures that are in excess of the utility industry average, such as the following: Metric Otter Tail Figure Utility Sector Average EPS Diluted Growth 11.14% 8.59% EPS Forward Long-Term Growth (3-5Y CAGR) 7.00% 6.38% Levered FCF Growth -23.63% -40.03% Working Capital Growth 108.16% -0.75% Dividend Per Share Growth 6.09% 5.30% 1-Year Dividend Growth Rate 6.27% 5.41% Click to enlarge (all figures from Seeking Alpha’s Quant tool) The slightly better-than-average dividend growth rate could prove very attractive to any investor who is seeking to maximize the income from their portfolio. After all, dividend growth does compound over time, so even a small difference can result in a large amount of incremental income compared to the sector as a whole after an extended period. With that said, though, Otter Tail does have a D rating from the Seeking Alpha Quant tool in terms of growth, and it underperforms the utility sector average in most measures of growth. Otter Tail also currently yields 2.02%, which is pretty low when compared to its peers. For example, consider the following utility companies’ yields: Company Current Yield Otter Tail Corporation 2.02% DTE Energy (DTE) 3.51% NextEra Energy (NEE) 2.86% Eversource Energy (ES) 4.68% Exelon Corporation (EXC) 4.21% Entergy Corporation (ETR) 4.09% Click to enlarge As we can see, Otter Tail Corporation generally has a significantly lower yield than any of its peers. This might prove to be a bit of a turn-off for any investor who is seeking to earn a very high level of income from the assets in their portfolios. Thus, what we appear to have here is a situation where the company’s dividend growth rate is higher than the sector average, but the yield is lower. When in this situation, an investor with a very long-time horizon may be willing to accept the lower yield today in exchange for stronger dividend growth and the extra compounding that this dividend growth should provide over time. However, it can take a considerable amount of time for this scenario to play out, so investors who want a higher income today or within the next few years should probably stick with companies that possess a higher current yield. As regular readers might remember, we previously discussed Otter Tail Corporation in the middle of October of 2023. The market since that time has generally been fairly strong, even for utilities. After all, the previous article was published very close to the market bottom that followed the Federal Reserve’s decision to hike interest rates in July 2023. As such, we can probably assume that Otter Tail Corporation has delivered a reasonable performance since that article was published. This is indeed the case, as shares of Otter Tail Corporation are up 23.45% since that previous article was released: Seeking Alpha As we can immediately see, Otter Tail Corporation slightly underperformed the S&P 500 Index (SP500) over the period since that previous article was published. This is not particularly surprising due to the simple fact that utilities have lower growth rates than much of the rest of the market. As such, their share prices will usually underperform the large-cap index. The fact that Otter Tail managed to beat the iShares U.S. Utilities ETF (IDU) is rather nice as a consolation prize, however. However, Otter Tail’s current dividend yield of 2.02% is higher than the 1.32% of the S&P 500 Index. As such, the dividends that the company paid out should add a performance boost relative to the broad-based market index. We can see this impact in this chart: Seeking Alpha As we can immediately see, when we consider the dividends that the company pays out as part of its overall investment return, Otter Tail is almost tied with the performance of the S&P 500 Index since mid-October of last year. Once again, Otter Tail managed to substantially beat the performance of the domestic utility sector as a whole. This should improve the company’s perception in the eyes of most investors. The fact that Otter Tail Corporation has delivered a reasonably good return over the past nine months is not necessarily a sign that the company will be a good investment today. Let us have a closer look at the company and update our thesis as appropriate. About Otter Tail Corporation As mentioned in the introduction, Otter Tail Corporation is primarily an electric utility that operates in the rural areas of Minnesota, North Dakota, and South Dakota. Otter Tail Corporation The company’s service territory does not, notably, include the Twin Cities region of Minnesota, which is by far the largest population center in this region of the United States. It does include a few other cities, including the capital of North Dakota, but these cities are hardly major cities. As such, the company’s customer count is not nearly as large as might be expected given the large square mileage of its service territory. In a presentation that the company gave to its investors during the first quarter of this year, Otter Tail Corporation claimed to have 133,000 residential, industrial, and commercial customers at that time. The company has not provided any more recent information contradicting this figure, so it seems reasonable to assume that it still has somewhere between 130,000 and 135,000 electric utility customers split between residential, commercial, and industrial users. After all, none of these three states are growing at an especially rapid pace: State Population Growth Rate Minnesota 0.41% North Dakota 0.64% South Dakota 1.03% Click to enlarge (all figures from World Population Review) Thus, we can expect that the company’s customer count cannot possibly be growing at an especially rapid pace, so its customer base should be relatively close to what the company had back in the first quarter. On its website, Otter Tail Corporation specifically states that its electric utility is its largest business and that it is devoting much of its efforts to growing that particular business: Our strategy is to continue to grow our largest business, the regulated electric utility, which will lower our overall risk, create a more predictable earnings stream, improve our credit quality, and preserve our ability to fund the dividend. Over time, we expect the electric utility business will provide approximately 65% of our overall earnings. We expect our manufacturing and plastic pipe businesses will provide 35% of our earnings and will continue to be a fundamental part of our strategy. Reliable utility performance along with rate base investment opportunities over the next five years will provide us with a strong base of revenues, earnings, and cash flows. As we can clearly see, Otter Tail Corporation states that approximately 65% of its earnings can be expected to come from the electric utility over time. That is sufficient to make Otter Tail primarily a utility company, although the 35% of the company’s earnings that come from its non-utility operations will certainly have a noticeable impact on the company’s financial performance. As such, we should not ignore either business segment when attempting to determine whether or not an investment makes sense. For the first quarter of 2024, Otter Tail Corporation’s electric utility business had total operating revenues of $141.488 million, compared to $347.068 million for the company as a whole. This means that the electric company accounted for 40.77% of Otter Tail Corporation’s operating revenue in the first quarter. That is far below the 65% level that the company quotes in the above paragraph. However, it is important that we keep in mind that this is operating revenue, but the quote specifically mentions profit. As we are all well aware, revenue and profit are not the same thing, and the relative expenses and margins of each business play a key role in determining how much profit each business unit creates. Despite the clear difference in revenue and net income, the company failed miserably at accomplishing its stated goal of having approximately 65% of its net income come from the electric utility. For the first quarter of 2024, Otter Tail Corporation stated that the electric utility alone had a net income of $22.470 million compared with $74.338 million for the entire company. Thus, the electric utility only accounted for 30.23% of the company’s total first-quarter earnings. This is substantially below the 65% of earnings level that Otter Tail has specifically targeted for this business. However, it does not appear to be an atypical thing for the electric utility to account for a relatively low proportion of the company’s earnings during the first quarter. For the first quarter of 2023, the electric utility earned a net income of $23.221 million, compared with a total consolidated net income of $62.481 million. Thus, the electric utility accounted for 37.16% of the company’s earnings in the first quarter of last year. This is a lot higher than what the business earned proportionally during the most recent quarter, but it does clearly show us that the electric utility is not usually as profitable as the company’s other business operations during the deepest winter months. One possible reason for this could be that electric consumption tends to be lower during the winter months than in the summer months. It is unlikely to be a surprise to anyone reading this that Minnesota and both Dakotas are among the coldest states in the nation. Despite the push by some politicians to replace fossil fuels with electricity for most purposes, the fact is that fossil fuels are much cheaper to use for heating purposes than electricity. Shrink That Footprint, which is generally in favor of reducing carbon emissions, performed an analysis in January 2024 of the relative cost of heating a home with each of the most popular methods. Here are the results of this study: ShrinkThatFootprint.com As we can see, the organization determined that it is cheaper to heat a home with natural gas or other fossil fuels than with an electric furnace. Households in cold areas will normally prefer to use the most cost-effective method of heating their homes when given a choice, and right now, that appears to be fossil fuels. This explains why only about 14% of Minnesota households heat their space with electricity. This comes from a 2020 study conducted by the U.S. Energy Information Administration into the preferred heating sources of American households. Here is what this study found for the three states in Otter Tail’s service territory: State % of Homes Heated by Electricity Minnesota 14% North Dakota 34% South Dakota 25% Click to enlarge Clearly, it is a minority of homes in each of the three states that are heated by electricity. As such, we can conclude that most of the company’s customers will be purchasing electricity in much higher levels during the summer (due to air conditioners) than during the winter. Thus, the electric utility’s revenue and profits will likely be much higher during the summer months than they would be during the first quarter. However, the company’s fixed expenses are generally the same year-round. Therefore, we can expect that higher profits in the summer will offset the low profits in the winter for the company’s electric utility. This should generally result in the electric utility accounting for 65% of the company’s net income during most rolling twelve-month periods. However, this is not what the company’s guidance points towards. Here is the guidance that the company provided in its first-quarter earnings conference call: Otter Tail The company clearly expects that its plastics manufacturing operations will outperform its electric utility in 2024, just as they did in 2023. As the company expects that the majority of its earnings will come from the electric utility over time, it cannot be the case that the plastics unit will continue to generate higher earnings per share than the electric utility. Therefore, it appears that management could believe that the current strong performance of the company’s manufacturing segment is a temporary condition that will reverse itself at some point. The company’s first-quarter earnings press release supports this conclusion. From the release: Our Plastics segment continues to capitalize on favorable market conditions. Sales volumes are returning to more normal levels following distributor destocking efforts throughout much of last year. The comment about “favorable market conditions” suggests that the current conditions in the market for the plastic components that the company’s businesses produce is much stronger than usual. This is something that is always a temporary condition, although it can admittedly last for a fairly extended period of time. Thus, this statement appears to confirm that the strong earnings per share that the plastics unit is expected to generate this year will not be a permanent occurrence. Investors should not make their decisions about buying or selling the company’s stock based on expectations that the current elevated earnings of the Plastics segment will continue going forward. Financial Considerations As I stated in my previous article on Otter Tail Corporation: It is always important to look at the way that a company finances itself before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is normally accomplished by issuing new debt and using the money to repay the existing debt. This can cause a company’s interest expenses to increase following the rollover, depending on the conditions in the market. In a few articles on other utility companies, we have seen that their interest expenses have been rising fairly rapidly over the past few quarters. While this is the case with Otter Tail Corporation, the problem is not as great as it is with many other companies. Here are the company’s total and net interest expenses over the past eleven quarters: Seeking Alpha We can see that the company’s net interest expenses have been increasing since the middle of 2023. However, for the most part, its expenses have been relatively range-bound between $9 million and $10 million over the period. This suggests that Otter Tail Corporation has not been impacted by the rising interest rate environment to the same extent as many of its peers. In past articles on this company, I have speculated that Otter Tail Corporation’s manufacturing arm basically requires it to keep a firmer handle on its debt than its peers that only invest in utilities. While this is not necessarily the real reason, and management has never admitted to it, as we will see in a moment, Otter Tail does have a substantially stronger balance sheet than any of its peers. As of March 31, 2024, Otter Tail Corporation has a net debt of $705.4 million compared to a shareholders’ equity of $1.4975 billion. This gives the company a net debt-to-equity ratio of 0.47 right now. This compares favorably to the company’s peers, as shown here: Company Net Debt-to-Equity Ratio Otter Tail Corporation 0.47 DTE Energy 1.93 NextEra Energy 1.32 Eversource Energy 1.91 Exelon Corporation 1.71 Entergy Corporation 1.83 Click to enlarge (all figures are as of March 31, 2024) As I stated previously: As we can see, Otter Tail Corporation is by far the least leveraged company out of its peer group. This is not surprising, since this company is one of the only utilities in the industry that is more reliant on equity than on debt to finance its operations. This is a very good sign though, as it clearly indicates that investors should not have to worry too much about the company’s financial structure or the impact that its debt will have on its financial performance. Interestingly, Otter Tail Corporation is the only company out of this group that has strengthened its balance sheet since the publication date of my previous article on it. All of the other companies in this group have grown more reliant on debt over the past several months, which is certainly not a good position for them to be in as interest rates continue to be high and create a drag on their net incomes. Otter Tail’s very low debt and relatively stable interest expenses should allow for more of its profits to make their way down to the company’s net income, which is something that we can all appreciate. Valuation According to Zacks Investment Research, Otter Tail Corporation trades at a forward price-to-earnings ratio of 14.54 at the current stock price. This is quite a bit more attractive than the 22.69 ratio of the S&P 500 Index. Here is how it compares to the company’s peers: Company Forward P/E Ratio Otter Tail Corporation 14.54 DTE Energy 17.34 NextEra Energy 21.17 Eversource Energy 13.44 Exelon Corporation 14.90 Entergy Corporation 15.31 Click to enlarge As we can see, Otter Tail Corporation appears to have a very reasonable valuation when compared to its peers. The only company with a cheaper valuation is Eversource Energy, and that company has been plagued by rapidly rising interest expenses and the termination of one of its biggest growth engines. Otter Tail Corporation is clearly not suffering from the same sort of negative trends that its peer is, so it appears that the company’s current price could be very reasonable. Conclusion In conclusion, Otter Tail Corporation is a unique electric utility with a very attractive valuation. The company is one of the few utilities that has significant non-utility operations, and in this case, the company’s non-utility operations are providing significant financial benefits for it. Unfortunately, that will not be a permanent situation, as its Plastic manufacturing unit is currently benefiting from much higher-than-normal demand that will eventually fall off. When it does, Otter Tail Corporation will probably see its earnings decline as the electric utility becomes the primary profit driver. That could cause an adverse impact on the company’s stock price when that occurs.

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