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Otter Tail Corporation (NASDAQ:OTTR)

Q1 2013 Earnings Conference Call

May 7, 2013 11:00 ET

Executives

Loren Hanson - Investor Relations

Jim McIntyre - President and Chief Executive Officer

Kevin Moug - Senior Vice President and Chief Financial Officer

Charles MacFarlane - President and Chief Executive Officer of Otter Tail Power Company

Analysts

Matt Tucker - KeyBanc Capital Markets

Michael Klein - Sidoti & Company

Alex Heinen - D.A. Davidson & Co

Neil Stein - Levin Capital Strategies

Operator

Good day, ladies and gentlemen and welcome to the Otter Tail Corporation's First Quarter 2013 Earnings Conference Call. Today's call is being recorded and there will be a question-and-answer session after the prepared remarks.

I would now like to introduce your host for today's conference, Mr. Loren Hanson. Please go ahead, sir. Loren Hanson. Please go ahead sir.

Loren Hanson

Good morning, everyone and welcome to our call. My name is Loren Hanson, and I manage the Investor Relations area at Otter Tail Corporation. Last night we announced our first quarter results. Please note that our complete earnings release and slides accompanying this earnings call are available on our website at www.ottertail.com. A replay of the call will be available on our website later today.

With me on the call today is Jim McIntyre, Otter Tail Corporation's President and CEO, Kevin Moug, Otter Tail Corporation's Senior Vice President and Chief Financial Officer and Charles MacFarlane, President and CEO of Otter Tail Power.

Before I begin, I would like to remind you that during the course of this call, we will be making forward-looking statements. These forward-looking statements are covered under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and includes statements regarding Otter Tail Corporation's future financial and operating results or other statements that are not historical facts. Please be advised that actual results could differ materially from those stated or implied by our forward-looking statements to the certain risks and uncertainties, including those described in our most recent form 10-K and subsequent quarterly reports on Form 10-Q. Otter Tail Corporation disclaims any duty to update or revise our forward-looking statements as a result of new information, future events, developments or otherwise.

For opening remarks, I would now like to turn the call over to Otter Tail Corporation's President and CEO, Mr. Jim McIntyre. Jim?

Jim McIntyre

Good morning and thanks for joining our call today. 2013 is off to a good start with first quarter earnings per share from continuing operations of $0.41 compared to $0.28 last year. Given more favorable weather this year, earnings from the Electric segment met our expectations. Manufacture and performance was down slightly, but was in line with expectations and results demonstrate continued improvement in operations.

Our Construction segment is greatly improved over last year, despite reporting a loss for the quarter. Plastics had a very strong first quarter, acting on favorable market conditions. In our view these results were a clear indication that our effort to focus and realign our portfolio is beginning to pay off, improving shareholder value and positioning the company for the future.

Furthering this goal, this past quarter we completed the sale of ShoreMaster, another important step in our portfolio of realignment. We are well on our way to achieving a more optimal configuration of manufacturing infrastructure holdings. As we narrow our focus to our electric business and entire portfolio of manufacturing infrastructure businesses, management and the Board of Directors are better able to understand and improve our companies, using a more targeted and disciplined approach.

This increases options for sharing expertise, knowledge and leadership through the exchange of information and job rotations. It also offers a wider variety of talent development and the ability to attract the right people looking for a company with a broad range of career opportunities.

In addition to the strong first quarter utility results, there were also a number of events that highlight this growth strategy for the utility. As part of the bidding and planning process related to our Big Stone Plant air quality control system or AQCS Otter Tail Power Company was able to reduce its planned capital expenditures on Big Stone and on April 26, we had the official groundbreaking for this important environmental upgrade to the plant which is expected to be completed by 2016.

Decreased capital expenditures affiliated with Big Stone AQCS will reduce our rate base growth; however, the lower cost estimate will also benefit customers by helping to reduce future rate increases. In addition, we recently approved -- received final approval for plans for our plant at Hoot Lake. The $10 million investment in environmental upgrades represents cost effective collaborative solution for continued operation until 2020, when the plant will most likely be replaced by natural glass.

We are pleased with our investments at Big Stone and Hoot Lake will significantly reduce emissions. In addition to the Big Stone air quality system at Hoot Lake, current electric utility projects include remaining investments in CapEx 2020 and also in MISO-determined MVP transmission projects that will serve the 12 state MISO region.

The foundation of Otter Tail Corporation's diversification strategy is a well run utility with rate based growth opportunities as discussed, complemented by strategic manufacturing and infrastructure companies to realize the full potential of our non-utility holdings and provide better oversight for management and the Board of Directors we are now operating our portfolio of manufacturing and infrastructure companies under our existing Varistar name.

Within Varistar, we have added or reassigned selected resources and subject matter experts and operations, talent management and finance, who are all charged with improving operational excellence and ultimately earnings power of the companies. This should bring more focus to Otter Tail Corporation's diversification strategy designed in part to offset periods of lower growth from our utility.

I would now like to turn the call over to Kevin, who will comment further on our financial performance.

Kevin Moug

Thank you, Jim and good morning. Please refer to slide four as I walk through the quarter's results. Our manufacturing segment experienced a slight decrease in earnings when compared with the same quarter a year ago. Reduced demand across construction, energy, and lawn and garden end markets was the primary cause of reduced sales volume of $6.3 million.

This segment improved its return on sales on a quarter-over-quarter basis to 6.2% of sales compared to 5.8% of sales primarily due to improved productivity at both BTD and T.O. Plastics in spite of the lower sales volumes.

Our corporate expenses decreased $600,000 between the quarters as a result of lower interest expense related to the early redemption of the corporation's 50 million senior unsecured notes in July of 2012 and decreases in professional and contracted service expenses.

These lower costs were partially offset by increases related to staffing additions to support the manufacturing and infrastructure platform and additional stock incentive cost resulting from the strong performance of our common stock price.

Our plastics segment had a strong first quarter due to increased sales volume as housing markets improved in the South Central and South West regions of the United States. These improvements were partially offset by lower sales in the North Central region due to a harsher winter.

Moving on to the Electric segment. The colder weather led to a 33.8% increase in heating degree days this year compared to the unusually mild winter last year, contributing to an 8.8% increase retail kilowatt hour sales and a $900,000 increase in net earnings. The number of heating degree days in the first quarter of 2013 was 5% greater than normal for the same period.

Our revenues were also impacted by higher fuel and purchase power prices due to increased market demand for electricity caused by the colder winter and power purchases to meet the increased demand. Fuel cost increased $2.5 million as a result of an 11.4% increase in kilowatt hours generated from the electric utilities steam, power and combustion turbine generators combined with a 4.5% increase in the cost of fuel per kilowatt hour generated.

The average cost of fuel per kilowatt hour of generation increased in part because of the electric utilities Coyote station was shut down for generator repairs during the first seven weeks of 2013. The cost of purchase power for retail sales increased due to the -- due to increased demand due to colder weather and also to the Coyote station repairs.

Our electric operating and maintenance expenses increased $2.7 million as discussed in the earnings release. Our construction segment results improved significantly over the first quarter of 2012. The main reason for better financial results is an improvement at Foley. Foley's net loss decreased by $3.6 million due to the completion of several challenged projects and improved construction contract management. All the projects contributing to the losses in the first quarter of 2012 were substantially completed by the end of 2012.

Aevenia's net loss increased by $500,000 due in part to adverse weather in the Midwest, which delayed the start of many construction projects as compared to the early start to construction and extremely mild weather in the first quarter of 2012.

I would like you to go to slide five to review our updated consolidated capital expenditures. We are revising our consolidated capital expenditure expectations for 2013. We now expect 2013 capital expenditures to be in a range of $165 million to $175 million. We are also revising estimates for our share of capital expenditures required for the air quality control system at Big Stone Plant from $265 million to $218 million.

This is due to prudent design changes, low bids in a buyer’s market and in-house project management. The change in the transmission five-year capital plan from the previous disclosure is primarily due to a $15 million reduction in total transmission spend over the five-year period because of reduced cost. Moving projects closer to construction results in better cost estimates as opposed to planning level estimates.

Also $30 million has been shifted to 2018 and 2019 which is outside the five-year window that we are showing for the Big Stone-Ellendale transmission project. This change is a result of better cash flow as the project has moved along in development. We continue to focus on the execution of the currently anticipated electric utility capital expenditure plan as it is expected to grow rate base and be a key driver in utility earnings over the 2013 through 2017 timeframe.

I would now like to give you an update on our business outlook and have you move to slide six of the presentation. First we are reaffirming our consolidated earnings per share from continuing operations for 2013 to be in the range of $1.30 to $1.55. However, we are reducing our previous guidance for 2013 for our Electric segment. The change is primarily based on an updated capital expenditure plan, which is lower than original expectations.

These reductions in anticipated capital expenditures are expected to result in lower rider recovery revenues and lower AFUDC earnings in 2013. Also, the electric segment continues to expect lower conservation improvement program incentives and increases in operating and maintenance expenses due to higher benefit and administrative cost.

Management benefit costs are expected to increase $2.7 million in 2013. We are also reducing earnings guidance for the manufacturing segment in 2013 due to softening order volume in the construction, energy and lawn and garden end markets impacting BTD's customer base. In addition, lower earnings are now expected to T.O. Plastics for 2013 due to a major customer announcing they're going to produce certain products in-house rather than outsource to T.O. Plastics.

We are maintaining our earnings guidance, earnings per share guidance for the construction segment. This improvement over 2012 is due in part to improved cost control processes in construction management. In addition, Foley's projects that negatively impacted last year were substantially completed in 2012, so we do not expect to see similar losses in 2013.

We are increasing the guidance for our plastics segment based on the strength of its first quarter performance and corporate general and administrative costs are expected to increase primarily because of costs associated with the stock incentive awards that have been impacted by the recent increase in the price of our common stock.

After the Q&A, Jim will return with a few closing remarks. We are now ready to take your questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Matt Tucker of KeyBanc Capital Markets. Your line is open. Please go ahead.

Matt Tucker - KeyBanc Capital Markets

Hey guys. Good morning. Just a couple of questions on the non-utility businesses. You mentioned the plastics guidance raise was related to the first quarter performance, which was obviously strong. Should we just think about it that way, or is there anything about the outlook for the rest of the year that's changed?

Jim McIntyre

I would primarily think about it that we did have very strong first quarter performance as compared to what our original budgets and expectations were Matt and as we based on the current conditions as we look forward, we would expect that that strong first quarter performance -- we don't expect to have to give that back. We expect to be able to maintain that, and thus we are increasing the guidance as a part of that in terms of the current market conditions that we were currently seeing. We've included that view in the guidance as well.

Matt Tucker - KeyBanc Capital Markets

Thanks. That's very helpful. And then just on the construction side, I guess that's the one segment where you really kept the guidance intact. Could you comment on how the first quarter performance compared with your internal expectations, and then also has weather impacted the second quarter at all thus far, or has it just been a more normal quarter so far?

Jim McIntyre

In terms of how the construction companies compared against our internal expectation, Foley was pretty much on the internal expectations. Aevenia was behind the internal expectations, really for the reasons that we discussed as it relates to why earnings were down quarter-over-quarter.

In terms of weather heading into the second quarter, April was a pretty challenging month around here and so there is some impact, particularly from a venue standpoint for weather in the early part of the first quarter that those things were contemplated as we were pulling together our updated forecast as well.

Matt Tucker - KeyBanc Capital Markets

Okay, thanks a lot. I'll jump back in the queue.

Operator

Thank you. Our next question is from the line of Michael Klein of Sidoti & Company. Your line is open. Please go ahead.

Michael Klein - Sidoti & Company

Hey good morning guys.

Jim McIntyre

Good morning.

Michael Klein - Sidoti & Company

Does the reduced CapEx number change your plans around the timing of external financing, or do you still think 2014 is the likely time for that?

Kevin Moug

Mike we are still, we would expect based on our current plans that 2014 is still a timeframe that we are looking at for having to issue equity.

Michael Klein - Sidoti & Company

Okay. And how should we think about the dividend now, especially in light of the improved cash flow and the reduced CapEx? Can we start to think that the dividend is being discussed more frequently, or how should we think about that?

Kevin Moug

Well, you can be certain that it has our full attention as follows out of the Board. The things you referenced, the improved cash flow, the dependability of their earnings also were all good steps towards a time when the Board might decide to make a change.

I think 2013 is a year where we really want to work hard at executing and showing and demonstrating our ability to have strong earnings throughout the full year. So we’ll work our way through 2013, but clearly at some point we would expect and we would be in a position to consider a change in dividend. But, we’ll review that with the Board quarter-by-quarter as we go forward.

Michael Klein - Sidoti & Company

Okay. And do you guys have a target payout ratio that you'd eventually like to get into, or has that not been discussed at this point yet?

Kevin Moug

We had a discussion around that. I believe we’d probably be targeting a 65% to 70% overall payout ratio, with a makeup coming from higher percentage from the utilities and from our diversified businesses consistent with better volatility that those businesses will have from time to time. We want to get into that comfortable zone, so that the dividend is viewed to be secure for an ongoing period of time.

Michael Klein - Sidoti & Company

Okay, great. Thanks a lot.

Operator

Thank you. Our next question comes from the line of Mike Bates of D.A. Davidson. Your line is open. Please go ahead.

Alex Heinen - D.A. Davidson & Co.

Hi guys. It’s actually Alex Heinen in for Mike today.

Jim McIntyre

Hi Alex.

Alex Heinen - D.A. Davidson & Co.

So I was wondering, do you guys believe that an uptick in construction and plastics environment could make these operations more attractive to potential buyers in the future?

Jim McIntyre

Well, first off, we very much appreciate the earnings contribution that the plastics provides to us. We believe our two plastics companies are very well run. They are low cost both in terms of fixed cost and operating cost. So as you can see like for the last year in particular they did provide a -- they provided a very strong set of earnings for us.

We know that they’re very opportunistic and any earnings opportunity that is there, they’ll take advantage of it and so we’re very pleased with them. I think when you look at overall market for plastics, there’s still an oversupply of plastic pipe manufacturing capability in the U.S. but our plants tend to do pretty well most years, even in tough time. So that may well be true, but we’re very -- we’re comfortable with our current ownership of the facilities.

Alex Heinen - D.A. Davidson & Co.

Okay, thanks. That's great. And then did you guys give the weather impact on EPS versus normal?

Kevin Moug

We did not give the EPS impact. We just stated that the weather in the first quarter this year. The heating degree days are about 5% above normal.

Alex Heinen - D.A. Davidson & Co.

Okay. All right, thanks. That’s all I have.

Operator

Thank you. (Operator Instructions) Our next question comes from the line of Brendan Naeve of Levin Capital. Your line is open. Please go ahead.

Neil Stein - Levin Capital Strategies

Yes, good morning. It's Neil Stein from Levin Capital. I just had a couple of questions, if I could. The first was on the growth rate that you provided on the last conference call, which was 4% to 7%, is that still a growth rate that you believe in? You didn't mention it in the press release today.

Kevin Moug

Well, I am surprised. I think it was in one of the earlier drafts of the press release. That’s still where we are at and of course on these front end years, as we’re re-establishing our baseline of earnings, you would expect that it would be somewhat higher than that and it will be until we get into a more stable mode. But, yes, 4% to 7% is where we think we’ll tend to be long term.

Neil Stein - Levin Capital Strategies

And when you talk about 4% to 7%, what's the base year we should be thinking about?

Kevin Moug

That was really off of 2011 year.

Neil Stein - Levin Capital Strategies

What did you earn in 2011? I was looking on Bloomberg; it shows $0.53. But I don't think you intend to mean that you're going to grow 4% to 7% off of a $0.53 base year

Kevin Moug

Well, the 2011 - I am sorry continuing operations number Neil was $0.95 a share.

Neil Stein - Levin Capital Strategies

$0.95 okay. Well, if you're going to grow 4% to 7%, and you're already up to $1.40 versus the $0.95 here in 2011, that would imply, really, over the long term from 2013, that the growth isn't going to be really nearly that high at all, right?

Kevin Moug

No, I think as I try to make with operator getting into the numbers. You know as we make a recovery from the very challenging number of years that we had, we are re-establishing kind of our base level of earnings. When you look at the substantial growth opportunity that the utility has and even with a slight reduction in CapEx over the five year period of time, the growth that the utility will provide from its rate based growth is very, very significant, couple that with building out the capacity we have within our existing diversified companies and we believe we can provide of 4% to 7% growth even as we get ourselves back to a more -- I'll just say more normalized level of earnings for the company.

Neil Stein - Levin Capital Strategies

It's helpful to hear that number, and we have our own analysis on this. But when you say 2011 is the base year, it starts to be very confusing. So is 2011 the base year or not, I guess, for 4% to 7% growth?

Kevin Moug

Well when we started talking about 4% to 7% growth in 2012, it was off plans that we had in place from our base year of 2011. So that’s what we've – because we started to talk about the 4% to 7% in 2011.

Neil Stein - Levin Capital Strategies

But, yes, I'm just trying to -- again, for the purpose of a -- it seems to be -- you seem to be implying that maybe you could do better than 4% to 7% off of the 2011 pace? So it's a higher growth rate, but off of that base? I'm just -- you can understand the source of the confusion here.

Kevin Moug

What -- there is going to -- what Jim is trying to say is that these earnings there is higher growth rates in the earlier years and lower growth rates our later on the planning spectrum. So when we look at 2011 as our base year that we were growing off of collectively over the timeframe it’s a 4% to 7% growth rate. We will see higher growth rates in some years. We will see lower growth rates in lower years.

Neil Stein - Levin Capital Strategies

Because it's just already, the growth has been 20%, compound annual, for off of the '11 base through your '13 guidance. So if you average that into 4% to 7%, it just gets to be considerably lower growth in future years. But maybe it just needs to be reworked or restated, but we could take it offline. Thanks very much.

Jim McIntyre

I just would add this. It's a work in progress. When you look at the CapEx utility expenditures the part of the information that’s provided with also indicated over time that we believe our utility will provide us with 75% of our earnings and our diversified business will provide 25%.

We know that we are going to go out for equity offering some time in the future in order to fund the utility growth and keep our cap structure in place, but when you look at those piece I think you can get to a place where you can and should be comfortable with the 4% to 7% growth rate even after we get our sales back into our more normal level of ongoing earnings.

Neil Stein - Levin Capital Strategies

And could you say, is it a three-year growth rate, a five-year growth rate? Just trying to -- like it sounds good, and it's in what you might call the top half or the top quartile of what other companies say, so that's a good thing. But then when I'm trying to figure out, well, what does this mean from, how does this help me project forward earnings, it starts to get really complicated. So is this going to be through 2015? Is it through 2017? I'm just trying to understand that.

Jim McIntyre

Our planning period was we were looking at this as (inaudible) to that 2017 timeframe.

Neil Stein - Levin Capital Strategies

4% to 7% growth off of an '11 base through 2017?

Jim McIntyre

Right.

Neil Stein - Levin Capital Strategies

So off of the $0.95 that you earned in 2011, we should just apply 4% to 7% growth through 2017, and that will get to your 2017 earnings forecast?

Jim McIntyre

I would suggest you create the model from the other information we provided, recognizing that we are working to re-establish, what I would call more traditional earnings level toward this company. And on top of that, I have 4% to 7% over five years period. I think you can get to that and it’s in these early years, it's a little bit of a mathematical challenge to try to do this en masse, but I think the basic in there in terms of the growth opportunities from the utility, the recommitment and refocusing we've done with regard to our diversified businesses, and the commitment that we have to really deliver and execute so that’s shareholders are adequately compensated for the investment they make in our Company, we take very seriously.

Kevin Moug

The other thing just to add to that as we provide the rate base chart, you know that we typically look to capitalize the utility at 51% or so equity probe cap ratio and assuming an ROE environment of 10%, 10% that helps give you the earning picture as well in terms of the 47% growth rate.

Operator

Thank you. And that does conclude our question-and-answer session. I would like to turn the conference back over to Jim McIntyre for any closing remarks.

Jim McIntyre

Well slide eight of the material provided reflects a transformed Otter Tail Corporation. We've seen this realignment Otter Tail Power Company continues as strong electric utility and is aligned with strategic manufacturing infrastructure companies under Varistar.

This transformation has allowed us to become more agile able and disciplined. It will help us I am sure more formidable earnings changes to support the dividend while maintaining an acceptable level of risk. It will also help increase profitability and deliver financial results in more stable manner.

Our occurrence to access can be linked directly to the proper execution of the right strategies. As our first quarter results demonstrate, we are on strategy and we are on target. Thank you for joining our call and we look forward to speaking with you next quarter.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Have a great rest of the day.

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