Otter Tail's (OTTR) CEO Chuck MacFarlane on Q3 2017 Results - Earnings Call Transcript

Otter Tail Corporation (NASDAQ:OTTR) Q2 2017 Earnings Conference Call November 2, 2017 11:00 AM ET

Executives

Loren Hanson – Investor Relations

Chuck MacFarlane – President and Chief Executive Officer

Kevin Moug – Senior Vice President and Chief Financial Officer

Analysts

Tate Sullivan – Sidoti

Paul Ridzon – KeyBanc

Operator

Good morning, and welcome to the Otter Tail Corporation’s Third Quarter 2017 Earnings Conference Call. [Operator Instructions]

I will now turn the call over to the Company for the opening remarks.

Loren Hanson

Good morning, everyone, and welcome to our call. My name is Loren Hanson, and I manage Otter Tail’s Investor Relations area.

Last night, we announced our third quarter 2017 results. A 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 are Chuck MacFarlane, Otter Tail Corporation's President and CEO; and Kevin Moug, Otter Tail Corporation's Senior Vice President and Chief Financial Officer.

Before we begin today's call, I'd like to remind you that we will be making forward-looking statements during this call. As noted on Slide 2, these statements represent our current judgment or opinion of what the future holds. They are subject to risks and uncertainties that may cause actual results to differ materially from forward-looking statements made today.

So please be advised about placing undue reliance on any of these statements. Our forward-looking statements are described in more detail in our filings with the Securities and Exchange Commission, which we encourage you to review. Otter Tail Corporation disclaims any duty to update or revise our forward-looking statements due to new information, future events, developments or otherwise.

For opening remarks, I will now like turn the call over to Otter Tail Corporation's President and CEO, Mr. Chuck MacFarlane.

Chuck MacFarlane

Thank you, Loren, and good morning, everyone. As communicated in our news release, Otter Tail delivered improved quarter-over-quarter earnings for the third time this year. Net income was $17.8 million, or $0.45 a share. This is $0.08 better than the third quarter last year and follows a second quarter that was a penny better than the second quarter last year and a first quarter that was $0.11 better.

As a result, we are raising and tightening our earnings guidance to a range of $0.75 to $0.85 a share. While we had a good quarter, we arrived here through a slightly different flight path than expected.

Our Plastics segment sold more pounds and earned higher margins than expected due, in part, to hurricane-related market dynamics. Hurricane Harvey made landfall on August 25 in an area with significant PVC resin and other petrochemical production. The petrochemical industry executed significant plant shutdowns as the storm progressed.

Our major resin suppliers declared force measure due to down production facilities, raw material shortages and lack of inbound and outbound rail transportation. But our two PVC pipe companies, Northern Pipe Products and Vinyltech, worked closely with resin producers to reallocate our orders to plants that were not impacted.

Contractors and PVC pipe distributors began to be concerned about the availability of pipe for ongoing and future planned construction projects. This resulted in accelerated pipe demand and increasing prices. The backlog at both companies spiked, and production and shipping rates accelerated. With the experience of working through similar previous situations, our pipe companies managed the dynamics of the storm impact extremely well. We don't expect these type of devastating storms to occur very often.

We're proud of our team and their ability to meet the increased demand during this timeframe. Our path was also not what we expected at the utility. Revenues were up, but net income was down primarily due to a final true-up of interim rate refund provision for the Minnesota rate case. The final interim refund level was higher than previously estimated. The drop in ROE from a modified filing and transitioning writers in the base rates drove the $1.1 million pretax charge for the quarter. This only impacts our interim refund.

Our final rates, which go into effect this month, are unchanged from previous estimates. I'll focus the remainder of my remarks on the continuing execution of our strategy to grow utility rate base, which includes both generation and transmission investment. And I'll discuss improved operations at our other manufacturing companies.

As described on previous calls, the Minnesota Public Utilities Commission granted Otter Tail Power a revenue increase of 6.2%, including the rate case we filed last year. This was 83% of our modified requests as submitted during rebuttal's testimony. The commission set the return on equity at 9.41% on an equity layer of 52.5%.

Otter Tail Power will implement the approved rates in Minnesota, including an interim rate refund beginning this month. Today, Otter Tail Power filed a request with the North Dakota Commission for a general rate increase. We proposed to increase non-fuel base rates by approximately $13.1 million, or 8.7%. The North Dakota Commission established the current rates almost a decade ago in 2009 based on 2007 costs.

Since our costs we incur to provide customers with energy and related services have increased, and we've invested in cleaner, more flexible technologies, such as environmental controls at Big Stone Plant wind projects and transmission lines that can move more renewable and other energy to market. If the commission approves the request as filed, the average residential customer will see a bill increase of approximately $11.50 a month, and the average general service business customer will see a bill increase of approximately $22 a month.

Otter Tail Power is asked to increase rates on an interim basis while the commission considers this proposal. If approved, the interim rate increase would be effective January 1, 2018, and would remain in effect until the commission makes its final determination, which we expect later in the year.

Most of Otter Tail Power's 130,000 customers are divided between North Dakota and Minnesota, but the company also serves 12,000 customers in South Dakota. And we're running cost-to-service studies to determine when to file a rate request in that state. Even with these rate cases, Otter Tail Power's rates continue to be among the lowest in the nation.

On previous quarterly calls, we've also discussed the Minnesota Commission's approval of Otter Tail Power's 2017 to 2031 resource plan. Key ordering points included a five-year action plan, with the addition of up to 200 megawatts of wind, 30 megawatts of solar and 250 megawatts of peaking capacity in 2021. These generation projects are included in the list of rate base projects on Slide 6.

In March, we announced our plan to construct a 250-megawatt natural gas plant near Astoria, South Dakota. Please see the map on Slide 7. We submitted our application for a site permit to the South Dakota Public Utilities Commission in October. We also reached settlement with the North Dakota Public Service Commission's staff on our Advanced Determination of Prudence request in October.

We expect the final commission decisions on both by the end of the year. This natural gas project will be a simple cycle plant near the intersection of the Northern Border Pipeline and the recently completed Big Stone South to Brookings 345 kV transmission line. We chose this site to avoid significant costs for extending gas for transmission facilities and to minimize land owned impact.

We expect the project to cost $165 million, to be online in 2021, with three to five full-time employees. Combined with 150-megawatt Merricourt project we announced in November last year, it will cost-effectively replace expiring power purchase agreements and prepare for the retirement of the aging Hoot Lake coal plant in 2021.

When we filed the request for Advanced Determination of Prudence for Astoria, we also requested Advanced Determination for the Merricourt wind project. As mentioned, we have reached settlement with the North Dakota Commission staff and expect the commission rule on the ADPs for both projects by the end of the year.

Here are updates on other filings related to Merricourt. The project filed a generator interconnection request with MISO in May of 2015. The North Dakota Public Service Commission conducted a hearing on modifications to the existing site permit in September, and we expect a decision by year-end.

And in October, we received confirmation from the Minnesota Public Utilities Commission that we can include the project in riders in Minnesota. EDF Renewable Energy will build the 150-megawatt wind project in Southeast North Dakota in 2019. You can see it on the map on Slide 8. It will cost approximately $250 million, and Otter Tail Power will take 100% ownership when completed. This will boost our renewable resources to nearly 30%.

We continue to be pleased with the performance of our existing wind farms, and this new wind farm will have a very low delivered energy price. The two 345-kV transmission projects Big Stone South to Brookings and Big Stone South to Ellendale are also part of our rate base growth plan. The map on Slide 9 shows the relative locations. Both are designated as multi-value projects within MISO, allowing recovery of construction work- in-progress from all customers in MISO's upper Midwest footprint.

We are 50% owner in the Brookings project with lead developer Xcel Energy. The line was energized on September 8, on schedule and slightly under budget. It extends 70 miles from Brookings, South Dakota to Big Stone City, South Dakota. During an August 30 celebration to mark the completion of the project, speakers reinforced the importance of the line to expand the high-voltage transmission grid, improve system reliability and resilience and enable renewables and other generation resources, like natural gas generation, from generation from our proposed Astoria station to connect to the system.

The Ellendale project will bring similar benefits. We are 50% owner in this 163-mile line with MDU. Otter Tail Power is the lead developer, and the project has obtained all easements, completed 75% of foundations and set two thirds of the structures and remains on schedule to be energized in 2019.

These two transmission projects have a combined Otter Tail investment of approximately $250 million. The wind, natural gas and transmission projects are part of our Electric platform's plan to grow rate base plan annual growth rate of 7.5% using 2015 base year.

As shown on Slide 10, Otter Tail Power plans to make capital investments of $862 million during the 2017 to 2021 time frame. Slide 11 shows our regulatory framework, which continues to be constructive. As noted on the slide, 50% of our future project investments are eligible for rider recovery while under construction. The balance of our capital spend, except for Astoria, is at current depreciation levels and effectively covered in base rates. Allow me to mention a couple of other utility highlights.

First, J.D. Power released its 2017 Electric Utility Residential Customer Satisfaction Study results, ranking Otter Tail Power third in the Midwest midsize region. Our overall customer satisfaction score improved from 2016. We're proud of our employees and their contributions to this outstanding ranking. In environment headlines last month, the EPA issued a Notice of Proposed Rulemaking to repeal the Clean Power Plan. Our resource plan remains unchanged by a potential repeal.

As part of the process, EPA will gather public comment. The electric utility industry is advocating for a replacement plan to be developed under the current EPA. Our company has a representative on the industry's Utility Air Regulatory Group, which is working on a recommendation.

Turning now to our manufacturing platform. I covered the plastic segment companies at the beginning of my comments but, again, commend them on their operational performance for the quarter. The two manufacturing segment companies, BTD and T.O. Plastics, each showed improvement in net income quarter-over-quarter. BTD is our custom metal fabricator. It's serves some of the top OEMs in the nation and met our expectations for the quarter.

Key factors include higher product sales, increased scrap metal sales and lower interest costs. The company is seeing some pickup in orders from customers in the recreational vehicle in oil and gas end markets in the third quarter, even though we are lower year-to-date than last year. Our thermoforming business, T.O. Plastics, improved operations for year-over-year net income growth for the third consecutive quarter. Sales increased in all of the major end markets, horticulture containers, life science products and industrial packaging. Overall, we are pleased with the third quarter results, which follow an excellent first and second quarter.

I'll now turn it over to Kevin for the financial perspective.

Kevin Moug

Good morning. All of our businesses and the corporate cost center experienced quarter-over-quarter improvement, except for our Electric segment. Clearly, the highlight of the quarter is our Plastics' performance. Please refer to Slides 12 through 14 as I discuss our third quarter results. The utility net earnings decreased approximately $1.6 million quarter-over-quarter. Key drivers contributing to this were a $1.4 million net decrease in the interim rate revenue as well as decrease in environmental and transmission rider revenues. This is due to a true-up in our estimate of an interim rate refund that is due customers as part of moving to final rates in November.

Final true-ups for lower return on equity and other adjustments resulting from the rate case order were part of completing our compliance filing in the third quarter. We also experienced lower kilowatt hour sales mainly to industrial customers and decreased revenues related to milder weather in this current quarter. Weather negatively impacted earnings per share by approximately $0.01 both quarter-over-quarter and compared to normal.

Net earnings for the Manufacturing segment increased $362,000. At BTD, revenues improved from increased product sales and scrap revenues, which contributed to improved operating margins. Third quarter results were also positively impacted by lower interest costs. This was offset, in part, by increased operating expenses and income taxes. The effect of these items resulted in approximately $200,000 increase in net earnings at BTD between the quarters.

At T.O. Plastics, revenues and earnings increased as a result of improved sales of life science and industrial products and lower interest expense, resulting in improved earnings of approximately $100,000. Our Plastics segment's revenues and earnings increased between the quarters as a result of a 22.9% increase in pounds of pipes sold as well as 13% increase in PVC pipe sales prices. The $3.7 million increase in earnings, or $0.09 per share, was driven by two items.

First, an increase of approximately $2 million in earnings, or $0.05 per share, and improved profitability from normal business operations. This is reflective of the better business conditions in July and August of 2017 compared with the same time frame a year ago. Second, earnings were also stronger by $1.7 million, or $0.04 of share, directly related to the impact of Hurricane Harvey hitting the Gulf Coast region in late August. This caused major resin suppliers to shut down their production facilities.

This impacted raw material availability and caused distributors and contractors to be concerned about pipe availability, resulting in accelerated pipe demand and upward pressure on pipe sales prices. It is important to note that we had sufficient raw materials in September to run our plants and meet the additional demand. The increase in earnings in Plastics also benefited from lower interest costs.

Our corporate expenses, net of taxes, decreased $700,000 primarily due to lower employee wage and benefit expense, along with lower insurance and equipment repair costs. A comment on our financial condition and liquidity. We did amend our two credit agreements to extend the expiration dates by one year to October 31, 2022. We have the appropriate levels of liquidity in these facilities to support both of our business platforms.

Moving on to our business outlook on Slide 15. We are raising and tightening our consolidated earnings per share guidance to $1.75 to $1.85 from $1.65 to $1.80 based on the Plastics segment's strong third quarter results. Our Electric segment's 2017 net income is expected to be higher than 2016 based on normal weather for the remainder of the year. Milder than normal weather has negatively impacted earnings per share by $0.04 for the nine months ended September 30, 2017. A full year of increased rates from Minnesota rate case compared to 8.5 months in 2016.

Rider recovery increase is related to increased investments in multi-value transmission projects offset, in part, by declining environmental riders due to decreasing rate base and increased sales to industrial and commercial customers. These items are offset by increased operating and maintenance expenses related to higher medical – workers' compensation and retiree medical benefits, also increased pension costs due to a decrease in the discount rate as well as lowering the assumed long-term rate of return.

We have a higher property tax expense due to large transmission projects being put into service and lower SIP incentives in Minnesota as a result of a new state initiative program. We also experienced some increased costs related to certain capacity agreements. We expect increased earnings from our manufacturing segment in 2017 due to a slight increase in sales due to capturing new business with existing customers, along with higher scrap and lawn and garden end market sales. This is offset, in part, by lower recreational vehicle and market sales.

Improved margins combined with lower interest costs and increased earnings at T.O. Plastics primarily driven by increased sales, along with lower interest costs. The backlog for this segment is approximately $53 million for the balance of 2017 compared with $42 million a year ago. We are raising Plastics 2017 net income expectations again based on the following items: strong year-to-date results and the impact of Hurricane Harvey on market conditions from September through December.

As we have previously mentioned, the hurricane created concerns of resin availability, as major resin suppliers shut down production facilities. Distributors and contractors became concerned about pipe availability, which accelerated pipe demand. This caused an uplift in sales prices, which further improved operating margins in September.

We expect this to continue into the fourth quarter of 2017. When comparing the lower end of the updated earnings per share range to the 2016 earnings per share for this segment, $0.08 of the increase is due to improved profitability from normal business operations, and $0.08 is due to the impact of Hurricane Harvey.

The segment's net income also benefits from lower interest costs. And our corporate costs are expected to be in line with 2016. We're pleased with our strong year-to-date results. The Plastics segment's performance, in particular, has exceeded our expectations. It is important to note, we don't expect the market conditions resulting from the devastating hurricanes to continue beyond your-end.

We continue to focus on our strategic initiatives. These include the continued rate base growth from our investments in the Electric segment and successful outcomes from our upcoming North Dakota rate case, and continued improvement in profitability at BTD focused especially on improving our Georgia operations. Our efforts to remain focused on executing our key initiatives also further position us to meet our long-term goal of 4% to 7% compounded growth rate in earnings per share using 2016’s $1.60 a share from continuing operations.

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

Question-and-Answer Session

Operator

[Operator Instructions] After the Q&A, Chuck will return with a few closing remarks. Your first question comes from the line of Tate Sullivan with Sidoti.

Tate Sullivan

Hi, thank you, good morning. I just start on Plastics. And I think your higher guidance for Plastics for the full year implies some ongoing benefits from the hurricane in its fourth quarter. Is that correct? Have you already seen that so far this quarter?

Kevin Moug

Hey, Tate, good morning, this is Kevin. It does. I mean, I think I actually made that statement in my comments that we not only in September are we seeing an uplift from the hurricane, but there is – some benefit of that continuing on into the fourth quarter as well. And so that's – the impact of the hurricane on earnings in Q3 was $0.04. And basically, we're saying we expect another $0.04 in the fourth quarter because of the total impact for the year from the hurricane is that $0.08 a share that we're talking about in the guidance section.

Tate Sullivan

Okay. In the fourth quarter, too. Okay, thank you. And then I mean, I think you made a comment, though, that you're not extending that strength into 2018, as, I mean, I guess, the resin prices will subside from current levels. Is that the consideration?

Kevin Moug

Well, we don’t expect these conditions to continue into 2018. I mean, we've seen this before back in 2015 when we had Hurricane Katrina and Rita come through the Gulf Coast probably within a three-week, four-week time frame. We saw the same kind of conditions and experienced back then very healthy earnings at the time, and it kind of ran its course in those last five months of the year. And then those people realized that resin is going to be available.

By now the resin suppliers' plants are open and running. Concerns about rail delivery are now subsided. Product is being delivered to the PVC manufacturers. And the concern that contractors and distributors have about not getting pipe eventually subsides within that kind of five-month time frame. And so those market dynamics just end basically at the end of this year, and we just don't – we're not going to see those continue into the next year. So there will certainly be probably some type of pullback in where pipe prices are, because that demand, that additional demand and concern doesn't exist.

And so as we typically look at the business, we are – we expect a normal range of earnings based on the market conditions in time at the time we look at those earnings for a given year. And then we will adjust those as we go throughout the year based on market conditions that are changing as we go through the year.

Tate Sullivan

Okay, thank you. And then in the manufacturing business, too, to clarify, you mentioned $53 million backlog number. Is that just T.O. Plastics or is that all of manufacturing?

Kevin Moug

That's all of manufacturing, the predominant of which would be BTD.

Tate Sullivan

Okay. Yes, I mean, $53 million in 3Q 2017, and you said, up from $42 million. Is that the prior year?

Kevin Moug

Yes.

Tate Sullivan

Okay.

Kevin Moug

That's the backlog from September – basically, October 1 through the end of this year.

Tate Sullivan

Okay, thanks. And then can we talk – can you just talk about Merricourt wind farm a little bit in terms of – I mean, I think you're currently working on the site and installing. Can you – what are you doing there for the rest of the year?

Chuck MacFarlane

Tate, this is Chuck. For the rest of the year, I mean, we're just focused on completing the permitting and the MISO interconnection, the transmission interconnection. We have study results coming out of MISO. But the physical activity at the site is really outside of surveying and those types of things. We don't see any actual construction this year.

Tate Sullivan

Okay. When in 2018 might the construction start or is it more in 2019?

Chuck MacFarlane

Likely it won't start in earnest until 2019.

Tate Sullivan

Okay. I’m just trying to figure out the time line for your cumulative CapEx through 2021 on that. Okay. So that helps. All right, well, thank you very much and great quarter. Have a great rest of the day.

Chuck MacFarlane

Thanks, Tate.

Operator

[Operator Instructions] Your next question comes from the line of Paul Ridzon with KeyBanc. Your line is open.

Paul Ridzon

Good morning.

Kevin Moug

Good morning, Paul.

Paul Ridzon

Just back to Plastics. You indicated that part of the uplift is kind of split between $0.08 of just regular business improvement, regular business conditions and then, obviously, the Harvey impact. How do you see the former of those playing out into 2018? I guess, kind of what drove that? Is it housing starts? Is it – and – okay. I guess, only that.

Kevin Moug

Yes, Paul, I mean, in terms of how we looked at the just the normal business kinds of operations, I mean, we went back and looked at the volume of pounds that we were selling in the individual months of the three quarters in 2016 and compared that with the same time frame in 2017, and we were seeing and we'd been seeing it in the first six months of the year as well where our volumes of pounds being sold were up in terms of just overall better market conditions. In terms of housing starts, we have continued lower interest rates. And so the market conditions for – whether it's commercial or residential construction seemed to be more favorable here in 2017 as they had been in 2016.

And as we look at – as we – we're not going to be giving guidance for 2018 until February. I think maybe one way to try and help you as if you go back and look at the last four years of our profitability in Plastics. So I just would take you back to 2013. We made $13.8 million in 2013 under some pretty good market conditions that year, and that was $0.38 a share. In 2014 we made $12.1 million, which is $0.33 a share. In 2015 we made the same amount, $12.1 million and that was $0.32 a share. And then in 2016 we saw some more challenging conditions in terms of resin prices, in sales prices, and we made $10.6 million, or $0.27 a share.

And so we based on history, and you can go back to – we tend to go back to the recession of 2009 and look at what kind of profitability does this business generate over the cycle, and we would expect that these businesses, they've been able to deliver pretty consistently at $0.045 of net income per pound over the cycle. Certainly, some years are higher, some are lower. But that's kind of how we view it, and then we look at kind of the current conditions as we head into 2018, and we'll look at where we think the year is going to be.

And as I mentioned to Tate's question, we'll update that guidance as we go through the year based on what we're seeing. There is pressure on resin prices going up. If the demand is softened because of housing starts starting to come down or interest rates are moving the wrong way, we would certainly look to update it. But that's – hopefully, that helps you in terms of how we're thinking about the business.

Paul Ridzon

How would – through the course of 2017, has that business environment just steadily been ticking up?

Kevin Moug

Yes.

Paul Ridzon

Okay. And then just any risk that you cannibalized from '2018 sales due to this Harvey phenomenon?

Kevin Moug

We have not seen that happen in terms of – we've certainly been looking at that here internally, as has there been some acceleration of demand from 2018 into the 2017, and we haven't seen that. There certainly was probably some acceleration of demand because of the concern of the availability of resin. But there isn't anything that we've seen in talking with our folks on the business side as we see a big pull forward from 2018 into 2017.

Paul Ridzon

So any acceleration is probably confined to within 2017 itself?

Kevin Moug

Yes.

Paul Ridzon

Okay. Thank you very much.

Kevin Moug

You’re welcome.

Operator

Your next question comes from the line of Tate Sullivan with Sidoti. Your line is open.

Tate Sullivan

Hi. Thank you. Couple of follow-up on, first, manufacturing. Did I hear Kevin mention something about Georgia improvement? I thought has the plant you bought in Georgia already improved? But are you just indicating further improvement? Or maybe I misunderstood.

Chuck MacFarlane

This is Chuck. It has improved, but it is not where we want to be or where we believe it can be. So it has made year-over-year improvement, both in sales volume and in margin and in net income. But we continue to be focused on improving that facility.

Tate Sullivan

It is to clarify and if you can't mention it. Is most of that facility related to the Polaris factor? Is it working with other clients as well?

Chuck MacFarlane

We have a number of clients. The Polaris facility is really just starting to open. They're running a little behind on that. So we have not seen a large transfer of work, but we do expect more of that to be occurring in 2018 and beyond.

Tate Sullivan

Okay. And then on – I think when you were discussing – you were discussing some corporate costs, including higher pension earlier, maybe some higher property expenses. But I wasn't sure if that's within your utility or is that within the corporate line item? I'm just looking at your EPS guidance for – I mean, EPS guidance for 2017 between $0.10 and $0.14 for the corporate expenses of a per share loss.

Kevin Moug

Tate, it’s Kevin. The pension costs and those things, that's all related to predominantly effects of the electric utility, because the electric utility provides to the pension – the most of the pension benefit is provided in the electric utility.

Tate Sullivan

Okay.

Kevin Moug

So in terms of the property tax expenses and the pension costs, that's all in the guidance related to our electric utility business. The corporate costs of the $0.10 to $0.14, that's the remaining unallocated corporate costs that are not, if you will, sent out to our either the electric utility or to our Manufacturing businesses. And those costs were down – on a quarter-over-quarter basis, they were lower by about $700,000, and collectively for the year, we're maintaining that range of that $0.10 to $0.14 a share for the corporate costs for 2017.

Tate Sullivan

Okay. Thanks for taking my follow-up.

Operator

There are no further questions over the phone at this time.

Chuck MacFarlane

Well, to summarize, net earnings increased $0.08 quarter-over-quarter following two earlier quarters of year-over-year improvement. Our Plastics segment drove the improvement, selling more pounds of pipe and earning higher margins than expected, partially due to hurricane-related market dynamics. Manufacturing segment earnings were up slightly. Corporate costs were below last year's third quarter. And utility earnings were down primarily due to a final true-up in the estimated interim rate refund provision for the Minnesota rate case. Given our strong first three quarters, we are raising and tightening our 2017 earnings guidance to a range of $1.75 to $1.85 per share.

Thank you for joining our call, and we look forward to speaking with you next quarter.

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.