Otter Tail Corp

NASDAQ:OTTR

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, and welcome to Otter Tail Corporation's 2018 Second Quarter Earnings Conference Call. Today's call is being recorded and we will host a question-and-answer session after the prepared remarks. I will now turn the call over to the company for their opening comments.

[Loren Hanson, Manager of Investor Relations]

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 second quarter results and increased our 2018 earnings per share guidance range. Our complete earnings release and slides accompanying this call are available on our website at 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, I want 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. 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 turn the call over to Otter Tail Corporation's President and CEO, Mr. Chuck MacFarlane.

[Charles MacFarlane, President and Chief Executive Officer]

Thanks Loren. Good morning, everyone. Last night we released our second quarter results. For the quarter, net income from continuing operations was $18.7 million or $0.47 a share compared with $16.7 from continuing operations at $0.42 a share last year.

All operating segments improved net income quarter-over-quarter contributing to positive results, our electric segment had favorable weather across the service area and interim rates in place in North Dakota.

Our manufacturing segment experienced increased revenue and our plastic segment delivered improved operating margins. Lower tax rates also contributed to earnings increases in both manufacturing and plastics.

Allow me to briefly discuss each segment. We mentioned during our last call that Otter Tail Power received authority to reduce interim rates in North Dakota effective March 1st to accommodate lower federal tax rates.

This decreased our overall request from 13.1 million to 7.1 million. In July, we reached a proposed settlement agreement with the North Dakota public service commission staff and interveners in the case. The proposed settlement results in an annual revenue increase of 5.4 million and allowed return on equity of 9.77% and future eligibility for costs associated with the natural gas generation project – Astoria and natural gas generation project to be covered in riders.

We expect the North Dakota Commission to decide on the case by the end of the third quarter. The South Dakota Public Utilities Commission established Otter Tail’s current rates in 2011 based on 2009 cost.

Since then, the costs we incurred to serve customers have increased. On April 20, we requested a rate review on South Dakota. As a result of tax reform, we are able to reduce the overall rate request by more than a million.

This is a multiyear request; the first step would be to increase nonfuel rates by approximately 3.3 million or 10%. If the commission approves the request as filed, a typical residential customer's bill would increase by approximately $11 a month.

The second step would be a 1.7% increase to recover costs for the Merricourt wind generation project, when that facility goes into service. We anticipate the commission will make a final determination on our overall request in October. Even with the combined increase, we expect our South Dakota rates to continue to be among the lowest in the nation.

In Minnesota, we are part of an ongoing docket with other Minnesota utilities regarding the handling of tax reform in that state. Otter Tail Power also continues to manage the Big Stone South, the Ellendale 345 kV transmission project. The map on Slide 8 shows its relative location. We are a 50% owner in this 163-mile line with MDU. The project has obtained all easements, completed all 750 foundations, set 85% of the structures, and remains to be on schedule to be completed in 2019.

Our share of the project will be approximately $125 million. This is a Midcontinent Independent System Operator Multi-Value Project, allowing formula rate recovery from all customers in MISO's Upper Midwest footprint. Otter Tail Power customers will pay about 1% of the cost. Otter Tail Power is also working its way through the MISO generator interconnection process for both the Merricourt wind and Astoria natural gas generation projects. These two projects are included in the list of rate base projects on slide 11.

Both are included in the approved Minnesota Integrated Resource Plan and have received North Dakota Advanced Determination of Prudence and have their major permits. These projects are part of our electric segments plan to grow rate base by an annual growth rate of approximately 9% from 2017 to 2022.

Customer satisfaction continues to be a key performance indicator at Otter Tail Power. In July J.D. Power released its 2018 Electric utility residential customer satisfaction results, indicating Otter Tail Power’s overall score of 733 on a 1000 point scale.

Our target is to be among the top three of ten utilities in our neighboring peer group. We thank our dedicated employees for achieving that goal in 2018.

Now turning to the manufacturing segment. Earnings per share were up $0.02 compared with second quarter last year primarily due to the impact of tax reform.

BTD, our custom metal fabricator, is our largest manufacturing business. BTD's quarter-over-quarter revenue was up $8.3 million due to increased sales in its primary markets. Though the second quarter steel tariffs did not greatly impact our product prices, in large part, because BTD’s secured contract prices for steel, before tariffs took effect.

Looking forward, we do not anticipate higher steel prices from tariffs having a significant impact on BTD’s margin as steel cost are largely passed through to customers.

BTD is working to enhance productivity in a period of increased volume and tight labor markets. Our investment in the company’s Minnesota facilities has provided additional capabilities and capacity and BTD’s expansion to the Southeast has created new opportunities.

Vinyltech and Northern Pipe Products or PVC pipe companies continue to have strong financial performance with a $0.04 earnings improvement quarter-over-quarter. Market conditions continue to support strong sales prices and operating margins, which primarily drove this segments earning improvement.

As we pointed out in the past, these companies have low capital and operating cost that provide excellent customer service. They have strong earnings; strong cash flows and they are highly competitive.

Overall, we are pleased with the second quarter results which include improved operational and commercial performance across all of our companies.

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

[Kevin Moug]

Thanks, Chuck and good morning, everyone. All of our business has delivered another solid quarter resulting in increased revenues and earnings. Please refer to slide 16 through 18 as I discuss our second quarter results.

The Electric segment net earnings increased $466,000 quarter-over-quarter. Key drivers contributing to these 4.6% increase were $2.5 million as a result of an increase in kilowatt-hour sales due to colder weather in April and warmer weather in May and June compared to the same time frame a year ago.

Weather positively impacted earnings per share by approximately $0.05 quarter-over-quarter and compared to normal, weather also positively impact their earnings by approximately $0.04 per share for the quarter.

$1.9 million as result of increased megawatt-hour sales to an industrial customer, $1.4 million increase in retail revenues net of an estimated refund related to interim rates that went into effect in January of 2018 in conjunction with the 2017 North Dakota general rate increase request.

Also positively impacting earnings were increased, renewable resource, rider revenues in Minnesota and North Dakota along with conservation improvement program incentives in Minnesota.

These items were offset in part by the $2.4 million reduction in revenues related to a provision for refunds to recognize that current retail rates in Minnesota and South Dakota are recovering federal income taxes which are more than the reduced tax rate from tax reform, $1.3 million reduction in revenues related to final rates implemented in Minnesota that were lower than interim rates in effect during the second quarter of 2017.

Lower North Dakota and South Dakota Environmental cost recovery rider revenue due to the impact from the lower tax rate and the lower investment balance subject to recovery resulting from depreciation. Also impacting earnings were higher O&M and depreciation expenses. And income tax expense decreased $1.8 million mainly due to the reduced tax rate from tax reform.

Net earnings for the manufacturing segment increased $628,000 quarter over quarter. Key items contributing to this improvement were BTD revenues grew $8.3 million from increased product sales of recreational vehicle, agricultural and heavy construction equipment, as well as increased scrap metal revenues caused both by higher volume and improved prices.

These increases were offset by higher cost of goods and operating expenses and although BTD's income before taxes decrease quarter-over-quarter, lower tax expense of $500,000 due to the impact of reduced tax rate resulted in a $400,000 increase in BTD's net earnings.

At T.O. Plastics revenues improved $600,000 mainly due to increased sales of horticultural containers and industrial products. Earnings were also positively impacted by reduced tax expense from the lower tax rate resulting in improved earnings of $200,000.

Our plastic segments earnings increased $1.6 million quarter-over-quarter primarily due to a 12.3% increase in PVC pipe sales prices, increased pipe prices more than offset a 4% decrease in pounds of pipe sold and a 10.6% increase in the cost per pound of pipe sold resulting in a $1.5 million increase in gross margins.

Lower income tax expense from the lower federal tax rate also positively impacted net earnings. In our corporate expenses net of taxes increased approximately $700,000 quarter-over-quarter primarily due to increased employee benefit costs as well as a reduction in income tax savings due to the reduced federal tax rate.

Moving on to our business outlook on slide 19. We are raising our 2018 consolidated earnings per share guidance range to a $1.95 to $2.10 from a $1.90 to $2.05 based on our plastic segments stronger than expected year-to-date results.

Our electric segments 2018 net income is expected to be higher than 2017 based on normal weather for the remainder of the year, milder than normal weather in 2017 caused a reduction in earnings per share of $0.04 compared normal. Weather is favorable to normal by $0.06 a share for the first six months of this year.

The constructive outcome of the rate cases filed in North Dakota last November and this past April on South Dakota and increase transmission investments. These items were offset by increased operating and maintenance expenses related to a planned outage at Big Stone plant during the last half of 2018 and higher pension medical workers compensation and retiree medical benefits.

The increase in pension costs as a result of a decrease in the discount rate from 4.6% to 3.9%. Higher depreciation due to large transmission projects being put into service and increased interest expense related to replacing short-term debt with long-term debt carrying a higher interest rate combined with increased borrowings to fund capital expenditures.

We expect increased earnings from our manufacturing segment in 2018 due to increased sales and improved operating margins at BTD through cost reductions and improve productivity, increased earnings at T.O. Plastics primarily driven by increased sales and horticultural life science and industrial end markets and lower income taxes due to lower federal tax rates implemented as part of the new tax law.

The backlog for this segment is approximately $107 million for 2018 compared with $84 million a year ago. We are also raising plastics 2018 net income expectations based on continued strong performance through the second quarter.

Higher than expected operating margins along with favorable business conditions have driven the strong performance. The solid business conditions forecasted for the remainder of the year we now expect 2018 earnings to be in line with 2017.

Earnings in 2017 included an estimated impact of $0.09 per share due to market reaction to hurricanes in the Gulf region of the United States. In plastics 2018 net income continues to be positively affected by lower tax rates.

In corporate costs, net of tax are expected to be higher in 2018 primarily due to the impact of the lower tax rate. The change in the guidance range for corporate costs is primarily driven by increased employee benefit costs resulting from increasing the company's overall guidance range.

We have also updated our 2018 through 2022 anticipated capital expenditures. The update primarily relates to the expected timing of capital spend for the Merricourt wind generation facility because of a change in the expected timing of the MISO interconnection approval.

We also have accelerated the exercise of a purchase option on the Ashtabula III wind farm project from 2023 to 2022. Of the $980 million in the capital expenditures anticipated the electric segment over the next five years approximately 38% is earmarked towards renewable projects.

Our current earning guidance for 2018 reflects 66% of earnings per share from our electric segment and 34% from our manufacturing and plastic segments net of unallocated corporate costs.

This current mix is primarily impacted by the strong financial performance of our plastic segment. We expect the long-term earnings mix to be back in line with the 75% of earnings from our electric segment and 25% for our manufacturing plastic segments net of unallocated corporate costs.

This will be driven by the capital plan which calls for approximately 93% of our capital spend over the 2018 to 2022 time frame to be in the electric segment. This will continue to drive our proximate 9% compounded annual growth rate in rate base and move our earnings contribution back in the 75% to 25% mix and continue to maintain our moderate risk profile.

We are pleased with our second quarter and strong year-to-date financial performance achieving our 2018 earnings per share guidance remains dependent on the business and economic challenges are two platforms we'll face.

Key initiatives include constructive outcomes in the North Dakota and South Dakota rate cases, BTD's continued operational improvements across all locations to further improve our return on sales margins and increased sales that are resulting from an improved economy and continued strong earnings, cash flows and returns on invested capital from the Plastics segment. We continue to be well positioned to achieve a 4% to 7% compounded annual growth rate and earnings per share based on 2017's $1.81 per share.

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

[Operator]

Thank you. [Operator Instructions] Our first question comes from the line of Paul Ridzon with KeyBanc. Your line is open. Please go ahead.

[Paul Ridzon, KeyBanc]

Good morning, guys.

[Charles MacFarlane, President and Chief Executive Officer]

Good morning, Paul.

[Paul Ridzon, KeyBanc]

You mention the Tax Cuts and Jobs Act a couple of times in your utility commentary. Did that all flush to zero from an EPS standpoint when it works through your income statement?

[Kevin Moug]

Yes. I mean, there is – Paul, this is Kevin and we're seeing obviously a reduction in revenues as we anticipate the amount of dollars that's go back from the benefit of the taxes, but then that is offset down in the tax expense line. So they're netting to zero.

[Paul Ridzon, KeyBanc]

Thank you. And is the strength in Plastics, is any of that related to follow on from the hurricanes or is that well behind us?

[Kevin Moug]

No, Paul, Kevin again. There is – the impact of the hurricanes had pretty well subsided back in the probably by November or so of 2017 and then we've just continue to see strong sales prices hold and continue through in the 2018 and some of the announced resin increases that were expected during the first three, four months of 2018 haven't fully materialized and so we've been benefiting by the strong prices and not as high as expected resin costs which are really driving the performance of the segment.

[Paul Ridzon, KeyBanc]

And then lastly, because they are comparative businesses, have we started to get any sense that the benefit of tax reform is going to get competed away?

[Charles MacFarlane, President and Chief Executive Officer]

While, we've not seen any pressure at all to-date from customers asking to get that benefit of tax reform passed through to them in the form of pricing. I don't -- from that perspective I think we're probably just would worry more about particularly in Plastics, competitors doing something to just reduce prices, but I don't think it would necessarily be related to anything having to do with tax reform. And that's just based on historical experience in the business where some competitors will, from time to time take a different strategy with pricing and reduce their prices which then certainly impact our margins.

On the manifest -- and that I would say the same thing would be similar for T.O. Plastics and at BTD, we've not seen any pressure to give that back. And then the other thing that of course is driving particularly BTD is the labor market, and the labor market is certainly positive in terms of unemployment. There's lots of jobs available for people and of course we're seeing wage pressure on the expense side at BTD and so that too we're something we're cognizant of and trying to make sure that we are able to get that wage rate pressure passed on into our prices as well.

[Paul Ridzon, KeyBanc]

And then at PVC, is it just housing starts that's kind of the volume there?

[Charles MacFarlane, President and Chief Executive Officer]

That is tends to be the best indicator, Paul. This is Chuck. So there are other major infrastructure projects, road and highway that type of deal, but the best indicator we look at is new home starts and they have to be in our regions that we serve.

[Paul Ridzon, KeyBanc]

And how much of that business is residential?

[Charles MacFarlane, President and Chief Executive Officer]

A large percentage of it.

[Paul Ridzon, KeyBanc]

Thanks again.

[Operator]

Thank you. [Operator Instructions] I’m showing no further questions at this time. And I would like to turn the conference back over to Mr. Chuck MacFarlane for any further remarks.

[Charles MacFarlane, President and Chief Executive Officer]

Thank you. Well to summarize, earnings per share increased $0.05 or 12% quarter-over-quarter in part due to a favorable weather at Otter Tail Power service area and the interim rate revenues in North Dakota.

Increased volumes and lower taxes at B2B and T.O. Plastics and improved sales margins and lower taxes at Vinyltech and Northern Pipe Products. I like to extend our appreciation to employees across our organization for their hard work and the second quarter results.

Looking ahead, we have the right long term strategy in place supported by a solid capital growth plan. We remain on track to deliver shareholder value in 2018 and have increased our full year guidance range.

Thank you for joining our call. We appreciate your interest in Otter Tail Corporation and look forward to speaking with you next quarter

[Operator]

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a great day.