Otter Tail Corp

NASDAQ:OTTR

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, and welcome to Otter Tail Corporation's Second Quarter 2019 Earnings Conference Call. Today's call is being recorded. [Operator Instructions]

I will now turn the call over to the company for the opening comments.

[Loren Hanson, executive]

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 2019 earnings results. 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.

[Chuck MacFarlane, executive]

Thank you, Loren. Good morning, everyone. Last night, we released our second quarter results. Please refer to Slide 5 as I begin my comments. Operating revenues increased slightly quarter-over-quarter while net income and earnings per share decreased compared to second quarter 2018.

Our financial performance is in line with our expectations, and we are reaffirming our 2019 guidance range of $2.10 to $2.25. Our Electric segment quarter-over-quarter earnings decreased mainly due to the planned outage at Coyote Station, unexpected turbine repairs at our Hoot Lake Plant and milder weather. As anticipated, our Plastics segment second quarter results were lower than 2018 due to lower sales prices on slightly high volumes.

We expect our financial performance for the second half of 2019 to remain in line with our forecast. Recall, the last half of 2018 included a planned outage at Big Stone Plant, cost associated with the establishment of foundations at Otter Tail Corporation and Otter Tail Power and the increased expense related to certain tax matters. We don't expect these costs to reoccur in the second half of 2019. Let's take a closer look at Otter Tail Power. Investments, on Slide 11, including the Merricourt Wind Energy Center and Astoria station, along with our South Dakota transmission reliability project, will produce an annual rate base growth of 8.6% between 2018 and 2023 in a constructive regulatory environment.

I'll touch briefly on a few of these projects. On Slide 14, you'll see that July 16 marked a significant milestone for the Merricourt Wind Energy Center when Otter Tail Power closed on the purchase of development assets and issued a notice to proceed for construction.

The project has received Minnesota Renewable Resource rider and North Dakota Advance Determination of Prudence approvals. We estimate the project will cost approximately $270 million and will generate enough energy to power more than 65,000 homes.

This is the largest capital project in Otter Tail Power history. Construction of Astoria Station began in May. Astoria will be a highly efficient 245-megawatt natural gas combustion turbine. It will complement our wind generation by providing a reliable backstop when the wind isn't blowing. And it will have flexible operating options and low CO2 emissions. We will invest $158 million in the project, which, during the peak of its construction period, will create approximately 70 construction jobs.

It is eligible for cost recovery in North Dakota and South Dakota during construction, we expect Astoria Station to be online in 2021. We have the opportunity to add $30 million to $55 million of rate base associated with new generator interconnection upgrades as proposed by the MISO generator interconnection process.

Self-fund is an election by the MISO transmission owner, in this case, Otter Tail Power, to fund the network upgrades associated with new generator interconnections. If approved, Otter Tail will fund and earn a return on and a return of the capital cost of the network upgrades over 20-year period from these interconnection customers.

MISO submitted its tariff modifications to provide the self-fund option deferred last year after the D.C. Circuit Court of Appeals had vacated prior orders, which had denied transmission owners the right to self-fund certain interconnection network upgrades. We anticipate this will create additional investment opportunity from generator interconnection projects over the long term.

In May, the South Dakota Public Utilities Commission approved a return on equity of 8.75% and a revenue increase of approximately $2.6 million or about 7.7%. Interim rates have begin -- been in place since October of 2018 because final rates, which began in August, are less than interim rates. Customers will receive a refund in October.

Now turning to our Manufacturing segment. BTD, our contract metal fabricator, improved return on sales on a consolidated basis and again, improved financial results at the Georgia facility, where we added stamping capability in Q2. This was done to improve logistics and better serve existing and new customers in the Southeast. Court volumes remained steady and operations continue to balance production output a costs to build the right level of inventory to ensure on-time delivery remained strong.

BTD employee accounts are mainly static for 2019 after a 15% increase in 2018.

T.O. Plastics earnings remained essentially unchanged between the quarters. In anticipation of the horticulture Q4, Q1 primary buying season, T.O. Plastics is strategically building product inventory. In Q2, we experienced growth in the plug tray sales to certain horticulture markets, and we expect we will increase production capacity in Q4 to serve those markets. We continue to improve factory output, despite tight labor markets at the Otsego and Clearwater facilities.

In our Plastics segment, Northern Pipe Products and Vinyltech had lower quarter-over-quarter results primarily due to lower sales price on slightly higher volumes. We continue to monitor resin costs and evaluate potential volatility throughout the remainder of the year. Hurricane Barry did not interrupt any of our resin supply. Both companies are implementing continuous improvement projects to enhance efficiency and capacity, and they continue to improve in the markets they serve by demonstrating responsiveness to customer needs.

On a final note, we continue to enhance our balance-generation mix. As shown on Slide 6, we anticipate that by 2022, Otter Tail Power customers will receive 30% of their energy from renewable resources, and our carbon emissions will be at least 30% below 2005 levels, all while keeping rates nearly 30% below the national average. Merricourt and Astoria, which I discussed earlier, are catalysts in these 30% trajectories.

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

[Kevin Moug, executive]

Thanks, Chuck, and good morning. Consolidated earnings per share for the quarter were in line with our expectations, despite the extended plant outage at Coyote Station, the unplanned outage at Hoot Lake plant, and milder weather compared with the second quarter last year. Our Manufacturing segment had another solid quarter with net earnings up 11% and our Plastics segment earnings were in line with expectations.

Please refer to Slide 22 and 23 as I discuss our second quarter results. Electric segment net earnings decreased $3 million quarter-over-quarter. The key items causing this decline were: Higher O&M expenses primarily related to the $2.6 million increase in maintenance and material costs associated with the extended outage at our Coyote Station; and an unplanned outage at our Hoot Lake Plant related to turbine repairs; lower revenues related to milder weather quarter-over-quarter, weather negatively impacted earnings by $0.03 a share compared to the second quarter of 2018 and compared to normal, weather had a positive impact of $0.01 a share. Other items affecting the quarter are increased retail revenues in Minnesota due to a reduction in expected refunds associated with the Tax Cuts and Jobs Act.

The effect of lower tax expense recovery requirement was rolled into base rates starting in June of '19. Interim rates net of estimated refunds associated with our South Dakota rate case that went into effect in October of 2018 increased renewable resource transmission and conservation improvement cost recovery revenues in Minnesota and increased revenues due to the establishment of a generation cost recovery rider in North Dakota related to the Astoria Station while under construction. These items were offset in part by increased property and depreciation expense and income tax expense increase, despite lower pretax earnings due to the decrease in federal production tax credits, which expired in November of 2018.

Net earnings for the Manufacturing segment increased $407,000 or 11%. At BTD, net revenues increased $3.9 million. This was driven by a $4.5 million increase in product sales to agricultural, construction and recreational vehicle end markets. $4.2 million of this increase relates to higher material costs passed through to customers with the balance due to increased value-add sales.

BTD's scrap metal revenues decreased $600,000 primarily due to lower scrap metal prices. And the overall increase in revenues at BTD were offset in part by higher cost of goods sold and higher operating and income tax expenses resulting in a $400,000 increase in earnings.

T.O. Plastics earnings were basically unchanged. Increased revenues related to increased horticultural sales driven by an early order program offered to customers during the second quarter, the catch-up on shipments that were delayed due to inclement weather during the first quarter of the year and growth of plug tray sales associated with certain horticultural end markets. This was partially offset by lower sales of industrial products. And also impacting earnings were increased cost of goods sold and higher operating expenses.

Our Plastics segment earnings decreased $437,000 due to a 3.6% decrease in pipe prices, offset in part by a 2% increase in pounds of pipe sold. Although we anticipate lower overall sales volumes in 2019 compared to 2018, quarter-over-quarter sales volumes were higher due to a stronger demand in the South Central and Southwestern regions of the United States, offset by lower sales volumes to certain customers in the Northern region of our sales territory. Cost of goods sold decreased despite the increased sales volumes due to a 2% decrease in cost per pound sold. The impact of the lower pipe sales prices exceeded the decrease in the cost of pound sold, resulting in a 9% decrease in gross margins. Our corporate pretax expense and net of tax losses increased primarily due to increased employee benefit expense.

Slide 25 reflects an updated 2019 to 2023 capital expenditure plan from $1.07 billion to $1.1 billion, based on a need for additional wind and other technology and transmission investments. We now expect capital expenditures to be $233 million for 2019, which include $79 million for Merricourt and $46 million for Astoria. With this revision, our compounded annual growth rate in rate base is now projected to be 8.6% over the 2018 through 2023 time frame. These investments will continue to positively impact the corporation's earnings and returns on capital.

Moving to our business outlook on Slide 26. We are reaffirming our 2019 consolidated earnings per share guidance of $2.10 to $2.25, which equates to a return on equity of 11.5% to 12.3% based on an estimated equity to total cap ratio of 54%. We expect a strong second half of 2019, driven in large part by increased earnings in our Electric segment. This is a result of the expected increase in revenues from South Dakota final rates being in place for the entire 6 months of 2019 compared to 2.5 months of 2018.

Increased earnings from our planned capital projects, including our Merricourt and Astoria station projects, Astoria Station started construction in May and Merricourt will begin construction in August. Additional transmission investments related to our South Dakota transmission reliability project and decreased O&M expenses due to a decrease in pension, medical, workers' compensation and retiree medical benefits. Our discount rate for the pension plan increased in 2019 to 4.5% from 3.9%, driven by higher interest rates.

Also, we incurred $0.07 a share of cost in the last half of 2018 related to the plant -- Big Stone Plant outage in Q3 and Q4 and the contribution to Otter Tail Powers foundation that are not expected to occur in the last half of 2019. We expect increased earnings from our Manufacturing segment in 2019 primarily driven by increased sales at BTD. However, we have lowered both ends of the 2019 guidance range due to an expected decrease in scrap metal revenue for the remainder of the year, resulting from lower scrap metal prices.

And as noted last quarter, we expect lower earnings at T.O. Plastics mainly due to first quarter volume softness and the expected impact on business operations from the partial collapse and replacement of the warehouse roof, which was damaged in March during a winter strong. The backlog for this segment is approximately $115 million for 2019 compared with $107 million a year ago. We expect Plastics 2019 net income to be lower than 2018 due to lower operating margins, resulting from increased resin prices on lower sales volumes and slightly lower sales prices compared to last year.

We have increased both ends of the 2019 guidance range for this segment as expected price increases for resin have moderated. And corporate costs net of tax are expected to be lower in 2019. This is due, in large part, to an $0.08 a share of expenses incurred in the fourth quarter of 2019 related to a contribution to establish the Otter Tail Corporation foundation and accruals related to certain tax matters.

These costs are not expected to occur in the last half of 2019 and are highlighted on Page 27 of the earnings call presentation. Our second quarter earnings per share results are in line with our expectations, and we are well positioned to achieve our 2019 earnings guidance as we enter the second half of the year. As noted earlier, Astoria started construction in May and Merricourt will start construction in August. Otter Tail Power Company continues to execute on major construction projects safely on-time and within budget.

We remained well positioned to grow our rate base in support of regulatory environments at 8.6% compounded annual growth rate over the next 5 years. Over time, the electric utility will provide approximately 75% of our overall earnings. The Manufacturing and Plastics segments continue to provide organic growth through new products and services, market expansion and increased efficiencies.

The Manufacturing and Plastics segments are expected to provide around 25% of our earnings over time. We expect to be able to deliver total shareholder return of 8% to 10%. Our earnings per share are expected to increase at a 5% to 7% growth rate of 2018 results, and our dividend yield is approximately 3%.

Looking forward, we would expect to grow the dividend in line with our earnings per share growth rate, while maintaining a dividend payout ratio of 60% to 70%. And our company is on solid footings with strong balance sheet and corporate credit ratings.

We are now ready to take your questions.

[Operator]

[Operator Instructions] Our first question comes from Tate Sullivan of Maxim Group.

[Tate Sullivan, analyst]

Real quickly, I have a couple of follow-ups on the utility. Did -- Kevin, can you -- I'm sorry, if you went over it a little early, the higher CapEx guidance for materials, what causes the estimate revision in that? And I assume it's all rate based.

[Kevin Moug, executive]

Yes. Thanks for the question, Tate. The revision in the CapEx is additional wind-related. We have an option to purchase the Ashtabula wind farm.

That is now included in our 2022 time frame of CapEx, that's been moved forward from 2023. And then also, there is additional technology kind of related investments that we are looking at that have been included in the revised CapEx as well.

[Tate Sullivan, analyst]

Okay. And then Manufacturing, Chuck, did I hear you earlier say that you added employees in 2Q? Or did it -- did I hear layer that it was a stable headcount in the Atlanta region facility in BTD?

[Chuck MacFarlane, executive]

Yes. Tate, in BTD, the reference was to BTD. And in 2018, we increased employee levels about 15% and that varies by location but it was primarily the Georgia and one of the Minnesota locations. And the comment was that in '19, we are at sort of static employee levels, we have not increased or decreased employee levels through the first half of '19.

[Tate Sullivan, analyst]

Okay. And then I don't think I missed it earlier. I saw your comments and heard about the lower scrap prices in BTD. What are the drivers behind that, in general?

[Kevin Moug, executive]

Yes. I mean there's been lower steel pricing in the market, Tate. And so then as a result, as those lower steel prices have come down and scrap metal prices have come down as well.

[Tate Sullivan, analyst]

And is that dynamic still in place for this current quarter too...

[Kevin Moug, executive]

The dynamic -- we expect the dynamic to be in place for the rest of the year, like we said in our comments. It was in place in the second quarter and we continue to expect in our guidance. Our forecast reflect those lower scrap prices through the rest of the year.

[Tate Sullivan, analyst]

And last one for me on Plastics and pricing versus the volumes. And I understand is it consistent how it -- how it has worked in the last couple of years? Was it a delay that factored in lower resin prices on the pricing side for the PVC, please?

[Kevin Moug, executive]

Sorry, maybe just to clarify, are you referring to sales prices, resin prices or both?

[Tate Sullivan, analyst]

Sales prices. Yes, what drove the lower sales prices or sales price specifically?

[Kevin Moug, executive]

Yes. I think that there -- 2018 was our record year for us in terms of earnings and sales prices and operating margins. And as we headed into 2019, Tate, we -- based on where we expected resin prices to move up and we are seeing some softening in sales prices. We just didn't expect that the sales price levels in '18 could hold through all of '19 and that's -- you've seen a softening in sales prices in the first 6 months of the year, and they are slightly lower throughout '19 compared to '18.

On the resin price, we -- as we headed into the year, we expected that there were going to be increased resin prices coming from our suppliers. And while we've seen some increases, we now think that there's going to be moderation in those increases the rest of the year. And so as a result, that uplift in the guidance from the first quarter to the second quarter is being driven by that moderation in expected resin price increases.

[Operator]

And our next question comes from Chris Ellinghaus of Williams Capital.

[Christopher Ellinghaus, analyst]

Kevin, you -- I appreciate Slide 27, but it kind of ruined half of my question. How do we think about the foundation and when -- and sort of future contribution timing?

[Kevin Moug, executive]

Yes. The -- we had a -- it was a $2 million contribution to the parent company foundation last year to kind of get it on good footing and establish it on a go-forward basis.

We -- every year, we -- in our budget plans, we anticipate that we would contribute to the foundation. And as we go throughout the year, we look at where we're at in terms of the foundation and how it's proceeding with its activities and its needs. And so we will evaluate that on an annual basis. This year, we think we're in good shape with the $2 million contribution that we've made to it and don't see a need to put any additional funds into it this year.

[Christopher Ellinghaus, analyst]

Okay. Great. Chuck, you were talking about the interconnection opportunity. Can you just make or clarify, is there -- is that money in the CapEx now? And is it completely in the CapEx?

[Chuck MacFarlane, executive]

It would be in the $1.1 billion estimate. This -- the range I gave of the $30 million to $55 million is in there. There could be future -- each time a interconnection customer, which is generally not Otter Tail Power, somebody else hooking up a wind farm that interconnects or has network upgrade implications through our system adds that. So as renewables grow in our region, we anticipate there could be more in future years. But we have not included anything other than known projects in the $37 million estimate that's on Page 12 of the deck.

[Christopher Ellinghaus, analyst]

Okay. So that's your best current guess?

[Chuck MacFarlane, executive]

Correct. But we anticipate, there will be more show up. We don't -- some of these customers haven't even made interconnection request that could show up within the 2023 or 2018 to 2023 time frame. But we haven't included anything on projects where we aren't aware of it, I guess.

[Christopher Ellinghaus, analyst]

Okay. PVC, the Plastics segment, your guidance is still suggesting that you would be at a level that's consistent with or slightly higher than 2017, that was -- it got the Hurricane benefit.

Is this sort of your thought process is 2019 sort of a new normal for the Plastics segment? This will be maybe the second-best year ever, down from the spike in 2018. But is this the new normal?

[Kevin Moug, executive]

Chris, this is Kevin. I think we're still not expecting that, call it, the $20 million range.

It might be on, I'd say, the high end of the new normal. I think we still -- as we look and see the dynamics in the industry, a range of normal, I would say, is -- I'm going to say in that $16 million to $20 million range.

[Christopher Ellinghaus, analyst]

Okay. The Hoot Lake outage, can you give us a number for what that cost?

[Kevin Moug, executive]

It was $0.01 a share. So roughly about a little over $300,000.

[Christopher Ellinghaus, analyst]

Okay. And lastly, with Merricourt scheduled to start construction this month, would -- have you got any update or change in thought process on when you think it will be complete?

[Chuck MacFarlane, executive]

No real change. We continue to believe it will be in, in the late third or fourth quarter of '20. The -- it's a fully 100% BTD safe harbor project. So it has to be in an operational before the end of 2020.

[Operator]

[Operator Instructions] And at this time, I'm showing no other callers in the queue for questions. I'd like to turn the call back over to Mr. McFarlane for closing remarks.

[Chuck MacFarlane, executive]

Thank you. Our financial performance continues to demonstrate the value employee -- of employee actions to grow our business, achieve operational and commercial excellence and develop talent. We are excited to have Astoria and Merricourt projects moving to construction, and we are reaffirming our 2019 earnings per share guidance range of $2.10 to $2.25. Thank you for your continued interest in Otter Tail Corporation. We appreciate you 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. You may now disconnect. Everyone, have a wonderful day.