Otter Tail Corporation

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

Otter Tail Corporation is a diversified company involved in electric utilities, manufacturing, and plastics, primarily operating in the upper midwest of the United States.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Otter Tail Corporation (OTTR) operates as a multifaceted entity with three primary business segments: Electric, Manufacturing, and Plastics. This diversity allows for some mitigation against the cyclicality of any single industry, but also introduces complexity in evaluating the business.

Business Overview:

Electric Segment: The company’s electric segment focuses on the generation, transmission, and distribution of electricity, mostly through coal and natural gas. This segment serves a broad range of customers, including residential, commercial, and industrial, primarily in Minnesota, North Dakota, and South Dakota. Their regulatory environment is complex and highly influenced by state and federal entities.
Manufacturing Segment: This segment produces machined and fabricated metal parts, stampings, fabricated metal products, as well as the painting and plating of metal products.
Plastics Segment: This segment primarily engages in the extrusion of PVC pipes, conduit, and fabricated products through its two divisions: Northern Pipe Products and PVC Plastics. They manufacture and market PVC pipe, conduit, and specialty product in the upper midwest of the United States and parts of Canada.

Industry Trends and Competitive Landscape:

Electric: The electric utility industry is highly regulated and capital intensive. Growth is often tied to population increases and economic expansion. It is also increasingly influenced by government policies promoting renewable energy sources and energy efficiency, which can lead to substantial investments and operating changes. The sector is becoming more competitive with a growth in distributed energy generation and the rising cost of electricity that drives innovation in reducing electricity consumption.
Manufacturing: The manufacturing segment is marked by high competition and cyclical patterns tied to the economy. Automation, supply chain management, and technological changes affect the costs and efficiency of companies within this industry.
Plastics: The plastics sector faces rising raw material costs, particularly resin, and increasing competition. Companies must invest in product differentiation, quality management, and customer satisfaction to maintain a strong position in the market.

What Makes Otter Tail Different? Otter Tail’s diversified business structure sets it apart from its peers. This can give some stability through diversification and mitigate the risks from any single industry. Most peer companies, including the ones mentioned, only operate within one sector. Furthermore, their geographical presence is limited.

Financial Analysis:

Revenues:

OTTR’s revenue sources are reasonably diversified across their three main divisions: Electric, Manufacturing, and Plastics. However, there is a shift towards their Electric division, which is also a higher margin division.

From the latest Q3 2024 results, the overall operating revenues for the three months ended September 30, 2024, was $338.03 million, an increase of $7.16 million, or 2.1% over 2023.
Electric Segment: Generated $130.7 million in operating revenue in Q3 2024, which increased by 0.2% compared to the previous year period.
Manufacturing Segment: Generated $79 million in operating revenue, a decrease of 28.6% from 2023.
Plastics Segment: The plastics segment generated $127.8 million in operating revenue, an increase of 3.5% year-over-year.

Operating Income and Margins:

The operating income for the quarter decreased by 12.3% to $107.5 million in Q3 2024 as compared to $122.7 million.
The company’s profitability, especially in the Electric segment, can vary based on fluctuations in fuel costs, regulatory changes, and customer demand. There’s been a visible shift away from manufacturing and towards Electric, a higher margin division.

Key Financial Metrics

Return on equity (ROE): 12% as of September 30, 2024.
Debt-to-equity ratio: 0.85 as of September 30, 2024.

Recent Concerns/Controversies and Management Perspective:

Rate Hikes and Regulatory Environment: The most immediate risk is that OTTR is undergoing several rate cases with regulatory agencies that are looking for better customer protection, which may impact the company’s profits and margins. For instance, the rate increase that the company has already agreed to implement in North Dakota has been limited. Management has noted that they are exploring other alternatives with different states and regulatory commissions.
Weather Impact and Fuel Costs: In earnings calls, the company has cited the negative impacts of drought on its operations, affecting hydroelectric power generation, and also has had negative influence from lower energy prices and the reduced demand during warmer winters. The management has indicated they are taking steps, including new power generation technology to improve profitability in a volatile environment.
Supply Chain Issues: In the plastics segment, supply chain issues related to PVC resin still persist. These have been mentioned in the latest filings. The company is working on increasing domestic and contracted supply for PVC resin in order to reduce supply chain risks.
Inflation: The company also faces inflationary pressures that they are dealing with by implementing cost cutting measures and increasing productivity.

Moat Assessment: OTTR’s competitive advantage isn’t strong. While the company has a stable customer base and has been in the business for a long time, their operations are dependent on commodity products and regulated prices, leaving little room for the company to increase its prices without regulatory approval. This, along with limited geographical presence, does not build enough moat for the company to have a higher rating. The company has had some progress in developing intangible assets, particularly related to a good reputation and brand loyalty among customers.

Moat Rating: 2/5 - While OTTR has some defensible competitive advantages in specific regions and niches, they are limited to create a significant economic moat.

Risks to the Moat and Business Resilience:

Regulatory Risks: Changes in regulation, particularly in the electric utility segment, can significantly affect pricing, profitability, and the company’s ability to grow through acquisitions.
Commodity Price Risk: The price of key inputs for all three segments, such as natural gas, oil, metals and resins, are subject to price fluctuations, which can lower profitability.
Disruptive Technologies: Changes in technology, including the rise of distributed generation and alternative energy sources could reduce demand for the company’s core offerings in the electric sector.
Industry Cyclicality: The manufacturing and plastics segments are closely tied to economic cycles, which leads to volatile earnings.
Competition: The increase in competition in the utility sector can cause downward pressure on their margins, and will negatively impact the profitability of the company.
Weather & Climate Risks: Changes in the weather, especially drought, can have a significant impact on hydrogeneration and impact the company’s profits.

Business Understandability: OTTR’s multi-business approach with a large regulated element, can be confusing for outsiders to understand fully. The company’s earnings can be influenced by a lot of factors, and the regulatory environment and capital intensive business of electric generation is complex. That makes valuing the business extremely difficult.

Understandability Rating: 2/5 - Given the wide variety of businesses that OTTR engages in, the many aspects of the business, and the complex regulatory environment, understanding the core fundamentals of the business can be hard.

Balance Sheet Health: OTTR’s balance sheet is relatively strong with a history of low leverage. Their debt-to-equity ratio is under 1, implying they are not overleveraged. While the company has debt obligations, they are well structured and are manageable. They also maintain a healthy amount of cash that can be used for capital expenditure.

Balance Sheet Health Rating: 4/5 - The company has a good balance between debt and equity and a strong liquidity position.

In conclusion, OTTR is a company with diverse businesses, but they are limited in moat, making the valuation and business understanding extremely difficult. The company’s financial health is robust, but risks do exist and should be monitored carefully.