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Otter Tail Corporation is a diversified utility. Its electrical segment supports its dividend payments while its manufacturing and infrastructure segments offer earnings growth potential. Otter Tail has paid a dividend since 1938. From 1975 to 2008, it increased the dividend annually. With the onset of the financial crisis, dividend bumps were put on hold. Otter Tail is positioned to grow earnings from recent investments as well as cap-ex plans in its manufacturing and infrastructure segments. As earnings grow, its share price should naturally increase. Diversification in a portfolio is strongly recommended. With the recent pressure in the oil and gas industry, it’s easy to understand how a single-focused portfolio could be devastated. Of course, allotments to different sectors for the purpose of diversification vary depending on the goal of the portfolio. The utilities sector is typically included to provide a stable income stream. It is not uncommon for a utility company to offer a dividend yield above the market average. With that in mind, many investors aren’t necessarily looking for share price appreciation when they invest in a utility name. After all, the growth potential for a utility company is quite often limited. But, Otter Tail Corporation (NASDAQ: OTTR ) is a different duck – uh, otter – forget it, it’s a different type of utility company. Otter Tail is a diversified utility company operating in four distinct business segments. It produces and distributes electricity to 130,000 customers in Minnesota, North Dakota and South Dakota. In the other three of its four business segments, it provides manufacturing and infrastructure contracting services under the moniker of Varistar. It is exactly this diversification that differentiates Otter Tail from many of its utility competitors. In its latest investor presentation , Otter Tail management explains its strategy: “Strong and stable regulated electric operations provide cash flow to support dividends.” So, in that regard, Otter Tail is much like other electric utility companies. On the other hand, Otter Tail is also striving to grow: “Manufacturing and Infrastructure businesses provide above average earnings growth potential.” This excerpt from the 2013 annual report details well Otter Tail’s strategy: “The Company has lowered its overall risk by investing in rate base growth opportunities in its Electric segment and divesting certain nonelectric operating companies that no longer fit the Company’s portfolio criteria. This strategy has provided a more predictable earnings stream , improved the Company’s credit quality and preserved its ability to fund the dividend . The Company’s goal is to deliver annual growth in earnings per share between four to seven percent over the next several years, using 2012 as the measurement year. The growth is expected to come from the substantial increase in the Company’s regulated utility rate base and from planned increased earnings from existing capacity already in place at the Company’s manufacturing and infrastructure businesses.” (emphasis added) Dividend Support In the electric utility sector, rates are regulated. Rates grow based on capital expenditures. For the next five years, Otter Tail’s rate base growth is already approved. Based on 2013 rates, Otter Tail has either the lowest or next-to-lowest rate base compared to its competitors in the three states where it operates. Its compound annual growth rate for its average rate base is expected to equal just over 10% per year through 2018. This steady income stream, as mentioned above, is how Otter Tail supports its dividend payments. Having paid a dividend since 1938, Otter Tail is also committed to growing its dividend. From 1975 to 2008, Otter Tail bumped its dividend annually. When the financial crisis ensued, it forced Otter Tail to abandon raising dividends. But, it neither eliminated or lessened dividend payouts through the recovery even though its dividend payout exceeded its net income in 2009 , 2010 , 2011 and 2012 . In February 2014, Otter Tail raised its dividend for the first time since 2008. The chart below compares Otter Tail’s net income to dividends paid. (click to enlarge) Compared to other electric utility companies, Otter Tail is a more-than-fair payer. The utilities sector averages a yield of 3.16 with electric utilities averaging 3.35. In the diversified utilities segment of the utilities sector, only one domestic company offers a higher yield than Otter Tail. But, the chart below displays an important consideration when evaluating dividend paying companies – the earnings compared to the dividend rate also known as the payout ratio. The chart shows the higher-yield-payer, Pattern Energy Group (NASDAQ: PEGI ) and Otter Tail’s direct competitors in the three states it serves, MDU Resources Group (NYSE: MDU ), ALLETE (NYSE: ALE ) and Xcel Energy (NYSE: XEL ). (click to enlarge) The next chart compares the same companies in regard to dividend rate, the stock’s 50-day moving average and the resulting dividend yield. (click to enlarge) Between the two charts, Otter Tail’s allure as an income-producing investment becomes clearer. Growth Support In its non-regulated Varistar business, the three segments are Manufacturing, Plastics and Construction. Otter Tail expects increased earnings potential in these segments. The next chart displays the consistency of the regulated electric segment’s annual net income for the past few years compared to the other three segments’ net income. It is clear in this chart how the financial crisis impacted Otter Tail’s bottom line. (click to enlarge) As the excerpt from the 2013 annual report details, some growth will come from “the substantial increase in the Company’s regulated utility rate base.” The chart below displays the rate base projections and a subsequent extrapolated annual EPS projection for the electrical segment. (click to enlarge) The latter part of the 2013 excerpt references “planned increased earnings from existing capacity already in place at the Company’s manufacturing and infrastructure businesses.” In the recovery years following the financial crisis, Otter Tail undertook two distinct paths. It divested itself of business that did not fit its criteria. It also invested in manufacturing and infrastructure capacity. The chart below shows both historical and planned investments in those three segments. (click to enlarge) The return on capitalization has been growing since 2009 as shown in the next chart. (click to enlarge) In the 2014 third quarter earnings call, management commented about the manufacturing and infrastructure segments: “We expect these companies to provide approximately 25% of Otter Tail Corporation’s earnings, while earning a return on invested capital in excess of our weighted average cost of capital.” Understanding Varistar The company’s SEC filings describe the Varistar segments succinctly: “Manufacturing consists of businesses in the following manufacturing activities: contract machining, metal parts stamping and fabrication, and production of material and handling trays, horticultural containers and produce packaging. These businesses have manufacturing facilities in Illinois and Minnesota and sell products primarily in the United States. Plastics consists of businesses producing polyvinyl chloride (PVC) pipe at plants in North Dakota and Arizona. The PVC pipe is sold primarily in the upper Midwest and Southwest regions of the United States. Construction consists of businesses involved in commercial and industrial electric contracting and construction of fiber optic, electric distribution, water, wastewater and HVAC systems primarily in the central United States.” The manufacturing segment of Otter Tail provides custom metalwork services through BTD. BTD has five locations in the midwestern United States. In June 2014, The Fabricator named BTD to the number three spot on its FAB 40 list. The Fabricator is a magazine focused on North America’s metal forming and fabricating industry. The FAB 40 list is sorted by self-reported annual revenue. In October 2013, BTD was honored as Minnesota’s Large Manufacturer of the Year. BTD’s customer list includes industry leaders such as 3M, Caterpillar, Cummins, GE, John Deere, Polaris and many more familiar names. Though somewhat confusing, T.O. Plastics is also an Otter Tail manufacturing company (not a plastics company). It provides thermoformed products and packaging solutions to a host of industries. T.O. Plastics has two strategic locations in the St. Paul/Minneapolis area to serve the many medical device manufacturers headquartered nearby. T.O. Plastics is also food packaging compliant and ISO compliant. Northern Pipe Products is one of Varistar’s two plastics businesses. It is headquartered in Fargo, North Dakota and produces PVC pipe and products. NPP serves many municipal water, rural water, plumbing and irrigation markets in the midwestern United States and Canada. Its products are third party inspected and tested by industry QA agencies. VinylTech also sells PVC pipe. Its pipe is primarily used in sewer and wastewater applications. VinylTech is headquartered in Phoenix, Arizona. Its products are also inspected and tested by third party agencies. In the construction segment, Varistar operates Aevenia in Moorhead, Minnesota and the Foley Company in Kansas City and Nashville. Aevenia provides construction expertise to the energy and electrical construction sector regarding transmission and distribution, substations, fiber optics, underground and urban telecom and power projects. The Foley Company is a specialty contractor to the mechanical and general construction industry. It has over 100 years of experience on projects such as water/wastewater, industrial/power, commercial/healthcare and fabrication. As shown in the chart below, revenues for Varistar returned to pre-crisis levels in 2011. However, the net income level is still lagging. Full-year 2014 net income may finally surpass the 2007 level. The second chart displays the profit margins for the applicable time period and reflects the same recovery trends. (click to enlarge) (click to enlarge) Stepping a level deeper, the profit margins relative to each Varistar segment are displayed comparing 2007 to 2014 year-to-date. As shown, the manufacturing segment is the laggard in regard to margin recovery. (click to enlarge) Varistar’s Outlook Otter Tail recently decided to commit $33 million in capital investment to Varistar’s BTD. At its Detroit Lakes plant, stamping and tooling capabilities will be enhanced. Also, a plant expansion will allow raw materials to be housed in the same facility as production rather than in an offsite warehouse. This will reduce the costs to transport and track raw materials while providing an overall better production flow. This warehouse consolidation and plant expansion will span 2015 and should be operational early in 2016. At the Lakeville plant, paint and assembly services will be initiated. The painting services will eliminate an outsourcing process, which will tighten processes related to logistical tracking and scheduling requirements. Addressing operational efficiencies such as this should help drive profit margins upward as well as provide additional revenue. Otter Tail expects the painting capability to be operational in the first quarter of 2015. In the Plastics segment, Otter Tail is positioned to benefit from the rising global demand for plastic pipe. According to Underground Construction Magazine , the demand for plastic pipe is projected to increase 8.5% annually through 2017. In August 2014, a summary of a recent market research report about the U.S. Plastic and Competitive Pipe Market estimated the industry will grow to $13.6 billion annually by 2018. Plastic pipe has been replacing copper, concrete and steel due to its lower cost, ease of installation, better performance and corrosion resistance. While the demand for HDPE pipe is expected to see the strongest growth percentage through 2018, the demand for PVC pipe is expected to continue to dominate. The domestic commercial construction industry was slow to recover after the financial crisis. The American Institute of Architects reported early in 2014: “With such sustained growth in design activity, continued improvement in construction activity will follow suit. While the residential sector has led the upturn in the ABI, firms specializing in the commercial/industrial sector have reported solid results for most of the past year. Even firms serving the institutional sector have generally been reporting modest levels of growth over the past year.” By its mid-year review , even with weather slowing progress at the beginning of 2014, the AIA found: “But we continue to have an optimistic outlook for the commercial and industrial sectors both for the rest of this year and into 2015.” The Value of Diversification Otter Tail’s diversification strategy has proven fruitful for its shareholders. For the past ten years, shareholder return was a compounded average of 5.6%. Most of this return is the result of the tidy dividend. Remembering the dividend is supported by the earnings from the electrical segment, the chart below displays the EPS by segment and shows the solid footing supporting the dividend. (click to enlarge) Further, comparing the corporate costs to Varistar’s earnings, the chart below displays two factors – the decreasing costs allocated to corporate and the increasing gains from the Varistar segments. The footing for share price appreciation is solidifying. (click to enlarge) Referencing the planned capital expenditures and the steadily increasing return on capital displayed in the charts above, it is reasonable to further expect share price appreciation. When share price appreciation meets a tidy dividend, a shareholder’s return becomes quite intriguing. Additional disclosure: I belong to an investment club that owns shares in OTTR. Scalper1 News
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