October Idea of the Month: Otter Tail

by Travis Johnson, Stock Gumshoe | October 31, 2008 3:51 pm

This Halloween, I think I’d like to dress up as an otter.

Seriously, don’t otters always look like they’re having more fun than most animals?  all that sliding, and laying on your back supping on sea anemones … aaaahhh, much more relaxing than watching CNBC.

Otter Tail (OTTR), however, has not been having fun.  At least not this year.

This company, teased a while back by the Motley Fool (and a long time pick of theirs), is a conglomerate built around a small electric utility, and the shares were sent to the stratosphere on the back of enthusiasm for wind energy.  That enthusiasm was largely based on their business of building towers for wind turbines and buying shares in wind farms. The tower business is a relatively small part of the company but, in terms of revenue, is the division that’s growing the fastest.

I’ve actually been fairly conflicted about which stock to write about today — I also looked at some extremely cash-rich companies, and very nearly decided to send you to KHD Humboldt Wedag (KHD), which is an engineering and construction firm that primarily sells cement plant equipment to Asia, Eastern Europe, Russia, and the Middle East.  KHD could be bought for less than their net cash early this week, though that caught the attention of a lot of investment writers who talked it up, and the price climbed dramatically in the space of a few days.  On the cash-rich front, I’ve also been intrugued by Cowen (COWN), a niche investment bank that also trades at a big discount to their net cash position.  And on the super-stable front, I’ve been tempted to delve into some of the pipeline companies that we’ve seen so heavily teased lately, with both Boardwalk Pipeline Partners (BWP) and Kinder Morgan Management (KMR) looking very promising to me right now.

But in the end, I decided that the fact that Otter Tail is again trading as a reasonably priced utility — for arguably the first time in many years — means that it’s worth a look.

Earlier this year, you could have paid well over $40 for Otter Tail, when the Pickens Plan and Jim Cramer were both bringing wind energy strongly into the investor’s consciousness.  That was clearly too much — the shares were expensive relative to almost anything you can think of  — dividends, earnings, other electric utilities, other diversified manufacturers, whatever.  The company for years has been a steady performer that uses the cash flow from its utility to buy small and profitable manufacturing and service companies — it hasn’t ever been a lightning-fast growth company, though it was arguably priced as one for much of the past year.

But I’d argue that the “expensive” part is gone — the shares are now much more fairly priced, about 10% above their 52-week low, and though there could well be some more growing pains as they try to dramatically increase their capacity in the tower business, I think the shares are a good buy at today’s price of $22 or so, and probably are even quite reasonable to purchase up to about $25.  I do own shares of Otter Tail, purchased this week, and I have a lowball order in to purchase more.

So what is Otter Tail?

At its heart, this is a relatively small electric utility that services the northern Midwest — the Dakotas and Minnesota.  It operates in a regulated environment (a mixed blessing lately — more on that in a minute), and though they do own interests in some wind generation projects, they primarily generate electricity in the same way as most midwestern utilities, by burning coal.  For the full year 2007, Otter Tail’s revenues from the electric utility were about 26% of overall sales, but they supplied about 45% of net earnings.  Since most changes in fuel costs can be passed through to customers, at least through the regulated retail electricity business, this should remain a fairly stable and profitable core of the company.

Over the years, as regulated electricity rates have failed to keep up with inflation, the earnings of the utility have dropped — for most of the past decade the utility earned about a dollar per share per year, but it still pulled in about 75 cents a share in net income in each of the past two years, and the other businesses have supplied the necessary growth to keep the bottom line in-line, if not always growing.

And as befits a company that began as a utility and still gets the lion’s share of its profits from that business, they pay a good dividend — currently, the yield stands at 5.4%, well above the average utility yield of closer to 3.5%, and they have raised the dividend every year since 1975.  I would actually not be surprised to see the dividend growth reverse briefly or stop for a while, or be scaled back to very low levels as they invest in growth and face some required investments in their generation business, but it’s quite possible the dividend will continue to grow annually — once a company gets into that pattern for a few decades, it is very hard to stop.  The company’s current guidance for 2008, which is significantly lower than their initial guidance, is for earnings of $1.25-$1.50 per share.  That doesn’t give much room for improving a dividend which now stands at $1.19 per share on an annual basis.  Otter Tail has historically paid out about 2/3 of earnings as dividends, this year that number is likely to be much higher.

Before I get into the current operating problems that have helped the shares come down to this level, let’s briefly go over the company’s structure.

Based on sales, the largest divisions in Otter Tail are Manufacturing, Electricity, Plastics, and Health Services, in that order.

Manufacturing includes DMI Industries, the heavy steel and wind tower manufacturer that is expanding rapidly, and also a plastic parts maker and a precision metal fabricator, and Shoremaster, a company that makes commercial and recreational water stuff — inflatable trampoline rafts, boat docks, marina facilities, etc., which sound like things that are probably likely to suffer with a down economy (as they have so far this year).

The plastics companies make and sell mostly PVC and similar plastic pipe in the Central and Western US, which I would assume are fairly sensitive to construction demand.

Health services is run under the DMS Health Group name, and they sell, lease, and service medical equipment, mostly imaging equipment — including mobile CT-Scan vans, X-Ray machines, etc.

The other major businesses under the Otter Tail umbrella include an Idaho-based producer of dehydrated potato stuff for food processors, a couple engineering and construction/contracting companies, including one that does electrical infrastructure work, and a flatbed and specialty trucking company.  It’s an odd mix, to be sure.

Otter Tail carries a fairly large debt load, though I wouldn’t say that it’s unusually large for a capital intensive utility and manufacturing business — their regulatory standard is a 50/50 equity/debt ratio for the utility, and the parent company has a bit less than that much long-term debt ($700 million market cap, $500 million+ long term debt).

They are profitable and have been for decades, and they have no shortage of cash — they just raised $150 million with a well-timed equity offering that raised money in late September, when the shares were still over $30.  That equity raise, which is earmarked for their investment in expansion of DMI’s wind tower business and for an investment in a new wind farm project, will probably also be dilutive in at least the near term, since those are both long-term investments that won’t instantly boost earnings.  They also recently replaced their credit line with a much larger one ($170 million versus $75 million) for utility operations, so it does not appear to my non-accountant eyes that they’re likely to have any liquidity problems.

So why are the shares down so far this year?  Well, to be fair, to some degree they’ve just participated in the general re-valuation of the market.  Over the last 12 months, OTTR and the S&P 500 have more or less the same return — down about 25%.  It’s just that OTTR was outperforming the index by about 50 percentage points (up 30%, versus down 20%) early this Summer, so the fall in OTTR shares has been much more sudden and dramatic.

Essentially, OTTR has done very poorly of late because they badly missed their earnings estimates in the last two quarters.  Investors gave them some benefit of the doubt for missing the first quarter estimate, it appears, but when their earnings for the second quarter came in 80% below expectations, the stock was clobbered.

So, why did they so badly miss the expectations for recent earnings, and lower their guidance for this year?

Well, here are the facts: In the second quarter of 2007, they earned 53 cents per share.  In the second quarter of 2008, which is the most recent reported quarter, they earned 11 cents.  Massive growth hadn’t been predicted, but analysts did think they’d get to 56 cents, so that 45 cent miss is the 80% screaming red light warning that started to bring the shares down.  The next leg came with the market’s collapse, which was right on the heels of their fundraising and their further reduction of earnings guidance for this year (the guidance had been cut at the second quarter earnings announcement, too).

The big and most unexpected declines in earnings came from trouble at DMI, the wind tower division, and from the disappointing 2.9% rate increase approval by Minnesota regulators.  Here’s how the CEO described it in the quarterly release:

“Essentially, we are experiencing significant growing pains at DMI as the company ramps up at its newer locations and continues to integrate new customers. DMI is our fastest-growing company and a leader in the flourishing wind energy industry. This will be a year of expanding production capabilities, not one of record-breaking results. However, we see great potential in 2009 and beyond as DMI continues to increase output across its production locations.”

And the Minnesota power rate miss was significant, too — Otter Tail had raised rates by 5.4% last November on an interim basis, in conjunction with a request for a 6.7% increase.  The regulators approved only a 2.9% increase, so Otter Tail had to record those six months+ of 2.5% increases as a liability and refund that money to customers.  This means, of course, that the rates for the rest of the year will also be lower than they had expected. Overall, they do still see 2008 earnings from the utility growing, thanks to the 2.9% increase and to extra credit for their wind generation facilities, but not growing as fast as they originally planned.

There were some other reasons for the missed earnings, too, though some of those seem now to be more temporary — increased energy and fuel costs ate into their profits in the food processing unit and in their transportation division, both of which are big fuel customers, and the potato zapping market saw some lower demand due to a better European crop and some reduction in snack food demand — I can’t imagine that a recession will really cut Pringles consumption, or more broadly, processed foods consumption, so I would assume that this business is likely to muddle along.

The PVC makers faced higher costs and lower demand, thanks to the soft residential construction market, and the demand slide seems likely to continue even if resin prices fall.

Really, though, the big deal is DMI.  That’s where investors saw growth coming, and where there really has been dramatic growth in sales and order backlog, but the problems in getting new facilities up and running, and in expanding existing facilities, were clearly understated.  The business is there — wind energy continues to be pushed by the government with tax credits and benefits of various types, and the demand is large, with many new wind farms planned just in the U.S. and Canada.  Installation of wind energy set new records in each of the last four years in the U.S., and there are several very large projects under construction now, so even though the building might slow a bit for next year it appears that the long term trend is going to be positive for quite a while. But the fact is, DMI has apparently not managed its growth all that well — they’ve had to pay more for staff and facilities to build up capacity, and the new capacity is going to take a bit longer to become profitable.

Will the wind energy demand continue?  I expect so, and that’s part of the argument for these shares, but that’s not guaranteed.  One wild card is the government, a more aggressive push for more wind energy from a new administration could add another boost, but wind energy has also been subject to some very erratic tax policies over the past decade, with programs that were allowed to expire and then restarted, so sometimes long term planning for new projects gets thrown off.  The industry is getting stronger, and there are many more turbine and component manufacturers expanding their U.S. capacity right now, including big players like Vestas as well as many smaller companies, so there is a strong demand for consistent government policy from an industry that is creating jobs, which can’t hurt.

The shares traded at a premium for the past four or five years because the firm got attention as a growing conglomerate, even being compared in some circles to a young Berkshire Hathaway, and the stock had a huge boost earlier this year because investors got overly excited about the potential growth in the wind business.

Much of that growth should still be there, after these growing pains, but it’s not going to explode overnight the way many were probably expecting.  If you think of Otter Tail as primarily a utility, it stands up well against its competitors — valuations are similar, the yield is higher.  More short term weakness could definitely come to bear on the shares, however, though the company remains quite optimistic about 2009 for DMI and the electric business, and they continue to expand where they can with an eye toward steady long term growth.  They are also looking to get approval for higher rates in North and South Dakota in the coming year or two, so there is perhaps some hope that future growth is possible for the regulated utility as well, though the vicissitudes of electricity sales seem to be driven more by industrial demand (ie, all those new ethanol plants that were new customers in recent years) and by summer temperatures than by anything else.

2008 has been an awful year for Otter Tail, including two very weak earnings reports in a row that probably shook out all the growth-focused investors, and it’s quite possible that the next six months will not be dramatically better.  But I think their patient and careful acquisition philosophy will serve them well in the long term, and that their stable of largely profitable and diverse businesses can, on average, at least tread water in a weak economy.  And if DMI Industries is able to more effectively manage their expansion and turn their backlog into revenue and profits, there is potential for a short term boost as investors forgive them for their growing pains and some significant sales growth kicks in.

If you like wind, there are other manufacturers of wind towers and components you might want to consider — Trinity Industries builds these towers, though their larger focus is on rail cars; and Thomas and Betts has a structural steel tower business that makes some wind towers but appears more focused on electrical transmission line towers, and overall it makes up only a tiny part (less than 20%) of a company that is focused on electrical products and supplies.  And of course, you can also look to one of the huge European companies like Vestas, or to one of the Wind ETFs that primarily focuses on those companies.  You can also look at one of the big utilities that has developed expertise in wind, like FPL.

There are a lot of choices, I just think that Otter Tail represents a potential value because of the recent price decline — it seems as though investors went from expecting a booming wind business, to expecting that none of their non-electric businesses will be profitable … over the next five years, I expect that a future that drives the middle ground between those extremes is probably the most likely.  OTTR hasn’t seen prices this low since 2000, and I think it’s a reasonable port in the current storm — the half of their earnings that comes from the electric utility should be a solid bulwark against any other weakness, since people don’t turn out the lights in a recession.

If you’re interested in these shares, I’d suggest you be mindful of the earnings release that’s due probably next week — I have no idea whether the bad news is all out for this firm yet, so I’d think about splitting any long-term purchase around earnings, half before and half a few weeks after, and be mindful that it’s certainly possible that the shares could hit new lows from here, too, particularly if they have more problems with DMI expansion, or they further reduce guidance or cut the dividend.  I believe the future will be OTTR’s friend, but the next few months are anyone’s guess.

Best of luck — and happy Halloween.

full disclosure: I own shares of Otter Tail and have had an order in place to buy more if they drop substantially (20% or so).  I also own shares of Berkshire Hathaway, but not of any other firm mentioned above.

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