SimonSkafar
Usually, I find it very difficult to invest in conglomerates, large or small. They attract a conglomerate discount that doesn’t go away unless there is a radical restructuring and divestments or spinoffs. There are, of course, some exceptions that prove the rule – think Berkshire Hathaway (BRK.A, BRK.B), for example – but mainly conglomerates are not successful. The malaise at General Electric (GE) is a case in point.
Otter Tail Corporation (NASDAQ:OTTR) is one company that manages itself more like Berkshire, successfully managing a diverse business model. This small-cap stock is a quality company, in my opinion, and operates three independent segments Electric, Manufacturing and Plastics, as per its most recent Form 10-K. The company can trace its roots back to 1871 and now has a market capitalization of $2.3 billion.
Electric operates across generation, transmission and distribution and supplies power in Minnesota, North Dakota, and South Dakota to residential, industrial, and commercial customers. Its electricity is generated from coal, natural gas, wind, and hydropower.
Manufacturing operates in metals fabricating, contract machining, painting and the production of plastic thermoformed horticultural containers supplying various industries, such as agricultural, construction, industrial, and energy. It manufactures clamshell packing, blister packs, returnable pallets, and handling trays for shipping and storage also.
Plastics manufactures polyvinyl chloride pipes for municipal and rural water, wastewater, storm drainage, and water reclamation systems. This business makes sales into wholesalers and distributors using independent and company sales representatives.
The company’s Q3 earnings, released on 31 October, showed record earnings. Consolidated operating revenue was up 21% to $384 million, and total net income rose 60% to $84 million. Earnings per share on a fully diluted basis rose 60% to $2.01.
One of the key reasons for this performance was the growth from Plastics, which reported $56 million profit in Q3, compared to $28.4 million in Q3 last year. Operating margins for Plastics are benefiting from elevated spreads of polyvinyl chloride pipe sale realized prices relative to resin input costs. Electric’s earnings were up 10.3% relative to Q3 last year, mainly thanks to increased commercial and industrial sales volumes. Manufacturing saw earnings up by 48.1% compared to Q3 last year, also on higher sales volumes, but also more manufacturing cost savings and savings in operating and maintenance expenses.
In his CEO overview, Chuck MacFarlane said:
Our long-term focus remains on executing our strategy to grow our business and achieving operational, commercial and talent excellence to strengthen our position in the markets we serve. We remain confident in our ability to achieve a compounded annual growth rate in earnings per share in the range of 5% to 7% using 2024 as the base year. We currently expect to see elevated earnings from our manufacturing platform into 2023 with our earnings mix expected to move to approximately 65% from our Electric segment and 35% from our manufacturing platform beginning in 2024.
Otter Tail Corp keeps a strong financial position with cash of $73 million and long-term debt of $823 million. It is rated investment grade at BBB and maintains a $170 million line of credit. Seeking Alpha scores it with a Profitability Grade of B+, Dividend Consistency of A, Dividend Growth of B+ and Dividend Safety of B.
Right now, about 70% of the company’s earnings come from the two manufacturing segments because of the high prices and unusually strong margins it is achieving. Historically, about two-thirds of profits came from the electric utility segment and one-third from the two manufacturing segments.
It is likely that we will get some normalization in operating margins in 2023 that would cause profits to decline next year. Earnings estimates per share estimates for 2023 are just under $4, which is a slump from the $6.73 expected this year. This puts the stock selling at 8.3x next year’s non-GAAP earnings, which seems cheap for this kind of group of businesses of an electric utility and manufacturing. While the utility business is stable thanks to regulations, the plastics business has a lot of growth given the continued rollout of plastic piping to replace metal pipes in the water network.
Otter’s dividend consistency score of A is because it has paid an annual dividend uninterrupted since 1938. The current dividend is $1.65 and a dividend yield (forward) of 2.95%.
I came across Otter Tail because I noticed that investment legend Joel Greenblatt had bought the stock and maybe he thinks it is a Special Situation. There would no doubt be value realized if the utility and manufacturing businesses were split. That would be a typical Greenblatt investment, realizing the conglomerate discount.
Conclusion
Otter Tail is an interesting opportunity because of the stability of its dividend thanks to its electricity utility side, with the added bonus of upside growth driven by its manufacturing and plastics segments. Planned rate (power price) increases have been approved by state regulators so the electric utility segment can provide single-digit growth too. This gives the stock an element of inflation protection.
Otter Tail Corporation is an investment opportunity for investors prepared to look at alternatives to the big utilities that sit in the Dow Jones Utilities Index. The stock appears to be on the cheap side, and the Greenblatt investment indicates there is more value to be gotten. Otter Tail Corporation is managed in a sensible way, as a holding company, so any potential break-up should not be too difficult to execute.
For investors wanting to know more, I highly recommend going through Otter Tail’s presentation at Sidoti’s September Small-Cap Virtual Conference.
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