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Otter Tail’s (OTTR) CEO Chuck MacFarlane on Q1 2016 Results – Earnings Call Transcript

Otter Tail Corporation (NASDAQ: OTTR ) Q1 2016 Earnings Conference Call May 3, 2016 11:00 AM ET Executives Loren Hanson – Investor Relations Chuck MacFarlane – President and CEO Kevin Moug – Senior Vice President and Chief Financial Officer Analysts Paul Ridzon – KeyBanc Operator Good morning. Welcome to Otter Tail Corporation’s First Quarter 2016 Earnings Conference Call. This call is being recorded and there will be a question-and-answer session after the prepared remarks. Loren Hanson Good morning, everyone and welcome to our call. My name is Loren Hanson and I manage the Investor Relations area at Otter Tail. Last night, we announced our first quarter 2016 results. Our complete earnings release and slides accompanying this earnings call are available on our website at www.ottertail.com. A replay of the call will be available on our website later today. With me on the call today is Chuck MacFarlane, Otter Tail Corporation’s President and CEO and Kevin Moug, Otter Tail Corporation’s Senior Vice President and Chief Financial Officer, who by the way is also celebrating his birthday today. Before we begin, I’d like to remind you that during the course of this call, we will be making forward-looking statements. These forward-looking statements are covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and include statements regarding Otter Tail Corporation’s future financial and operating results, or other statements that are not historical facts. Please be advised that actual results could differ materially from those stated or implied by our forward-looking statements due to certain risks and uncertainties, including those described in our most recent Form 10-K and subsequent quarterly reports on Form 10-Q. Otter Tail Corp revise our forward-looking statements as a result of new information, future developments, events, or otherwise. For opening remarks, I would now like to turn the call over to Otter Tail Corporation’s President and CEO, Mr. Chuck MacFarlane. Chuck? Chuck MacFarlane Thanks, Loren. Good morning and thanks for joining our call. For the quarter net income was $14.5 million or $0.38 per share. This is in line with our expectations with the exception of warmer than normal weather. The warm weather impacted Otter Tail Powers first-quarter earnings per share by $0.04 compared to the normal. But this was partially mitigated by improved margins in our manufacturing platform. Our business model continues to combine a strong regulated electric utility for the portfolio manufacturing businesses intended to enhance long-term returns. A key component of these two platform strategies are planned to grow the utility business. My remarks today will focus on our strategy to grow rate base and a recently filed rate case. I will also update you on efforts within our manufacturing platform to improve our competitive position. Slide 5, shows our utility rate base expansion, which will drive earnings per share growth for the next five years. We plan to invest 858 million in Otter Tail Power during this time frame. This will result a compound average annual growth rate in rate base of more than 8% from 2016 to 2020 – natural gas generation and renewable generation projects will account for the majority of this rate base expansion. With most eligible for construction cost recovery during construction, this is noted on the bottom of the Slide 6, which shows our regulatory framework. As we’ve discussed on prior calls, we’re investing in two 345-kv transmission line within Otter Tail Power services area that the mid-continent independent system operator has deemed multi-value projects. The cost of these projects will be allocated across all customers in my source 12 state upper mid-west footprint. One line will run from Brookings, South Dakota, 70 miles north to a new substation near Big Stone Plant. It’s the next leg of a recently completed CapX2020 line from the twin cities to Brookings. Slide 7, shows how they are connected. We are 50% owner in the transmission line portion of this project with the Xcel energy, our investment is $97 million, and we’ve all required easements and permits. Xcel started construction late last year and has the line on schedule to be service in 2017. The other line will run from the new substation near the plant, 170 miles North-West to Ellendale, North Dakota and is schedule to be in service in 2019. Otter Tail Power manages the project and is a 50% owner with MDU. Our investment is $153 million, construction will begin this summer, landowners have signed more than 325 of the 350 needed easements, we are finalizing contract with construction vendors and the steel tower vendor has begun producing transmission structures. We also expect to invest in new generation. Utility management has identified options within our service territory, for natural gas plant to replace capacity from the Hoot Lake Coal Plant which we plan to retire in 2021. We have identified three sites each with good access to transmission and natural gas supply. We expect to announce our site selection later this year. Otter Tail Power management is also determining the most beneficial timing and location for additional renewable energy. The company already has 250 MW of cost-effective wind generation that’s 19% of the company’s retail energy sales. Fuel utilities in the nation have a higher percentage of wind energy. We anticipated adding up to 200 MW of additional wind energy before 2021, which would put the company wind resources near 30%. We also planned to add enough solar to power 1.5% of our Minnesota electric retail sales by 2020. This equates to approximately 30 MW of new solar. Otter Tail Power will file an updated resource plan in Minnesota on June 1. Rate base investment is important to the health of our company, also important is the successful outcome to the request Otter Tail Power filed in February with the Minnesota Public Utilities Commission for permission to increase rates by approximately $19.3 million on – 9.8%. This reflects the 10.4% return on equity and a 52.5% equity ratio. The company’s current rates were established in 2011 based on 2009 costs. The portfolio has increased reflecting investments in new environmental technologies, a strength in delivery system, expiration of integrated transmission agreements and overall rising cost. On March 24, the PUC granted a 9.56% rate increase on an interim basis while it considers the overall request. The interim rates went into effect on April 16, and we expect final decision on the rate case in 2017. We intend to keep delivering affordable energy and expect Otter Tail Powers rates to remain among the lowest in the nation and region, even with the increase. I’d like to mention three other projects of Otter Tail Power. One is a10 week schedule maintenance over at Coyote Station. The largest projects are replacing the lower boiler wall, installing a separated over fire air system to reduce NOX emissions and tying into the new mine coal conveyor system. Crews have completed six of the ten weeks, so far everything is on schedule, we’ve encountered no surprises and boiler make availability has been good. This is a $35 million project and Otter Tail shares 35% or $12 million. Second project I want to mention is implementation of a new customer information system. The new system will be able to integrate new rate design, geographic information in average management system. Otter Tail Power has dedicated a strong team to this $15 million project. Attention to detail and tracing requirements, validating business processes, testing deliverables, and managing change will ensure a successful final implementation. The third project I want to mention is relicensing the five small hydroelectric plants we own on the Otter Tail River in near Fergus falls. Hydroelectric power is being part of our energy mix since 1907. It was the origin of Otter Tail Power’s name, these five small plants are combined under one folkway [ph] since it must be relicensed by 2021. We begin the relicensing effort which takes 4 to 5 years. Before turning to our manufacturing platform, I should also mention – with this clean power plant to limit CO2 emissions from existing power plants. When we held our earnings call in February, the U.S. Supreme Court had not yet issued its stay on the rule pending a lower court’s review. We expect the outcome from this review later this year followed by a review at the Supreme Court. You may recall the changes from the draft rule to the final rule were positive for Big Stone Plant in South Dakota, but created new concerns for Coyote Station in North Dakota. We don’t have an immediate compliance concern in Minnesota because we intend to retire Hoot Lake Plant in 2021. We’re continuing to meet with stakeholders in all three states as each state determines whether we’ll continue implementation planning during the stay. Now turning to our manufacturing platform, as reported out in our earnings release net income was up quarter-over-quarter, that said, our manufacturing company is continuing to be impacted by economic challenges in agriculture, energy and recreation vehicle end markets, leaving the lower sales quarter-over-quarter excluding skip sales from BTD Georgia which was acquired in September last year. Our Plastics Companies continued to be impacted by tightening margins on PVC pipe. The presence of these companies continued to guide improvement in each of their businesses as they work through the current economic challenges in the markets they serve. We look for much of our future growth in the manufacturing segment to come from BTD, a metal fabricator. In the past year we expand of the size and capabilities of our Minnesota facilities and made a strategic acquisition of $30 million annual revenue in metal fabricator near Atlanta. BTD has nearly $33 million in spending commitments to expand its facilities in Detroit Lakes and Lakeville, Minnesota. The goal is to increase capabilities, reduce logistics cost, enhance margins. The Detroit Lakes portion of the plan is complete. A new state-of-the-art paint line is operational in the expanded Lakeville facility and previously outsourced work is now painted in-house. BDT will finish consolidating the fabrication facility in Lakeville in May. We are beginning to realize productivity improvements associated with these products. The integration of BTD, Georgia has gone smoothly. We began implementing IT production systems or began integrating IT production systems this summer. At T.O. Plastics, net income was slightly ahead of first quarter in 2015, again on slightly lower revenues. The company continues to focus on horticulture containers, which is its primary market. At the PVC pipe companies Northern Pipe Products and Vinyltech, volume was stronger in the quarter, which offset a reduction in margins. Our resin suppliers announced additional resin pricing increases for the second quarter. Both of these customer companies are efficient, low-cost operators. They are in a good position and are working to ensure the pricing policies appropriate. Now, I’ll turn it over to Kevin for the financial perspective. Kevin Moug Good morning. Please refer to Slide 10, as I discuss our first quarter results. The utility net earnings decreased $640,000 quarter-over-quarter. The decline is due to; one, milder weather in first quarter of 2016 compared to the first quarter last year. Heating degree days were down by 16%. As a result weather negatively impacted earnings per share by approximately $0.04 quarter-over-quarter and compared to normal; two, higher operating and maintaining expenses; and three, higher depreciation expense due to increased rate based investments. These items were offset in part by increased environmental and transmission cost recovery writers and increased sales by client customers. Our manufacturing segment earnings increased $669,000 quarter-over-quarter primarily due to the BTDs performance. Revenues increased quarter-over-quarter for BTD by $3.9 million. The components of this increase are as follows, our Minnesota locations revenues were down $5.6 million due to softening demand from the agriculture, oil and gas and recreational vehicle end markets. Our Illinois location had an increase in revenues of $1.7 million driven by strong demand for wind tower components. And our Georgia facility accounted for $7.8 million in new revenues. We acquired the Georgia facility in September 2015. The higher net income at BTD is due to improved productivity relating to lower cost and expedited trade, manufacturing consumables, cost and quality and lower labor and benefit cost. Our plastic segment revenues increased between the quarters as a result of 18.5% increase in the amount of pounds sold, despite 13.3% decrease in the price per pound sold. Increased sales came primarily from the South-West and Central regions in the United States where construction activities remained strong. And our earnings were basically flat between the quarters due to margin compression that occurred with large drop in PVC pipe selling prices. And our corporate expenses decreased $648,000 quarter-over-quarter primarily due to a reduction in employee headcount and lower benefit cost. We are reaffirming our consolidated earnings per share guidance of $1.50 to $1.65 as shown on Slide 12. Our 2016 guidance is dependent on the business and economic challenges our platforms are facing. As part of this we are updating our segment guidance to reflect current conditions being experienced by our operating companies. We are maintaining our guidance range for the electric segment. We expect 2016 electric segment net income to be slightly higher than 2015 net income based on the reasons listed in the press release. We are increasing the expected earnings per share range for the manufacturing segment by $0.01 on both ends of the range. We are able to do this through aggressive cost management and improved productivity to address challenges for softening end markets at BTD manufacturing. We are reducing the expected range of earnings per share for our plastic segment to $0.28 from $0.26 to $0.30. We are expecting operating margins to tighten for the rest of 2016 as announced resin price increases are not expected to be fully passed on to sales prices due to current competitive market conditions. And we are improving the range of our corporate cost by obtaining a share on both ends of the range due to continued cost reduction efforts. 2016 continues to be dependent on the following items; the constructive outcome of our Minnesota rate case that was filed in February of 2016, BTDs successful growth and sales from its new paint line along with continued focus on operational improvements needed to improve our return on sales as well as full integration of BTD Georgia to better serve our customers in the South-East. These initiatives are especially important in light of the continued market softness and the agriculture, oil, gas and recreational vehicle end markets that BTD serves and continued strong earnings, cash flows and returns on invested capital from our plastic segment. We are pleased with our first quarter results, we also like our position, a strong balance sheet reflective of our current equity to total capitalization ratio of 51%. Investment grade senior unsecured credit ratings, solid regulatory environments and rate based growth in our electric segment. And we are well-positioned for a rebound in end markets served by BTD with the strategic investments we have made over the last two years. This ongoing effort positions us to meet our long-term goal of 4% to 7% compounded growth rate in earnings per share, using 2013’s $1.50 share as adjusted for the base year. We are now ready to take your questions and after the Q&A, Chuck will return with a few closing remarks. Question-and-Answer Session Operator Thank you. [Operator Instructions] Our first question or comment comes from the line of Paul Ridzon with KeyBanc. Your line is now open. Paul Ridzon Good morning. How are you? Chuck MacFarlane Good Paul and you? Paul Ridzon Well, thank you. Just one quick question, you mentioned a ten-week outage, was that cost to be capitalized or will soon that hit O&M? Chuck MacFarlane Paul, that the majority of those are capitalized. I believe the entire project has approximately $2 million in operating costs and the remainder is capital. Paul Ridzon Thank you very much. Operator [Operator Instructions] And at this time I’m showing no further questions or comments. So with that I would like to turn the conference back over to President and CEO, Mr. Chuck MacFarlane for closing remarks. Chuck MacFarlane Thank you. To summarize net earnings increased quarter-over-quarter from continued operations. Our manufacturing segment has improving performance including increased margins associated with improved operations. Otter Tail Power filed the first rate increase request in Minnesota in five years and received approval for interim rates which began in April. And we reaffirmed our 2016 earnings guidance of $1.50 to $1.65 per share. Thank you for joining our call and for your interest in Otter Tail Corporation. We look forward to speaking with you next quarter. Operator Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program, you may now disconnect. Everyone, have a wonderful day. Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited. 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Amazon, Facebook Admit Stock Compensation Is A Normal Cost

For more than a decade, technology companies doled out heaps of stock to recruit top talent — then pretended this wasn’t a normal part of doing business by reporting profit numbers that subtracted the cost. That’s changing as the industry grows up and responds to pressure from regulators and investors. Amazon.com ( AMZN ) started breaking out stock-based compensation in the results of its different businesses in the first quarter. This is “the way we now evaluate our business performance and manage our operations,” Chief Financial Officer Brian Olsavsky told analysts after the earnings report last week. Facebook ( FB ) Chief Financial Officer David Wehner had a similar message. From now on, he said he’ll talk about the social network’s results and other metrics based on U.S. standards known as Generally Accepted Accounting Principles, or GAAP, which include equity-based pay costs, instead of a mix of GAAP and non-GAAP numbers. “We view it as a real expense,” he said. Some technology companies, such as Netflix ( NFLX ) and Intel ( INTC ), already take this approach, but many don’t. If the shift to focusing on the real bottom line catches on more broadly, it could slice billions of dollars off the reported profits and official forecasts that underpin the technology sector’s lofty market valuations. Facebook stock trades at about 35 times estimated earnings over the next 12 months. Add in equity compensation expense and that price-to-earnings ratio jumps to 50, according to a Sanford C. Bernstein & Co. analysis. Amazon would trade at 122 times projected profit, rather than a multiple of 63. Using GAAP numbers, Alphabet ( GOOGL ) would trade at 26 times forecast profit, versus 21 times, Bernstein estimates. The change also highlights the struggles of smaller Internet companies like Twitter ( TWTR ) and LinkedIn ( LNKD ) to generate GAAP earnings. Facebook, Amazon and Alphabet may have high stock valuations, but they are also very profitable by GAAP and non-GAAP measures. Twitter shares trade at about 36 times estimated profit, but including stock-based compensation analysts expect it to have a loss over the next 12 months, Bernstein research shows. “If you can act from a position of strength, which Amazon and Facebook clearly are, there’s no better time to change your behavior,” said Denny Fish, who helps oversee $2.5 billion in technology stocks at Janus Capital Group Inc. “They look more responsible and it makes them accountable for how they issue stock for compensation in the future.” New Disclosure Amazon in prior quarters disclosed overall stock-based compensation, but didn’t tell investors how much went to each business and didn’t allocate this expense to these divisions for its own management purposes. In the fourth quarter, the AWS cloud business generated $687 million in operating income, and investors were left to estimate how much of Amazon’s total equity-pay costs of $606 million went into that division. Last Thursday, the company said AWS had first-quarter operating profit of $604 million, including $112 million in stock-compensation expense. Alphabet may focus more on GAAP results in the future, while Twitter is unlikely to do so because that would make its numbers look a lot worse, Fish said. In February, Alphabet started reporting stock-based compensation for its Google business and a group of newer businesses known as Other Bets. The Google unit had $1.3 billion in equity pay expense in the final quarter of 2015, leaving an operating profit of $6.8 billion. Other Bets spent $498 million on equity awards for the whole of last year, contributing to a $3.6 billion annual operating loss. ‘Egregious’ Compensation Twitter reported 2015 non-GAAP profit of $277 million, or 40 cents a share. On a GAAP basis, including stock-based compensation, the company posted a loss of $521 million, or 79 cents. “Some companies have been egregious with stock compensation,” Fish said, citing LinkedIn, which has relatively high equity-based pay compared to its revenue and earnings. Analysts on average project that LinkedIn will have profit of $591 million, or $4.27 a share, in 2017 — a non-GAAP number that excludes stock-based compensation costs. When that expense is included, along with other items, the company is forecast to lose $36 million, or 29 cents, according to data compiled by Bloomberg. LinkedIn cut growth forecasts earlier this year, making it more important for investors to assess its long-term compensation costs. “When fundamentals deteriorate relative to high-growth expectations and stock-based comp is high as well, companies can be doubly penalized,” Fish said. LinkedIn shares have declined 44 percent this year, while rival social network Facebook is up 13 percent. “Non-GAAP results are the most accurate representation of our operating results,” LinkedIn spokesman Hani Durzy wrote in an e-mail. Still, he said the company aims to reduce stock-based compensation to about 10 percent of revenue from the current 17 percent, while still using equity as a hiring tool. “Talent is critical in this industry, and we want to make sure that we’re balancing the trade-offs appropriately,” Durzy said. Representatives at Facebook, Amazon and Alphabet declined to comment. A Twitter spokesman didn’t respond to an e-mail seeking comment. Mounting Criticism Facebook and Amazon’s new approach follows mounting criticism about many companies’ overuse of non-GAAP numbers, especially in technology, where big equity awards are common. In his latest shareholder letter, Warren Buffett disparaged the omission of pay as “the most egregious” example of non-GAAP accounting. “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?” he wrote. Companies have taken note. The Society of Corporate Secretaries and Governance Professionals, which represents company executives and other managers, sent a memo to members last month highlighting comments on this issue by officials at the U.S. Securities and Exchange Commission and the Public Company Accounting Oversight Board. SEC Chief Accountant James Schnurr said executives and directors on boards’ audit committees should ask why non-GAAP numbers are an appropriate way to measure performance and probe whether they’re really useful to investors. Investor Pressure Shareholder pressure may also have had a big impact at Facebook and Amazon. The companies recently told one large technology investor that they made the change in response to investor requests and for competitive reasons. When large, profitable technology companies exclude stock-based compensation, they promote an accounting concept that lets smaller rivals appear more profitable than they actually are. This helps these same rivals compete better for talented employees, who are looking to work at the most successful firms, said this investor, who asked not to be identified because the conversations were private. If the tech industry keeps shifting toward treating share-based pay as a real expense, Twitter may be most exposed, according to Carlos Kirjner, an Internet analyst at Bernstein. The social-media company has to compete with Internet behemoths Facebook and Alphabet and venture-backed startups to hire talented product and engineering employees, and issuing stock as part of a job offer is a good way to lure candidates. Yet these expenses will eat up a “very large portion” of Twitter’s future free cash flow, and long-term investors should consider this when deciding whether to back the company, Kirjner said. “Some companies like Twitter that pay their employees generously with hundreds of millions of dollars in equity grants will say they are free-cash-flow positive before expensing stock-based comp,” the analyst wrote. “Maybe they should define free cash flow before any expenses, which would look even better,” he joked.