Initiating Coverage on Otter Tail Corporation (OTTR US: Model)

Date of Initiation: November 19, 2024

Price Target: $88.81

Conviction: 4/10

Holding Period: 3 Year Hold

Model: Otter Tail Corporation.xlsx

Otter Tail Corporation is an idea that I pitched individually to Brigham Capital at BYU. I was attracted to Otter Tail because of the strong earnings growth it has seen in recent years along with the undemanding valuation. Otter Tail is my third largest of three holdings at the time of initiation, which I believe is representative of the level of tentativeness I have in the holding. Since pitching OTTR and having some conversations with more seasoned investors, I have realized that cyclical companies look their cheapest on a multiples basis right before earnings begin to decline. However, I think my pitch still stands, and if I am proved to be wrong, this will serve as a great learning opportunity for how to invest in a cyclical.

The thesis is two-pronged. I believe that the market is being overly pessimistic concerning OTTR's Plastics segment earnings. I also believe that this focus on the Plastics segment earnings is not allowing investors to properly value the growth of the Electric segment.

Company Overview

Otter Tail Corporation is an industrials holding company that operates in three different verticals, all of which represent roughly one-third of revenue. The least exciting operation is their metal fabrication and metal stamping, which accounted for $0.51 of EPS in FY2023. These operations are essentially contract manufacturing, and I modeled this segment growing with GDP moving forward. Because it doesn't represent a large portion of consolidated earnings, I don't feel it is critical to the thesis or earnings power of OTTR moving forward. OTTR also operates a Plastics segment, which buys PVC resin and molds it into piping used to carry water. This segment has seen rapid growth over the last few years, with demand for their offerings skyrocketing. The company used to have an 18% EBIT margin selling pipe and now gets a 60% margin. EPS has risen dramatically in this segment, and the street is expecting these figures to fall back down to pre-peak demand levels. The last segment is OTTR's regulated electric utilities. The Electric segment has seen consistent 9% EPS growth since 2018 and is expected to continue growing at 7% through 2028. This growth is fueled by the company consistently expanding its rate base. Impressively, the company has been able to sustain this growth without taking on debt, pushing large amounts of riders, or making sloppy capital allocation choices.

Plastics Hyperfixation

When examining sell-side reports (which are very minimal) and reading through earnings call transcripts, it is clear that people care the most about fundamentals in the Plastics segment. In fact, I would argue that this focus is distracting the market from recognizing the other incredible accomplishments of Otter Tail over recent years. While the market stays fixated on the Plastics segment earnings, earnings in the Electric segment have managed to CAGR at 9.0% from 2018-2023, with OTTR forecasting a 7.7% CAGR through 2028.

I believe sell-side consensus estimates and rhetoric are making the hasty assumption that the net income margin has to return to the pre-COVID mean of low-to-mid teens. I believe this is an incorrect assumption and that OTTR might end up being a case study in a company whose economics have changed so much that they find themselves settling into a new mean net income margin in the high teens or low twenties. I have this belief because there is a systemic increase in demand for their Plastics segment product offerings over the medium-term future. Reports from the FPA estimate that water system upgrades across America could demand more than $1 trillion in spending. Furthermore, the markets OTTR sells its products into—Arizona and the Dakotas—are in particular need of better water infrastructure. This supports my claim that margins can remain higher for a much longer period of time than the market is currently anticipating.

Compounding Electric Segment

As mentioned in the previous thesis, OTTR's Electric segment has maintained a 9.0% CAGR from 2018-2023, largely by sustainably growing its rate base. What is even better is that they have managed to maintain this growth without passing on the costs to their customers. In expanding their rate base, OTTR management has proven its abilities as capital allocators. They maintain a much higher CapEx/Rev than many of their peer comps and have maintained positive ROIC throughout this major investment in their rate base.

This is important because the Dakotas, and particularly North Dakota, appear to be likely destinations for increased data center construction. While I don't necessarily model this into my base thesis, if data centers were to start popping up across the Dakotas, OTTR would directly benefit from the states' increased need for energy. The CEO said the following on the last earnings call: "We have several projects that are in discussions or have a letter of intent... I would expect we will have to have something here within the next two quarters." While my holding period is three years, the announcement of major new projects would serve as a near-term catalyst for my theses to be recognized by the broader market.

Conclusion

In summation, Otter Tail Corporation is a well-managed industrial holding company whose long-term earnings potential is being misunderstood by the market. The focus on the Plastics segment fundamentals and the potential for new large projects in the Electric segment give this holding reasonable upside. I do maintain concerns about the timing of the investment, which is reflected in a relatively low conviction and small weighting in my portfolio. I will be looking at this next earnings release very closely for signs of thesis affirmation.