Description

We believe Otter Tail is a compelling short.

Otter Tail is a regulated utility based in Minnesota that happens to own a municipal pipe manufacturing business. The pipe business contributed a small amount to total earnings in 2019, at just 22%, but due to unusual & transient market conditions, the pipe business has close to 10x’d its profitability. Astoundingly, the sleepy utility shareholder base & consensus has placed a utility multiple on this peak pipe earnings power. Meanwhile, pipe pricing is declining in real time now. On normalized earnings power in 2025, we believe the stock has 40-50% downside. This is the best r/r we have come across in a long time.

Utility segment:

We are not differentiated here. This is a regulated utility and EPS will grow in line w/ the rate base / regulated ROE.  The utility earned ~$1.48 of EPS in 2019 and we believe this will CAGR at 6% to 2025 for $2.06 of regulated utility earnings power. SMID cap utility peers trade for 16-17x EPS, so at 16.5x fwd 2025 EPS, the utility is worth $34 per share at year end 2024, or ~$31 discounted back a year.

At the current price, the market is then paying $51 per share for the pipe & manufacturing business, or $2.1bn.

Manufacturing segment:

The manufacturing segment is not a focus of the writeup. It is a basic metal stamping & fabrication business (off-road, oil field equipment). It did $13mm of net income in 2019 and we forecast this at ~$20mm in 2025, or around $.50 / share. Giving it a utility like multiple for conservatism, this is worth $8 per share in 2025 or ~$7.50 discounted back a year. We’d note that backlog trends in the manufacturing segment suggest orders materially below revenue, and declines set forth to come (we use the Company’s current 2023 forecast as our 2025 estimate for conservatism).

Municipal pipe segment:

Assuming the above on both manufacturing and the utility, the market is paying $43.5 per share for the municipal pipe business, or $1.8bn. That is insane! It compares with 2019 EBIT of just $28mm (65x 2019 ebit). The market is assigning this valuation, presumably, because they are assigning a utility multiple on peak 2023 earnings power for the pipe business.

See below for the Municipal pipe EPS historicals and projections for 2023 to 2025, if one was not thinking at all and put a 12.5x multiple on the 2023 EPS of $3.50, you would arrive at $43.75 value per share from PVC pipe (in-line with the above):

Why is this over-earning so much?

Disruptions in the PVC supply chain due to a back to back freeze and then hurricane in the U.S. led to a severe shortage of PVC resin (inputs for PVC pipe). On top of this, there was a general supply chain disruption from COVID effects.

This led to a supply shock for municipal pipe pricing, as can be seen below, that results in spreads skyrocketing:

Source: OTTR 2Q23 Earnings Presentation

We estimate that this led EBIT/Unit to 10x from 2019 to 2022 levels:

While this spread has begun to decline in 2023, we think the decline will dramatically accelerate into the end of the year as pricing comes down.

Why will earnings begin to decline now?

We have a proprietary source for municipal pipe pricing, which shows that price declines really only began to take place mid 2023 and are accelerating:

The reason pricing has held in until now is distributors like Core & Main have been de-stocking their elevated pipe inventories, and they do not yet want to move the price down. Once inventory levels are normalized, this will suddenly flip to severe price declines and seems to be starting to take place.

Assuming EBIT/unit normalizes 65% above 2019 levels but down 80% from 2023 levels, we arrive at normalized EBIT of $42mm in 2205, or $.73 of EPS. At a 12x multiple, this would be wort $9 per share, or $8 discounted back.

As a sanity check, the Co is spending $50mm to expand capacity here by 8%, which implies a replication value of around $600mm. We believe the market is assigning a market value nearly 4x replacement here.

Valuation

In 2025, we estimate the utility earning $2.06 of EPS, manufacturing earning $.50, and PVC Pipe earning $.73 for $3.29 of total EPS, this is 11% lower than Street but 44% below mgmt’s guide for 2023. Applying a utility multiple of 16.5x would yield $54 of value in YE24, or around $49 discounted back (40% downside). If we assign a 16.5x multiple to the utility and 12x to the PVC and manufacturing businesses we would arrive at a $44 PT (~46% downside).

We think this is just highly skewed. If we are wrong and the current guided EPS for 2023 (including near peak PVC earnings) is right, and the market awards the whole biz a utility multiple, this would be 16.5x * $5.85 of EPS = $96.5. 

Disclaimer: The author of this memorandum presently has a position in securities of this issuer and may trade in and out of these positions without notice. This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation. This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

2024 earnings miss