Fitch Affirms Otter Tail Corp. and Otter Tail Power's IDRs; Outlooks Stable

Otter Tail

05/09/2019 17:55

(The following statement was released by the rating agency)


Fitch Ratings-Chicago-September 05: 

Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR) of Otter 
Tail Corporation (OTTR) at 'BBB-' and the Long-Term IDR of its regulated 
electric utility subsidiary, Otter Tail Power Company (OTP) at 'BBB'. Fitch has 
also affirmed the short-term IDR of OTTR 'F3' and upgraded the short-term IDR of 
OTP to 'F2' from 'F3. The Rating Outlooks for both OTTR and OTP is Stable. The 
rating affirmation reflects the predictable earnings and cash flows from the 
company's predominately regulated operations and strong performance at its 
manufacturing businesses. Due to the risks inherent in the diversified business 
portfolio, Fitch rates OTTR one notch below its regulated subsidiary OTP. OTTR's 
current IDR of 'BBB-' takes into consideration the company's business mix 
including a small regulated electric utility serving a rural service territory 
and two relatively small manufacturing industrial business segments that operate 
in fragmented, competitive markets. OTP is the main driver of consolidated 
earnings and cash flows and comprised 68% of consolidated EBITDAR for the LTM 
period ending June 30, 2019. Recently, the contribution of earnings from OTTR's 
nonregulated operations has increased due to the positive impacts of tax reform 
and increased sales at its PVC pipe and metal fabrication manufacturing 
businesses. OTTR's business mix is expected to move back in line with historical 
levels with the utility segment projected to approximate up to three-fourths of 
consolidated earnings due to increased utility investments with nonregulated 
businesses providing the remainder. The Stable Outlook reflects Fitch's 
expectations that utility earnings and cash flows will be supported by 
regulatory recovery mechanisms that afford timely recovery on investments during 
a period of high capital spending at OTP.Based on its assessment of OTP's 
financial flexibility, Fitch has assigned the higher of the two Short-Term 
rating options (F2) for the current rating profile and removed the Short-Term 
rating from 'Under Criteria Observation'. Any material weakening in financial 
flexibility, financial structure or operating environment conditions could lead 
to the assignment of the lower of the two short-term rating options for the 
current long-term profile.

Key Rating Drivers

OTTR - KEY RATING DRIVERSImproved Business Risk Profile: OTTR's ratings and 
Stable Outlook reflect the higher operating risk profile and earnings volatility 
of its economically sensitive nonregulated business. OTTR's business risk 
profile has improved in recent years and nonregulated activities consist of two 
segments: manufacturing and plastics. The risks inherent in OTTR's diversified 
business portfolio are mitigated by their strong financial profile including low 
levels of debt and positive FCF.Parent-Subsidiary Linkage: Fitch has applied a 
bottom-up approach in rating OTP and OTTR. The linkage follows a weak 
parent/strong subsidiary approach. OTP is considered stronger than its parent, 
OTTR, due to the low business risk of its regulated utility operations and low 
leverage. The absence of guarantees, cross-defaults and dividend restrictions 
among other factors render legal ties weak between OTP and OTTR. While 
operational and strategic ties are robust, a prescribed regulatory capital 
structure for OTP leads to moderate linkage with OTTR, allowing for OTP's IDR to 
be notched above the Parent's. OTP's ratings reflect its stand-alone credit 
profile while OTTR's ratings reflect a consolidated credit profile. Fitch will 
typically rate the IDR of OTP a maximum of two notches above the IDR of OTTR. 
Solid Credit Metrics: Fitch projects OTTR's credit metrics to remain 
commensurate with their current rating category through the forecast period and 
projects FFO interest coverage to average 6.3x and FFO-adjusted leverage to 
average 3.5x through 2019-2023. Fitch's projections assume OTTR will issue 
equity to support the utility's statutory capital structure and high capex 
program.Steady Earnings from Nonregulated Operations: OTTR's manufacturing and 
plastic business segments are benefitting from the positive impacts of tax 
reform and improving market conditions. Consequently, the contribution of 
earnings from nonregulated operations approximated 32% of consolidated EBITDAR 
for the LTM ending June 30th. The plastics segment has been benefitting from 
strong demand and increased operating margins due to a combination of resilient 
sale prices and lower than expected resin prices. Additionally, BTD, a metal 
fabrication company and OTTR's largest manufacturing business, has been 
benefitting from increased sales in its primary end markets. OTTR's nonregulated 
businesses are not expected to grow materially from current levels and are 
supported by low levels of parent only long-term debt approximating 14% of total 
indebtedness as of June 30th.OTP - KEY RATING DRIVERSBalanced Regulatory 
Environment: Otter Tail Power Co.'s (OTP) ratings reflect the relatively stable 
earnings and cash flows provided by its regulated electric utility operations. 
Fitch expects the regulatory environment to remain supportive of credit quality 
across its three-state jurisdictions in Minnesota, North Dakota and South 
Dakota. While Fitch considers the regulatory environments in OTP's two largest 
jurisdictions, Minnesota and North Dakota, to be balanced, Fitch views the 
regulatory environment in South Dakota as somewhat challenging. OTP's current 
authorized ROE's in Minnesota, North Dakota, and South Dakota are 9.41%, 9.77% 
and 8.75%, respectively. Fitch notes that OTP's earned ROE was 9.0% in the LTM 
ending June 30, 2019. Minnesota and North Dakota account for 91% of OTP's total 
rate base.Concerns around regulatory lag during a period of high capital 
spending are mitigated by recent GRC's in all three of its jurisdictions, the 
use of fully forecast forward looking test years in OTP's two largest 
jurisdictions, Minnesota and North Dakota, a utility capex program focused on 
projects that are eligible for rider recovery, and the expectation for OTP to 
implement multi-year rate plans in future GRC proceedings.Constructive GRC 
Outcome in North Dakota: In September 2018, the North Dakota Public Service 
Commission (PSC) approved a settlement agreement between OTP and key 
intervenors. The agreement provided for a $4.6 million rate increase predicated 
on a 9.77% ROE and a 52.50% equity layer. The authorized ROE is modestly above 
prevailing industry averages. Favorably, the ruling established a rate rider for 
costs associated with OTP's new gas plant. The rate increase represents 64.00% 
of OTP's revised request for a $7.1 million rate increase predicated on an ROE 
of 9.77% and a 52.50% equity layer. This was OTP's first GRC in North Dakota 
since 2008.Unfavorable GRC Outcome in South Dakota: In May and July 2019, the 
South Dakota PSC approved a $2.6 million net rate increase based on an 8.75% ROE 
and a 52.92% equity layer. The rate increase excludes $2.2 million of new rates 
that were rolled into rate base rates from rate riders. OTP had requested an 
effective $3.7 million rate increase based on a 10.3% ROE and a 53.1% equity 
layer. While the rate increase represented 69% of the total requested, the 
authorized ROE is approximately 85 bps lower than recent industry averages. The 
lower returns are partially offset by the retention of $1 million of refunds 
related to lower rates under the Tax Cut and Jobs Act of 2017 and the 
implementation of a multiyear rate plan. Although the authorized returns are 
lower than expected, South Dakota only represents 9% of OTP's total rate base, 
and as such the GRC decision is not expected to have a material impact on credit 
quality. This was OTP's first GRC in South Dakota since 2010.Generation 
Investments To Pressure Leverage: Fitch expects OTP's credit metrics to remain 
commensurate with its current rating category despite the negative effects of 
tax reform and a large capital spending program that will pressure leverage 
metrics through the 2019-2023 forecast period. OTP's FFO-adjusted leverage is 
projected to weaken to approximately 4.3x in 2020 as capex peaks and then 
strengthen to approximately 4.0x by 2023 as projects under construction are 
completed and begin contributing to earnings and cash flow. FFO interest 
coverage is expected to average approximately 5.5x over the next five years. 
Timely Return on Invested Capital: OTP benefits from tariff recovery mechanisms 
that provide for a timely return on invested capital, including full commodity 
and purchased power recovery across its three state jurisdictions. OTP has capex 
rider recovery mechanisms for new transmission, renewable and environmental 
compliance investments that provide for timely cost recovery in between general 
rate case (GRC) proceedings. Additionally, transmission projects are supported 
by construction work in progress (CWIP) accounting.Large Utility Capex Program: 
Fitch expects OTTR to spend $1.1 billion on capex in 2019-2023 with 91% focused 
on utility investments at OTP, levels approximately 53% higher than the 
preceding five years. In contrast to utility operations, OTTR's nonregulated 
businesses are not capital intensive. Approximately half of utility capex is 
recoverable through rider mechanisms. Capex is primarily focused on new wind and 
gas generation and, to a lesser extent, new transmission and distribution 
projects. OTP's largest generation projects include a 150MW wind farm and a 
245MW simple-cycle gas plant that will support fast ramping needs and lost 
generation associated with the planned retirement of the 138MW coal-fired Hoot 
Lake plant in 2021. The wind farm is projected to cost $270 million with an 
expected in-service date in 2020 and the gas plant is projected to cost $158 
million with an expected in service date in 2021. OTP's capex plan is aligned 
with state and Minnesota Public Utilities Commission (MPUC) energy policy, 
emphasizing clean energy resources and renewable generation. Favorably, costs 
associated with the new gas plant are recoverable under a rate rider in North 
Dakota and South Dakota.Transition to Clean Energy Generation: The utility is 
retiring older coal-fired generation and replacing it with new wind and natural 
gas-fired plants to meet its environmental targets and Minnesota's 26.5% 
Renewable Portfolio Standard by 2025, which includes a solar carve out of 1.5%. 
Under the company's latest Integrated Resource Plan (IRP), the company plans to 
reduce CO2 emissions by 30% below 2005 levels in 2022.FCF Negative: Fitch 
expects OTP to remain FCF negative through the forecast period, with future 
funding needs met by a balanced mix of debt and equity, and that parent Otter 
Tail Corp. will downstream additional equity as needed to support the balanced 
capital structure.

Derivation Summary

The credit profile of Otter Tail Corp. is weaker than that of its peer utility 
holding companies, MDU Resources (MDU; BBB+/Stable), Xcel Energy Inc. (XCEL; 
BBB+/Stable), and Black Hills Corp. (BKH; BBB+/Stable) and reflects the 
increased risk inherent in its nonregulated diversified business portfolio. OTTR 
is the parent holding company of its primary subsidiary, OTP, a small regulated 
electric utility serving a rural service territory and two small cyclical 
industrial businesses that operate in fragmented, competitive markets. OTTR's 
financial metrics are strong and in line with higher rated peers but its ratings 
are constrained due to the higher operating risk profile of its nonregulated 
businesses. OTTR's EBITDAR leverage approximated 3.1x in 2018, better than MDU 
at 3.9x, Xcel at 4.6x and BKH at 5.5x. While OTP remains the main driver of 
consolidated earnings and cash flows the earnings from OTTR's nonregulated 
operations can be volatile and are projected to continue to comprise one fourth 
of consolidated earnings. Consequently, Fitch expects to maintain a one notch 
rating deferential between OTTR and OTP.The credit profile of OTP is well 
positioned compared with that of peers, Black Hills Power (BHP; BBB+/Stable), 
Northern States Power Company Minnesota (NSPC; A-/Stable) and Northwestern Corp. 
(BBB+/Negative). While OTP's financial metrics are strong and in line with 
higher rated peers, its credit ratings are constrained due to the small scale of 
its utility operations relative to peers and ownership by a weaker parent. OTP's 
EBITDAR leverage approximated 3.7x in 2018, slightly weaker than NSPC at 3.3x 
and BHP at 2.9x, but better than Northwestern Corp. at 4.8x. Fitch considers 
OTP's regulatory environment in Minnesota and North Dakota to be balanced while 
the regulatory environment in South Dakota is somewhat challenging. OTP's peers 
operate in many of the same states. However, the scale of OTP's utility 
operations are much smaller than higher-rated peers NSPC and Northwestern Corp. 
While OTP's utility operations are similar in size to BHP, BHP benefits from the 
financial strength of a much larger corporate parent, which owns a mix of 
regulated gas and electric utilities spanning eight states.

Key Assumptions

Fitch's Key Assumptions Within the Rating Case for the Issuer--Balanced 
Regulatory Environment; --Earned ROE at OTP averaging 9.6%;--Large capex program 
at OTP totaling $1 billion through 2023;--Anticipated equity infusions from OTTR 
to OTP to preserve balanced capital structure;--Long-term debt maturities 
including $140 million at OTP in 2021.

RATING SENSITIVITIES

For OTTR:Developments That May, Individually or Collectively, Lead to Positive 
Rating Action--While an upgrade is not anticipated given OTTR's current business 
mix, the further downsizing of nonregulated businesses could warrant a positive 
rating action;--Retirement of parent-only debt;--An upgrade at OTP; --Sustained 
FFO-adjusted leverage below 4.25x. Developments That May, Individually or 
Collectively, Lead to Negative Rating Action--A sustained downturn in the 
economically sensitive nonregulated businesses;--An acquisition that is 
debt-financed or that materially heightens the business risk profile;--Sustained 
FFO-adjusted leverage above 5.0x. For OTP:Developments That May, Individually or 
Collectively, Lead to Positive Rating Action--Better-than-expected regulatory 
outcomes in future GRC proceedings;--Sustained FFO-adjusted leverage below 
4.5x;--Successful execution and balanced funding of the large capital investment 
program.Developments That May, Individually or Collectively, Lead to Negative 
Rating Action--Adverse future regulatory outcomes;--Failure to maintain a 
balanced equity component in its capital structure;--Sustained FFO-adjusted 
leverage above 5.5x.

Liquidity and Debt Structure

OTTR's liquidity is sufficient with $256 million of consolidated liquidity 
available as of June 30, 2019 including $1 million of cash and cash equivalents. 
OTTR and OTP maintain liquidity though separate revolving credit facilities 
totaling $130 million and $170 million, respectively. The unsecured credit 
facilities mature on Oct. 31, 2023 and the companies may increase the size to 
$250 million with the consent of the lenders. The credit facilities contain a 
maximum debt-to-capitalization ratio covenant of 60%, and both OTTR and OTP were 
in compliance with balanced debt-to-capitalization ratios of 46% and 47% as of 
June 30, 2019. Fitch notes that the MPUC requires OTP to maintain an equity to 
capitalization ratio between 47.4% and 58.0%. Long-term debt maturities are 
minimal over the next five years and include: $140 million at OTP in 2021 and 
$30 million at OTP in 2022. Fitch expects maturing debt to be refinanced on a 
timely basis.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit 
relevance for both OTTR and OTP is a score of 3 - ESG issues are credit neutral 
or have only a minimal credit impact on the entity, either due to their nature 
or the way in which they are being managed by the entity.

Otter Tail Corporation; Long Term Issuer Default Rating; Affirmed; BBB-; RO:Sta

; Short Term Issuer Default Rating; Affirmed; F3

----senior unsecured; Long Term Rating; Affirmed; BBB-

Otter Tail Power; Long Term Issuer Default Rating; Affirmed; BBB; RO:Sta

; Short Term Issuer Default Rating; Upgrade; F2

----senior unsecured; Long Term Rating; Affirmed; BBB+

Contacts: 

Primary Rating Analyst

Daniel Neama, 

Associate Director

+1 212 908 0561

Fitch Ratings, Inc.

70 West Madison Street 

Chicago 60602

Secondary Rating Analyst

Philip Smyth, CFA

Senior Director

+1 212 908 0531

Committee Chairperson

Eric Rosenthal, 

Senior Director

+1 212 908 0286

 

Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: 
elizabeth.fogerty@thefitchgroup.com.

Additional information is available on www.fitchratings.com

Applicable Criteria 

Corporate Rating Criteria (pub. 19 Feb 2019)

https://www.fitchratings.com/site/re/10062582

Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018)

https://www.fitchratings.com/site/re/10024585

Parent and Subsidiary Rating Linkage (pub. 16 Jul 2018)

https://www.fitchratings.com/site/re/10036366

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