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 at 'F3' and the Short-Term IDR of OTP at 'F2'. The Rating Outlooks for both OTTR and OTP is Stable.

The rating affirmation and Stable Outlook 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.

Key Rating Drivers

Key Rating Drivers - Otter Tail Corporation

Improved 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.

Shift Towards Regulated Operations Expected: OTP is historically the main driver of consolidated earnings and cash flows although its contribution to consolidated earnings has diminished primarily due to continued strong performance from OTTR's non-regulated PVC plastics business and to a much lesser extent, its metal stamping manufacturing business. OTP comprised approximately 51% of consolidated 2021 EBITDA with OTTR's nonregulated operations accounting for the remainder. Going forward, OTTR's business mix is expected to move back in line with historical levels with the utility segment projected to approximate up to two-thirds of consolidated earnings due to increased utility investments over the forecast.

Parent-Subsidiary Linkage: Fitch has applied a weak parent/strong subsidiary approach in rating OTTR and OTP. OTP is considered stronger than its parent, OTTR, due to the low business risk of its regulated utility operations and relatively low leverage. OTP's ratings reflect its standalone credit profile, while OTTR's ratings reflect a consolidated credit profile. Emphasis is placed on OTP's status as a regulated integrated electric utility company.

Strategic and operational ties between OTTR and OTP are strong and include a shared treasury team while legal ring fencing is considered porous given the general protections afforded by economic regulation including an authorized regulatory capital structure. Access and control are evaluated as open. OTTR is the sole source of equity; however, OTP issues their own debt. Due to the aforementioned linkage considerations, Fitch will limit the difference between the ratings of OTTR and OTP to a maximum of one notch.

Strong Credit Metrics: Fitch projects OTTR's credit metrics to remain strong through the forecast period and projects FFO fixed charge coverage to average 7.2x and FFO adjusted leverage to average 3.6x through 2022-2026. Fitch assumes OTTR will issue equity as needed to support the utility's statutory capital structure

Strong Earnings from Nonregulated Operations: OTTR's plastic segment has continued to perform strongly due to robust housing demand over the last few years. As a result, the contribution of earnings from the plastics segment increased by 16% to 55% of consolidated EBITDA for the LTM ending Sept. 30 as compared with 2021. Nonregulated operations comprised 64% of consolidated EBITDA for the same period. The plastics segment was the main driver of non-regulated earnings resulting from increased sales and record margins due to continued strong construction demand and a relative decrease in resin prices.

BTD, a metal fabrication company and OTTR's largest manufacturing business, has also benefited from increased sales volumes and improved operating margins resulting from an increase in production volumes. 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 10% of total indebtedness as of Sept. 30.

Key Rating Drivers - Otter Tail Power Company

Balanced Regulatory Environment: OTP's 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 9.48%, 9.77% and 8.75%, respectively. 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 relatively 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 potential for OTP to implement multi-year rate plans in future GRC proceedings.

Constructive GRC Outcome in Minnesota: In November 2021, the Minnesota Public Utility Commission (MPUC) approved a fully litigated settlement agreement between OTP and key intervenors. The agreement provided for a rate increase of $17.9 million (approximately 63% of requested) based on a 9.48% ROE (improved by 7bps) and a 52.5% equity layer (unchanged). Fitch views the GRC outcome as constructive since it's the first instance of rate relief in the state in over four years on a rate base that is approximately 48% larger.

Fitch view OTP's prior GRC outcomes in North Dakota in 2018 as constructive and its prior outcome in South Dakota in 2019 as unfavorable. In North Dakota regulators approved a 9.77% ROE, while in South Dakota regulators approved an 8.75% ROE (that was materially below the recent industry average of 9.5% ROE for electric utilities in 2022). However, 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.

Strong Credit Metrics: Fitch expects OTP's credit metrics to remain strong despite a large capital spending program that will modestly pressure leverage metrics through the forecast period. OTP's FFO leverage is projected average 4.3x in 2022-2026 and FFO fixed charge coverage is expected to average approximately 5.9x 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 can qualify for construction work in progress (CWIP) accounting.

Large Utility Capex Program: Fitch expects OTTR to spend $1.1 billion on capex in 2022-2026 with nearly all expenditures (85%) comprised of utility investments at OTP, levels approximately 6% higher than the prior five-years. In contrast to utility operations, OTTR's nonregulated businesses are not capital intensive. Approximately one-third of utility capex is recoverable through rider mechanisms. Capex is focused on new renewable generation (wind and solar) along with new transmission and distribution investments. Following the 150MW wind farm and a 245MW simple-cycle gas plant that entered service in 2020-2021, future generating needs are primarily focused on renewables including the recent acquisition of a 64MW wind farm in January 2023 and the addition of up to 150MW of new renewable generation. 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 renewables are recoverable under a rate rider in North Dakota and South Dakota.

Transition to Clean Energy Generation: The utility is planning to continue to retire older coal-fired generation and replace it with a combination of renewables including new wind and solar to meet its self-imposed goal of achieving a 30% renewable resource mix by 2022 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 FFO leverage approximated 2.7x in 2021, stronger than MDU at 3.6x but materially better than Xcel at 5.5x and BKH at 6.6x. 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 at least one-third 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/Stable). 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 FFO leverage approximated 4.2x in 2021, worse than NSPC at 3.9x, equal to BHP at 4.2x, but better than Northwestern Corp. at 6.0x. 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 is much smaller than its larger peers.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Balanced regulatory environment;

9.2% Earned ROE at OTP;

Large capex program at OTP totaling 1.1 billion on capex in 2022-2026;

Anticipated equity infusions from OTTR to OTP to preserve balanced capital structure;

Long-term debt maturities including $80 million maturing in 2026 and $42 million maturing in 2027 at OTP.

RATING SENSITIVITIES

For OTTR

Factors that could, individually or collectively, lead to positive rating action/upgrade:

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 leverage below 4.3x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

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 leverage above 5.0x.

For OTP:

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Better-than-expected regulatory outcomes in future GRC proceedings;

Sustained FFO leverage below 4.5x;

Successful execution and balanced funding of the large capital investment program.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Adverse future regulatory outcomes;

Failure to maintain a balanced equity component in its capital structure;

Sustained FFO leverage above 5.5x.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

OTTR's liquidity is sufficient with $403 million of consolidated liquidity available as of Sept. 30, 2022, including $73 million of cash and cash equivalents. OTTR and OTP maintain liquidity though separate $170 million revolving credit facilities. The unsecured credit facilities mature on Oct. 29, 2027. To enhance liquidity, OTTR and OTP may increase the size of the facilities to $290 million and $250 million, respectively, 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 41% and 45% as of Sept. 30, 2022. The MPUC requires OTP to maintain an equity to capitalization ratio between 48% and 58.7%, based on structure petition effective by order of the MPUC on Jan. 26, 2022. As of Sept. 30, 2022, OTP's equity-to-total-capitalization ratio, including short-term debt, was 54.9% and its net assets restricted from distribution totaled approximately $686.6 million.

Under the MPUC order, total capitalization for OTP cannot exceed $1.7 billion. Long-term debt maturities are minimal over the next five years and includes $80 million maturing in 2026 and $42 million maturing in 2027, respectively. Going forward, Fitch expects that any maturing debt to be refinanced on a timely basis.

Issuer Profile

OTTR is the parent holding company of its utility subsidiary, OTP, and two small cyclical industrial businesses that operate in fragmented, competitive markets. OTTR's nonregulated activities consist of two segments: manufacturing and plastics. OTP is a small, regulated, integrated electric utility serving over 130,000 rural customers in Minnesota, North Dakota and South Dakota.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means 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. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

(C) 2023 Electronic News Publishing, source ENP Newswire