Item 7. Management’s Discussion and Analysis
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes appearing under Item 8 of this Form 10-K.
OVERVIEW
Otter Tail Corporation and its subsidiaries form a diverse group of businesses with operations classified into three segments: Electric, Manufacturing and Plastics. Our Electric business is a vertically integrated, regulated utility with generation, transmission and distribution facilities to serve our customers in western Minnesota, eastern North Dakota and northeastern South Dakota. Our Manufacturing segment provides metal fabrication for custom machine parts and metal components, and manufactures extruded and thermoformed plastic products. Our Plastics segment manufactures PVC pipe for use in, among other applications, municipal and rural water, wastewater and water reclamation projects.
Our strategy includes investing in rate base growth opportunities in our Electric segment and capitalizing on organic growth opportunities in our Manufacturing and Plastics segments. Investments in our Electric segment are expected to produce increased earnings and cash flows, lower our overall risk, create a more predictable earnings stream, improve our credit quality and preserve our ability to fund our dividend. Our Electric segment is complemented by our Manufacturing and Plastics segment businesses, which we expect to contribute to earnings growth by capitalizing
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on market expansion opportunities and increasing utilization of existing capacities, along with planned investments to create additional capacity and increased efficiencies. Collectively, our mix of businesses is expected to contribute to the achievement of our targeted annual growth in earnings per share of five to seven percent over the next several years, using 2024 as the base for measurement.
2022 FINANCIAL RESULTS
In 2022, our diversified business model generated record financial results, producing net income of $284.2 million, or $6.78 per diluted share, an increase of 61% from $176.8 million, or $4.23 per diluted share, in 2021. All three of our operating segments produced double digit earnings growth in 2022 compared to the prior year, led by our Plastics segment, which capitalized on the continuation of unique market conditions to produce extraordinary financial results. In 2022, we paid an annual dividend of $1.65 per share, or $68.8 million, completing our 84th consecutive year of dividend payments to our shareholders.
Our Electric segment produced earnings growth of 10% in 2022, driven by increased customer demand from commercial and industrial customers, including the addition of a new large commercial customer in North Dakota, and the impacts of favorable weather. We continued the construction of rate base investments, including our Hoot Lake Solar project, which we anticipate will be in commercial operation by the end of 2023. Our utility also accomplished all of its key regulatory objectives for the year, including completing a general rate case in Minnesota, with final rates becoming effective on July 1, 2022, and securing all necessary approvals to acquire the Ashtabula III wind farm, which was finalized and purchased on January 3, 2023.
Our Manufacturing segment produced earnings growth in 2022 of 22%, as strong end market demand across most markets we serve led to increased sales volumes. Pricing increases and favorable cost absorption offset increased labor, material, and overhead costs, which resulted in consistent gross profit levels. Our Manufacturing segment was also impacted in 2022 by steel price volatility, as further discussed below.
Our Plastics segment produced earnings of $195.4 million in 2022, compared to $97.8 million in 2021. The unprecedented level of earnings in 2022 resulted from extraordinary industry supply and demand dynamics which emerged in 2021 and continued into 2022. As further described below, increases in the price of resin, the primary raw material used in the manufacturing of PVC pipe, coupled with robust end market demand for PVC pipe led to a rapid escalation in PVC pipe prices and gross margins in 2021 and into 2022. Resin prices declined from peak levels in the second half of the year, and pipe distributors and contractors reduced purchase volumes and inventory levels in response to changing market conditions. Despite softening demand in the second half of the year, strong pipe sales prices and profit margins resulted in earnings growth of 100% in 2022.
Our earnings mix in 2022 was 28% from our Electric segment and 72% from the combination of our Manufacturing and Plastics segments net of unallocated corporate costs. Electric segment earnings as a percentage of our total earnings were less than our long-term target of 65% due to the unique market conditions that occurred in our Plastics segment. We expect our earnings mix to return to our targeted mix of 65% from the Electric segment and 35% from the Manufacturing and Plastics segments in 2024.
STEEL PRICING
Volatility in the price of steel, a key material input to our Manufacturing segment, significantly impacted our operating results in 2022. Steel prices increased rapidly throughout 2021, peaking in the fourth quarter at historically high levels. Steel prices, which were highly volatile in 2022, began to steadily decline at the end of the second quarter and returned to near historical levels by the end of the year. The increase in steel prices led to increased sale prices for our products at BTD, our metal fabrication business within our Manufacturing segment, as we passed along material cost increases to our customers. Scrap metal prices, which typically follow steel prices, also increased throughout 2021 and remained elevated in the first half of 2022, but declined sharply throughout the second half of the year, negatively impacting our 2022 financial results.
PVC PIPE SUPPLY AND DEMAND CONDITIONS
PVC resin is the primary material input of the PVC pipe manufactured by our Plastics segment businesses. Resin supply disruptions throughout 2021, along with robust domestic and global demand for PVC resin, led to significantly increased resin prices. Supply disruptions for resin and other additives and ingredients used in the manufacturing process also resulted in reduced manufacturing of PVC pipe and low pipe inventories across the industry. This combination of disrupted raw material supply and the resulting low PVC pipe inventories, along with robust demand for PVC pipe, led to rapidly increasing sale prices for PVC pipe throughout 2021 and 2022. The increase in sale prices outpaced the increase in PVC resin costs and led to expanding gross profit margins which positively impacted our 2022 financial results. However, beginning in the third quarter of 2022, demand for PVC pipe began to decline as PVC pipe distributors and contractors reduced purchase volumes and inventory levels in response to changing market conditions.
The unique market dynamics experienced by our Plastics segment businesses in 2021 and 2022 resulted in a significant increase in earnings compared to prior periods. We currently expect earnings of our Plastics segment to decrease in 2023, but to remain elevated relative to historical levels. We currently expect segment earnings to normalize in 2024, as industry supply and demand conditions normalize throughout 2023.
The marketplace dynamics impacting both our Manufacturing and Plastics segments are fluid and subject to change which may impact our operating results prospectively.
FINANCIAL AND OTHER METRICS
Heating Degree Days (HDDs) is a measure of how much (in degrees), and for how long (in days), the outside air temperature was below a certain normalized level. Normal weather conditions are defined as the 20-year average of actual historical weather conditions. This measure is commonly used in calculations relating to the energy consumption required to heat buildings.
Cooling Degree Days (CDDs) is a measure of how much (in degrees), and for how long (in days), the outside air temperature was above a certain normalized level. This measure is commonly used in calculations relating to the energy consumption required to cool buildings.
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OTP generally bases its forecasted kwh sales and rates on expected consumption under a normal level of HDDs and CDDs over a given period of time in its service territory. Increased or decreased levels of consumption for certain customer classifications are attributed to deviation from the norms and are a significant factor influencing consumption of electricity across our service territory. We present HDDs and CDDs to provide an indication of the impact of weather on kwh sales, revenues and earnings relative to forecast and on period-to-period results.
Utility Rate Base is the value of property on which a public utility is permitted to earn a specified rate of return in accordance with rules set by a regulatory agency. In general, rate base consists of the value of property used by the utility in providing service. Rate base can also include cash, working capital, materials and supplies, deductions for accumulated provisions for depreciation, contributions in aid of construction, customer advances for construction, accumulated deferred income taxes, and accumulated deferred investment tax credits dependent on the method that is used in the calculation, which can vary from jurisdiction to jurisdiction. We present actual and forecasted levels of utility rate base to provide an indication of expected investments on which we expect to earn future returns.
RESULTS OF OPERATIONS
For a comparison of fiscal year 2021 to 2020, see Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our report on Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on February 16, 2022.
Provided below is a summary and discussion of our operating results on a consolidated basis followed by a discussion of the operating results of each of our segments, Electric, Manufacturing and Plastics. In addition to the segment results, we provide an overview of our Corporate costs. Our Corporate costs do not constitute a reportable segment but rather consist of unallocated general corporate expenses, such as corporate staff and overhead costs, the results of our captive insurance company and other items excluded from the measurement of segment performance. Corporate costs are added to operating segment totals to reconcile to totals on our consolidated statements of income.
CONSOLIDATED RESULTS
The following table summarizes our consolidated results of operations for the years ended December 31, 2022 and 2021:
(in thousands) 2022 2021 $ change % change
Operating Revenues $ 1,460,209 $ 1,196,844 $ 263,365 22.0 %
Operating Expenses 1,069,770 947,136 122,634 12.9
Operating Income 390,439 249,708 140,731 56.4
Interest Charges 36,016 37,771 (1,755) (4.6)
Nonservice Cost Components of Postretirement Benefits (1,075) 2,016 (3,091) (153.3)
Other Income 2,037 2,900 (863) (29.8)
Income Before Income Taxes 357,535 212,821 144,714 68.0
Income Tax Expense 73,351 36,052 37,299 103.5
Net Income $ 284,184 $ 176,769 $ 107,415 60.8 %
Operating Revenues increased $263.4 million on a consolidated basis in 2022. Each operating segment contributed to the overall growth. Electric segment operating revenues increased 14% primarily due to increased fuel recovery revenues and higher sales volumes. Manufacturing segment operating revenues increased 18% mainly as a result of higher sales volumes and increased pricing to pass through material input costs. Plastics segment operating revenues increased 35% due to an increase in the price per pound of PVC pipe sold, partially offset by decreased sales volumes. See our segment disclosures below for additional discussion of items impacting operating revenues.
Operating Expenses increased $122.6 million in 2022. Electric segment operating expenses increased 17% primarily due to increased purchased power costs resulting from increased purchase volumes and higher operating and maintenance expenses. Operating expenses in our Manufacturing segment increased 18%, driven by increased cost of products sold, which resulted from higher material input costs and increased sales volumes. Operating expenses in our Plastics segment were consistent year over year due to lower sales volumes which were offset by higher costs of products sold from higher resin costs and increased operating costs. See our segment disclosures below for additional discussion of items impacting operating expenses.
Interest Charges decreased $1.8 million in 2022 primarily due to a decrease in our average short-term borrowings, partially offset by increased interest rates on our short-term borrowings and a net increase in our long-term debt of $60.0 million. The increase in our long-term debt was largely used to finance rate base investments in our Electric segment.
Nonservice Cost Components of Postretirement Benefits decreased $3.1 million in 2022 primarily due to the amortization of actuarial gains resulting from the increase in the discount rates used to measure our pension benefit and other postretirement benefit liabilities as of December 31, 2021.
Other Income decreased $0.9 million in 2022 primarily due to investment losses on our corporate-owned life insurance policies and the investments of our captive insurance entity.
Income Tax Expense increased $37.3 million in 2022 primarily due to an increase in income before income taxes. Our effective tax rate was 20.5% in 2022 and 16.9% in 2021. See Note 12 to our consolidated financial statements included in the report on Form 10-K for additional information regarding factors impacting our effective tax rate.
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ELECTRIC SEGMENT RESULTS
The following table summarizes the operating results of our Electric segment for the years ended December 31, 2022 and 2021:
(in thousands) 2022 2021 $ change % change
Retail Sales Revenue $ 470,300 $ 405,484 $ 64,816 16.0 %
Transmission Services Revenues 52,213 48,835 3,378 6.9
Wholesale Revenues 18,539 17,936 603 3.4
Other Electric Revenues 8,647 8,066 581 7.2
Total Operating Revenue 549,699 480,321 69,378 14.4
Production Fuel 65,110 59,327 5,783 9.7
Purchased Power 100,281 65,409 34,872 53.3
Operating and Maintenance Expenses 181,378 159,669 21,709 13.6
Depreciation and Amortization 72,050 71,343 707 1.0
Property Taxes 17,742 17,609 133 0.8
Operating Income $ 113,138 $ 106,964 $ 6,174 5.8 %
Electric kwh Sales (in thousands)
Retail kwh Sales 5,592,368 4,789,879 802,489 16.8 %
Wholesale kwh Sales 267,184 420,044 (152,860) (36.4)
Heating Degree Days 7,122 5,794 1,328 22.9
Cooling Degree Days 531 704 (173) (24.6)
Our Electric segment operating results are impacted by fluctuations in weather conditions and the resulting demand for electricity for heating and cooling. The following table presents heating and cooling degree days as a percent of normal for the years ended December 31, 2022 and 2021:
2022 2021
Heating Degree Days 112.5 % 91.3 %
Cooling Degree Days 113.5 % 151.7 %
The following table summarizes the estimated effect on diluted earnings per share of the difference in retail kwh sales under actual weather conditions and expected retail kwh sales under normal weather conditions for the years ended December 31, 2022 and 2021, and between years:
2022 vs Normal 2022 vs 2021 2021 vs Normal
Effect on Diluted Earnings Per Share $ 0.11 $ 0.10 $ 0.01
Retail Revenues increased $64.8 million primarily due to the following:
• A $42.5 million increase in fuel recovery revenues primarily due to increased purchased power volumes and pricing to recover production fuel costs, as described below.
• A $12.8 million increase in retail revenues from increased sales volumes from commercial and industrial customers, including the impact of a new commercial customer load in North Dakota.
• A $5.4 million increase in revenues from the favorable impact of weather compared to last year.
• A $4.1 million increase in interim rate revenue due to the finalization of the interim rate refund, as approved by the MPUC in the second quarter of 2022.
Retail revenues also benefited from increased transmission, renewable and phase-in rider revenue in 2022. These increases were partially offset by a decrease in CIP revenue as a result of decreased CIP spending and related cost recovery.
Transmission Services Revenues increased $3.4 million primarily due to increased recovery of higher transmission costs and increased transmission investments along with increased transmission volumes and formula rate adjustments.
Production Fuel costs increased $5.8 million due to a 22% increase in fuel cost per kwh, which was partially offset by a decrease in kwhs generated from our fuel-burning plants due to an outage at Coyote Station in 2022, and the retirement of Hoot Lake Plant in May 2021.
Purchased Power costs to serve retail customers increased $34.9 million due to a 54% increase in the volume of purchased power, resulting from outages at both Coyote Station and Big Stone Plant, the retirement of Hoot Lake Plant and increased customer demand.
Operating and Maintenance Expense increased $21.7 million primarily due to:
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• A $6.7 million increase in employee compensation and benefit costs, including discretionary incentive and retirement benefit compensation based on current year financial results.
• A $3.7 million increase in transmission tariff expenses.
• A $3.3 million increase in maintenance and other costs due to our plant outages at Coyote Station and Big Stone Plant during the year.
• A $1.4 million increase in travel costs driven by higher fuel costs for our vehicle fleet and increased travel activities.
• Other additional costs including additional maintenance costs, increases in information technology expenses, increases in insurance costs and various other expenses.
These expense increases were partially offset by, among other items, a $2.1 million reduction in CIP expenses compared to the previous year.
MANUFACTURING SEGMENT RESULTS
The following table summarizes operating results of our Manufacturing segment for the years ended December 31, 2022 and 2021:
(in thousands) 2022 2021 $ change % change
Operating Revenues $ 397,983 $ 336,294 $ 61,689 18.3 %
Cost of Products Sold 315,375 259,581 55,794 21.5
Other Operating Expenses 37,341 37,163 178 0.5
Depreciation and Amortization 16,202 15,436 766 5.0
Operating Income $ 29,065 $ 24,114 $ 4,951 20.5 %
Operating Revenues increased $61.7 million primarily due to the following:
• At BTD, operating revenues increased $52.8 million due to a combination of higher sales volumes and increased pricing. Sales volumes increased 12% compared to the previous year due to strong end market demand. Material costs, which are passed through to customers, increased 8%, as annual steel prices increased from the previous year. Steel prices increased drastically in 2021, peaking in the fourth quarter, and remained elevated compared to historical levels throughout the first half of 2022. Increases in sales volumes and prices were partially offset by a $2.5 million decrease in scrap revenues due to a decrease in both scrap metal prices and scrap volumes.
• At T.O. Plastics, revenues increased $8.8 million due to a combination of increased sales prices and higher sales volumes. Sales prices increased 16% and sales volumes increased 7% due to strong customer demand primarily in horticulture product sales.
Cost of Products Sold increased $55.8 million due to the following:
• Cost of products sold at BTD increased $50.2 million primarily due to higher sales volumes and increased material costs, as discussed above. Cost of products sold also increased due to higher labor and overhead costs, partially offset by lower freight costs.
• Cost of products sold at T.O. Plastics increased $5.6 million primarily due to higher sales volumes, primarily in horticulture product sales, partially offset by favorable cost absorption.
PLASTICS SEGMENT RESULTS
The following table summarizes operating results for our Plastics segment for the years ended December 31, 2022 and 2021:
(in thousands) 2022 2021 $ change % change
Operating Revenues $ 512,527 $ 380,229 $ 132,298 34.8 %
Cost of Products Sold 227,569 228,789 (1,220) (0.5)
Other Operating Expenses 16,175 14,326 1,849 12.9
Depreciation and Amortization 4,205 4,354 (149) (3.4)
Operating Income $ 264,578 $ 132,760 $ 131,818 99.3 %
Operating Revenues increased $132.3 million primarily due to a 66% increase in the price per pound of PVC pipe sold, as sales prices remained high and continued to increase in 2022, due to a continuation of extraordinary market conditions first experienced in the previous year. Sales volumes decreased 19% due to raw material constraints in the first half of 2022 and softening customer demand during the second half of 2022 driven by contractors delaying projects due to supply chain issues, softening housing market outlook, and customers reducing purchases of PVC pipe in order to use up existing on hand inventory.
Cost of Products Sold decreased $1.2 million primarily due to a 19% decrease in sales volumes, partially offset by a 22% increase in the cost per pound of PVC pipe sold, largely due to higher resin costs.
Other Operating Expenses increased $1.8 million due to increases in various cost categories including compensation costs and sales commissions.
CORPORATE COSTS
The following table summarizes Corporate results of operations for the years ended December 31, 2022 and 2021:
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(in thousands) 2022 2021 $ change % change
Other Operating Expenses $ 16,202 $ 13,905 $ 2,297 16.5 %
Depreciation and Amortization 140 225 (85) (37.8)
Operating Loss $ 16,342 $ 14,130 $ 2,212 15.7 %
Other Operating Expenses increased $2.3 million primarily due to increased external service costs during the year, as well as increased employee compensation and other costs.
REGULATORY MATTERS
The following provides a summary of OTP's current general rates and a summary of recent rate case filings and rate rider filings that have or are expected to have a material impact on our operating results, financial position, or cash flows.
GENERAL RATES
The following includes a summary of electric base rates as determined in OTP's most recent general rate case in each state:
Revenue Allowed
Implementation Requirement Return on Return Equity
Jurisdiction Date (in millions) Rate Base on Equity Ratio
Minnesota 07/01/22 $ 209.0 7.18 % 9.48 % 52.50 %
North Dakota 02/01/19 153.1 7.64 9.77 52.50
South Dakota (1)
08/01/19 35.5 7.09 8.75 52.92
(1) Includes an earnings sharing mechanism to share with South Dakota customers any weather-normalized earnings above the authorized ROE of 8.75%. The mechanism requires 50% of any weather-normalized revenue creating annual earnings in excess of the authorized ROE up to a maximum of 9.50% be returned to customers and 100% returns of revenue creating annual earnings above 9.50%.
Minnesota Rate Case: On November 2, 2020, OTP filed an initial request with the MPUC for an increase in revenue recoverable through base rates in Minnesota, and on December 3, 2020, the MPUC approved an interim annual rate increase of $6.9 million, or 3.2%, effective January 1, 2021.
On February 1, 2022, the MPUC issued its written order on final rates. The key provisions of the order included a revenue requirement of $209.0 million, based on a return on rate base of 7.18% and an allowed ROE of 9.48% on an equity ratio of 52.5%. The order also authorized recovery of our remaining Hoot Lake Plant net asset over a five-year period and approved the requested decoupling mechanism for most residential and commercial customer rate groups with a cap of 4% of annual base revenues.
On May 12, 2022, OTP's final rate case compliance filing was approved by the MPUC. The filing included final revenue calculations, rate design, and resulting tariff revisions, along with a determination of the interim rate refund, which resulted in an increase in revenues in 2022 of $4.1 million. Final rates took effect on July 1, 2022, and interim rate refunds of $15.3 million were completed in the third quarter of 2022.
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RATE RIDERS
The following table includes a summary of pending and recently concluded rate rider proceedings:
Recovery Filing Amount Effective
Mechanism Jurisdiction Status Date (in millions) Date Notes
RRR - 2022 MN Requested 11/01/22 $17.5 07/01/23 Includes the recovery of the Hoot Lake Solar Project, the purchase of the Ashtabula III wind farm, and true up PTCs in base rates to actual PTCs generated at the Merricourt wind farm.
CIP - 2022 MN Approved 04/01/22 10.8 10/01/22 Includes recovery of energy conservation improvement costs as well as a demand side management financial incentive.
CIP - 2021 MN Approved 04/01/21 9.4 12/01/21 Includes recovery of energy conservation improvement costs as well as a demand side management financial incentive.
TCR - 2021 MN Approved 11/23/21 7.2 08/01/22 Includes recovery of two new transmission projects.
RRR - 2021 MN Approved 12/06/21 7.0 08/01/22 Includes return on Hoot Lake Solar construction costs and costs associated with the acquisition of the Ashtabula III wind farm.
RRR - 2023 ND Requested 12/30/22 17.0 04/01/23 Includes recovery of Ashtabula III investment, along with other proposals, see additional information below.
RRR - 2021 ND Approved 03/07/21 11.8 04/01/21 Includes recovery of Merricourt investment and operating costs.
RRR - 2022 ND Approved 01/05/22 7.8 04/01/22 Includes Merricourt recovery, the proposed purchase of Ashtabula III, and credits related to deferred taxes and PTCs.
TCR - 2022 ND Approved 09/15/22 7.5 01/01/23 Includes recovery of three new transmission projects, one transmission rebuild project, and six transmission projects related to extending the useful life of transmission assets.
TCR - 2021 ND Approved 09/15/21 6.1 01/01/22 Includes recovery of three new transmission projects/programs.
TCR - 2020 ND Approved 08/31/20 5.6 01/01/21 Includes recovery of eight new transmission projects.
GCR - 2021 ND Approved 03/01/21 5.2 07/01/21 Includes recovery of Astoria Station, net of anticipated savings associated with the retirement of Hoot Lake Plant.
GCR - 2022 ND Approved 03/01/22 3.3 07/01/22 Annual update to generation cost recovery rider.
AMDT - 2022 ND Approved 07/08/22 3.1 01/01/23 Includes recovery of the advanced metering infrastructure, outage management system, and demand response projects.
PIR - 2022 SD Approved 06/01/22 3.0 09/01/22 Includes recovery of the Ashtabula III wind farm purchase, Merricourt, Astoria Station, and the Advanced Grid Infrastructure project, as well as load growth credits.
TCR - 2023 SD Requested 11/01/22 3.0 03/01/23 Includes the recovery of one new and four previously approved transmission projects.
TCR - 2022 SD Approved 10/29/21 2.2 03/01/22 Annual update to TCR rider.
TCR - 2021 SD Approved 10/30/20 2.2 03/01/21 Includes recovery of two new transmission projects.
Renewable Resource Rider (RRR) and Energy Adjustment Rider (EAR): On December 30, 2022, OTP filed an update to its North Dakota RRR. The update included, among other items, a request to modify load allocation factors in North Dakota given the large new load added in the state in 2022. If approved, the load allocation factor change would produce an additional $4.4 million of rider recovery over a 12 month period. On January 23, 2023, OTP filed an update to its North Dakota EAR proposing to refund MISO planning resource auction revenues to North Dakota customers if the NDPSC approves the load allocation factor modification as filed in the RRR docket. If approved, OTP would refund approximately $4.2 million of planning resource auction revenues to North Dakota customers.
MISO PLANNING RESOURCE AUCTION
OTP offered 88-megawatts of excess capacity into the annual MISO planning resource auction for the period June 2022 through May 2023. As a result of a capacity shortage in the MISO region, capacity prices cleared the auction at maximum pricing. As a result, the 88-megawatts of auctioned capacity will generate approximately $9.3 million of net capacity auction revenues over the twelve month period ending in May 2023. We anticipate the Minnesota allocated portion of net capacity auction revenues will be returned to customers through the FCA mechanism in the state, and the majority of the net capacity auction revenues allocated to our other jurisdictions will be used to mitigate customer rate increases or returned to customers through various mechanisms.
INTEGRATED RESOURCE PLAN
The MPUC recently approved a change to the procedural schedule for our 2022 IRP, which was originally filed in September 2021, and we plan to file an updated IRP in March 2023. In conjunction with the updated IRP, our preferred plan could change based on the results of the updated resource modeling we perform, incorporating recent changes affecting the energy industry and the passing of the IRA, as well as other changes. A change to our preferred plan could ultimately impact the nature, timing and amount of future capital investments, as well as the potential for OTP's withdrawal from Coyote Station, and could have a material impact on our operating results, financial position or cash flows.
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LIQUIDITY
LIQUIDITY OVERVIEW
We believe our financial condition is strong and our cash, other liquid assets, operating cash flows, existing lines of credit, access to capital markets, and borrowing ability because of investment-grade credit ratings, when taken together, provide us ample liquidity to conduct business operations and fund our capital expenditure program. Our liquidity, including our operating cash flows and access to capital markets, can be impacted by macroeconomic factors outside of our control. In addition, our liquidity could be impacted by non-compliance with covenants under our various debt instruments. As of December 31, 2022, we were in compliance with all debt covenants (see the Financial Covenant section under Capital Resources below).
The following table presents the status of our lines of credit as of December 31, 2022 and 2021:
2022 2021
(in thousands) Line Limit Amount Outstanding Letters
of Credit Amount Available Amount Available
Otter Tail Corporation Credit Agreement $ 170,000 $ — $ — $ 170,000 $ 147,363
OTP Credit Agreement 170,000 8,204 9,573 152,223 88,315
Total $ 340,000 $ 8,204 $ 9,573 $ 322,223 $ 235,678
We have an internal risk tolerance metric to maintain a minimum of $50 million of liquidity under the OTC Credit Agreement. Should additional liquidity be needed, this agreement includes an accordion feature allowing us to increase the amount available to $290 million, subject to certain terms and conditions. The OTP Credit Agreement also includes an accordion feature allowing OTP to increase that facility to $250 million, subject to certain terms and conditions.
CASH FLOWS
The following is a discussion of our cash flows for the years ended December 31, 2022 and 2021:
(in thousands) 2022 2021
Net Cash Provided by Operating Activities $ 389,309 $ 231,243
Net Cash Provided by Operating Activities increased $158.1 million primarily due to a $107.4 million increase in net income and a lower level of working capital needs compared to the previous year. Our working capital decrease was primarily the result of a $30.6 million decrease in accounts receivable and a $5.3 million decrease in inventories, which exceeded the decrease in accounts payable and accrued and other liabilities. The decrease in accounts receivable was primarily due to decreased sales prices in our Manufacturing segment in the second half of the year, as steel prices declined from historically high levels in 2021, and decreased sales volumes in our Plastics segment in the second half of the year, as customer demand softened. The decrease in inventories was largely the result of decreased material costs within our Manufacturing segment, due to the decrease in steel prices. The decrease in accounts payable was largely due to the decreased material costs in our Manufacturing segment and decreased sales volumes in our Plastics segment in the second half of the year.
Unique market dynamics experienced by our Plastics segment businesses in 2022 and 2021 resulted in a significant increase in our overall cash from operations compared to prior periods, and we do not expect cash from operations at these levels to continue in future years.
(in thousands) 2022 2021
Net Cash Used in Investing Activities $ 175,071 $ 171,510
Net Cash Used in Investment Activities increased $3.6 million due to a $7.8 million increase in capital investments in our Electric segment, combined with a decrease in proceeds received from the sale of debt and equity securities at our captive insurance entity, largely offset by a decrease in capital investments in our Manufacturing and Plastics segments.
(in thousands) 2022 2021
Net Cash Used in Financing Activities $ 96,779 $ 59,359
Net Cash Used in Financing Activities increased $37.4 million primarily due to repayments of short-term borrowings, partially offset by increases in long-term debt. Our financing activities in 2022 included the issuance of $90.0 million of long-term debt and the maturity and repayment of $30.0 million of debt at OTP, net repayments of short-term borrowings of $83.0 million, which were repaid with available cash resulting from increased cash from operations, and dividend payments of $68.8 million. In 2021, $140.0 million of long-term debt was issued and used to repay $140.0 million of maturing long-term debt at OTP, we incurred $10.1 million of net short-term borrowings on our lines of credit, and paid $64.9 million in dividends.
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CAPITAL REQUIREMENTS
CAPITAL EXPENDITURES
We have a capital expenditure program for expanding, upgrading and improving our facilities and operating equipment. Typical uses of cash for capital expenditures are investments in electric generation facilities and environmental upgrades, transmission and distribution lines, manufacturing facilities and upgrades, equipment used in the manufacturing process, and computer hardware and information systems. Our capital expenditure program is subject to review and is revised in light of changes in demands for energy, technology, environmental laws, regulatory changes, business expansion opportunities, the costs of labor, materials and equipment and our financial condition.
The following provides a summary of capital expenditures for the years ended December 31, 2022 and 2021 for our Electric segment and non-electric businesses and anticipated capital expenditures for the five year period 2023 through 2027:
(in millions) 2021 2022 2023 2024 2025 2026 2027 Total
Electric Segment:
Renewables and Natural Gas Generation $ 88 $ 119 $ 88 $ 79 $ 10 $ 384
Technology and Infrastructure 33 30 6 5 1 75
Distribution Plant Replacements 33 37 38 38 43 189
Transmission (includes replacements) 34 36 46 87 78 281
Other 26 25 30 25 22 128
Total Electric Segment $ 140 $ 148 $ 214 $ 247 $ 208 $ 234 $ 154 $ 1,057
Manufacturing and Plastics Segments 32 23 48 53 29 25 24 179
Total Capital Expenditures $ 172 $ 171 $ 262 $ 300 $ 237 $ 259 $ 178 $ 1,236
Total Electric Utility Average Rate Base $ 1,575 $ 1,624 $ 1,750 $ 1,850 $ 1,990 $ 2,110 $ 2,210
Rate Base Growth 13.7 % 3.1 % 7.8 % 5.7 % 7.6 % 6.0 % 4.7 %
CONTRACTUAL OBLIGATIONS
The following table summarizes our contractual obligations at December 31, 2022 and the effect these obligations are expected to have on our liquidity and cash flow in future periods.
(in millions) Total Less than
1 Year 1-3
Years 3-5
Years More than
5 Years
Debt Obligations $ 835 $ 8 $ — $ 122 $ 705
Interest on Debt Obligations 637 35 70 67 465
Coal Contracts 527 24 49 52 402
Capacity and Energy Requirements 5 — 1 — 4
Postretirement Benefit Obligations 86 5 12 13 56
Other Purchase Obligations (including land easements) 55 14 4 4 33
Operating Lease Obligations 21 6 10 4 1
Total Contractual Cash Obligations $ 2,166 $ 92 $ 146 $ 262 $ 1,666
Coal contract obligations are based on estimated coal consumption and costs for the delivery of coal to Coyote Station from Coyote Creek Mining Company (CCMC) under the LSA that ends in 2040. Postretirement benefit obligations include estimated cash expenditures for the payment of retiree medical and life insurance benefits and supplemental pension benefits under our unfunded Executive Survivor and Supplemental Retirement Plan (ESSRP), but do not include amounts to fund our noncontributory funded pension plan, as we are not currently required to make a contribution to that plan.
COMMON STOCK DIVIDENDS
We paid dividends to our shareholders totaling $68.8 million, or $1.65 per share, in 2022. The determination of the amount of future cash dividends to be paid will depend on, among other things, our financial condition, improvement in earnings per share, cash flows from operations, the level of our capital expenditures and our future business prospects. As a result of certain statutory limitations or regulatory or financing agreements, restrictions could occur on the amount of distributions allowed to be made by OTC subsidiaries. See Note 14 to our consolidated financial statements included in this report on Form 10-K for additional information. The decision to declare a dividend is reviewed quarterly by our Board of Directors. On February 3, 2023, our Board of Directors increased the quarterly dividend from $0.4125 to $0.4375 per common share.
CAPITAL RESOURCES
Financial flexibility is provided by operating cash flows, borrowing capacity under our lines of credit, strong financial coverages, investment grade credit ratings and alternative financing arrangements such as leasing. Debt financing will be required in the five-year period from 2023 through 2027 to refinance maturing debt and to finance our capital investments within our Electric segment. Our financing plans are subject to change and
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are impacted by our planned level of capital investments, a decision to reduce borrowings under our lines of credit, to refund or retire early any of our presently outstanding debt, to complete acquisitions or for other corporate purposes.
REGISTRATION STATEMENTS
On May 3, 2021, we filed a shelf registration statement with the SEC under which we may offer for sale, from time to time, either separately or together in any combination, equity, debt or other securities described in the shelf registration statement. The registration statement expires in May, 2024. No shares were issued pursuant to the registration statement in 2022.
On May 3, 2021, we filed a second registration statement with the SEC for the issuance of up to 1,500,000 common shares under an Automatic Dividend Reinvestment and Share Purchase Plan, which provides shareholders, retail customers of OTP and other interested investors a method of purchasing our common shares by reinvesting their dividends and/or making optional cash investments. Shares purchased under the plan may be new issue common shares or common shares purchased on the open market. The registration statement expires in May 2024. In 2022, we issued 133,827 shares under the plan. All shares issued under the plan to date have been open market purchases and there have been no new issue shares, resulting in no proceeds received by the Company. As of December 31, 2022, 1,250,993 shares remained available for purchase or issuance under the Plan.
SHORT-TERM DEBT
OTC and OTP are each party to a credit agreement (the OTC Credit Agreement and OTP Credit Agreement, respectively) which provides for unsecured revolving lines of credit. On October 31, 2022, the credit agreements were amended to extend the maturity date of each credit facility from September 30, 2026 to October 29, 2027, and to replace the London Interbank Offered Rate (LIBOR) as a benchmark interest rate. The agreements generally bear interest at the Secured Overnight Financing Rate (SOFR) plus an applicable credit spread, which is subject to adjustment based on the credit ratings of the issuer. The weighted-average interest rate on all outstanding borrowings as of December 31, 2022 and 2021 was 5.61% and 1.42%.
The following is a summary of key provisions and borrowing information as of and for the year ended December 31, 2022:
(in thousands, except interest rates) OTC Credit Agreement OTP Credit Agreement
Borrowing Limit $ 170,000 $ 170,000
Borrowing Limit if Accordion Exercised 1
290,000 250,000
Amount Restricted Due to Outstanding Letters of Credit at Year-End — 9,573
Amount Outstanding at Year-End — 8,204
Average Amount Outstanding During Year 11,686 22,698
Maximum Amount Outstanding During the Year 58,715 74,519
Interest Rate at Year-End 5.9 % 5.6 %
Expiration Date October 29, 2027 October 29, 2027
1 Each facility includes an accordion feature allowing the borrower to increase the borrowing limit if certain terms and conditions are met.
LONG-TERM DEBT
At December 31, 2022, we had $827.0 million of principal outstanding under long-term debt arrangements. Note 9 to our consolidated financial statements included in this report on Form 10-K includes information regarding these instruments. The agreements generally provide for unsecured borrowings at fixed rates of interest with maturities ranging from 2026 to 2052. One OTP debt instrument with a principal balance of $30.0 million matured in August 2022. Pursuant to a Note Purchase Agreement executed in June 2021, OTP issued its Series 2022A notes in May 2022, for aggregate proceeds of $90.0 million, and used a portion of the proceeds to repay the $30.0 million which matured in August 2022.
Financial Covenants
Certain of our short- and long-term debt agreements require OTC and OTP to maintain certain financial covenants. As of December 31, 2022, we were in compliance with these financial covenants as further described below:
OTC, under its financial covenants, may not permit its ratio of Interest-Bearing Debt to Total Capitalization to exceed 0.60 to 1.00, may not permit its Interest and Dividend Coverage Ratio to be less than 1.50 to 1.00, and may not permit its Priority Indebtedness to exceed 10% of our Total Capitalization. As of December 31, 2022, our Interest-Bearing Debt to Total Capitalization was 0.41 to 1.00, our Interest and Dividend Coverage Ratio was 11.12 to 1.00 and we had no Priority Indebtedness outstanding.
OTP, under its financial covenants, may not permit its ratio of Debt to Total Capitalization to exceed 0.60 to 1.00, may not permit its Interest and Dividend Coverage Ratio to be less than 1.50 to 1.00, and may not permit its Priority Debt to exceed 20% of its Total Capitalization. As of December 31, 2022, OTP's Interest-Bearing Debt to Total Capitalization was 0.45 to 1.00, its Interest and Dividend Coverage Ratio was 3.66 to 1.00 and it had no Priority Indebtedness outstanding.
None of our debt agreements include any provisions that would trigger an acceleration of the related debt as a result of changes in the credit rating levels assigned to the related obligor by rating agencies.
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Credit Ratings
The credit ratings of OTC and OTP as of December 31, 2022 are summarized below:
Otter Tail Corporation Otter Tail Power Company
Moody's Fitch S&P Moody's Fitch S&P
Corporate Credit/Long-Term Issuer Default Rating Baa2 BBB- BBB A3 BBB BBB+
Senior Unsecured Debt n/a BBB- n/a n/a BBB+ BBB+
Outlook Stable Stable Stable Stable Stable Stable
CRITICAL ACCOUNTING ESTIMATES
Preparation of financial statements in accordance with accounting principles generally accepted in the United States of America and the Company’s discussion and analysis of its financial condition and operating results requires management to make assumptions, estimates and judgments that affect the reported amounts. While we believe the estimates, assumptions, and judgments we use in preparing our consolidated financial statements are appropriate and are based on the best available information, they are subject to future events and uncertainties regarding their outcome and therefore actual results may materially differ from these estimates. Management has discussed the application of these critical accounting policies and the development of these estimates with the Audit Committee of our Board of Directors. The following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.
REGULATORY ACCOUNTING
Our utility business is subject to regulation of rates and other matters by state utility commissions in Minnesota, North Dakota and South Dakota and by the FERC for certain interstate operations. Accordingly, our utility business must adhere to the accounting requirements of regulated operations, which requires the recognition of regulatory assets and regulatory liabilities for amounts that otherwise would impact the statement of income or comprehensive income when it is probable that such amounts will be collected from customers or credited to customers through the rate-making process. This guidance also provides recognition criteria for adjustments to rates outside of a general rate case proceeding which are provided to encourage or incentivize investments in certain areas such as conservation, renewable energy, pollution reduction or control, improved infrastructure of the transmission grid or other programs that provide benefits to the general public under public policy, laws or regulations. Regulatory assets generally represent costs that have been incurred but have been deferred because future recovery from customers, as established through the rate-making process, is probable. Regulatory liabilities generally represent amounts to be refunded to customers or amounts currently collected from customers for future costs.
We assess the probability of recovery of regulatory assets and the obligations arising from regulatory liabilities on a quarterly basis. Our probability estimates incorporate numerous factors, including recent rate making decisions, historical precedents for similar matters, the regulatory environments in which we operate and the impact these incurred costs may have on our customers. Changes in our assessments regarding the likelihood of recovery or settlement of our regulatory assets and liabilities may have a material impact on our operating results and financial position. Further, if we determine that all or a portion of our utility business no longer meets the criteria for continued application of regulatory accounting, or our regulators disallow recovery of a previously incurred cost or eliminate a regulatory liability, we would be required to remove the associated regulatory assets and liabilities from our consolidated balance sheet and recognize in the consolidated statement of income as an expense or income item in the period in which this accounting treatment is no longer applicable.
As of December 31, 2022 and 2021, we had regulatory assets of $119.7 million and $152.9 million and regulatory liabilities of $261.8 million and $259.3 million. If future recovery of amounts recorded as regulatory assets was no longer probable we would be required to recognize expense or other comprehensive loss in the period in which recovery was deemed to no longer be probable.
PENSION AND OTHER POSTRETIREMENT BENEFITS OBLIGATIONS AND COSTS
Pension and postretirement benefit liabilities and expenses are determined by actuaries using assumptions about the discount rate, expected return on plan assets, rate of compensation increase and healthcare cost-trend rates. See Note 10 to our consolidated financial statements included in this report on Form 10-K for additional information on our pension and postretirement benefit plans and related assumptions.
These benefits, for any individual employee, can be earned and related expenses can be recognized and a liability accrued over periods of up to 30 or more years. These benefits can be paid out for up to 40 or more years after an employee retires. Estimates of liabilities and expenses related to these benefits are among our most critical accounting estimates. Although deferral and amortization of fluctuations in actuarially determined benefit obligations and expenses are provided for when actual results on a year-to-year basis deviate from long-range assumptions, compensation increases and healthcare cost increases or a reduction in the discount rate applied from one year to the next can significantly increase our benefit expenses in the year of the change. Likewise, compensation decreases and healthcare cost decreases or an increase in the discount rate applied from one year to the next can significantly decrease our benefit expenses in the year of the change. Also, a change in the expected rate of return on pension plan assets in our funded pension plan or realized rates of return on plan assets that are well above or below assumed rates of return or a change in the anticipated life expectancy of plan participants could result in significant increases or decreases in recognized pension benefit expenses in the year of the change or for many years thereafter because actuarial losses can be amortized over the average remaining service lives of active employees.
We estimate the discount rate through the use of a hypothetical bond portfolio method, which incorporates yields on a collection of high credit quality bonds that produce cash flows similar to our anticipated future benefit payments.
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We estimate the assumed long-term rate of return on plan assets based on asset category studies using historical market returns achieved by our asset portfolio allocation over long-term periods, as well as long-term projected return levels.
Pension plan assets are invested in a portfolio according to our return, liquidity and diversification objectives to provide a source of funding for plan obligations and manage contributions to the plan. The principal process for achieving these objectives is the asset allocation given the long-term risk, return, correlation and liquidity characteristics of each particular asset class.
At December 31, 2022, we set the discount rate used to measure our pension plan obligations at 5.51% and at 5.52% to measure postretirement healthcare obligations, a 248 and 251 basis point increase, respectively, from the estimates used at December 31, 2021. Our estimates used to determine benefit cost for 2022 included a discount rate of 3.03% for pension benefits and 3.01% for postretirement healthcare costs, a 25 and 26 basis point decrease, respectively, from 2021 estimates. In addition, we estimated our assumed rate of return on pension assets to be 6.30% for 2022, a 21 basis point decrease from our 2021 estimate.
The following table summarizes the impact on 2022 pension and postretirement costs for a 25 basis point increase or decrease, holding all other variables constant, on certain key assumptions:
(in thousands) +0.25 -0.25
Pension Plan:
Discount Rate $ (1,147) $ 1,207
Rate of Increase in Future Compensation 801 (757)
Long-Term Return on Plan Assets (940) 940
Other Postretirement Benefits:
Discount Rate (310) 326
For 2023, we expect pension benefit income for our pension plan to be $5.8 million compared to $3.1 million of pension benefit expense in 2022, due to an increase in the discount rate used to determine benefit costs and an increase in the expected return on plan assets, partially offset by an increase in expected future compensation costs. The estimated discount rate used to determine annual benefit cost accruals increased from 3.03% in 2022 to 5.51% in 2023. The assumed rate of return on pension plan assets is 7.00% for 2023, compared with the assumption of 6.30% in 2022.
Subsequent increases or decreases in actual rates of return on plan assets over assumed rates, increases or decreases in the discount rate, increases in future compensation levels, and increases in retiree healthcare cost inflation rates could significantly change projected costs.
We believe the estimates made for our pension and other postretirement benefits are reasonable based on the information that is known at the point in time the estimates are made. These estimates and assumptions are subject to a number of variables and are subject to change.
GOODWILL IMPAIRMENT
Goodwill is required to be evaluated annually for impairment and more frequently as events or circumstances require. Goodwill is tested for impairment at the reporting unit level. We have identified two reporting units which carry a material amount of goodwill.
The goodwill impairment test is a single-step quantitative assessment which compares the estimated fair value of the reporting unit to its carrying value. An impairment charge is recognized if the carrying amount exceeds the estimated fair value in an amount that is equal to the excess but limited to the amount of recorded goodwill of the reporting unit. An optional qualitative impairment assessment may be performed prior to and may eliminate the need to perform the quantitative assessment.
Estimating the fair value of a reporting unit under the quantitative impairment method requires significant judgments and estimates. We estimate the fair value of our reporting units primarily using an income approach, which includes a discounted cash flow methodology to arrive at a fair value estimate by determining the present value of projected future cash flows over a specified period plus a terminal value to reflect cash flows beyond the projection period. The discount rate applied to the estimated future cash flows reflects our estimate of the weighted-average cost of capital of comparable entities. To supplement our income approach, we reference various market indications of fair value, where available, and include fair value estimates using multiples derived from comparable enterprise values to EBITDA, comparable price earnings ratios and, if available, comparable sales transactions for comparative peer companies.
Our discounted cash flow methodology incorporates significant estimates, which include assumptions of future operating results and cash flows, which are impacted by economic and industry conditions, the amount and timing of estimated capital expenditures, an estimated terminal growth rate and the selection of an appropriate weighted-average cost of capital, among others.
Our goodwill impairment testing performed in the fourth quarter of 2022 indicated no impairment was present for either reporting unit and the estimated fair value of each reporting unit substantially exceeded the respective carrying value. As part of our testing we perform various sensitivity analyses to understand if our conclusions are sensitive to changes in certain assumptions. A 1% decrease in projected operating revenues, a one hundred basis point decrease in projected gross profit margins and a twenty five basis point increase in the discount rate would not lead to a goodwill impairment charge for either reporting unit.
We believe the estimates and assumptions used in our impairment assessments are reasonable and based on the best information available. However, these estimates and assumptions inherently include a degree of uncertainty. Significant adverse changes in our expectations for any of these estimates could result in an impairment charge in a future period which may materially impact our operating results and financial position.
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