SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

OTTER TAIL CORPORATION

(Exact name of registrant as specified in its charter)

Minnesota		41-0462685
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

215 South Cascade Street, Box 496, Fergus Falls, Minnesota				56538-0496
(Address of principal executive offices)				(Zip Code)

866-410-8780

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). YES o NO þ

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date:

October 31, 2006 – 29,505,159 Common Shares ($5 par value)

 

 

OTTER TAIL CORPORATION

INDEX

				Page No.
Part I.		Financial Information
Item 1.		Financial Statements
		Consolidated Balance Sheets – September 30, 2006 and December 31, 2005 (not audited)			2 & 3
		Consolidated Statements of Income — Three and Nine Months Ended September 30, 2006 and 2005 (not audited)			4
		Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2006 and 2005 (not audited)			5
		Notes to Consolidated Financial Statements (not audited)			6-22
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			23-40
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			41-43
Item 4.		Controls and Procedures			43
Part II.		Other Information
Item 1.		Legal Proceedings			44
Item 1A.		Risk Factors			44
Item 6.		Exhibits			45
Signatures					45
Certification
Certification
Certification
Certification

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Otter Tail Corporation

(not audited)

		September 30,				December 31,
		2006				2005
		(Thousands of dollars)
Current assets
Cash and cash equivalents		$	7,999			$	5,430
Accounts receivable:
Trade—net			130,421				117,796
Other			9,599				11,790
Inventories			106,601				88,677
Deferred income taxes			6,967				6,871
Accrued utility revenues			20,091				22,892
Costs and estimated earnings in excess of billings			41,733				21,542
Other			14,360				16,476
Assets of discontinued operations			409				13,701
Total current assets			338,180				305,175
Investments and other assets			36,992				33,824
Goodwill—net			98,110				98,110
Other intangibles—net			20,360				21,160
Deferred debits
Unamortized debt expense and reacquisition premiums			6,193				6,520
Regulatory assets and other deferred debits			17,259				19,616
Total deferred debits			23,452				26,136
Plant
Electric plant in service			921,642				910,766
Nonelectric operations			235,893				228,548
Total plant			1,157,535				1,139,314
Less accumulated depreciation and amortization			472,876				459,438
Plant—net of accumulated depreciation and amortization			684,659				679,876
Construction work in progress			37,042				17,215
Net plant			721,701				697,091
Total		$	1,238,795			$	1,181,496

See accompanying notes to consolidated financial statements

Otter Tail Corporation
Consolidated Balance Sheets
(not audited)
-Liabilities-

		September 30,				December 31,
		2006				2005
		(Thousands of dollars)
Current liabilities
Short-term debt		$	54,037			$	16,000
Current maturities of long-term debt			3,087				3,340
Accounts payable			115,118				97,239
Accrued salaries and wages			25,684				24,326
Accrued federal and state income taxes			2,108				8,449
Other accrued taxes			10,008				12,518
Other accrued liabilities			16,248				14,124
Liabilities of discontinued operations			187				10,983
Total current liabilities			226,477				186,979
Pensions benefit liability			24,397				23,216
Other postretirement benefits liability			28,033				26,982
Other noncurrent liabilities			17,137				18,683
Deferred credits
Deferred income taxes			112,351				113,737
Deferred investment tax credit			8,467				9,327
Regulatory liabilities			65,343				61,624
Other			1,430				1,500
Total deferred credits			187,591				186,188
Capitalization
Long-term debt, net of current maturities			256,223				258,260
Class B stock options of subsidiary			1,258				1,258
Cumulative preferred shares authorized 1,500,000 shares without par value; outstanding 2006 and 2005 — 155,000 shares			15,500				15,500
Cumulative preference shares — authorized 1,000,000 shares without par value; outstanding — none			—				—
Common shares, par value $5 per share authorized 50,000,000 shares; outstanding 2006 — 29,499,053 and 2005 — 29,401,223			147,495				147,006
Premium on common shares			98,124				96,768
Unearned compensation			—				(1,720	)
Retained earnings			242,392				228,515
Accumulated other comprehensive loss			(5,832	)			(6,139	)
Total common equity			482,179				464,430
Total capitalization			755,160				739,448
Total		$	1,238,795			$	1,181,496

See accompanying notes to consolidated financial statements

Otter Tail Corporation

(not audited)

		Three months ended								Nine months ended
		September 30,								September 30,
		2006				2005				2006				2005
		(In thousands, except share and								(In thousands, except share and
		per share amounts)								per share amounts)
Operating revenues
Electric		$	71,206			$	85,770			$	227,308			$	233,403
Non-electric			209,336				175,417				590,945				489,667
Total operating revenues			280,542				261,187				818,253				723,070
Operating expenses
Production fuel — electric			15,846				14,485				42,108				40,211
Purchased power — electric system use			8,590				13,295				44,990				44,737
Electric operation and maintenance expenses			26,433				23,383				77,889				72,635
Cost of goods sold — non-electric (excludes depreciation; included below)			161,148				135,662				449,905				372,894
Other non-electric expenses			29,543				26,428				85,097				74,712
Depreciation and amortization			12,552				11,720				37,155				34,658
Property taxes — electric			2,260				2,735				7,429				7,816
Total operating expenses			256,372				227,708				744,573				647,663
Operating income			24,170				33,479				73,680				75,407
Other income			1,060				1,071				2,147				1,472
Interest charges			5,078				4,633				14,622				14,007
Income from continuing operations before income taxes			20,152				29,917				61,205				62,872
Income taxes — continuing operations			6,676				10,749				21,737				21,676
Net income from continuing operations			13,476				19,168				39,468				41,196
Discontinued operations
(Loss) income from discontinued operations net of taxes of $0; ($391); $28 and ($161) for the respective periods			—				(589	)			26				(252	)
Goodwill impairment loss			—				(1,003	)			—				(1,003	)
Net gain on disposition of discontinued operations — net of taxes of $0; $17; $224 and $5,786 for the respective periods			—				27				336				9,937
Net income from discontinued operations			—				(1,565	)			362				8,682
Net income			13,476				17,603				39,830				49,878
Preferred dividend requirements			183				185				551				552
Earnings available for common shares		$	13,293			$	17,418			$	39,279			$	49,326
Basic earnings per common share:
Continuing operations (net of preferred dividend requirement)		$	0.45			$	0.65			$	1.33			$	1.39
Discontinued operations		$	—			$	(0.05	)		$	0.01			$	0.30
		$	0.45			$	0.60			$	1.34			$	1.69
Diluted earnings per common share:
Continuing operations (net of preferred dividend requirement)		$	0.45			$	0.64			$	1.31			$	1.39
Discontinued operations		$	—			$	(0.05	)		$	0.01			$	0.29
		$	0.45			$	0.59			$	1.32			$	1.68
Average number of common shares outstanding — basic			29,412,526				29,245,640				29,377,158				29,176,625
Average number of common shares outstanding — diluted			29,805,897				29,441,410				29,764,752				29,289,438
Dividends per common share		$	0.2875			$	0.2800			$	0.8625			$	0.8400

See accompanying notes to consolidated financial statements

Otter Tail Corporation

(not audited)

		Nine months ended
		September 30,
		2006				2005
		(Thousands of dollars)
Cash flows from operating activities
Net income		$	39,830			$	49,878
Adjustments to reconcile net income to net cash provided by operating activities:
Net gain from sale of discontinued operations			(336	)			(9,937	)
(Income) loss from discontinued operations			(26	)			1,255
Depreciation and amortization			37,155				34,658
Deferred investment tax credit			(860	)			(864	)
Deferred income taxes			52				(1,854	)
Change in deferred debits and other assets			(564	)			3,310
Discretionary contribution to pension plan			(4,000	)			(4,000	)
Change in noncurrent liabilities and deferred credits			4,552				4,466
Allowance for equity (other) funds used during construction			(611	)			(601	)
Change in derivatives net of regulatory deferral			3,364				(2,927	)
Stock compensation expense			1,871				1,885
Other — net			(123	)			349
Cash (used for) provided by current assets and current liabilities:
Change in receivables			(9,063	)			(7,605	)
Change in inventories			(17,663	)			(7,682	)
Change in other current assets			(19,260	)			(9,370	)
Change in payables and other current liabilities			12,248				(7,840	)
Change in interest and income taxes payable			(3,831	)			(3,996	)
Net cash provided by continuing operations			42,735				39,125
Net cash provided by discontinued operations			1,011				3,117
Net cash provided by operating activities			43,746				42,242
Cash flows from investing activities
Capital expenditures			(53,291	)			(42,150	)
Proceeds from disposal of noncurrent assets			3,623				3,923
Acquisitions—net of cash acquired			—				(11,223	)
(Increases) decreases in other investments			(3,540	)			3,369
Net cash used in investing activities — continuing operations			(53,208	)			(46,081	)
Net proceeds from the sales of discontinued operations			1,898				33,685
Net cash provided by investing activities — discontinued operations			—				559
Net cash used in investing activities			(51,310	)			(11,837	)
Cash flows from financing activities
Change in checks written in excess of cash			(11	)			1,970
Net short-term borrowings			38,037				(6,950	)
Proceeds from issuance of common stock, net of issuance expenses			1,634				8,266
Payments for retirement of common stock			(463	)			(365	)
Proceeds from issuance of long-term debt			142				339
Debt issuance expenses			(302	)			—
Payments for retirement of long-term debt			(2,523	)			(5,304	)
Dividends paid			(25,954	)			(25,060	)
Net cash provided by (used in) financing activities — continuing operations			10,560				(27,104	)
Net cash used in financing activities — discontinued operations			—				(2,996	)
Net cash provided by (used in) financing activities			10,560				(30,100	)
Effect of foreign exchange rate fluctuations on cash			(427	)			(305	)
Net change in cash and cash equivalents			2,569				—
Cash and cash equivalents at beginning of period — continuing operations			5,430				—
Cash and cash equivalents at end of period — continuing operations		$	7,999			$	—
Supplemental cash flow information
Cash paid during the year from continuing operations for:
Interest (net of amount capitalized)		$	11,419			$	11,321
Income taxes		$	28,967			$	26,625
Cash paid during the year from discontinued operations for:
Interest		$	91			$	118
Income taxes		$	423			$	2,293

See accompanying notes to consolidated financial statements

OTTER TAIL CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(not audited)

In the opinion of management, Otter Tail Corporation (the Company) has included all adjustments (including normal recurring accruals) necessary for a fair presentation of the consolidated results of operations for the periods presented. The consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes as of and for the years ended December 31, 2005, 2004 and 2003 included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. Because of seasonal and other factors, the earnings for the three-month and nine-month periods ended September 30, 2006 should not be taken as an indication of earnings for all or any part of the balance of the year.

Revenue Recognition

Due to the diverse business operations of the Company, revenue recognition depends on the product produced and sold or service performed. The Company recognizes revenue when the earnings process is complete, evidenced by an agreement with the customer, there has been delivery and acceptance, and the price is fixed or determinable. In cases where significant obligations remain after delivery, revenue is deferred until such obligations are fulfilled. Provisions for sales returns and warranty costs are recorded at the time of the sale based on historical information and current trends. In the case of derivative instruments, such as the electric utility’s forward energy contracts and the energy services company’s swap transactions, marked-to-market and realized gains and losses are recognized on a net basis in revenue in accordance with Statement of Financial Accounting Standards (SFAS) No. 133 and Emerging Issues Task Force (EITF) Issues 02-3 and 03-11. Gains and losses on forward energy contracts subject to regulatory treatment are deferred and recognized on a net basis in revenue in the period realized. Idaho Pacific Holdings, Inc. (IPH), enters into forward natural gas contracts to hedge its exposure to fluctuations in natural gas prices related to future purchases of natural gas for its Ririe, Idaho and Center, Colorado dehydration plants. These forward contracts are derivatives subject to mark-to-market accounting that qualify as cash flow hedges, with unrealized gains and losses being recognized as components of other comprehensive income. On settlement, realized gains and losses are recognized as components of fuel expense in cost of goods sold.

For the Company’s operating companies recognizing revenue on certain products when shipped, those operating companies have no further obligation to provide services related to such product. The shipping terms used in these instances are FOB shipping point.

Some of the Company’s operating companies enter into fixed-price construction contracts. Revenues under these contracts are primarily recognized on a percentage-of-completion basis. The method used to determine the percentage of completion is based on the ratio of labor costs incurred to total estimated labor costs at the Company’s wind tower manufacturer, square footage completed to total bid square footage for certain floating dock projects and costs incurred to total estimated costs on all other construction projects. The following summarizes costs incurred, billings and estimated earnings recognized on uncompleted contracts:

		September 30,				December 31,
(in thousands)		2006				2005
Costs incurred on uncompleted contracts		$	224,633			$	194,076
Less billings to date			(240,269	)			(203,862	)
Plus estimated earnings recognized			26,782				22,834
		$	11,146			$	13,048

The following amounts are included in the Company’s consolidated balance sheets. Billings in excess of costs and estimated earnings on uncompleted contracts are included in accounts payable:

		September 30,				December 31,
(in thousands)		2006				2005
Costs and estimated earnings in excess of billings on uncompleted contracts		$	41,733			$	21,542
Billings in excess of costs and estimated earnings on uncompleted contracts			(30,587	)			(8,494	)
		$	11,146			$	13,048

Adjustments and Reclassifications

The Company’s consolidated statements of income for the three and nine months ended September 30, 2005, its consolidated statement of cash flows for the nine months ended September 30, 2005 and its December 31, 2005 consolidated balance sheet reflect the reclassifications of the operating results, assets and liabilities of the natural gas marketing operations of OTESCO, the Company’s energy services company, to discontinued operations as a result of the sale of these operations in June 2006. The reclassifications had no impact on the Company’s total consolidated net income or cash flows for the three or nine months ended September 30, 2005, or on its total consolidated assets or liabilities as of December 31, 2005.

Inventories

Inventories consist of the following:

		September 30,				December 31,
(in thousands)		2006				2005
Finished goods		$	45,429			$	38,928
Work in process			9,546				7,146
Raw material, fuel and supplies			51,626				42,603
		$	106,601			$	88,677

Goodwill and Other Intangible Assets

Goodwill did not change in the first nine months of 2006 as the Company did not acquire any businesses or make any adjustments to goodwill during the period.

The following table summarizes the components of the Company’s intangible assets at September 30, 2006 and December 31, 2005.

		September 30, 2006												December 31, 2005
		Gross								Net				Gross								Net
		carrying				Accumulated				carrying				carrying				Accumulated				carrying
(in thousands)		amount				amortization				amount				amount				amortization				amount
Amortized intangible assets:
Covenants not to compete		$	2,198			$	1,734			$	464			$	2,338			$	1,620			$	718
Customer relationships			10,599				910				9,689				10,575				583				9,992
Other intangible assets including contracts			2,083				1,229				854				2,785				1,680				1,105
Total		$	14,880			$	3,873			$	11,007			$	15,698			$	3,883			$	11,815
Non-amortized intangible assets:
Brand/trade name		$	9,353			$	—			$	9,353			$	9,345			$	—			$	9,345

Intangible assets with finite lives are being amortized over average lives ranging from one to twenty-five years. The amortization expense for these intangible assets was $831,000 for the nine months ended September 30, 2006 compared to $855,000 for the nine months ended September 30, 2005. The estimated annual amortization expense for these intangible assets for the next five years is: $1,078,000 for 2006, $848,000 for 2007, $727,000 for 2008, $636,000 for 2009 and $507,000 for 2010.

Comprehensive Income

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Net income		$	13,476			$	17,603			$	39,830			$	49,878
Other comprehensive income (net-of-tax)
Minimum pension liability adjustment			—				—				—				(1,263	)
Foreign currency translation (loss) gain			(19	)			666				545				407
Unrealized (loss) on cash flow hedges			(271	)			—				(271	)			—
Unrealized gain (loss) on available-for-sale securities			45				(15	)			33				(21	)
Total other comprehensive income			(245	)			651				307				(877	)
Total comprehensive income		$	13,231			$	18,254			$	40,137			$	49,001

The foreign currency translation adjustments are associated with the Canadian operations of IPH. The unrealized loss on cash flow hedges is associated with forward natural gas contracts entered into by IPH that are derivatives subject to mark-to-market accounting. The unrealized losses on available-for-sale securities are associated with investments of the Company’s captive insurance company.

New Accounting Standards

SFAS No. 123(R) (revised 2004), Share-Based Payment, issued in December 2004 is a revision of SFAS No. 123, Accounting for Stock-based Compensation, and supersedes Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees. Beginning in January 2006, the Company adopted SFAS No. 123(R) on a modified prospective basis. The Company is required to record stock-based compensation as an expense on its income statement over the period earned based on the fair value of the stock or options awarded on their grant date. The application of SFAS No. 123(R) reporting requirements will result in recording compensation expense of approximately $160,000, net-of-tax, in 2006 for non-vested stock options that were outstanding on December 31, 2005. Additionally, the application of SFAS No. 123(R) reporting requirements will result in recording compensation expense of approximately $240,000 in 2006 for the 15% discount offered under the Company’s Employee Stock Purchase Plan based on amounts currently being withheld for investment by participants. See additional discussion under Share-based Payments in the footnotes that follow. For years prior to 2006, we reported our stock-based compensation under the requirements of APB No. 25 and furnished related pro forma footnote information required under SFAS No. 123.

SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of Financial Accounting Standards Board (FASB) Statements No. 133 and 140, was issued in February 2006. This statement amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, to resolve issues addressed in SFAS No. 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. This statement also amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company has not issued nor does it currently

hold any financial instruments that would be affected by this statement and does not anticipate that this statement will have any impact on its consolidated financial statements on the date the statement becomes effective.

FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109, was issued by the FASB in June 2006. FIN No. 48 clarifies the accounting for uncertain tax positions in accordance with SFAS 109, Accounting for Income Taxes. The Company will be required to recognize in its financial statements the tax effects of a tax position that is “more-likely-than-not” to be sustained on audit based solely on the technical merits of the position as of the reporting date. The term “more-likely-than-not” means a likelihood of more than 50%. FIN No. 48 also provides guidance on new disclosure requirements, reporting and accrual of interest and penalties, accounting in interim periods and transition. FIN No. 48 is effective as of the beginning of the first fiscal year after December 15, 2006, which will be as of January 1, 2007, for the Company. Only tax positions that meet the “more-likely-than-not” threshold at that date may be recognized. The cumulative effect of initially applying FIN No. 48 will be recognized as a change in accounting principle as of the end of the period in which FIN No. 48 is adopted. The Company is currently assessing the impact of FIN No. 48 on its uncertain tax positions.

SFAS No. 157, Fair Value Measurements, was issued by the FASB in September 2006. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 will be effective for fiscal years beginning after November 15, 2007. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements where fair value is the relevant measurement attribute. Accordingly, this statement does not require any new fair value measurements. The Company cannot predict what, if any, impact this new standard will have on its consolidated financial statements when the standard becomes effective in 2008.

SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, was issued by the FASB in September 2006. SFAS No. 158 requires employers to recognize, on a prospective basis, the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and to recognize, as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits and transition assets or obligations that have not been recognized as components of net periodic benefit cost. SFAS No. 158 also requires additional disclosures in the notes to financial statements. SFAS No. 158 will not change the amount of net periodic benefit expense recognized in an entity’s income statement. It is effective for fiscal years ending after December 15, 2006. The Company is currently assessing the impact of SFAS No. 158 on its consolidated financial statements. Application of this standard at December 31, 2005 would have resulted in an increase in the pension benefit and other postretirement liability of $44.4 million, a decrease in intangible pension asset of $6.5 million, a decrease in deferred tax liability of $20.4 million and a decrease in stockholders’ equity of $30.5 million. The effect at December 31, 2006, the adoption date, could vary significantly. The amounts recorded at December 31, 2006 will depend on a number of assumptions, including the discount rates in effect at December 31, 2006, the actual rate of return on the pension plan assets for 2006 and the tax effects of the adjustment. Changes in these assumptions since our last measurement date could increase or decrease the expected impact of implementing SFAS No. 158 in our consolidated financial statements at December 31, 2006. The Company does not expect adoption of this standard to have an effect on compliance with debt covenants maintained in its financing agreements. The Company is reviewing the regulatory accounting implications of this standard to determine if any amounts indicated for inclusion in other comprehensive income may qualify for regulatory accounting treatment and be classified as regulatory assets under SFAS No. 71, Accounting for the Effects of Certain Types of Regulation.

Securities and Exchange Commission Staff Accounting Bulletin (SAB) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, was issued in September 2006 to address diversity in practice in quantifying financial statement misstatements. SAB No. 108 requires a company to quantify misstatements based on their impact on each of its consolidated financial statements and related disclosures. SAB 108 is effective for the Company as of December 31, 2006, allowing a

one-time transitional cumulative effect adjustment to retained earnings as of July 1, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB 108. The Company does not expect the adoption of SAB 108 to have a material impact on its consolidated financial statements.

Segment Information

The Company’s businesses have been classified into six segments based on products and services and reach customers in all 50 states and international markets. The six segments are: electric, plastics, manufacturing, health services, food ingredient processing and other business operations.

Electric includes the production, transmission, distribution and sale of electric energy in Minnesota, North Dakota and South Dakota under the name Otter Tail Power Company. Electric utility operations have been the Company’s primary business since incorporation.

Plastics consist of businesses producing polyvinyl chloride and polyethylene pipe in the Upper Midwest and Southwest regions of the United States.

Manufacturing consists of businesses in the following manufacturing activities: production of waterfront equipment, wind towers, material and handling trays and horticultural containers; contract machining; and metal parts stamping and fabrication. These businesses are located primarily in the Upper Midwest and Missouri.

Health services consists of businesses involved in the sale of diagnostic medical equipment, patient monitoring equipment and related supplies and accessories. These businesses also provide service maintenance, diagnostic imaging, positron emission tomography and nuclear medicine imaging, portable X-ray imaging and rental of diagnostic medical imaging equipment to various medical institutions located throughout the United States.

Food ingredient processing consists of IPH, which owns and operates potato dehydration plants in Ririe, Idaho; Center, Colorado and Souris, Prince Edward Island, Canada, producing dehydrated potato products that are sold in the United States, Canada, Europe, the Middle East, the Pacific Rim and Central America.

Other business operations consists of businesses involved in residential, commercial and industrial electric contracting industries; fiber optic and electric distribution systems; waste-water, water and HVAC systems construction; transportation; energy services; and the portion of corporate general and administrative expenses that are not allocated to other segments. These businesses operate primarily in the Central United States, except for the transportation company which operates in 48 states and six Canadian provinces.

The Company’s electric operations, including wholesale power sales, are operated as a division of Otter Tail Corporation, and the Company’s energy services operations are operated as a subsidiary of Otter Tail Corporation. Substantially all of the other businesses are owned by a wholly owned subsidiary of the Company.

The Company evaluates the performance of its business segments and allocates resources to them based on earnings contribution and return on total invested capital. Information on continuing operations for the business segments for three and nine month periods ended September 30, 2006 and 2005 and total assets by business segment as of September 30, 2006 and December 31, 2005 are presented in the following tables.

Operating Revenue

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Electric		$	71,206			$	85,770			$	227,308			$	233,403
Plastics			45,941				45,462				136,731				113,621
Manufacturing			76,667				59,803				226,555				183,190
Health services			35,432				30,653				100,341				89,775
Food ingredient processing			11,474				9,808				30,635				27,297
Other business operations			40,739				30,805				99,397				78,781
Intersegment eliminations			(917	)			(1,114	)			(2,714	)			(2,997	)
Total		$	280,542			$	261,187			$	818,253			$	723,070

Income (Loss) Before Income Taxes

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Electric		$	9,982			$	24,351			$	29,958			$	43,906
Plastics			7,645				4,873				23,450				13,230
Manufacturing			4,146				1,459				14,849				10,678
Health services			543				1,898				2,044				5,282
Food ingredient processing			(1,768	)			505				(5,156	)			2,114
Other business operations*			(396	)			(3,169	)			(3,940	)			(12,338	)
Total		$	20,152			$	29,917			$	61,205			$	62,872

Total Assets

		September 30,				December 31,
(in thousands)		2006				2005
Electric		$	663,349			$	654,175
Plastics			81,502				76,573
Manufacturing			219,118				177,969
Health services			65,636				67,066
Food ingredient processing			96,004				96,023
Other business operations			112,777				95,989
Discontinued operations			409				13,701
Total		$	1,238,795			$	1,181,496

No single external customer accounts for 10% or more of the Company’s revenues. Substantially all of the Company’s long-lived assets are within the United States except for a food ingredient processing dehydration plant in Souris, Prince Edward Island, Canada and a wind tower manufacturing plant in Ft. Erie, Ontario, Canada.

The following table presents the percent of consolidated sales revenue by country:

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
United States of America			96.8	%			97.8	%			97.0	%			97.9	%
Canada			1.4	%			0.8	%			1.5	%			1.0	%
All other countries			1.8	%			1.4	%			1.5	%			1.1	%

Rate and Regulatory Matters

On December 29, 2000 the North Dakota Public Service Commission (NDPSC) approved a performance-based ratemaking plan that links allowed earnings in North Dakota to seven defined performance standards in the areas of price, electric service reliability, customer satisfaction and employee safety. The plan was in place through 2005. The electric utility’s 2005 rate of return was within the allowable range defined in the plan, so no refunds or recoveries were ordered under the plan for 2005. The electric utility had applied to the NDPSC for a three year extension of the performance-based ratemaking plan with certain modifications. In May 2006, the NDPSC indicated that it did not wish to continue performance-based ratemaking at this time and the electric utility requested that its application be withdrawn.

In September 2004, a letter was provided to the Minnesota Public Utilities Commission (MPUC) summarizing issues and conclusions of an internal investigation completed by the Company related to claims of allegedly improper regulatory filings brought to the attention of the Company by certain individuals. On November 30, 2004 the electric utility filed a report with the MPUC responding to these claims. In 2005, the Energy Division of the Department of Commerce (DOC), the Residential Utilities Division of the Office of Attorney General and the claimants filed comments in response to the report, to which the Company filed reply comments. A hearing before the MPUC was held on February 28, 2006. As a result of the hearing, the electric utility agreed that within 90 days it would file a revised Regulatory Compliance Plan, an updated Corporate Cost Allocation Manual and documentation of the definitions of its chart of accounts. The electric utility filed these documents with the MPUC in the second quarter of 2006. The Company has received comments on its filings from the DOC and the claimants and filed reply comments in August 2006. The DOC has recommended accepting the revised Regulatory Compliance Plan and the chart of accounts definition. The Company continues to work with the MPUC staff and the DOC on the Corporate Allocation Manual and expects to file supplemental comments in November 2006. The electric utility also agreed to file a general rate case in Minnesota on or before September 30, 2007.

In a letter from the Federal Energy Regulatory Commission (FERC) Office of Market Oversight and Investigations (OMOI) dated September 27, 2005 the electric utility was informed that the Division of Operation Audits of the OMOI would be commencing an audit of the electric utility. The purpose of the audit is to determine whether and how the electric utility’s transmission practices are in compliance with the FERC’s applicable rules and regulations and tariff requirements and whether and how the implementation of the electric utility’s waivers from the requirements of Order No. 889 and Order No. 2004 restricts access to transmission information that would benefit the electric utility’s off-system sales. As of the date of this report on Form 10-Q, the Division of Operation Audits of the OMOI had completed its audit work but had not issued an audit report. The Company cannot predict if the results of the audit will have any impact on the Company’s consolidated financial statements.

In December 2005 the MPUC issued an order denying the electric utility’s request to allow recovery of certain Midwest Independent Transmission System Operator (MISO)-related costs through the fuel clause adjustment (FCA) in Minnesota retail rates and requiring a refund of amounts previously collected pursuant to an interim order issued in April 2005. A $1.9 million reduction in revenue and a refund payable was recorded in December 2005 by the electric utility to reflect the refund obligation. On February 9, 2006 the MPUC decided to reconsider its December 2005 order. The Commission’s final order was issued on February 24, 2006. In the final order the MPUC ordered jurisdictional investor-owned utilities in the state to participate with the Minnesota Department of Commerce and other parties in a proceeding that will evaluate suitability of recovery of certain MISO Day 2 energy market costs through the FCA. The Minnesota utilities and other parties submitted a final report to the MPUC in July 2006. As of the date of this report on Form 10-Q, the MPUC had not reached a decision on the future treatment of certain MISO-related costs within the FCA or responded to the report submitted by the Minnesota utilities and other parties. In addition, the February 24, 2006 order eliminated the refund provision from the December 2005 order, and allowed that any MISO-related costs not recovered through the FCA may be deferred for a period of 36 months, with possible recovery through base rates in the electric utility’s next general rate case which, for Otter Tail Power Company, is expected to be filed on or before September 30, 2007. As a result of this order, the electric utility recognized $1.9 million in revenue and reversed the refund payable in February 2006 and expects to recover all MISO-related costs through the FCA or to seek recovery, in a rate case, of any MISO-related costs not recoverable through the FCA.

On April 25, 2006 the FERC issued an order requiring MISO to refund to customers, with interest, amounts related to real-time revenue sufficiency guarantee (RSG) charges that were not allocated to day-ahead virtual supply offers in accordance with MISO’s Transmission and Energy Markets Tariff (TEMT) going back to the commencement of MISO Day 2 markets in April 2005. On May 17, 2006, the FERC issued a Notice of Extension of Time permitting the MISO to delay compliance with the directives contained in its April 2006 order, including the requirement to refund to customers the amounts due, with interest, from April 1, 2005 and the requirement to submit a compliance filing. The Notice stated that the order on rehearing would provide the appropriate guidance regarding the timing of compliance filing. On October 26, 2006, the FERC issued an order on rehearing stating it would not require refunds related to real-time RSG charges that had not been allocated to day-ahead virtual supply offers in accordance with MISO’s TEMT going back to the commencement of the MISO Day 2 market in April 2005. However, the FERC ordered prospective allocation of RSG charges to virtual transactions consistent with the TEMT to prevent future inequity and directed MISO to propose a charge that assesses RSG costs to virtual supply offers based on the RSG costs they cause within 60 days of the October 26, 2006 order.

Regulatory Assets and Liabilities

As a regulated entity the Company and the electric utility account for the financial effects of regulation in accordance with SFAS No. 71, Accounting for the Effect of Certain Types of Regulation. This accounting standard allows for the recording of a regulatory asset or liability for costs that will be collected or refunded in the future as required under regulation.

The following table indicates the amount of regulatory assets and liabilities recorded on the Company’s consolidated balance sheet:

		September 30,				December 31,
(in thousands)		2006				2005
Regulatory assets:
Deferred income taxes		$	14,718			$	16,724
Accrued cost-of-energy revenue			11,529				10,400
Reacquisition premiums			2,768				2,995
Deferred marked-to-market losses			1,722				1,423
Deferred conservation program costs			546				1,064
Accumulated ARO accretion/depreciation adjustment			279				209
Plant acquisition costs			163				196
Total regulatory assets		$	31,725			$	33,011
Regulatory liabilities:
Accumulated reserve for estimated removal costs		$	58,056			$	52,582
Deferred income taxes			5,412				5,961
Deferred marked-to-market gains			1,723				2,925
Gain on sale of division office building			152				156
Total regulatory liabilities		$	65,343			$	61,624
Net regulatory liability position		$	33,618			$	28,613

The regulatory assets and liabilities related to deferred income taxes result from changes in statutory tax rates accounted for in accordance with SFAS No. 109, Accounting for Income Taxes. Reacquisition premiums included in Unamortized debt expense and reacquisition premiums are being recovered from electric utility customers over the remaining original lives of the reacquired debt issues, the longest of which is 15.8 years. Deferred conservation program costs represent mandated conservation expenditures recoverable through retail electric rates over the next 1.5 years. Plant acquisition costs will be amortized over the next 3.7 years. Accrued cost-of-energy revenue included in Accrued utility revenues will be recovered over the next 10 months. All deferred marked-to-market gains and losses are related to forward purchases and sales of energy scheduled for delivery prior to March 2007. The accumulated reserve for estimated removal costs is reduced for actual removal costs incurred. The remaining regulatory assets and liabilities are being recovered from, or will be paid to, electric customers over the next 30 years.

If for any reason, the Company’s regulated businesses cease to meet the criteria for application of SFAS No. 71 for all or part of their operations, the regulatory assets and liabilities that no longer meet such criteria would be removed from the consolidated balance sheet and included in the consolidated statement of income as an extraordinary expense or income item in the period in which the application of SFAS No. 71 ceases.

Share-based Payments

On January 1, 2006 the Company adopted the accounting provisions of SFAS No. 123(R) (revised 2004), Share-Based Payment, on a modified prospective basis. SFAS No. 123(R) is a revision of SFAS No. 123, Accounting for Stock-based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. Under SFAS No. 123(R), the Company records stock-based compensation as an expense on its income statement over the period earned based on the estimated fair value of the stock or options awarded on their grant date. The Company elected the modified prospective method of adopting SFAS No. 123(R), under which prior periods are not retroactively revised. The valuation provisions of SFAS No. 123(R) apply to awards granted after the effective date. Estimated stock-based compensation expense for awards granted prior to the effective date but that remain nonvested on the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123 pro forma disclosures. Additionally, the adoption of SFAS No. 123(R) resulted in the reclassification of $798,000 in credits related to outstanding restricted share-based compensation from equity on the Company’s consolidated balance sheet to a liability on January 1, 2006 because of income tax withholding provisions in the share-based award agreements. The adoption of SFAS 123(R) also resulted in the elimination of Unearned compensation from the equity section of the Company’s consolidated balance sheet on January 1, 2006 by netting the account balance of $1,720,000 against Premium on common shares.

On April 10, 2006, the Company’s shareholders approved amendments to the 1999 Stock Incentive Plan, as Amended (Incentive Plan) increasing the number of common shares available under the Incentive Plan from 2,600,000 common shares to 3,600,000 common shares, extending the term of the Incentive Plan from December 13, 2008 to December 13, 2013 and making certain other changes to the terms of the Incentive Plan.

As of September 30, 2006, the total remaining unrecognized amount of compensation expense related to stock-based compensation was approximately $4.0 million (before income taxes), which will be amortized over a weighted-average period of 2.1 years.

The Company has six share-based payment programs. The effect of SFAS No. 123(R) accounting on each of these programs is explained in the following paragraphs.

1999 Employee Stock Purchase Plan, as Amended (Purchase Plan)

On April 10, 2006, the Company’s shareholders approved an amendment to the Purchase Plan increasing the number of common shares available under the Purchase Plan from 400,000 common shares to 900,000 common shares.

The Purchase Plan allows employees through payroll withholding to purchase shares of the Company’s common stock at a 15% discount from the average market price on the last day of a six month investment period. Under SFAS 123(R) the Company is required to record compensation expense related to the 15% discount which was not required under APB No. 25. Based on the participants’ current level of withholdings, the Company estimates that the 15% discount will amount to approximately $240,000 in 2006. The Company recorded $174,000 in compensation expense for the nine month period ended September 30, 2006 related to the Purchase Plan. The 15% discount is not taxable to the employee and is not a deductible expense for tax purposes for the Company. The shares to be purchased by employees participating in the Purchase Plan are not considered dilutive for the purpose of calculating diluted earnings per share during the investment period. At the discretion of the Company, shares purchased under the Purchase Plan can be either new issue shares or shares purchased in the open market. The purchase of 27,543 common shares in the open market to satisfy the requirements of the Purchase Plan for the six month investment period ended June 30, 2006, was completed on August 1, 2006.

Stock Options Granted Under the Incentive Plan

Since the inception of the Incentive Plan in 1999, the Company has granted 2,041,500 options for the purchase of the Company’s common stock. Of the options granted, 1,999,412 had vested or were forfeited and 42,088 were not

vested as of September 30, 2006. The exercise price of the options granted has been the average market price of the Company’s common stock on the grant date. These options were not compensatory under APB No. 25 accounting rules. Under SFAS No.123(R) accounting, compensation expense will be recorded based on the estimated fair value of the options on their grant date using a fair-value option pricing model. Under SFAS No. 123(R) accounting, the fair value of the options granted will be recorded as compensation expense over the requisite service period (the vesting period of the options). The estimated fair value of all options granted under the Incentive Plan has been based on the Black-Scholes option pricing model.

Under the modified prospective application of SFAS No.123(R) accounting requirements, the difference between the intrinsic value of nonvested options and the fair value of those options of $362,000 ($217,000 net-of-tax) on January 1, 2006 is being recognized on a straight-line basis as compensation expense over the remaining vesting period of the nonvested options, which, for nonvested options outstanding on January 1, 2006, will be from January 1, 2006 through April 30, 2007. Accordingly, the Company recorded compensation expense related to nonvested options issued under the Incentive Plan for the three and nine month periods ended September 30, 2006 of $68,000 ($41,000 net-of-tax) and $204,000 ($122,000 net-of-tax), respectively.

Had compensation expense for stock options been determined based on estimated fair value at the award date, as prescribed by SFAS No. 123, the Company’s net income for the three and nine month periods ended September 30, 2005 would have decreased as presented in the table below.

		Three months ended				Nine months ended
(in thousands)		September 30, 2005				September 30, 2005
Net income
As reported		$	17,603			$	49,878
Total stock-based employee compensation expense determined under fair value based method for all stock option awards net of related tax effects			(213	)			(497	)
Pro forma		$	17,390			$	49,381
Basic earnings per share:
As reported			$0.60				$1.69
Pro forma			$0.59				$1.67
Diluted earnings per share:
As reported			$0.59				$1.68
Pro forma			$0.58				$1.67

For the purpose of calculating diluted earnings per share, the underlying shares of all vested and nonvested in-the-money options (options where the reporting date average market price of underlying shares exceeds the exercise price of the options) are considered dilutive.

Presented below is a summary of the stock options activity for the nine months ended September 30, 2006:

										Aggregate
						Weighted average				intrinsic value
		Options				Exercise price				(000’s)
Outstanding, January 1, 2006			1,237,164				$25.58
Granted			—
Exercised			85,523				$22.85				$   614
Forfeited			28,468				$28.90				$     52
Outstanding, September 30, 2006			1,123,173				$25.71				$4,652
Exercisable, September 30, 2006			1,081,085				$25.65				$4,556

The aggregate intrinsic value in the preceding table represents the total intrinsic value (before income taxes), based on the average market price of the Company’s common stock on September 30, 2006, which would have been received by the option holders had all option holders exercised their options on that date.

The Company received cash of $1,948,000 for options exercised in the first nine months of 2006.

The following table summarizes information about options outstanding as of September 30, 2006:

						Options outstanding								Options exercisable
						Weighted-
						average				Weighted-								Weighted-
		Outstanding				remaining				average				Exercisable				average
Range of		as of				contractual				exercise				as of				exercise
exercise prices		9/30/06				life (yrs)				price				9/30/06				price
$18.80-$21.94			261,871				3.0			$	19.49				261,871			$	19.49
$21.95-$25.07			61,350				8.5			$	24.93				61,350			$	24.93
$25.08-$28.21			580,952				5.3			$	26.52				538,864			$	26.47
$28.22-$31.34			219,000				5.5			$	31.19				219,000			$	31.19

Restricted Stock Granted to Directors

Under the Incentive Plan, restricted shares of the Company’s common stock have been granted to members of the Company’s Board of Directors as a form of compensation. Under APB No. 25 accounting rules, the Company had recognized compensation expense for these restricted stock grants, ratably, over the four-year vesting period of the restricted shares based on the market value of the Company’s common stock on the grant date. Under the modified prospective application of SFAS No.123(R) accounting requirements, compensation expense related to nonvested restricted shares outstanding will be recorded based on the estimated fair value of the restricted shares on their grant dates. On April 9, 2006 the Compensation Committee of the Company’s Board of Directors granted 19,800 shares of restricted stock to the directors under the Incentive Plan. The restricted shares vest ratably over a four-year vesting period. The amount of compensation expense recorded related to nonvested restricted shares granted to directors under SFAS No. 123(R) for the three and nine month periods ended September 30, 2006 was $80,000 ($48,000 net-of-tax) and $321,000 ($193,000 net-of-tax), respectively. The amount of compensation expense recorded related to nonvested restricted shares granted to directors based on the intrinsic value of the restricted stock grants under APB No. 25 for the three and nine month periods ended September 30, 2005 was $71,000 ($43,000 net-of-tax) and $190,000 ($114,000 net-of-tax), respectively. Nonvested restricted shares granted to directors are considered dilutive for the purpose of calculating diluted earnings per share but are considered contingently returnable and not outstanding for the purpose of calculating basic earnings per share.

Presented below is a summary of the status of directors’ restricted stock awards for the nine months ended September 30, 2006:

						Weighted average
						grant-date
		Shares				fair value
Nonvested, January 1, 2006			27,000			$	24.59
Granted			19,800			$	28.24
Vested (fair value: $376,000)			14,025			$	26.82
Forfeited			—
Nonvested, September 30, 2006			32,775			$	27.27

Restricted Stock Granted to Employees

Under the Incentive Plan, restricted shares of the Company’s common stock have been granted to employees as a form of compensation. Under APB No. 25 accounting rules, the Company had recognized compensation expense for these restricted stock grants, ratably, over the vesting periods of the restricted shares based on the market value of the Company’s common stock on the grant date. Because of income tax withholding provisions in the restricted stock award agreements related to restricted stock granted to employees, the value of these grants is considered variable, which, under SFAS No. 123(R), will require the offsetting credit to compensation expense to be recorded as a liability. Under the modified prospective application of SFAS No.123(R) accounting requirements and accounting rules for variable awards, compensation expense related to nonvested restricted shares granted to employees will be recorded based on the estimated fair value of the restricted shares on their grant dates and adjusted for the estimated fair value of any nonvested restricted shares on each subsequent reporting date. The reporting date fair value of nonvested restricted shares under this program will be based on the average market value of the Company’s common stock on the reporting date.

The amount of compensation expense recorded related to nonvested restricted shares granted to employees based on the estimated fair value of the restricted stock grants under SFAS No. 123(R) for the three and nine month periods ended September 30, 2006 was $183,000 ($110,000 net-of-tax) and $625,000 ($375,000 net-of-tax), respectively. The amount of compensation expense recorded related to nonvested restricted shares granted to employees based on the intrinsic value of the restricted stock grants under APB No. 25 for the three and nine month periods ended September 30, 2005 was $281,000 ($169,000 net-of-tax) and $830,000 ($498,000 net-of-tax), respectively. The equity account, Unearned compensation, was credited when compensation expense was recorded related to these shares under APB No. 25 accounting. Under SFAS 123(R) accounting, a current liability account is credited when compensation expense is recorded. Accumulated liabilities related to nonvested restricted shares issued to employees under this program will be reversed and credited to the Premium on common shares equity account as the shares vest. Nonvested restricted shares granted to employees are considered dilutive for the purpose of calculating diluted earnings per share but are considered contingently returnable and not outstanding for the purpose of calculating basic earnings per share.

Presented below is a summary of the status of employee’s restricted stock awards for the nine months ended September 30, 2006:

						Weighted average
						reporting-date
		Shares				fair value
Nonvested, January 1, 2006			72,974			$	28.91
Granted			—
Vested (fair value: $1,167,000)			41,308			$	28.25
Forfeited			—
Nonvested, September 30, 2006			31,666			$	29.52

Restricted Stock Units Granted to Employees

On April 9, 2006, the Compensation Committee of the Company’s Board of Directors granted 47,425 restricted stock units at a weighted average grant-date fair value of $25.41 per unit to key employees under the Incentive Plan payable in common shares. Each unit is automatically converted into one share of common stock on vesting. Vesting occurs from April 10, 2006 through April 8, 2010, with a weighted average contractual term of stock units outstanding as of September 30, 2006 of 2.8 years.

Presented below is a summary of the status of employee’s restricted stock unit awards for the nine months ended September 30, 2006:

		Restricted				Aggregate grant-date
		stock				fair value
		units				(000’s)
Outstanding, January 1, 2006			—			$	—
Granted			47,425				1,205
Converted			7,450				220
Forfeited			1,105				27
Outstanding, September 30, 2006			38,870			$	958

The amount of compensation expense recorded related to both vested and nonvested restricted stock units granted to employees in April 2006 based on the estimated fair value of the restricted stock unit grants under SFAS No. 123(R) using a Monte Carlo valuation method for the three and nine month periods ended September 30, 2006 was $69,000 ($41,000 net-of-tax) and $358,000 ($215,000 net-of-tax), respectively. The underlying shares related to nonvested restricted stock units granted to employees are considered dilutive for the purpose of calculating diluted earnings per share.

Stock Performance Awards granted to Executive Officers

The Compensation Committee of the Company’s Board of Directors has approved stock performance award agreements under the Incentive Plan for the Company’s executive officers. Under these agreements, the officers could be awarded shares of the Company’s common stock based on the Company’s total shareholder return relative to that of its peer group of companies in the Edison Electric Institute (EEI) Index over a three-year period beginning on January 1 of the year the awards are granted. The number of shares earned, if any, will be awarded and issued at the end of each three-year performance measurement period. The participants have no voting or dividend rights under these award agreements until the shares are issued at the end of the performance measurement period. Under APB No. 25 accounting, these awards were valued based on the average market price of the underlying shares of the Company’s common stock on the award grant date, multiplied by the estimated probable number of shares to be awarded at the end of the performance measurement period with compensation expenses recorded ratably over the related three-year measurement period. Compensation expense recognized was adjusted at each reporting date subsequent to the grant date of the awards for the difference between the market value of the underlying shares on their grant date and the market value of the underlying shares on the reporting date. Under the modified prospective application of SFAS No.123(R) accounting requirements, the amount of compensation expense that will be recorded subsequent to January 1, 2006 related to awards granted in 2004 and 2005 and outstanding on September 30, 2006 is based on the estimated grant-date fair value of the awards as determined under the Black-Scholes option pricing model.

On April 9, 2006 the Compensation Committee of the Company’s Board of Directors granted stock performance awards to the Company’s executive officers under the Incentive Plan. Under these awards, the Company’s executive officers could earn up to an aggregate of 88,050 common shares based on the Company’s total shareholder return relative to the total shareholder return of the companies that comprise the EEI Index over the performance period of January 1, 2006 through December 31, 2008. The aggregate target share award is 58,700 shares. Actual payment may range from zero to 150 percent of the target amount. The executive officers have no voting or dividend rights related to these shares until the shares, if any, are issued at the end of the performance period. The amount of compensation expense that will be recorded related to awards granted in April 2006 and outstanding on September 30, 2006 is based on the estimated grant-date fair value of the awards as determined under a Monte Carlo valuation method.

The table below provides a summary of amounts expensed for the stock performance awards for the three and nine month periods ended September 30, 2006 and 2005:

		Maximum				Shares				Amount of expense								Amount of expense
		shares				used to				during the three								during the nine
Performance		subject				estimate				months ended								months ended
period		to award				expense				September 30,								September 30,
										2006				2005				2006				2005
2004-2006			70,500				23,500			$	47,000			$	101,000			$	140,000			$	423,000
2005-2007			75,150				50,872				94,000				223,000				281,000				393,000
2006-2008			88,050				58,700				127,000				—				381,000				—
Total			233,700				133,072			$	268,000			$	324,000			$	802,000			$	816,000

The offsetting credit to amounts expensed related to the stock performance awards is included in common shareholders’ equity. For the purpose of calculating diluted earnings per share, shares expected to be awarded are considered dilutive. Currently, the Company intends to purchase shares on the open market for stock performance awards earned.

Class B Stock Options and Class B Stock of Subsidiary

In 2006, IPH granted 305 options to purchase IPH Class B Common Stock to five employees at an exercise price of $2,085.88 per option. The options vested immediately on issuance. On the date the options were granted the value of a share of IPH Class B common stock was estimated to be $1,041.71. Therefore, the grant-date fair value of the options was $0 and no expense or liability was recorded related to these options under SFAS No. 123(R). Prior to the 2006 grant there were options for 755 shares of IPH Class B Common Stock outstanding. As of September 30, 2006, there were 1,060 options outstanding with a combined exercise price of $952,000, of which 755 options were “in-the-money” with a combined exercise price of $316,000.

Common Shares and Earnings per Share

In the first nine months of 2006 the Company issued 85,223 common shares for stock options exercised, 1,727 common shares and 19,800 restricted common shares for director’s compensation and 7,450 common shares for restricted stock units that vested on issuance in April 2006. The Company retired 16,370 common shares for tax withholding purposes related to 39,825 restricted shares that vested in the first nine months of 2006.

Basic earnings per common share are calculated by dividing earnings available for common shares by the average number of common shares outstanding during the period excluding any nonvested restricted shares outstanding during the period. Diluted earnings per common share are calculated by adjusting outstanding shares, assuming conversion of all potentially dilutive stock options and vesting of all nonvested restricted shares and restricted stock units outstanding and including contingently issuable shares related to outstanding stock performance awards.

Excluded from the calculation of diluted earnings per share are the following outstanding stock options which had exercise prices greater than the average market price for the three and nine month periods ended September 30, 2006 and September 30, 2005.

		Options Outstanding		Range of Exercises Prices
Three Months Ended September 30, 2006		213,000		$29.74 - $31.34
Three Months Ended September 30, 2005		234,374		$29.74 - $31.34
Nine Months Ended September 30, 2006		213,000		$29.74 - $31.34
Nine Months Ended September 30, 2005		409,749		$27.245 - $31.34

Pension Plan and Other Postretirement Benefits

Pension Plan—Components of net periodic pension benefit cost of the Company’s noncontributory funded pension plan are as follows:

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Service cost—benefit earned during the period		$	1,373			$	1,313			$	3,793			$	3,381
Interest cost on projected benefit obligation			2,738				2,413				7,826				7,309
Expected return on assets			(3,086	)			(3,040	)			(9,216	)			(9,032	)
Amortization of prior-service cost			185				805				557				1,286
Amortization of net actuarial loss			627				—				1,383				—
Net periodic pension cost		$	1,837			$	1,491			$	4,343			$	2,944

The Company made discretionary cash contributions to its pension plan of $4.0 million during each of the nine months ended September 30, 2006 and 2005.

Executive Survivor and Supplemental Retirement Plan—Components of net periodic pension benefit cost of the Company’s unfunded, nonqualified benefit plan for executive officers and certain key management employees are as follows:

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Service cost—benefit earned during the period		$	107			$	111			$	320			$	295
Interest cost on projected benefit obligation			325				318				977				950
Amortization of prior-service cost			18				17				53				53
Recognized net actuarial loss			118				145				354				353
Net periodic pension cost		$	568			$	591			$	1,704			$	1,651

Postretirement Benefits—Components of net periodic postretirement benefit cost for health insurance and life insurance benefits for retired electric utility and corporate employees are as follows:

		Three months ended								Nine months ended
		September 30,								September 30,
(in thousands)		2006				2005				2006				2005
Service cost—benefit earned during the period		$	321			$	342			$	989			$	964
Interest cost on projected benefit obligation			643				574				1,917				1,906
Amortization of transition obligation			187				187				561				561
Amortization of prior-service cost			(77	)			(76	)			(229	)			(230	)
Amortization of net actuarial loss			151				215				417				527
Effect of Medicare Part D expected subsidy			(571	)			(424	)			(1,157	)			(826	)
Net periodic postretirement benefit cost		$	654			$	818			$	2,498			$	2,902

Discontinued Operations

In June 2006, OTESCO, the Company’s energy services company, sold its gas marketing operations for $0.5 million in cash. In 2005, the Company completed the sales of Midwest Information Systems, Inc. (MIS), St. George Steel Fabrication, Inc. (SGS) and Chassis Liner Corporation (CLC). Net income from OTESCO’s gas marketing operations classified under discontinued operations includes an after-tax gain on disposition of $0.3 million for the nine months ended September 30, 2006. Net income from MIS, SGS and CLC classified under discontinued operations includes an after-tax gain on the sale of MIS of $11.9 million, an after-tax loss on the sale of SGS of $1.8 million and an after-tax loss on the sale of CLC of $0.2 million for the nine months ended September 30, 2005. Discontinued operations includes a $1.0 million goodwill impairment loss for the three and nine month periods ended September 30, 2005, related to OTESCO’s gas marketing operations. SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets requires that OTESCO’s gas marketing operations, MIS, SGS and CLC be classified and reported separately as discontinued operations.

The results of discontinued operations for the nine months ended September 30, 2006 and the three and nine months ended September 30, 2005 are summarized as follows:

		Three months ended
		September 30, 2005
		OTESCO
(in thousands)		GAS				SGS				CLC				Total
Operating revenues		$	11,471			$	213			$	1,868			$	13,552
(Loss) before income taxes			(1,145	)			(161	)			(677	)			(1,983	)
Gain on disposition — pretax			—				44				—				44
Income tax (benefit)			(57	)			(47	)			(270	)			(374	)

		Nine months ended					Nine months ended
		September 30, 2006					September 30, 2005
		OTESCO					OTESCO
(in thousands)		GAS					GAS				MIS				SGS				CLC				Total
Operating revenues		$	28,234				$	38,099			$	3,773			$	6,542			$	5,640			$	54,054
Income (loss) before income taxes			54					(1,163	)			2,167				(1,724	)			(696	)			(1,416	)
Gain (loss) on disposition — pretax			560					—				19,025				(3,002	)			(300	)			15,723
Income tax expense (benefit)			252					(64	)			7,975				(1,890	)			(396	)			5,625

At September 30, 2006 and December 31, 2005 the major components of assets and liabilities of the discontinued operations were as follows:

		September 30, 2006					December 31, 2005
							OTESCO
(in thousands)		SGS					Gas				SGS				CLC				Total
Current assets		$	409				$	11,384			$	857			$	1,455			$	13,696
Investments and other assets			—					—				—				5				5
Assets of discontinued operations		$	409				$	11,384			$	857			$	1,460			$	13,701
Current liabilities		$	187				$	10,611			$	328			$	44			$	10,983
Liabilities of discontinued operations		$	187				$	10,611			$	328			$	44			$	10,983

The remaining assets and liabilities of SGS consist of accounts receivable, deferred income tax assets and accounts payable that were not settled or disposed of as of September 30, 2006.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

RESULTS OF OPERATIONS

Comparison of the Three Months Ended September 30, 2006 and 2005

Consolidated operating revenues were $280.5 million for the three months ended September 30, 2006 compared with $261.2 million for the three months ended September 30, 2005. Operating income was $24.2 million for the three months ended September 30, 2006 compared with $33.5 million for the three months ended September 30, 2005. The Company recorded diluted earnings per share from continuing operations of $0.45 for the three months ended September 30, 2006 compared to $0.64 for the three months ended September 30, 2005 and total diluted earnings per share from continuing and discontinued operations of $0.45 for the three months ended September 30, 2006 compared to $0.59 for the three months ended September 30, 2005, which included $(0.05) per share from discontinued operations.

Following is a more detailed analysis of our operating results by business segment for the three and nine month periods ended September 30, 2006 and 2005, followed by our outlook for the remainder of 2006 and a discussion of changes in our consolidated financial position during the nine months ended September 30, 2006.

Amounts presented in the segment tables that follow for operating revenues, cost of goods sold and other nonelectric operating expenses for the three month periods ended September 30, 2006 and 2005 will not agree with amounts presented in the consolidated statements of income due to the elimination of intersegment transactions. The amounts of intersegment eliminations by income statement line item are listed below:

		Three months ended
		September 30,
(in thousands)		2006				2005
Operating revenues		$	917			$	1,114
Cost of goods sold			359				710
Other nonelectric expenses			558				404

Electric

		Three months ended
		September 30,												%
(in thousands)		2006				2005				Change				Change
Retail sales revenues		$	59,694			$	61,481			$	(1,787	)			(2.9	)
Wholesale revenues			6,099				17,467				(11,368	)			(65.1	)
Net marked-to-market gain			(207	)			2,406				(2,613	)			(108.6	)
Other revenues			5,620				4,416				1,204				(27.3	)
Total operating revenues		$	71,206			$	85,770			$	(14,564	)			(17.0	)
Production fuel			15,846				14,485				1,361				9.4
Purchased power – system use			8,590				13,295				(4,705	)			(35.4	)
Other operation and maintenance expenses			26,433				23,383				3,050				13.0
Depreciation and amortization			6,430				6,084				346				5.7
Property taxes			2,260				2,735				(475	)			(17.4	)
Operating income		$	11,647			$	25,788			$	(14,141	)			(54.8	)