ITC Corp (ITC) is the only pure play in the electrical transmission business, and it is about to become one of the biggest players. ITC is in the process of buying the transmission assets of Entergy (ETR) in a relatively complicated deal. The bottom line is current ITC shareholders will own about 49.9% of the company and ETR shareholders will own the balance, but ITC shareholders will also receive a $13.50 special dividend just before the deal closes in a few months. More information on the merger can be found here (video) and from a Zacks article.
From the ITC website:
ITC Holdings Corp. is the nation's largest independent electric transmission company. Based in Novi, Michigan, ITC invests in the electric transmission grid to improve reliability, expand access to markets, lower the overall cost of delivered energy and allow new generating resources to interconnect to its transmission systems. ITC's regulated operating subsidiaries include ITC Transmission, Michigan Electric Transmission Company, ITC Midwest and ITC Great Plains. Through these subsidiaries, ITC owns and operates high-voltage transmission facilities in Michigan, Iowa, Minnesota, Illinois, Missouri, Kansas and Oklahoma, serving a combined peak load exceeding 26,000 megawatts along 15,000 circuit miles of transmission line. Through ITC Grid Development and its subsidiaries, the company also focuses on expansion in areas where significant transmission system improvements are needed.
Earlier, in December 2011, Entergy entered into a definitive agreement with ITC Holdings under which the former will divest its electric transmission business to the latter. The divested business would be merged with the operations of ITC Holdings. The transaction will require consent from Entergy's retail regulators, the Federal Energy Regulatory Commission and ITC shareholders. The company expects the transaction to complete by 2013.
Post-merger, ITC will become one of the largest electricity transmission companies in the U.S. Its area of operations will stretch from the Great Lakes to the Gulf Coast, with more than 30,000 miles of transmission lines. Per the divestiture agreement, Entergy will divest its electric transmission business to a newly formed entity known as Mid South TransCo LLC ("Transco") which will be distributed to Entergy's shareholders in the form of a tax-free spin-off. Then, under an all-stock Reverse Morris Trust transaction, Transco will merge with and into a newly created merger subsidiary of ITC. Post-merger, Entergy shareholders will have an approximately 50.1% stake in ITC in exchange for their shares in TransCo. The balance 49.9% stake of the combined company will be with the existing shareholders of ITC.
Entergy is seeking approval to transfer approximately 15,800 miles of interconnected transmission lines at voltages of 69kV and above and the associated substations to ITC. ITC will then be one of the largest electric transmission companies in the U.S., with more than 30,000 miles of transmission lines spanning from the Great Lakes to the Gulf Coast. Meanwhile, Entergy's operating companies will continue to own and operate their respective distribution and generation businesses and will provide customer service, billing, outage reporting and restoration services to homes and businesses in the region."
There are several subsectors in the utility industry, each with unique investment and operational attributes. High-voltage power transmission is regulated by the Federal Energy Regulatory Commission and not by the individual state Public Utility Commissions. This difference is a positive for companies that operate high-voltage transmission assets as the FERC has been allowing higher rates of return than historically allowed by individual states.
ITC's rates are established by FERC on a cost-of-service model, which allows for the recovery of expenses, income taxes and a return on invested capital. The rate mechanism approved by FERC allows ITC Transmission to earn a return of 13.88%, METC to earn 13.38%, ITC Midwest to earn 12.38%, and ITC Great Plains to earn 12.16% return on equity.
According to the Edison Electrical Institute, the average ROE approved by various state utility commissions was between 10.0% and 11.0% from 2004 to 2006 and between 10.0% and 10.5% from 2006 to today. Historically, the average state utility commission allowed ROE has been declining over the years, falling from a high of over 12.5% in the 1990.
Stating the obvious, every dollar invested in FERC-regulated assets can produce a 20% to 30% higher return than the same dollar invested in the average state-regulated asset.
In a low interest rate environment, there is risk to the higher levels of returns offered by the FERC. However, if the FERC follows state commissions, where the average allowed ROE in rate cases decided last quarter broke above the 10.5% mark for the first time since 2005, the risk of the FERC lowering of allowed ROE seems to be manageable.
There are over 200,000 miles of high-voltage transmission lines in the US, and there is a need for expansion and upgrading. The tables below, from the Edison Electrical Institute (EEI) outlines capital investment in transmission assets since 2001 and in more detail since 2006:
EEI issues an annual report on upcoming transmission projects that have been approved. Last year's 120-page report outlines these investments by company and project, with ITC projects on pages 37 to 42 (pdf).
Pre-merger, there are 51 million shares outstanding and ITC has a market cap of $4.2 billion. Long-term debt currently stands at $2.9 billion. ITC offers a current dividend yield of 1.8% and 5-yr dividend growth rate of 5.5%. The payout ratio is 42%. ITC has generated a 5-year EPS growth rate of 29% and a capital expenditure growth rate to match of 27%.
Pre-merger, ITC is expected to earn $4.12 in 2012 and $4.92 this year. The merger is expected to be slightly accretive this year. Long-term earnings growth is estimated between 15% and 19%. With the stock currently trading at $82, the 2013 P/E ratio is 16.6 and offers a 2013 PEG ratio of between 1.00 and 0.78 - exceptionally cheap for a utility. However, Return on Invested Capital is a bit low at 4.2%.
Below is a 5-year stock chart comparing ITC to the S&P Utility ETF (XLU). What is obvious is the rewards ITC shareholders have enjoyed over the performance of the index.
ITC offers investors 3 times the EPS growth rate of an "average" regulated electric utility and the allowed ROE generated by the company is 20% to 30% higher than the "average" state regulated electric utility. While the current yield is sub-par, earnings growth may provide management the opportunity to goose up the dividend over time.
Investors looking for growth over current income in the utility field should add ITC to their "must have" list. However, investors should be aware share prices could fall by the $13.50 special dividend after the stock goes ex-dividend. A strategy may be to buy now, collect the special dividend, buy more right afterwards if share prices do decline by $13.50/share, wait 30 days for the wash sale rules, and then sell the initial shares at a short-term loss, offsetting the taxes due on the special dividend. Just a thought.
Author's note: See important disclaimer in Mr. Parepoynt's profile.