- ITC has offered long-term annual total returns of 11.1% vs. 7.7% for regulated utilities.
- FERC-Allowed ROE for ITC is between 21% and 38% higher than recent average State-PUC awards.
- ITC is laser-focused on expanding its Transmission Rate Base between now and 2018.
ITC Holdings (NYSE:ITC) has been one of the best performing regulated utility stocks since it went public in 2005. A $10,000 investment on its IPO of July 31, 2005 would be worth $50,000 today, for a total annual return of 11.07%. A similar investment in Morningstar's Regulated Utility Index would be worth $20,000, for a total annual return of 7.67%. The question for investors is: Will it continue?
Below is a graphic of this growth from its April 15, 2014 Investor's Day Presentation (pdf):
ITC is the only pure play electrical transmission business. There are other regulated utility companies with larger transmission networks, such as American Electric Power (NYSE:AEP), but exposure to transmission profitability is minimal when reviewing the overall sources of income. ITC has no other business interests, it relies on the spread between the FERC and the individual State PUC regulated allowed return. The difference is considerable and investors should take notice. In the current utility world of stagnate electrical demand, depressed electricity pricing, and reduced state PUC allowed returns, ITC should be considered as a core mid-cap utility holding.
ITC is broken into several operating units: ITC Transmission, METC, ITC Midwest, ITC Great Plains and ITC Grid development. The firm operates a total of 15,400 miles of transmission lines. ITC operates a network of transmission lines as shown in the following graphic:
Last fall, ITC broke off merger discussions with Entergy (NYSE:ETR) after various State PUCs failed to approve the combining of assets. At the heart of the state's merger discussion was the spread between the FERC and their allowed returns, and it is precisely this spread that makes ITC an attractive investment. The merger would have doubled the size of ITC's transmission network.
Mario Gabelli manages a very successful income mutual fund focused on the utility sector. In the latest annual report for Gabelli Utilities Fund (GABUX), Gabelli outlines the thesis of investing in transmission assets.
Transmission opportunities: The FERC's favorable incentive oriented regulation continues to make transmission investment one of the more compelling uses of capital for electric utilities. Allowed ROEs have ranged as high as 14% and, as a result, transmission growth opportunities command premium multiples and are among the more desirable projects sought by utility management teams. Not surprisingly, transmission investment continued to grow in 2013, nearly doubling from $8.6 billion in 2006 to $15.2 billion in 2013, and we expect transmission to be a focus for most management teams going forward. The level of announced project investment is expected to total approximately $41.6 billion from 2013 to 2015.
As the economy rebounds, we expect further investment. As of March 2013, twenty-nine states and the District of Columbia has implemented renewable portfolio standards that range as high as 33% over the 2015 - 2030 timeframe. Connecting these generation assets to the grid poses a number of additional reliability and transportation issues, due to the intermittency of renewable generation and the need to transport power from where it is generated to load centers. The consultancy, The Brattle Group, anticipates that the U.S. will need $240 - $320 billion of transmission investment through 2030 to ensure reliability and meet all current and proposed renewable standards. Even without a robust economic recovery, we believe that investment levels would be even higher in the absence of notable related challenges, including the larger scale and long-term nature of the projects.
In July of 2011, FERC Order 1000 authorized the cost sharing of larger regional transmission projects and opened up development opportunities to non-incumbent utilities. These rules allow pure play transmission companies to participate in projects throughout the country, and have led to an increase the number of multi-state projects.
According to the Edison Electrical Institute, the state PUC allowed return for regulated utilities has been declining over the past twenty years and the most often used reason is lower financing costs for utilities due to the current low interest rate environment. The 4th quarter 2013 average awarded allowed ROE was 9.9%, continuing the long-term trend of decline. Below is a graphic outlining this decline going back to 1990:
Comparing the 4th qtr. average state PUC awarded ROE to ITC's FERC earnings should make it obvious as to the benefit ITC offers to its investors. 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. This spread amounts to additional profitability for every equity dollar invested by ITC in its FERC-regulated asset base of between 21.6% and 38.8% over the average state PUC award in the 4th qtr.
With the demise of the ETR merger proposal, ITC recently announced its 5-yr capital investment budget. From 2014 to 2018, ITC anticipates to invest $4.5 billion in additional assets, and will represent almost a doubling of its regulated assets base. This investment will drive earnings higher by an average of 13% a year. The added profitability will allow for dividend increases of between 10% and 15% annually. The Investor Presentation outlining this aggressive budget is linked above.
Some electric utility investors have concerns with the growing trend of rooftop solar generation and the impact its growth may have on ITC's transmission network. Gabelli also addressed this issue in his annual report and his opinion is below:
Distributed generation: The penetration rates of residential rooftop solar panels in most states are extremely low, but strong enough in California, Hawaii, and Arizona to warrant investment consideration. The rapid growth in these states is at least partially driven by subsidies, lease/financing models, and favorable net metering rules, but it is also due to improving technology and lower costs.
The addition of rooftop solar panels negatively impacts electric demand, but customers remain dependent on the grid for reliability during absences of sunlight. Given that these states have decoupled revenues from sales, the lower demand does not negatively impact revenues, but becomes a cost sharing challenge. Residential customers using distributed generation reduce their net energy usage and, therefore, their contribution to transmission and distribution costs. In order to maintain revenue levels, utilities raise electric rates on customers, causing non-self-generating customers to subsidize self-generating customers, who are usually higher income customers.
We believe that regulators will continue to take action to limit the impacts of cost sharing when it becomes necessary. Further, we believe that major technological advances in battery storage would be required to significantly disrupt the long-standing utility business model.
The key takeaway from these comments is the need for distributed generation installations to invest in battery storage in order to be significantly disruptive. The added costs for sufficient battery storage to allow total disconnection from the grid tips the equation back towards transmission assets.
ITC's valuation seems compelling compared to its peers. The table below lists a few current valuation ratios with electrical peers from the S&P 400 Mid-Cap Utility Index: Great Plains (NYSE:GXP), Cleco Corp (NYSE:CNL), IDA Corp (NYSE:IDA), Westar Corp (NYSE:WR), Hawaiian Electric (NYSE:HE), and PNM Resources (NYSE:PNM). The columns are Ticker Symbol; Current Dividend Yield; Anticipated EPS Growth Rates; Current PE Ratio; Current PEG Ratio (price to earnings growth); Current Beta; Trailing Twelve Month TTM Return on Invested Capital ROIC; 5-yr Average ROIC; and Current Dividend Payout Ratio.
ITC is well positioned among its peers for Return on Invested Capital ROIC, EPS anticipated growth rates, and PEG ratio.
Dividend growth investors should stand up and take notice of the following table that compares the dividend growth characteristics of these stocks:
With its lower payout ratio and higher earnings growth projections, management feels comfortable in expecting dividend growth in the 10% to 15% range looking out to 2018.
ITC's operating earnings for the 1st qtr. of 2014 were $69.8 million or $0.44 per share compared to $58.8 million or $0.37 per share for the 1st qtr. of 2013. Management reaffirmed its previous guidance of $1.83 to $1.90 for all of 2014. The 1st qtr. 2014 Conference Call Transcript is found here.
This laser-focused transmission company with its above average growth prospects definitely compliments investments in traditional regulated electric utilities. It deserves a place in most all utility portfolios.
To answer the question raised in the first paragraph: It is my belief that ITC has the abilities to continue its 11% annual total return. This number is about twice the anticipated return of the regulated utility as a whole. A combination of sustained, high dividend growth and continued execution of its ROIC on a doubling of regulated assets should drive more than adequate shareholder returns.
Investors needing additional information for due diligence should review last month's Investors Day Presentation linked above.
Author's Note: Please review important disclaimer in author's profile.