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By Matthew Coffina, CFA | 03-17-2015 04:00 PM

The Future Looks Bright for This Wide-Moat Utility

ITC boasts much higher returns on capital and significantly lower risk than other utilities thanks to its friendlier regulatory situation, says Morningstar's Matt Coffina.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Matt Coffina. He is the editor of Morningstar StockInvestor newsletter. He recently added to his position in ITC (ITC), and we're here to talk to him about why.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: ITC is a rare wide moat in the utility space. Can you talk to us about why Morningstar likes this utility or thinks this utility has a stronger competitive advantage compared with its peers?

Coffina: I think ITC is really unique among utilities, and it's actually the only utility we hold in StockInvestor's portfolios. It's actually the third-largest position in our Tortoise portfolio right now. And what makes ITC so special is that it's exclusively focused on transmission. That means, first of all, that it's regulated by the Federal Energy Regulatory Commission, which tends to be much friendlier to utilities than state regulators are. State regulators tend to be much more concerned with consumers' utility bills. Federal regulators, particularly when it comes to transmission, are focused on the reliability and efficiency of the grid.

Also, ITC has much higher returns on capital than state-regulated utilities. This results from a few factors. One is part of its efforts to improve grid reliability. FERC has allowed higher returns on equity than is typical for state-regulated utilities. So, for ITC, that's somewhere around 13% right now, as their average allowed ROE.

And by the way, they almost always realize that allowed ROE because they have a formula-based rate-setting mechanism, which basically allows them to recover their operating costs directly from customers. If there are unexpected costs, unlike a state-regulated utility, [they don't have to] go back to regulators, file a rate case, [which will] usually involve at least some lag time and quite possibly [could mean] they won't get the full rate increase that they requested.

ITC is able to recover its costs immediately through the formula rate-setting mechanism. And then the allowed ROE, as I mentioned, is higher than average--around 13% right now. Though, there is some risk that that's going to come down over time. Better still, ITC is able to take on a second layer of financial leverage at the parent company that normally wouldn't be allowed for state-regulated utilities but has been endorsed by FERC--or at least FERC's been willing to allow it. And that basically means that ITC's parent-company return on equity is somewhere around 17.5%.

What we see from even the best state-regulated utilities, say a Southern Company (SO), is maybe 12%. That's really the highest you can expect in terms of realized returns on equity at the parent-company level. So, ITC, a huge growth opportunity from investments in transmission. We've underinvested in the transmission grid for the better part of two decades. It has very high returns on capital thanks to favorable FERC regulation and below-average risk because of that formula rate-setting mechanism.

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