ITC Holdings Isn't Just Any Regulated Utility

Morningstar recently picked up coverage of electricity transmission utility  ITC Holdings . We assign the company a wide moat, a stable moat trend, and exemplary stewardship. While the stock looks only modestly undervalued, with a price/fair value ratio of 0.91 as of Aug. 30, this is enough for ITC to earn a Morningstar Rating for stocks of 4 stars given the low degree of uncertainty surrounding our fair value estimate. I recently purchased ITC for Morningstar StockInvestor's real-money Tortoise portfolio.

A Wide-Moat Electricity Pipeline
Although ITC is officially classified as a regulated utility, it is more similar to wide-moat pipelines such as  Enterprise Products Partners (EPD) and  Magellan Midstream Partners (though without the unique tax characteristics of a master limited partnership). The company is engaged exclusively in the long-distance transmission of electricity--it owns the wires that take electricity from generators to distribution utilities. ITC is the only publicly traded utility of its kind; the vast majority of transmission lines are owned by integrated utilities that also hold generation and distribution assets.

The key to ITC's wide moat is its regulator: the Federal Energy Regulatory Commission. FERC tends to be less affected by local political pressures and more transparent and predictable than state utility regulators. After the 2003 blackout that stretched across much of the Northeast, Midwest, and parts of Canada, the Department of Energy made the reliability of the U.S. electricity grid a top priority. To encourage investment in transmission infrastructure, FERC has been allowing favorable returns on equity, with extra incentives provided to independent transmission operators such as ITC. Allowed returns on equity at ITC's regulated subsidiaries range from a low of 12.16% to a high of 13.88%, which is well above both allowed ROEs at most local distribution utilities (usually closer to 10%) and our 8% estimate of ITC's cost of equity. Better still, FERC regulation allows for formula-based adjustments to rates, so ITC's realized returns on equity at the operating company level usually match the allowed returns over a year or two.

Favorable Allowed Returns Support FERC Policy Goals
ITC is basically a monopoly within its service territories; as with oil and gas pipelines, it generally doesn't make sense to build a second set of electrical wires to traverse the same routes. As a result, ITC's earnings are heavily influenced by regulators. It seems likely that allowed ROEs will come down over time in response to the current low interest-rate environment. I don't expect ITC's 13.88% allowed ROE in Michigan, which was approved in 2003, to be repeated any time soon.

However, there appears to be a robust basis to maintain premium allowed returns on new transmission projects. Independent transmission companies are allowed to collect a 100-basis-point incentive above their base allowed ROE. This is because FERC wants to encourage an open, nondiscriminatory transmission grid. When the same company owns generation, distribution, and transmission assets, there is a potential for conflicts of interest. For example, a vertically integrated utility may not want to invest in transmission projects that would lower power prices for its generation assets. ITC receives an additional 50-basis-point bonus for participating in regional transmission organizations, which are necessary for competitive generation markets.

More to the point, the U.S. transmission infrastructure still needs significant upgrades, both to ensure reliability and to adapt to a shifting electricity-generation landscape. There can be huge disparities in electricity prices depending on geography. New transmission lines can frequently pay for themselves, by bringing power from low-cost regions with surplus generation to higher-cost regions that need it. Transmission is also necessary to support renewable-energy initiatives. In ITC's largely Midwestern territory, this usually means bringing power from wind farms to population centers.

ITC's management has identified $4.2 billion of capital spending projects between 2012 and 2016. With the company's high allowed returns on equity and low cost of equity, this investment is a powerful growth engine. Management is forecasting earnings per share growth of 15%-17% annually over this time, with 12%-13% of the growth attributable to projects "viewed as highly probable of occurring." Needless to say, this is much faster growth than you see at most regulated utilities. To arrive at our $98 fair value estimate, our analyst is projecting 12% annual earnings per share growth through 2017. Our model includes mild deterioration in allowed ROEs on new investment over the next five years, although we expect incremental ROE to still be a little over 12% in 2017.

In light of ITC's growth outlook, the valuation actually looks quite reasonable. ITC is trading for about 18 times consensus earnings estimates for this year, which is only slightly above the utility industry average.

Entergy Transaction and Risks
I find the investment case for ITC's existing business compelling on its own. However, the company is also pursuing a potentially transformative merger with the transmission business of  Entergy (ETR). This merger basically represents regulatory arbitrage: By transferring the transmission assets from diversified Entergy to independent ITC, the companies hope to capture higher allowed returns from FERC. If the merger goes through, ITC would pursue some kind of recapitalization (a share repurchase, special dividend, or some combination of both), and Entergy shareholders will end up owning just over 50% of the new ITC. ITC's exemplary management team would remain in charge, supplemented by key leadership from Entergy.

Not surprisingly, this merger has received some pushback, particularly from local regulators who are wary of higher utility bills for consumers in their states. To appease these regulators, ITC has been offering rate concessions that will diminish the accretion from the transaction, at least in the early years. ITC has already received approval for the merger from FERC, including acceptance of its proposed allowed ROE and capital structure.

The good news is that our current fair value estimate for ITC doesn't include any benefit from the Entergy transaction. If the deal goes through, it could boost our fair value estimate for ITC by a couple of dollars per share, but if it fails (which seems as likely as not at this point) it would not affect our fair value estimate. Depending on the ultimate terms at closing, I see the potential for additional upside from the Entergy deal in future years, as initial rate concessions wear off and ITC discovers new investment opportunities in its expanded service territory. However, I wouldn't count on this until the transaction is closed.

The most serious risk to ITC is that its allowed returns on equity from FERC could be lowered materially, both on existing and new transmission projects. While a variety of local interests are lobbying for this, I think it is relatively unlikely that allowed ROEs will dip below 12% or so. The need for additional transmission infrastructure is just too great--to prevent blackouts (which are extremely costly to the economy), to enable cross-regional electricity pricing arbitrage (by which new transmission capacity often pays for itself), and to encourage development of renewable energy sources. Transmission assets last for 50 years or more; operators need predictable and generous allowed returns to make investment worthwhile. Particularly considering that transmission only accounts for about 10% of customers' electric bills, it seems unlikely that lowering allowed ROEs is a priority for FERC.

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