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The Future Looks Bright for This Wide-Moat Utility

Matthew Coffina, CFA

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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Glaser: But often when you have a business that's performing so well and maybe has a good prospect for growth, you have to pay quite a pretty penny for that. What do valuations looks like in the utility space? Does ITC look cheap compared with its peers?

Coffina: Utility valuations have really been whipped around in the past couple of years. Utilities were one of the top-performing sectors in 2014, up more than 27%--which for a boring, staid, been-around-for-a-hundred-years business model is really quite something. Unfortunately, that left most utilities overvalued. And even today, over the past month and half or so, utilities have come back out of favor because of a rise in long-term interest rates. A drop in interest rates largely took credit for the 2014 strong performance, but interest rates are coming back up now. Utilities have fallen back out of favor, and ITC has been dragged along with its industry, both on the high end and at the low end. Even after the sell-off in the past month or so, we still think most utilities are relatively overvalued, usually 5% to 10% overvalued.

But we think that ITC is more like 5% to 10% undervalued, because I think investors are failing to appreciate just how much better than its state-regulated utility peers it is. So, again, the much higher returns on capital [along with] significantly lower risk justify, in my view, a valuation that's meaningfully higher than peers. ITC does trade at a slight premium to peers, maybe one or two price/earnings multiple points higher than state-regulated utilities. But I think that gap should be even wider. It's just so much better fundamentally than its peers, and I think it deserves a greater valuation premium.

Glaser: What are the risks here that investors need to keep in mind?

Coffina: I sort of alluded to it earlier, but the biggest risk is that the Federal Energy Regulatory Commission is going to reduce ITC's allowed returns on equity. So, especially in the current low-interest-rate environment, customers have been complaining that ITC is allowed to earn returns on equity that are unjustified, that are unreasonably high. A recent case in New England [provided] a lot of clarity on this matter. FERC did decide in New England to lower allowed ROEs. ITC doesn't operate in New England; their main region is MISO, which encompasses much of the middle of the country.

There's a similar complaint outstanding in MISO that ROEs are too high. But given the precedent set by the New England case, I think we have a pretty good sense now of the likely reduction in allowed ROEs. In ITC's case, I think it's going to be somewhere in the neighborhood of 100 basis points, maybe slightly more than that. Even with that reduction, ITC should be able to sustain high-single-digit or low-double-digit earnings growth over the next five years. Call it 8% to 12% on top of a 1.8% yield or so and a price/earnings multiple that I think is sustainable. In my view, investors in ITC today, while taking on much, much less risk than the market as a whole, could expect total return somewhere in the neighborhood of 10% to 14% a year--which, especially in the current overvalued market, I find very attractive.

Glaser: Matt, I certainly appreciate your update on ITC today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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