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ITC Holdings: Growth Comes At A Price
Summary Transmissions business carries less risk and higher allowed returns than other utilities. Dividend is slated to grow at a 10-15% annual pace through 2018 by management. ITC Holdings is highly leveraged and burns through cash – a change to allowed returns could be disastrous. ITC Holdings (NYSE: ITC ) is the largest electricity transmission company in the United States, operating out of the Midwest. Current operations sprawl out from the center of the country, impacting dozens of states. Unlike your typical regulated electric utility that directly produces energy to provide electricity to customers, ITC focuses fully on grid infrastructure. Electric transmission assets have been historically under-maintained, resulting in significant transmission constraints and stress on ageing equipment. To combat this, the regulatory environment has shifted to companies like ITC to fix these issues while receiving a stable, regulated rate of return. Given ITC’s estimates of $160-240B in additional necessary upgrades to infrastructure by 2030, substantial opportunity exists for utilities to earn a fair return on invested capital upgrading these assets. This business model has been a long-term outperformer. Looking back ten years, shares have trounced utility peers but have begun to underperform recently. Is this a healthy needed sell-off or an opportunity for investors to buy in before the next leg up in share price? Not Your Grandfather’s Utility Your typical state-regulated, power-producing utility has a tough time. Rates it can charge are set at fixed rates in between rate cases it makes with state regulators, hopefully with various riders in place that allow recovery of necessary capital expenditures or changes in commodity prices. In nearly every case, electric utilities experience “regulatory lag” – a gap between capital spending and eventual recovery. Disallowances are always a risk. Further exasperating utility management, a utility might make an investment assuming a return on equity that never materializes or an incredibly long amortization period that stretches out the timeline of recovery. Political gamesmanship between the utility, regulators, and the public that bears the costs is always present. ITC Holdings is instead governed by FERC, the Federal Energy Regulatory Commission. Working with the Feds directly avoids a large portion of the games played in the rate-making process. Regulatory lag isn’t as much of a problem as FERC rate-setting is forward-looking with annual adjustments. Further benefitting ITC is the much higher allowed returns on transmission infrastructure. Most publicly-traded utilities have seen their allowed return on equities plummet over the past decade to approximately 10%, give or take a half percentage either way. Allowed returns for transmission companies like ITC is in the 12% range depending on region. In a nutshell, this makes ITC a much more profitable business than most utility peers, with profit and operating margins that energy producers like Duke Energy (NYSE: DUK ) could only dream of. In spite of risk to drops in allowed return on equity (FERC dropped allowed return on equity on New England assets to 11.7%, setting off warning bells across transmission utilities), the company should enjoy meaningful returns above and beyond standard utilities for some time. Further cementing ITC’s advantages over electric utilities, transmission assets are simple. By and large, they are simply pole and wire assets with supporting infrastructure. The environmental and regulatory risk simply isn’t as present as it is for power-generating utilities. There is no nuclear waste requiring disposal or possible coal ash basin breaches to worry about. Operating Earnings The growth story is obvious here; you won’t find many other companies in the utilities segment growing at over 12% compound annual growth rate. Annual revenue growth is expected to continue at this pace over the next five years as ITC continues to take on projects. Operations and maintenance expenses have actually stayed relatively flat, indicative that maintenance costs are minimal for new transmission infrastructure once updated. Consistently better than 50% operating margins are stellar and more indicative of a company like Apple (NASDAQ: AAPL ) than a regulated utility. Getting a piece of these strong results doesn’t come cheap, because at more than 13x ttm EV/EBITDA, shares trade at a 30% premium to the broader utility industry. Serial Debtor Issue? If anything should concern investors, it is the rapid rise of the company’s debt. The company has breached $4B in debt compared to just $2.5B in 2010. Net debt/EBITDA of slightly over 5x has held steady as ITC’s earnings have grown as well, but this is a substantial amount of leverage as the company pours significant money into capital expenditures. Credit ratings are stable investment grade, but all ratings agencies note the risks in this heavy spending. A deterioration in the company’s regulatory or operating environment (increased regulatory lag, lowered allowed return on equity by regulators, litigation, rising interest rates) could stunt ITC’s cash flow which would hamstring further investment. Any company that perpetually issues hundreds of millions in debt year after year, especially one as small as ITC Holdings, should make investors pause and consider possible implications. Conclusion The small current dividend yield of 2.26% shouldn’t scare away investors. Per management’s 2014-2018 guidance, 10-15% annual dividend increases are to be expected. If management executes and hits the high end of this dividend growth target (as it did in 2015), your yield-on-cost would be 3.43% at the end of 2018, which would be a respectable number that you may not get by buying a slow-growing 3% yielder today. Additionally, ITC’s share repurchase program is rather unique in the utility industry, one that is most often plagued by dilutive equity issuance every few years that is never offset by buyback programs. However, the company’s high degree of leverage, price premium to other utilities, risk of more competition for projects, and uncertainty regarding future allowed returns on electric transmission infrastructure weigh heavily on my ability to issue a buy recommendation.
Drawing Inspiration From Short-Sellers In Avoiding Potential Value Traps
Summary Risk and opportunity are intertwined; avoiding value traps is key to investing success. Short-sellers have had a good track record and there are valuable insights to be drawn from their work. My exclusive research service, Asia/U.S. Deep-Value Wide-Moat Stocks, flags potential value traps with corporate governance issues, financial statement manipulation risks and other red flags. Short-Sellers And Their Track Record I recently wrote an article about value traps titled “How To Avoid Potential Value Traps With Net-Nets And Other Deep Value Stocks.” In the article, I highlighted several categories of stocks that I will reject as potential value traps, including those which were past targets of short-sellers. The short-sellers are “smart money” which I will not bet against, and I quote relevant research below to support my claims. Lei Chen, a researcher at Southwestern University of Finance and Economics, first published a paper titled “The Informational Role of Short Sellers: The Evidence from Short Sellers’ Reports on U.S.-Listed Chinese Firms” in January 2014 (The current version of the research paper is dated January 22, 2015). The study found that U.S.-listed Chinese firms targeted by short-sellers “experience an average three-day cumulative abnormal return (NASDAQ: CAR ) of -6.1% and -13.4% for initial coverage of the firm.” Lei Chen also added that “short sellers are more effective than equity analysts who follow Chinese firms,” and “targeted firms suffer long-term stock price declines and are often subsequently subject to class action lawsuits and SEC enforcement.” Activist Shorts Research, which calls itself “an independent database dedicated to tracking activist short-seller campaigns,” tracked the campaigns of 28 top activist short-sellers and published its findings in August 2014. A significant finding was that investors, who “piggybacked” short-sellers by shorting the targeted companies a week after the announcement of the activist campaign and continuing to hold the stocks till the end of the activist campaign, outperformed the S&P 500 by an average of 12.5% over the same period. Delving deeper into the track records of individual short-sellers, a prominent short-seller, Muddy Waters Research summarized the track record of its nine “strong sell reports” as follows: Four de-listings; Four resignations of auditor / CFO / board members; and Six or more formal investigations by regulators into covered companies. I intend to provide subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service with a list of the key short-sellers, their reports and the companies they have targeted in a separate bonus watchlist article. Categories Of Red Flags To Watch Out For While it is not possible for an individual investor to replicate the in-depth detective work that some of these professional short-seller firms have done in coming up with their short theses, there are a lot of takeaways. In particular, one can draft his or her own investment checklist incorporating certain red flags that can be detected using data & information from annual reports, public filings and other forms of desktop research. I list a couple of red flag categories in the sections below. Notwithstanding the accuracy of the allegations made by short-sellers, investing in stocks which are likely to be targets of short-sellers will most probably lead to significant financial losses, as per research referenced above. Therefore, it pays to understand what kind of companies are “favored” by short-sellers. Financials If something is too good to be true or simply does not make sense, investors should sit up and take notice. One example is companies with significantly higher margins than their peers despite similar (or even smaller) scale of operations compared with competitors, lack of competitive advantages and the commoditized nature of the industries they operate in. Shenguan Holdings ( OTCPK:SHGXY , 829 HK) was the subject of a September 2014 short-seller report titled “The Thick Skin of Shenguan’s High Margins” by Emerson Analytics.” Emerson Analytics wrote in its report: Shenguan has reported very high EBIT margins that averaged 53% in the last few years, much higher than the 18% or so enjoyed by two global giants Viscofan Group and Devro PLC. Its gross margin at 55- 60% was also a lot higher than the 25-40% reported by Liuzhou Honsen, a smaller Chinese competitor. This is just too good to be true. That being said, there are positive factors for Shenguan that should not be ignored in any balanced analysis of the company. Shenguan has engaged and retained Ernst & Young as auditors since IPO. It has also paid out dividends in every year since 2009 (IPO year), although it must be noted that Shenguan’s directors did not propose any interim dividend for 1H2015. For the record, Shenguan’s share price has declined from HK$2.80 (share price indicated in the short-seller report) in September 2014 to HK$1.15 as of October 15, 2015. Other red flag indicators include a combination of high cash levels with either low interest income, low dividend payout or high levels of debt; long or increasing cash conversion cycle; and divergence between cash flow and earnings. Auditing Auditors, or more specifically auditor turnover, need to be watched closely. Huabao International ( OTCPK:HUIHY , 336 HK) was the target of short-seller Anonymous Analytics in April 2012 in a report titled “Smoke and Mirrors.” One of the red flags highlighted by Anonymous Analytics was auditor turnover. Deloitte Touche Tohmatsu (NYSE: DTT ) resigned as Huabao’s auditors in March 2006, less than two years after Huabao was listed in April 2004. Huabao countered the short-seller’s allegations by clarifying that “DTT resigned in late March 2006 because the Company and DTT could not reach a consensus on the audit fees for the financial year ending 31 March 2006. DTT had also confirmed that there was no disagreement between it and the Company when it resigned.” Also, it is worth noting that PricewaterhouseCoopers ((PwC)) has remained as Huabao’s auditors since taking over in 2006 and has continued to provide an unqualified opinion on the company’s accounts since then. Huabao’s share price as of October 15, 2015 was HK$2.97, compared with its share price of HK$4.33 in April 2012 when Anonymous Analytics’ report was released. On that note, I will also to share some contrarian views on the risk factor with respect to having a non-Big Four auditor. The companies involved in arguably the “biggest” accounting frauds such as Enron, Sino Forest and Satyam engaged Big Four (or Five including Arthur Andersen at that time) auditors. Also, putting fees aside, Big Four audit firms, like any other profit-making enterprise, will give their biggest clients the top priority, suggesting that smaller companies can possibly get more attention and better service with a non-Big Four auditor. Other factors to take note of include different auditors for the parent and subsidiaries; auditor located in a different country from client’s key business operations; and delays in result announcements. Corporate Governance The Board of Directors serves as one of the most important checks & balances for companies. The behavior and past actions of directors provide clues as to how effectively a company is managed. Emerson Analytics issued a short-seller report on Sound Global ( OTCPK:SGXXY , 967 HK) in February 2015. Sound Global remains suspended for trading since March 16, 2015, when it announced that “the Company requires more time to prepare the required information to the auditors and the auditors are not able to complete the audit of the consolidated financial statements of the Company and its subsidiaries for the year ended December 31, 2014 (the “2014 Annual Results) by March 31, 2015, there will be a delay in the release of the 2014 Annual Results.” Even prior to the release of the short-seller report, there were certain disclosures by Sound Global which investors should have been concerned with. In 2013, it was disclosed that Mr. Wen Yibo, a controlling shareholder and executive director of Sound Global, has pledged his shares in Sound Global in connection with borrowings for the company in announcements here and here . In December 2014, Mr. Wen was publicly criticised by the The Securities and Futures Commission for a breach of Rule 31.3 of the Takeovers Code, which “provides shareholders with certainty that the offeror will not pay a price higher than the offer price for the shares in the offeree company in the 6-month period after the close of the offer.” Mr Wen bought 5.6 million Sound Global shares at prices ranging from $5.94 to $7.55 per share between March and May 2014, which were higher that the HK$4.37 conditional cash offer for all the shares in Sound Global in September 2013. Further to that, Sound Global announced on March 31, 2015 that its audit and nomination committee chairman, Mr. Wong See Meng, resigned on 26 March 2015 due to family and personal commitments. Mr Wong is also a member of remuneration committee. In addition, Sound Global’s audit committee comprising Mr Wong See Meng (Chairman), Independent Non-Executive Directors, Mr Seow Han Chiang Winston and Mr Fu Tao do not have either accounting or auditing experience. In July 2015, Sound Global announced that Deloitte Touche Tohmatsu has resigned as auditors of the company on 17 July 2015. Moving away from Sound Global, investors should consider factors such as the number of independent directors on the Board, the composition of the Audit and Remuneration Committees, and the profile & track record of the individual directors, when they are evaluating the Board of companies they are vested in. Closing Thoughts Risk and opportunity are intertwined. For example, Hong Kong-listed companies probably rank second in the list of global stocks targeted by short-sellers, after U.S. firms. But at the same time, Hong Kong is the stock market with the second most number of net-nets after Japan. Therefore, I will advise investors not to throw the baby out with the bathwater when they are considering emerging market opportunities, particularly in countries and markets where companies with corporate governance issues, financial statement manipulation risks are more prevalent. Note: I flag potential value traps with corporate governance issues, financial statement manipulation risks and other red flags as part of my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service. My subscribers get access to the list of value traps for both deep value & wide moat stocks, in addition to monthly top ideas, potential investment candidate profiles and potential investment candidate watchlists.