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.