ITC Holdings To Join Utility Industry M&A Wave
ITC Holdings announces strategic review that includes a sale of company; stock soars 12.8%. We believe transaction is likely at $44-$47 per share, as strategic bidders National Grid, Iberdrola, and Berkshire Hathaway participate in competitive bidding. ITC Holdings is attractive target with $120-$160 billion capital investment opportunity, unique regulatory structure; Merger approval process may be shorter than other industry M&A deals. Shareholders in ITC Holdings (NYSE: ITC ), a leader in electric transmission in the US, saw its stock soar 12.8% from Friday’s close to $38.04 per share following an announcement that the board is reviewing its strategic options. The possibilities under consideration include a sale of the company, and we believe, for several reasons, that an outright sale of ITC Holdings to a strategic bidder is a highly probable outcome. We are currently in the middle of a significant M&A boom in the power and utility industry: Over $45.4 billion in deals were announced in the third quarter of 2015. This quarterly total exceeds the total transaction value of announced deals in the prior four quarters combined by over $7 billion ($38.3 billion in total from Q3 2014 to Q2 2015). Among the largest announced deals were the acquisition of Oncor Electric Delivery from the bankrupt Energy Future Holdings for $12.6 billion, Southern Company’s (NYSE: SO ) $12 billion acquisition of AGL Resources (NYSE: GAS ) ( as discussed here ), and the $10.4 billion acquisition of TECO Energy (NYSE: TE ) by Emera ( OTCPK:EMRAF ). (click to enlarge) Source: PwC report on Power and Utility Industry, October 2015. The recent wave in M&A activity in the regulated power industry is precipitated by a change in market dynamics from higher operating and maintenance costs and increased capital investment requirements. The costs of new utility construction and facility improvements continue to march upwards, as expense for labor and building materials rise. While allowed rate increases have been able to offset a considerable portion of these costs, rate increases for customers have been under pressure from a lower cost of capital in a low interest rate environment. With this underlying shift in the market taking place across the industry combined with stagnant demand for many utilities in their existing territories, several companies are looking beyond their own market to expand their customer base and generate economies of scale through operating efficiencies. These factors have served as the catalyst for several strategic acquisitions over the past twelve months including the larger deals announced in the third quarter as well as transactions as Exelon’s (NYSE: EXC ) $6.8 billion purchase of Pepco Holdings (NYSE: POM ). We anticipate that these industry factors will continue to drive consolidation and M&A activity is likely to remain robust through 2016. (click to enlarge) Source: ITC Holdings investor presentation, Edison Electric Institute 50th financial conference, November 8, 2015. With this industry backdrop, we believe the Board of ITC Holdings is making a shareholder-friendly decision in reviewing all of its strategic alternatives at this time and the Board appears to be taking the first steps in fulfilling its obligation to pursue value-enhancing action when the opportunity arises. Over the past three months, ITC Holdings’ stock has traded in the $31-$33 per share range and as much as 31% below its 52-week high trading price of $44 per share. This underperformance is very discouraging for long-term shareholders and many patient investors may be ready to cash out of their holdings at the right price. (click to enlarge) Source: ITC Holdings investor presentation, Edison Electric Institute 50th financial conference, November 8, 2015. It is our view that putting the company up for sale now would deliver the greatest value for ITC Holding shareholders. We believe that a sale of ITC Holdings would result in an all-cash transaction with consideration worth between $39 to $47 per share. Our valuation is based on a PE multiple of 18.5x to 22.5x on projected 2016 earnings per share of $2.10. This PE multiple range is consistent with multiples seen on recent transactions in the regulated power industry. Furthermore, the typical premium over the unaffected stock price we have seen is 20% to 40% which would imply a transaction value of $39 to $45 per share. In our view, the high end of these ranges would represent tremendous value for shareholders and exceed the all-time high trading price for ITC Holdings. From the standpoint of the strategic bidders believed to be interested in ITC Holdings, there are many compelling reasons to acquire the company and pay top dollar. One of the most attractive aspects of ITC Holdings is the significant future infrastructure requirements. Management estimates an investment in upgrades of $120 – $160 billion will be required through 2030 driven by an aging infrastructure and regulatory and compliance investments. The opportunity to put well over a hundred billion in capital to work and earn a decent return on the invested capital for the foreseeable future will appeal to the larger strategic acquirers such as National Grid (NYSE: NGG ), Iberdrola ( OTCPK:IBDSF , OTCPK:IBDRY ), Berkshire Hathaway ( BRK.A , BRK.B ) Energy, and NextEra Energy (NYSE: NEE ). Additionally, the unique regulatory structure that ITC Holdings is subject to is a very attractive characteristic of the company and provides ITC Holdings with an advantage over other potential acquisition targets in the regulated power industry. ITC Holdings is regulated at the federal level by the Federal Energy Regulatory Commission and the agency acts in setting the rates for the company’s vast electric transmission assets that span the U.S. Midwest. As a result of this regulatory structure, the regulated return on equity for ITC Holdings has consistently exceeded that of its state-regulated peers by as much as 200 basis points. We believe there is also a transaction-specific benefit of the unique regulatory structure The downside risk for ITC Holdings shareholders (and any shareholder of a utility company that is acquired) is the complex regulatory approval process of an acquisition. The unpredictable and often politically-charged process has delayed some transactions for several months. The average length from announcement to completion of an acquisition in the power and utilities industry is nearly 8 months between 2009 and 2013. As many investors in recent M&A deals will attest, the figures for 2014 and through the third quarter of 2015 are likely higher. For example, the proposed Exelon-Pepco transaction has been pending for over 19 months and may finally be approved as we approach the two-year anniversary of the April 2014 acquisition announcement. (click to enlarge) Source: Deloitte Center for Energy Solutions. Understandably, this burdensome process may deter a potential acquirer from pursuing a negotiated agreement. However, for ITC Holdings, we do not believe this will hold true. In our view, a proposed transaction may not have to receive the approval of each state jurisdiction in which ITC Holdings’ electric transmission subsidiaries operate. We believe approval of the Federal Energy Regulatory Commission and the Federal Antitrust authorities would satisfy the company’s statutory requirements. According to ITC Holdings’ most recent 10-K filing, state regulators’ authority and scope of oversight is quite limited: “The regulatory agencies in the states where our Regulated Operating Subsidiaries’ assets are located do not have jurisdiction over rates or terms and conditions of service. However, they typically have jurisdiction over siting of transmission facilities and related matters as described below. Additionally, we are subject to the regulatory oversight of various state environmental quality departments for compliance with any state environmental standards and regulations.” In our view, the FERC will have jurisdiction, from a power and utility industry standpoint, over the approval of any proposed transaction and would make the determination of the competitive effects of a merger and the long-term impact on the ratepayers. While the state jurisdictions may be involved in a regulatory review, we do not expect a state agency within the power industry to be in a position to make a binding decision as to the competitive effects of a proposed transaction. This unique regulatory structure therefore avoids a potential “DC Public Service Commission”-type disruption to a merger approval process where a small, activist group minimally impacted by a large multi-jurisdictional merger has the ability to delay the process or extract additional financial benefits from the parties. In conclusion, we believe a sale of ITC Holdings in the range of $39-$47 per share is in the best interests of shareholders and is a very likely outcome of the Board’s current strategic review. Based on the attractive characteristics and prospects of ITC Holding, we believe there will be active and competitive bidding by large strategic players in the regulated power industry and the results will be a final transaction price in the $44-$47 per share range. As such, we expect the power and utility industry consolidation will show no signs of slowing in 2016. And importantly, in contrast to several of the current prolonged transactions, we believe a proposed acquisition involving ITC Holdings will navigate the complex regulatory process successfully and in a more appropriate timeframe. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.