Wide Moat and FERC Policy Should Continue to Drive Growth for ITC

Since its initial public offering in 2005,ITC Holdings (ITC) has achieved healthy returns on invested capital and strong earnings growth. This success has been due to the company's wide economic moat as well as incentive rates for independent transmission companies, which the Federal Energy Regulatory Commission has used to promote efficiency improvements to the U.S. electricity transmission grid. Although returns are likely to decline as growth shifts to ITC's transmission businesses with lower allowed returns on equity, we believe earnings growth will remain strong and returns will stay well above ITC's cost of capital. We think these attractive returns on capital,  growth prospects , low uncertainty due to constructive regulation, and 1.7% dividend yield make ITC an attractive opportunity for long-term investors.

ITC is the only pure-play independent transmission company in the United States. In 1999, FERC Order 2000 created the legal basis for ITC. The ruling required utilities to transfer operational control of their transmission systems to regional transmission organizations to facilitate more-competitive wholesale markets. It also allowed RTOs to accommodate independently owned, for-profit transmission companies like ITC.

ITC began operations in 2003 with the acquisition of DTE Energy's transmission system in Michigan and came public in 2005. ITC has been one of the fastest-growing utilities during the past decade and now has more than 15,000 miles of high-voltage transmission lines and supporting facilities in seven U.S. states, making it the ninth-largest transmission owner in the U.S. Most of that growth has come through acquisitions of transmission systems from other utilities. The company owns no generation but transmits more than 26,000 megawatts of peak load on its systems, primarily in the Midwest.

ITC would become the largest U.S. transmission owner if regulators approve its proposed merger with Entergy's transmission business. The transaction, announced in December 2011, would require Entergy to sell its transmission assets in Arkansas, Texas, Louisiana, and Mississippi and then merge those assets into ITC. In return, Entergy shareholders would receive a 50.1% stake in ITC. The merger would roughly double ITC's market capitalization and miles of transmission lines. Regulatory approvals continue to drag on, and commissioners in Arkansas, Louisiana, and Texas have expressed reservations about the merger. We give the deal a 50% likelihood of closing on the proposed terms.

Source of ITC's Wide Moat
We believe ITC's efficient-scale competitive advantage makes it the only regulated utility with a wide moat. Competitors have no incentive to build competing transmission lines if ITC's lines are already serving a market's full capacity. Costs for new transmission lines are too high and incremental benefits too low to offer sufficient returns on capital for two competing transmission owners. In addition, state and federal regulators approve new transmission lines only if there is a demonstrated need for new capacity, protecting ITC's efficient-scale advantage.

ITC's assets are essential to reliable electricity service. ITC's transmission systems (3) ensure that electricity flows smoothly from power plants (1) to distribution networks (5) and, ultimately, to millions of customers (6).

Reliability moved to center stage following the 2003 blackout that stretched from Ohio to New York City. The Energy Policy Act of 2005 requires the FERC to implement mandatory electric transmission reliability standards that are enforced by electric reliability organizations. In 2007, the FERC adopted mandatory reliability standards and introduced fines for noncompliance of up to $1 million per day. The North American Electric Reliability Corporation is the ERO responsible for enforcing these standards. We believe reliability will remain a key issue owing to changes in the generation mix and society's increasing demand for reliable power supply.

ITC offers economic benefits for all stakeholders. An efficient and flexible transmission network serving wholesale markets is crucial to giving customers access to the lowest-cost electricity and reducing regional pricing disparity. ITC's lines can arbitrage rate differences between regions with excess low-cost power and regions with high energy costs.

As long as customer costs for the transmission investment are lower than the energy cost savings the extra transmission provides a given region, we expect regulators will continue to use incentives to encourage transmission development. ITC's ability to capture these economic rents allows it to create economic value for shareholders. There is plenty of opportunity for additional investment in this area. Huge disparity in retail electricity prices still exists in the U.S., particularly in California and the Northeast, where federal regulators are offering some of the most attractive rates for transmission developers.

ITC's system supports renewable energy policies. ITC's transmission system is critical to supporting state and federal renewable energy policy by moving wind and solar power to load centers. Its system concentration in the Midwest and Central Plains enhances its competitive advantage, given the attractive economics of wind generation in those regions. Wind power developers rely on ITC for access to customer load while politicians and regulators rely on ITC to ensure their constituents have access to renewable energy. If costs to produce renewable energy locally are higher than the combined cost for generating and transmitting renewable energy from another region, regulators can offer incentives to reward existing transmission owners and attract additional transmission investment.

An industry study published in March 2013 estimated that investor-owned utilities were planning more than $38 billion of transmission projects to facilitate the integration of renewables. This represents more than 75% of total transmission investment planned. ITC has several projects that will link renewable energy developments to load centers.

Constructive regulation lowers ITC's cost of capital. ITC charges rates based on a formula that allows it to recover its expenses and earn a return on investment. The formula rate mechanism considers forecast expenses, investment base, revenue, and network load each year, then adjusts annually to true up ITC's returns.

FERC's formula-based rate-setting framework is more investor-friendly than typical state regulation that requires a utility to invest capital before adjusting customer rates to collect a return on and return of that capital. We believe the transparency and predictability of the formula-based rate mechanism results in a below-average cost of capital for ITC and supports stable cash returns. We assume an 8% cost of equity and 6.2% cost of capital in our fair value estimate of $98 per share, among the lowest costs of capital we use for any utility.