Saturday, August 1, 2015

ITC Holdings Corp. (ITC) Stock Analysis

I’m incredibly fortunate to be in a position where I’m able to consistently buy stock in high-quality companies that have track records of reliably and regularly paying and growing dividends.
And I’m taking maximum advantage of that fortunate position by once more deploying capital and buying shares in a fantastic business.
This most recent purchase is a bit unique for me.
And that’s mainly because it’s a utility, an industry I’m not all that enamored with or exposed to – this is just the third utility in the portfolio, although ONE Gas Inc. (OGS) is a very small (almost non-existent) position that’s only there because it was spun off from ONEOK, Inc. (OKE) last year.
However, this utility exudes quality, growth, and potential that is really unlike a lot of other utilities I’ve run across, which is why I became so excited about it. After investigating the company and its financials, I decided to put some hard-earned cash to work over the next few decades.
Let’s take a look!
I purchased 30 shares of ITC Holdings Corp. (ITC) on 7/15/15 for $33.72 per share.

Overview

ITC Holdings Corp. is the largest independent electricity transmission company in the United States.
They own more than 15,000 of high-voltage transmission lines along with supporting facilities across seven states in the Midwest. These seven states are Michigan, Iowa, Minnesota, Illinois, Missouri, Kansas and Oklahoma.
After an IPO in 2005, they became a publicly traded company.

Fundamentals

One of the big reasons I don’t particularly like the idea of investing in utilities is what I typically see as poor fundamentals.
In addition, limited growth potential due to being geographically landlocked along with heavy regulation means there’s a cap on potential growth. That’s offset somewhat by monopolized service and captive customers.
However, due to ITC’s unique business model and the markets they serve, the growth over the last decade and growth potential moving forward are both outstanding. And the rest of the fundamentals reflect high quality.
Revenue has increased from $205 million to $1.023 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 19.56%. Not only is that incredible in and of itself, but it’s extremely rare for a utility to demonstrate that kind of top-line growth over a long period of time.
That has trickled down into exceptional profit growth: The company’s earnings per share is up from $0.35 to $1.54 over this period, which is a CAGR of 17.89%.
Like many utilities, ITC’s share count has increased over the last decade, denting the EPS growth slightly. However, we’re still looking at really phenomenal numbers here.
S&P Capital IQ believes that EPS will compound at a 10% annual rate over the next three years, which, if that comes to pass, would be a very, very solid result.
Not a household name as a dividend growth stock, this belies their potential – ITC actually sports rather attractive dividend metrics across the board.
First, they’ve increased the dividend for the past 10 consecutive years, which, due to their IPO date, is as long as their track record could possibly be, meaning they started growing the dividend right out of the gate and haven’t stopped since.
The five-year dividend growth rate might not pop out at you since it’s only 7.9%. However, the dividend growth has been moving in the right direction, with the most recent dividend increase being just over 14%. Meanwhile, Morningstar predicts that dividend growth will be solidly in the double digits for the next five years.
A modest payout ratio of only 41.9% combined with that double-digit earnings growth substantiates that prediction.
On dividend growth, the company notes in the 2014 annual report:
Our dividend policy is premised on growing the dividend commensurately with earnings growth, to the benefit of our total shareholder return proposition.
The yield is, however, one of the drawbacks here, indicating that this is a Stage 3 stock. Yielding only 1.93%, one has to count on that double-digit dividend growth coming to fruition to present a compelling case of attractive total long-term income along with appealing total returns. The company should be announcing another dividend increase within weeks, so I’m excited to see how that plays out.
As probably expected, the company does have a leveraged balance sheet. A long-term debt/equity ratio of2.35 and an interest coverage ratio of just over 3 aren’t great in absolute terms, but aren’t particularly worrisome relative to the industry. It’s capital intensive to build out infrastructure and maintain these assets.
Profitability, however, appears to be quite robust. Over the last five years, ITC has averaged net margin of22.97% and return on equity of 14.50%. Margin is especially impressive, and it’s generally been increasingover the last 10 years.

Qualitative Aspects

Electricity is about as ubiquitous and necessary as it possibly gets. You literally cannot live without it, which is what, on the surface, attracts so many investors to the idea of investing in utilities. A captive customer base that quite literally cannot live without the service is, from an investor’s standpoint, pretty fantastic.
However, one of the major reasons I’m not real excited about major utilities is because I foresee increasing proliferation of cleaner energy sources – especially from solar and wind. Due to government regulation, that means electricity generation from the likes of coal will be far less attractive in the future. And we see this playing out with the shuttering of coal-fired plants occurring across the US.
But ITC owns no generation assets. They focus completely on transmission alone. That means the risk of changing generation doesn’t really impact them as heavily as integrated utilities. This is basically a play on infrastructure, which remains valuable and important (even increasingly so), in my view.
Not only that, but they’re specifically building out new projects (like the Thumb Loop Project) that are designed to carry electricity from far-out wind generation and newer natural gas generation to city centers where the electricity is needed. This “future-proofs” them somewhat, especially relative to some of the major incumbent utilities that have transmission assets based on older generation, like coal.
Continued investment in their network of infrastructure adds to their competitive advantages while also bringing in new customers. A five-year plan, unveiled in 2014, involves the company spending $4.5 billion on investments, which should allow them to effectively and efficiently compete for years to come.
The company’s scale is a competitive advantage as well, backed by regulation. The Federal Energy Regulatory Commission will only permit additional transmission lines if there is a demonstrated source of demand, but with ITC already competing effectively (and essentially alone) in their areas, and combined with their history of successful investment, they’re heavily entrenched in the Upper Midwest. Meanwhile, the company is also remaining open to expanding beyond this area, including internationally.
That positive regulation relationship extends to the rates that ITC can charge. To spur investment in infrastructure and transmission, incentive-based rate treatments exist by the FERC, allowing a transmission company like ITC to benefit fully.
I see this favorable environment playing out in their growth and profitability, leading me to believe that this is one of the best possible investments that exist in the Utilities sector.

Risks

While ITC faces essentially no competition across each of their MISO regulated operating subsidiaries (since they operate as the primary transmission service in their respective areas), competition could increase in the future, especially as a result of Order 1000, which amends certain planning and cost requirements.
Traditional integrated utilities could choose to build out their own transmission networks, which could add to the competitive environment, limiting returns and investment opportunities for ITC.
Like most utilities, ITC carries fairly significant debt on their balance sheet. Rising interest rates could constrain growth in the future.
An increase in solar power generation at the point of consumption could limit demand for transmission in the future.

Valuation

The stock’s P/E ratio is 21.75, which compares favorably to the five-year average of 22.5. And, unlike a lot of other utilities out there, I don’t think ITC’s P/E ratio has been unfavorably skewed due to the flight to income. So I think this is an apt comparison, relatively speaking, and also a very reasonable P/E ratio when looking at the growth. Many stocks growing at much slower rates require investors to pay even more than $22 for every $1 of profit.
I valued shares using a two-stage dividend discount model analysis with a 10% discount rate. I then assumed an initial dividend growth rate of 13% for the first ten years, with a terminal rate of 7%. The initial dividend growth rate is in line with recent raises and the forecast moving forward, while also factoring in the modest payout ratio. All in all, I think a mild margin of safety is there in the assumptions. The DDM analysis gives me a fair value of $37.90.
Pretty much every valuation metric you can look at (price/book, price/sales, yield, etc.) is currently lower than the five-year average, even though the company is showing no signs of slowing. The stock is down about 18% since the start of the year, which I think is presenting a long-term opportunity here. The stock appears at least 10% undervalued to me; an argument could be made it’s closer to 15% undervalued, or more. Either way, a margin of safety appears to be present in today’s valuation.

Conclusion

I don’t invest in utilities lightly or often, as I already discussed. But I think the focus on transmission and clean energy really makes a lot of sense here. Infrastructure investment is so necessary and infrastructure itself is so valued that ITC is able to garner favorable returns on its investments that exceed traditional utilities. Combined with the fact that this company doesn’t need to worry about bringing generation into the 21st century, and I like their chances.
The fundamentals across the board aren’t just outstanding for a utility, they’re outstanding for any company operating any business model. If there’s a utility that’s growing this fast and trading at a cheaper price – and one that will likely increase its dividend at a double-digit rate moving forward – I’m not aware of it.
The yield isn’t up to par with some other utilities out there, but the dividend growth, total returns, and overall quality far exceed most, if not all, I’ve ever come across. Overall, I’m very happy with this investment here and excited to see how the next decade or two pans out.
This purchase adds $19.50 to my annual dividend income, based on the current $0.165 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates ITC as a 5/5 star valuation, with a fair value estimate of $42.00.
S&P Capital IQ rates ITC as a 4/5 star “buy”, with a fair value calculation of $36.60.
I’ll update my Freedom Fund in early August to reflect this recent purchase.
Full Disclosure: Long OGS, OKE, and ITC.
Ever look at ITC? Like what you see? Think this is an interesting opportunity here? 
Thanks for reading.

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