Tag Archives: opinion

ITC Holdings: For Regulatory Risk-Averse Utility Investors

ITC Holdings is the largest independent FERC-regulated transmission utility with interesting growth opportunities. Even with the potential for lower allowed return on equity, ITC Holdings should generate 20% higher income per investment dollar compared to average state-regulated investments. The current share weakness has caused historical premium valuations to evaporate, creating a great long-term entry point. Morningstar has an interesting take on ITC Holdings (NYSE: ITC ). One key element of utility investing is the relationship between a specific utility’s geographic location and the regulatory environment in which it operates. Nowhere is this relationship more obvious than the current stand-off playing out in state regulatory offices across the country between distributed generation with rooftop solar and its impact on the base-load power generation profile of a specific utility. According to its fact sheet , ITC is an electric transmission company with a federally regulated rate base of $5.2 billion. The Federal Energy Regulatory Agency, FERC, is the rate-setting body for interstate transmission assets, and oversees 100% of ITC’s regulated revenues. ITC is the largest publicly traded transmission company, and operates one of the leading networks with 15,600 miles of high-voltage lines. This differentiator makes the company a unique player in the regulated utility sector. At the core of its lower risk are the higher allowed returns offered by the FERC versus the average state-regulated return on equity ROE. In an effort to draw needed investment capital to expand and upgrade the grid, the FERC has allowed a higher return on equity than the states, on average, have allowed. For instance, since going public in 2005, ITC’s FERC-allowed ROE has fluctuated between 12.1% and 13.8%, while the average state-regulated allowed ROE has been falling. The chart below from Edison Electric Institute plots the average awarded allowed ROE as of June 30, 2015, by quarter. As shown, the average state public utility commission PUC-approved ROE is substantially below those allowed for ITC’s equity investment. The most recent quarterly average from the EEI chart is a 9.73% ROE. The current rate mechanism approved by the FERC allows various ITC subsidiaries to earn the following ROE: ITC Transmission, 13.88%; METC, 13.38%; ITC Midwest, 12.38%; and ITC Great Plains, 12.16%. A comparison of federal versus state regulation is addressed in the most recent investor presentation PDF. The slide below outlines a few of the basic differences: (click to enlarge) Last year, Northeast consumer groups petitioned the FERC to lower its allowed ROE, and after a divisive skirmish, the FERC relented and is reducing allowed returns. The new rate approved for ISO New England transmission assets for ITC should be 11.7%, including a premium allowed for being an independent company. The FERC is under pressure to institute this rate across the country. Even with the potential lower rate, ITC could earn 20% more income from the same investment dollars compared to the most recent average state-approved ROE. This differential is the backbone of the company’s lower risk. From Morningstar’s analysis : “In our opinion, FERC’s formula rate-setting methodology is the most stable and least subject to political influence of any utility regulation in the United States. Therefore, we believe there is little risk of adverse regulatory decisions that would result in allowed returns below the average 10% state-level utilities returns or modify FERC’s favorable regulatory framework. This favorable regulatory framework covers 100% of ITC’s revenue and provides predictable earnings and cash flow. We believe the reduced risk associated with FERC regulation results in a lower average cost of capital than the typical utility.” Recently, its share price has been falling with the rest of the sector. The utility average peaked in January, and has fallen 15% since. ITC peaked in January as well, and has fallen 26% from $44 to its current $32.50. ITC stock has lost a bit of its love from analysts, with the current recommendations being two “Sell,” five “Neutral” and two “Buy.” The concern is based on the reduced ROE potential. However, ITC’s aggressive capital expenditure budget should partially offset lower ROE, driving earnings ahead by 8-12%. Currently, the company is forecast to invest $757 million this year, $852 million next and $818 million in 2017. Over the next three years, ITC’s regulated asset base could grow by over $2.2 billion. This capital expansion will be financed by $1.14 billion in new debt and the balance from internally generated funds. The company generates over $500 million in operating cash flow and pays out $100 million in dividends. Speaking of dividends, ITC recently raised its dividend by 14%, and the payout ratio remains well below the industry average at 38%. Utilities are generally considered to have a low payout ratio if it is below a 60% threshold. Earnings growth is expected to decline a bit to the 8-11% range. However, with a low payout ratio, the company’s dividends could continue to increase substantially above its EPS trend and still be below that of its peers. In an interview with the trade publication TransmissionHub , ITC management discusses two interesting expansion plans. It is proposing the first ever bi-directional connector from Ontario, Canada directly into the PJM grid at Erie, PA. The project is called the Lake Erie Connector, and the high-voltage cable connection would include 73 miles of underwater installation. The project is currently out for bids to potential customers and, if approved, the Lake Erie Connector could cost $1 billion. The second expansion opportunity is a joint venture with NRG Energy (NYSE: NRG ) and a private equity firm to rescue the Puerto Rican electric utility, Puerto Rico Electric Power Authority PREPA. After years of mismanagement, PREPA is on the verge of bankruptcy, driven partially by the need for capital expenditures to upgrade aging power plants to meet new environmental standards. Some generating plants are over 50 years in age and fail miserably in their pollution profile. An article published in Puerto Rico’s main business magazine, Caribbean Business , outlines the $3.3 billion proposed project: “The $3 billion investment would be used to expand PREPA’s existing liquefied natural gas-delivery infrastructure (in the range of $200 million); to bring online new combined-cycle, natural gas-turbine (CCGT) power generation and repower existing PREPA generation (1,200 to 1,500 megawatts [MW]) with investment ranging from $1.5 billion to $1.8 billion, and new renewable generation through solar power (300 to 400 MW) costing nearly $1 billion. The truth is that the coalition brings together three entities that could give PREPA a fighting chance to revitalize its obsolete infrastructure. York Capital, backed by more than $26 billion in assets, has vast experience in restructuring distressed assets; NRG Energy, a $33 billion energy company operates the largest conventional- and renewable-power generation portfolio in the mainland U.S.; and ITC Holdings is the nation’s largest independent electric-transmission company.” Morningstar, as usual, outlines the bull and bear case very succinctly for ITC: “Bulls say: ITC increased its annual dividend by 14% in 2014 and we expect annual increases to average close to 13% during the next five years. MISO expects capacity shortfalls, where the majority of ITC’s assets are located. The generation replacing the coal, mostly natural gas and wind, will require changes to the transmission grid providing substantial new investment opportunity for ITC. Management’s focus on high-voltage electricity transmission should result in better operating efficiency compared with integrated utilities that also have generation and distribution assets. Bears Say: An industrial group has asked FERC to cut ITC’s base allowed return on equity in MISO to 9.15% from 12.38%. An unfavorable outcome would result in lower allowed returns and dividend growth for ITC. ITC Great Plains and ITC Midwest have several competitors proposing transmission system development to move wind power from the Dakotas and Kansas east to load centers. Competition could limit growth opportunities. Several traditional regulated utilities have initiated plans to expand existing transmission or build new lines creating increased competition for ITC.” Below is a F.A.S.T. Graph for ITC going back to its IPO in 2005. Notice both the year-end dividend yield (red line) and the historical P/E (blue line). (click to enlarge) S&P Capital IQ offers a Quality rating for stocks trading longer than 10 years. ITC recently qualified for this evaluation, based on its 10-year history of generating earnings and dividend growth, two important criteria for dividend and utility investors. Company management has generated sufficient consistent growth to qualify for an A+ rating, which is reserved for only about 45 of the 4500 companies followed by S&P. Utility investors looking for a growth stock with high dividend growth potential and a lower regulatory risk profile should review ITC. With the current share price weakness, the company’s historical valuation premium has been reduced to virtually zero, as ITC trades in line with its slower-growth, state-regulated peers at a P/E of 15, when its historical P/E is in the 23 range. In addition, the company has not offered a 2.7% yield since year-end 2008. Now would be a great time to either institute a position or to add to an existing one. Author’s Note: Please review disclosure in author’s profile.

I’ll Take VNQ Over The Federal Reserve: Benefit From Low Rates

Summary The Vanguard REIT Index ETF is holding a diversified portfolio of REITs that can benefit from low rates. Wage growth is a bullish factor for domestic demand. Inventories at high levels relative to sales are bearish, but goods are frequently imported rather than built domestically. If the Federal Reserve follows the mandate to maintain high employment, they will need to keep rates low. The Vanguard REIT Index ETF (NYSEARCA: VNQ ) has been one of my core portfolio holdings and I don’t foresee it going anywhere. The fund offers investors a very reasonable expense ratio of .12%, a dividend yield running a hair under 4%, and a large degree of diversification throughout the industry as demonstrated in its sector allocations: Weak Bond Yields The yield on the 10-year treasury has dipped under 2% and I don’t expect it to end the year much higher. Our economy is depending on very low interest rates, which can be a boon for the equity REITs as it offers them access to lower cost debt financing for properties. Why Treasury Yields are Limited The Federal Reserve is largely incapable of pushing rates up. It might be technically possible for them to have some influence in pushing the rates higher, but it would be a disastrous scenario. The Federal Reserve is facing a dual mandate for low and steady inflation combined with high employment. If domestic interest rates are increased, it would encourage further capital flows into the country as globally investors would seek the security of buying treasuries. The predictable impact would be a stronger dollar that encouraged companies to ship more jobs abroad and a decline in domestic asset prices due to the “cheaper” goods being imported. Essentially, when interest rates are rising, it will need to be across the globe. Raising interest rates in only one developed country is asking for problems when the tools of production can be operated on a global scale. I understand investors are clamoring for respectable low-risk yields, but increasing rates is not practical. If Those Yields Stay Low If the bond yields are remaining low, investors are going to be searching for yield in other places. With that dividend yield around 4%, VNQ is one viable option for providing some yield to the portfolio. It isn’t just demand for the shares of the REIT, though. The REIT industry has another tailwind that makes it more favorable. Wage Growth is Bullish Some major employers like Wal-Mart (NYSE: WMT ), Target (NYSE: TGT ) and McDonald’s (NYSE: MCD ) have announced very substantial increases in their base wages. This is finally showing that domestic companies are finding value in their own employees. When capital is not flowing to labor, there is less demand in the society for physical goods. As corporate earnings were climbing in previous quarters, there wasn’t enough capital flowing back to “Main Street.” A growth in wages here should help combat weakness in sales for the corporate sector. This growth in wages is a favorable sign that major employers are seeing value from labor. Many investors may scoff that the jobs provided by these employers are creating “low wage” or “low class” jobs. That makes the increase in wages even more important. In a recovery in which too many of the new jobs were failing to provide material levels of income for workers, there is finally an increase near the bottom of the pyramid. Increasing Inventories to Sales is Bearish The following chart compares inventory levels with sales: (click to enlarge) We are seeing a growth in inventory levels, which is a dangerous macroeconomic sign, as higher inventory levels encourage companies to cut production. If the physical production is reduced, there is less demand for workers. That could bring us back towards higher levels of unemployment and weaker wage growth at the bottom of the pyramid. It also indicates that earnings could take a substantial hit. Weaker Earnings Projections Should Force Rates Down For the investors that are not familiar with the accounting for inventory costs, it is important to state that higher levels of production generally stretch fixed costs across more units of production. When companies have to cut production due to inventory levels becoming too high, it results in higher costs of production. Those higher costs can effectively be wrapped into the “inventory” line item and the expense won’t pass through the income statement until the inventory is sold. When the inventory is sold, the higher costs of production flow through the income statement as “cost of goods sold.” The REIT Impact If increasing inventories results in a large reduction in labor in the United States, it would be a problem for REITs as it would signal deteriorating fundamentals. On the other hand, a great deal of inventory comes from imports and a reduction in imports would not have the same dramatic impact. According to ABC news , in the 1960s only 8% of American purchases were made overseas. Now that value is greater than 60%. Whether we talk about residential REITs, office REITs, or retail REITs, a lack of domestic employment would be a bearish sign that would indicate a reduction in the consumption of goods. For residential REITs, the impact would be a drop in the amount of demand for apartments as unemployed workers are not a solid renting demographic. For the office REITs, there is a lack of demand for office space if the companies renting that space find their sales diminishing and must cut their costs. The retail REITs face a similar problem to the office REITs as they depend on consumers buying products from their tenants. Why I’m Still Holding onto VNQ The potential for weakening levels of employment as evidenced by factors like the increase in inventories relative to sales is a material concern. Despite that concern, I choose to remain long VNQ. The increasing inventories are a concern, but imports still fund a substantial portion of inventory. If rates were rising and forcing the dollar to appreciate even further, it would be a serious risk factor for the REITs, but it would also be a challenge directly to the mandate of full employment. So long as the Federal Reserve is following that part of their mandate, they will be forced to keep the rates low. That provides support to share prices as investors seek yield and it provides support to the underlying business by keeping the cost of debt capital lower. Because the REITs can benefit from a low cost of capital and the impact of higher wages, they are in position to gain twice. On the other hand, if I’m wrong and the Federal Reserve does opt to start jacking up short-term rates, then I’ll be eating some nasty losses on my portfolio value. I can’t be certain that I’m right, but I’m confident enough that I am holding VNQ and the Schwab U.S. REIT ETF (NYSEARCA: SCHH ) in my portfolio .

Why I’m Reiterating Income Investors Buy Consolidated Edison Instead Of Southern Company

Summary Southern Company’s 4.8% dividend yield beats many of its sector peers. But that is mostly because of Southern’s declining stock price in 2015. Fundamentally, Southern is struggling. Its revenue and core earnings are declining, due to major cost overruns at its Kemper project. Meanwhile, ConEd allows investors to sleep well at night, which should be the main concern when buying utility stocks. As a result, I continue to favor ConEd over Southern. Income investors are likely drawn to Southern Company (NYSE: SO ) and its 4.8% dividend yield. But Southern has given investors a number of headaches over the past year related to its massive Kemper project. Repeated completion delays and cost overruns have negatively affected Southern’s earnings over the past year. This has caused Southern to underperform many of its peers like Consolidated Edison, Inc. (NYSE: ED ) so far this year. Even though Southern Company’s dividend yield beats ConEd’s, I think ConEd is the better utility stock to buy. ConEd’s 4% dividend yield slightly trails Southern’s yield, but that is only because Southern’s stock price has declined this year. Investors should think about total return, and not just dividend yield, when evaluating an investment opportunity. ConEd has much smoother earnings growth, while Southern’s earnings are unusually volatile, especially for a utility. For these reasons, I recommend income investors consider ConEd instead of Southern. Trouble Lurks On the surface, there doesn’t seem to be anything wrong with Southern. Earnings per share grew 1% last quarter , and 15% in the first six months of 2015, year over year. That looks quite strong at first glance. But there are a number of caveats that make Southern’s true underlying earnings much less impressive than they appear. First and foremost, Southern is benefiting from a very easy comparison. Last year’s quarterly results were heavily weighed down by huge charges against earnings, due to the Kemper project. This has made Southern’s 2015 earnings results show solid growth, but that is only because last year’s numbers were so badly depressed. If you strip out the excess charges throughout 2014, Southern’s adjusted earnings are actually down 4.4% through the first six months of 2015. Therefore, investors looking at the headline reported numbers only may get a distorted image of Southern. The fact that excess cost overruns at Kemper have moderated somewhat this year is not exactly cause for celebration. Southern’s operating revenue declined 6.5% over the first six months of 2015, year over year, which is a disturbing indicator of the company’s shaky underlying fundamentals. This is why Southern’s stock price is down 8% year-to-date. Plus, the forward-looking picture is cloudy at best. Southern now anticipates the Kemper project will not be placed into service until after April of 2016. This will result in $15 million in additional total costs. Moreover, the company expects to incur $25 million-$30 million in additional costs each month for deferring the start-up beyond March, and another $20 million per month in financing and operating costs. If that weren’t bad enough, because the project will be delayed beyond April 19, Southern would be required to return $234 million to the IRS, which is what the company had received in prior tax credits for the project. In its press release, Southern vowed that its customers will not foot the bill for the added costs. Since there are no free lunches, someone has to foot the bill, and that someone will be Southern and its shareholders. As a result, while things are “less bad” this year than last year, it appears there is more trouble in store for future quarters. Reiterating My Preference For Consolidated Edison Income investors may see Southern’s higher dividend yield and stop there. But dividend growth is a consideration as well, and if Southern’s revenue and core earnings continue to decline, the company may not be able to maintain dividend growth that meets inflation. Southern has paid a dividend for 271 consecutive quarters, dating back to 1948. For its part, ConEd is no dividend slouch. It has increased its dividend for 41 years in a row. This makes ConEd a Dividend Aristocrat, while Southern is not. More importantly, Southern is struggling to grow revenue and earnings consistently, and Kemper is only exacerbating the problem. Meanwhile, ConEd gives investors stable revenue and earnings growth, as the company has not had nearly as many operating issues as Southern. For example, ConEd grew EPS by 3% last year, and is off to another good start to the current year. ConEd’s core earnings per share are up 11% through the first six months of 2015, year over year. Going forward, investors should continue to enjoy stable earnings growth. The company expects full-year earnings to reach $3.90 per share-$4.05 per share. At the midpoint of its forecast, that would represent 6.5% earnings growth from 2014, which would be a very solid earnings growth rate for a utility. I last wrote about my preference for ConEd over Southern in this article , dated June 15. Since the day that article was published, ConEd has outperformed Southern by 10 percentage points. Given Southern’s inability to get things right at Kemper, and ConEd’s solid growth, I expect ConEd’s outperformance to continue. Disclaimer : This article represents the opinion of the author, who is not a licensed financial advisor. This article is intended for informational and educational purposes only, and should not be construed as investment advice to any particular individual. Readers should perform their own due diligence before making any investment decisions.