ITC's Wide Moat Intact

A wide economic moat and the Federal Energy Regulatory Commission's desire to improve the U.S. electricity transmission grid by providing incentive rates to transmission companies have produced healthy returns on capital and strong earnings growth for

ITC's rates are based on allowed returns on equity that are relatively high compared with state-allowed returns for most other utilities. However, ITC's average allowed returns will probably decline in 2016. We believe continued low interest rates and the FERC's new methodology for calculating allowed return on equity in the June 2014 ISO New England decision increased the downward pressure on transmission investment allowed ROE. Despite this pressure on allowed returns, we still expect ITC's increasing capital expenditures to drive approximately 8% average annual earnings growth and almost 13% annual dividend increases during the next five years.

The FERC stated in the ISO New England decision that transmission ROEs should be greater than state commission ROEs for generation and distribution investments in order to increase investment levels and attract low-cost capital. Public policy to increase grid reliability, enhance wholesale market competition, and facilitate transmission of wind and other renewable generation to customers drives this support. We believe these trends combined with FERC policy are likely to continue for the foreseeable future, keeping ITC's wide moat intact and providing returns well above the company's cost of capital.

The FERC's formula-based rate mechanism is more transparent and regulatory decisions are less influenced by politics than state utility commissions. 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 for ITC than for the typical utility.

Transmission Assets Benefit the Moat We believe an efficient scale competitive advantage gives ITC a wide economic moat. Competitors have little incentive to build competing transmission lines if one that ITC owns already is serving a market's full capacity. Capital costs for new transmission lines are too high and incremental benefits too low to offer sufficient returns on invested capital for two competing transmission owners. In addition, ITC benefits from regulatory protection. The FERC approves new transmission lines only if there is a demonstrated need for new capacity.

In exchange for regulatory protection, ITC must charge 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. This rate treatment is more investor-friendly than typical backward-looking rates that require a utility to invest the capital before collecting a return on that capital. We believe the transparency and predictability of the formula rate mechanism result in a below-average cost of capital for ITC and support stable cash returns.

The economic benefits of transmission investment in the United States have led the FERC to offer higher returns for independent transmission companies, like ITC, than for integrated utilities. The FERC has two primary objectives, the first of which is to improve grid reliability that was shown to be inadequate during the 2003 blackout that stretched from Ohio to New York City. Second, the FERC wants wholesale power markets to be more competitive by providing increased access to different generation sources over a larger geographical area. The FERC also must support energy policy initiatives such as reducing greenhouse gas emissions and optimizing advancements in technology, like horizontal drilling and fracking, that have driven down the price of natural gas and made natural gas-fired generation competitive with coal-fired and nuclear plants.

Apart from regulatory considerations, ITC's transmission assets offer two economic benefits that should allow the company to continue earning economic returns. First, ITC's lines can arbitrage rate differences from one region with excess low-cost power to a constrained region with high energy costs. As long as customer costs for the transmission investment are lower than the energy cost savings, regulators should use incentives to encourage development. Second, transmission is the only way to support state and federal renewable energy policy. If costs to produce renewable energy locally are higher than the cost for transmission and renewable energy in another region, regulators can offer incentive returns to encourage transmission development.

ITC's first development project, the 13-mile 230-kilovolt Jewell-Spokane transmission connection in southeastern Michigan, is an example of the customer cost savings. Total project costs were about $8 million and the line has improved reliability and saved electricity customers roughly $60 million per year since 2004. The extra cost of ITC's FERC-allowed 13.88% ROE compared with the 10% ROE for the state-regulated utility is about $300,000 per year, a fraction of the annual customer savings that has been realized.

ITC's competitive advantages and the favorable FERC regulation have allowed the company to earn well above its cost of capital since it came public in 2005.

Fair Value Uncertainty Is Low In our opinion, the FERC's formula rate-setting methodology is the most stable and least subject to political influence of any utility regulation in the U.S. Therefore, we believe there is little risk of adverse regulatory decisions that would result in allowed returns below the average 10% state-level utility returns or modify the FERC's favorable regulatory framework.

We believe the most significant risk for ITC is an acquisition or development project that is too expensive or requires a rate freeze that materially hurts earnings. That said, management has been disciplined in the past. It has agreed to returns below those allowed by the FERC, but higher than typically allowed by state regulators.

ITC continues to grow rapidly as it invests in projects that receive returns well above its cost of capital. To fund this expansion, we estimate that ITC will add roughly $400 million of debt annually during the next five years. In addition, the company began a $250 million share-repurchase program in 2014 that is expected to be completed by the end of 2015. As a result of ITC's ongoing capital expenditures and the share buyback, we expect debt/total capital to average in the low 70s during the next five years. This is higher than the typical regulated utility, but we believe the FERC's formula-based rate-setting mechanism offers more stable cash flows to support the higher leverage.

Strategic Execution Sets Management Apart We assign ITC's management team an Exemplary stewardship rating for its vision and execution of strategy. Management provided a clear explanation of strategy at its IPO in 2005 and then executed on this strategy. The IPO was an unqualified success, and the acquisitions of METC and ITC Midwest proved to be good use of shareholder capital.

Management has completed development projects on budget and on schedule or abandoned them early in the process to minimize impaired capital. This discipline will be critical to maintain as the company takes advantage of its huge growth opportunities.

ITC's strong earnings growth has cut its payout ratio (on adjusted earnings) to the low 30s. ITC has stepped up its dividend increases and in 2014 increased its common dividend 14% versus increases that averaged about 5%-6% before 2013. Management targets 10%-15% annual dividend increases, and we project this will result in a payout ratio around 40% by 2019. This dividend payout will continue to be well below the 60%-75% range of traditional regulated utilities. However, we believe this below-average payout ratio is appropriate, given ITC's attractive investment opportunities.