Profit From Red Tape and Government Mandated Growth

Joshua is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is obvious that America needs to update her energy infrastructure and the government is willing to offer high ROE in order to spur new investment. Still, the approval of new interstate transmission lines can be a very costly and drawn out process. These political barriers benefit current insiders as they raise the barriers to entry. The strongest players in the transmission market are set to grow and profit along with government approved prices. 

The cost of green energy continues to fall, though the development of a significant amount of utility-scale generational capacity is still lacking. A major road block to a smarter and updated electricity grid is the lack of transmission infrastructure. Regardless of the future significance of renewable energy sources, America's transmission network needs significant investment in order to maintain a stable flow of power on which the economy can grow. The blackout in 2003 showed just how crucial it is that America maintains a modern and efficient grid. 

<img src="http://media.ycharts.com/charts/d2d7d9a3e0bdd873cc4901d694e92fc6.png" />

AEP Return on Invested Capital data by YCharts

American Electric Power (NYSE: AEP) is a major U.S. utility with EBIT over $2 billion. Their transmission assets are very diverse and include more than 2,100 miles of 765kv high voltage lines. 765kv transmission lines are a very efficient way to transmit large amounts of power because of their high voltage. American Electric Power is primarily a utility and as such their 39,000 miles of transmission lines only contribute a small portion of earnings. In the first three quarters of 2012 transmission operations contributed 2.5% of income before extraordinary items. The Ohio energy market is slowly undergoing a deregulation process which is forcing the firm to reorganize their assets. This instability is a negative aspect of the firm as regulated markets provide more stable earnings and ROIC. Their total debt to equity ratio of 1.20 is reasonable and their ROI of 5.10% is strong. At a P/E ratio of 14.0, American Electric Power is trading at a low valuation with a strong yield of 4.2%.

ITC Holdings (NYSE: ITC) is a pure play on the transmission market and a company which offers great growth prospects. The blackout in 2003 convinced the government of the need to update America's energy infrastructure. In order to help spur investment the government is willing to offer higher than average ROE. ITC Holdings' five year investment plan from 2011 to 2016 expects to generate a 15% to 17% CAGR in EPS. The company's Great Plains expansion project involves 5 projects and more than 2,700 miles of new transmission lines. 

This growth is already reflected in the company's stock price. The firm trades at a P/E ratio of 22.8 and a yield of 1.9%. Their total debt to equity ratio of 2.27 is rather high, but the steady nature of the transmission industry gives very consistent cash flow for debt payments. At current prices ITC holdings is too expensive. Regardless, it is a great utility to watch given its unique position and growth prospects within the sector. 

FirstEnergy (NYSE: FE) is another diversified utility which is involved with American Electrical Power Company in the deregulation of the Ohio market. Regulated transmission services play an important part in this company's bottom line and in the first three quarters of 2012 regulated transmission services contributed 18.6% of earnings. They recently constructed a new 500kv line from Virginia to Pennsylvania with a FERC approved ROE of 12.7%. FirstEnergy operates in Ohio, Pennsylvania, New Jersey, New York, Maryland, and West Virginia. Their current P/E ratio of around 16.0 and their total debt to equity ratio of 1.39 are close to the industry norms. FirstEnergy's current ROI of 3.7% and profit margin of 6.6% make American Electric Power appear to be the better run firm. FirstEnergy offers a yield of 5.5% and another way to enter into the transmission market. 

Conclusion

The utility industry is dominated by a number of regulatory agencies and a small number of utilities. Although the nation's transmission network does not get the same amount of press as the latest power plants, both form crucial parts of the United States' economic base. The growth of wind and solar coupled with the need to replace dilapidated infrastructure has pushed the transmission industry to the forefront. The government is offering higher than average ROE in order to spur investment and companies can benefit accordingly. ITC holdings, a pure play on the transmission market, is rather expensive. American Electrical Power is a diversified utility with a large amount of transmission lines, but its earnings are dominated by its generational assets. FirstEnergy does not have a strong ROIC though its yield of 5.5% provides some degree of compensation. The United States will continue to grow over the coming decades. Keeping a watchful eye on the transmission market will provide a number of investment opportunities as stock prices fluctuate. 


MrCanadian1 has no position in any stocks mentioned. The Motley Fool recommends ITC. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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