July 8, 2008

Sempra: A Smart Move in Utilities

San Diego's Sempra Energy (SRE; recent price, 56) currently trades at a small discount to its natural gas utility peers' estimated 2009 price-earnings ratio, a level we think leaves ample room for expansion of the price-earnings ratio.

We expect the average price for multi-utility stocks in our coverage group to appreciate 15% over the next 12 months, assuming no changes to the fundamentals of the companies in the group. In addition, we believe Sempra's fundamentals, quickly growing unregulated operations, opportunities for growth in its regulated operations, and what we see as its compelling valuation will attract investors to the stock and help push the stock's valuation to higher levels compared with peers.

By our analysis, Sempra's business model provides it with the opportunity to achieve earnings per share [EPS] growth higher than the peer average over the next five years, starting in 2008. We see utility regulatory settlements being enacted as well as utility projects that will increase the company's rate base. Unregulated businesses growth has been and will continue to be extremely strong, in our view, helped by the company's many growth projects. We also believe Sempra's balance sheet provides it with a great deal of financial flexibility. The stock carries Standard & Poor's highest investment recommendation of 5-STARS [strong buy].

Business Profile Sempra Energy is divided into five segments: Sempra Utilities; Sempra Pipelines & Storage; Sempra LNG; Sempra Generation; and Sempra Commodities. Sempra Utilities includes the company's two regulated utilities, San Diego Gas & Electric [SDG&E] and Southern California Gas. The other segments are mostly unregulated companies.

Sempra Utilities

SDG&E distributes gas and electricity to 1.4 million electric meters and 830,000 gas meters in a 4,100-square-mile area in and around San Diego. Southern California Gas distributes gas to 5.7 million gas meters in a 20,000-square-mile area of Southern and Central California. Both of the utilities have agreed to general rate case settlements and are waiting for regulatory permission to implement the new rates. Together, the rate hikes amount to a 7% increase in 2008 [$197 million], and average annual increases of 3% through 2012 [$96 million]. Sempra expects the segment to increase net income at a 6% compound annual growth rate [CAGR] through 2012.

Sempra plans utility capital expenditures totaling $1.2 billion in 2008 and about $1.6 billion in 2009. We believe most of the expenditures should expand the company's rate base, leading to future growth in net income.

Sempra Pipelines & Storage

Sempra Pipelines & Storage owns several pipelines and a number of gas and electric distribution utilities in Argentina, Chile, Mexico, and Peru. The company owns 100% of Gasoducto Bajanorte, a 140-mile, 0.5-billion cu. ft. per day [Bcfd] pipeline that stretches across northern Baja California, Mexico; a 25% interest in the $4.9 billion, 1.8-Bcfd Rockies Express Pipeline [REX] pipeline; and 100% of Transportadora de Gas Natural de Baja California, a 23-mile, 0.3-Bcfd pipeline that extends from the Pacific Coast to the western end of the Bajaducto pipeline and then north to SDG&E's gas system. The existing portion of the REX pipeline stretches 1,041 miles from Rio Blanco County, Colo., to Audrain County, Mo., the western 713 miles of which opened for business in December 2007. The REX pipeline is fully contracted through 2019.

Part of Sempra's largest project, REX-East, is expected to start construction in the near future and be completed by mid-2009. Construction has been completed on the $215 million Gasoducto Bajanorte expansion, which includes a 2.6-Bcfd extension to connect Sempra's Energia Costa Azul LNG station to the pipeline, and is preparing to become commercially operational. Sempra also expects to complete the 0.6-Bcfd $170 million Cameron Pipeline in the third quarter of 2008. The company has also signed an agreement to acquire a 25% stake in the Sunstone project, a proposed 585-mile 1.2-Bcfd pipeline to transport gas from Wyoming to Western markets through an interconnection with other pipelines in Oregon.

Future opportunities include a REX pipeline extension east of Ohio, a 770-mile pipeline to connect the REX pipeline to the Chicago markets, expansion of the Liberty Gas Storage system, and development of additional storage projects, possibly in the Northeast or Gulf regions.

Sempra recently entered the natural gas storage business with investments in the $250 million, 15-Bcf Liberty Gas Storage facility, which is expected to begin commercial operations shortly. The $250 million, 17-Bcf Liberty South Gas Storage project is projected to begin operations in mid-2010, pending regulatory approvals. With the commencement of operations at many projects, Sempra expects a segment net income CAGR of 18% through 2012.

Sempra LNG

Sempra LNG owns and develops North American LNG receipt terminals. Its first project, the Energia Costa Azul LNG terminal, has an initial capacity of 1 Bcfd and has received approvals to expand to 2.6 Bcfd. Located on Mexico's Pacific coastline, the terminal has contracted 100% of its existing volumes for 20 years. A second project, the Cameron LNG terminal in Louisiana, will have an initial capacity of 1.5 Bcfd and is expected to be completed in late 2008. The terminal can be expanded to 2.65 Bcfd under current regulatory approvals. Currently, Cameron's capacity is 40% contracted for 20 years, and Sempra is seeking to contract the remaining capacity; the company believes it should be able to contract the remaining capacity by 2012. Sempra expects segment net income to turn positive in 2009 and then to grow rapidly through 2012.

Sempra also has the regulatory approvals to build a 3-Bcfd LNG facility at Port Arthur, Tex., but has delayed development because of lack of contracts. In addition, it is exploring the possibility of developing an import and export facility for crude, petroleum products, and liquid petroleum gases next to the proposed LNG site. Sempra expects that any expansions of the LNG facilities would become operational after 2012.

Sempra Generation

Sempra Generation owns 2,630 megawatts [MW] of natural gas-fired generation that serves the Southwest and Southern California. The plants' on-peak output is 75% contracted and off-peak output is 79% contracted through the third quarter of 2011, mostly under a California Dept. of Water Resources [CDWR] contract. At the end of the CDWR contract period, SDG&E plans to purchase the 480-MW El Dorado plant in Nevada for book value. As a result, Sempra estimates the segment's net income will decline about 23% in 2012.

There are several growth opportunities for the segment, in our view. The company is developing a 640-MW natural gas-fired combined cycle plant in Catoctin, Md., that is expected to become operational in 2011. Sempra believes the market's constrained transmission and growing demand will support the plant. Separately, California's renewable energy standards mandate that 20% of power supplies must come from renewable sources. As a result, the company has signed a contract with Southern California Edison to supply 250 MW from its La Rumorosa wind power project in Baja California, Mexico. The initial 250-MW phase of La Rumorosa is expected to become operational in mid- to late-2010. The company also has plans to develop an additional 750 MW.

RBS Sempra Commodities

On Apr. 1, 2008, Sempra Energy formed a joint venture with the Royal Bank of Scotland (RBS) by contributing its commodities trading business in exchange for a 49% share of the joint venture named RBS Sempra Commodities, the return of $1.2 billion in cash collateral, and a preferred earnings sharing agreement. RBS will effectively manage the venture, while Sempra will have veto authority over substantial changes to the joint venture. However, the earnings sharing mechanism is structured in a way we believe motivates RBS to grow earnings swiftly.

We believe Sempra will add leverage to its balance sheet given lower business risk resulting from the placement of the commodities business into the joint venture. We think RBS brings a strong financial position to the partnership and has taken on counterparty risk that previously had tied up substantial portions of Sempra's cash. Because of the return of the $1.2 billion in cash collateral, received at closing, Sempra has begun the first phase of a planned share repurchase program of $1.5 billion to $2 billion, with a $1 billion accelerated share repurchase expected to be completed by the end of 2008's fourth quarter. As a result of flexibility afforded by the joint venture, Sempra will be able to issue debt. The company intends to increase its debt-to-capital ratio and generate cash for completion of the planned share repurchases. Total planned share repurchases are substantial, potentially reaching 10% to 14% of Sempra's $14 billion market capitalization on July 3, 2008.

Additionally, the steadier earnings stream expected from the venture has allowed Sempra to increase its dividend to $1.40 from $1.28. Sempra plans to pay out 35% to 40% of its earnings as dividends, which should lead to the potential for double-digit dividend growth over the next few years based on our earnings estimates.

Company Strategy Sempra's strategy is centered on growth projects at all of its primary businesses, while maintaining financial flexibility and enhancing shareholder value. We have a positive view of the company's financial goals, which include increasing EPS 11% annually from 2008 through 2012; repurchasing $1.5 billion to $2 billion of its shares; targeting a dividend payout ratio of 35% to 40% by 2012, or 12% growth; and targeting a 50% total debt to total capitalization ratio. Each of Sempra's businesses has its own operational growth strategy, and the company plans total capital investments of about $2.1 billion in 2008 and $2.3 billion to $2.9 billion in 2009. In many cases, projects are only approved if the company can obtain long-term contracts.

At Sempra's utilities, the company is focusing on successful outcomes of rate cases and on expanding its rate base. The Sempra Pipelines & Storage and Sempra LNG segments are focused on building new facilities and also have several projects nearing completion or recently completed as well as opportunities for future growth. The generation business also intends to focus on building new facilities, some of which are expected to address California's mandate for renewable energy. In addition to steady cash flows being generated by the regulated businesses, we think the company's use of long-term contracts in its unregulated businesses will also help to produce relatively steady cash flows.

Valuation After reaching an all-time high of $64.21 on Dec. 11, 2007, the stock has traded down 12.4% compared with an 8.8% decline in the S&P 500 Multi-Utilities & Unregulated Power Index and a 15% drop in the S&P 500, as of July 3, 2008. We believe the sell-off provides an attractive buying opportunity for investors.

We expect Sempra to achieve a three-year EPS CAGR of about 8%, lower than what we would expect over the longer term because of the loss of earnings from contributing its commodities business to the RBS Sempra joint venture. Our 2008 and 2009 EPS estimates are $3.86 and $4.47, respectively. In addition, we like the company's dividend growth prospects and planned share repurchases. With our view of its strong cash flows, and long-term debt to total capitalization currently near 43%, we believe Sempra is in a good position to continue periodic share repurchases, should it desire.

Sempra's stock recently traded at 12.6 times our 2009 EPS estimate, or at a small discount to the company's gas utility peers. Given our view of the company's financial flexibility and above-peer-average earnings growth expectations, we believe the stock should trade at a premium multiple to peers. Our 12-month target price of $70 reflects a p-e multiple of 15.7 times our 2009 EPS estimate, a slight premium to our average 12-month peer target p-e of about 15 times 2009 EPS expectations. Our peer target multiple reflects our expectations for normal multiple expansion over a one-year period.

Corporate Governance Overall, our view of Sempra's corporate governance is positive. Some of the practices we view favorably are that the board is controlled by a super-majority of independent directors; the audit and compensation committees are made up entirely of independent outside directors; and officers and directors have a vested interest in Sempra, owning a combined 0.6% of the outstanding stock. However, an area of concern for us is that the chairman of the board and CEO roles are combined, which we believe presents a potential conflict of interest.

Investment Risks Risks to our recommendation and target price include a failure to complete growth projects, declining wholesale power margins, slower-than-expected growth in the commodities joint venture, and a weaker California economy.