Sempra: A Smart Move in Utilities

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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.

Muir is an analyst for Standard & Poor's Equity Research Services .