Sempra: An Attractive Utility With LNG Upside (NYSE:SRE)

Shares of Sempra (NYSE:SRE) have been a poor performer over the last year, losing about 5% of their value. Higher interest rates have weighed on utilities and dividend-oriented stocks. While higher interest expense has had a negative impact on results, SRE has a strong growth position, which should enable upper single-digit dividend growth to continue for several years, creating the potential for low double-digit returns.

Sempra is primarily a utility company that also has exposure to Mexican renewable projects and US LNG export facilities, via its majority ownership in Sempra Infrastructure. California accounts for about half of earnings, with Texas and Infrastructure each one quarter. In the company’s third quarter, it earned $1.08 in adjusted EPS, and it now expects to earn at or above the high-end of its $4.30-$4.60 full year guidance. Alongside this, in 2024, it is guiding to $4.55-$4.90 with a targeted long-term growth rate of 6-8%.

This projection is underpinned by a large capital program. In fact, the company is poised to increase its five-year $40 billion capital plan by 10-20% in February. 90% of these investments are in the utility space. Here, the goal is to modernize the network, improve safety, and expand capacity in order to increase the rate base. As it grows the rate base, on which it earns a regulatory-approved return, earnings rise.

Now, Sempra’s two state exposure varies dramatically. It is not news to anyone that Texas’s population has boomed while California’s has not. As you can see below, Texas’s population has grown much more quickly than the country’s. California had been keeping pace nationally until about 2018, and since then, it has seen a meaningful population outflow.

Ultimately, a utility’s demand is tied to population growth, as well as how much electricity that population consumes. Now, Sempra’s CA-exposure is primarily in the southern part of the state, not San Francisco, which has seen the worst population dynamics. Still, California is not likely to be a material growth engine. Indeed, in Q3, from last year, earnings were flat in California, up $49 million in Texas, up $37 million from LNG & infrastructure, partially offset by $23 million of corporate interest and income tax headwinds.

I view California as likely to be a slow-to-no growth unit. Population trends are unfavorable, but there is a favorable mix shift. For instance, Sempra California has seen a 35% increase in EVs in its territory, a source of incremental demand. These competing factors are why California earnings were flat at $290 million. It has also received $1.2 billion in federal funding for clean hydrogen projects.

By comparison, Sempra added 20,000 premises in Texas, via its ownership of Oncor last quarter. As the population grows, it should continue to add customers. Further, it expects Permian Basin demand to quadruple by 2032. This strikes me as somewhat aggressive, in part because the oil & gas producers continue to generate productivity gains, but this should be a source of growth.

Texas is the leading focus of its capital plan, given the growth of the state. Sempra seeks to double Oncor’s rate base over the next 5-6 years. Sempra acquired Oncor out of bankruptcy in 2018. Oncor was a pre-financial crisis LBO that went poorly, with private equity simply putting too much debt on the company. As its financials struggled, it likely limited capital spending to the bare minimum, creating tremendous opportunity for a better capitalized parent, like Sempra, to invest in its network, modernize and expand it, which should meaningfully grow the rate base and earnings over time.

Sempra’s operating and maintenance expenses were up 15% to $1.38 billion in Q3. As the company continues to invest in the utility, we should see these expenses moderate, creating some margin expansion potential. With Texas earnings rising to $305 million from $256 million last year, some of these efforts are beginning to pay off.

These varied dynamics in CA and TX are apparent in usage trends. As you can see, this year California gas sales are flat while electric deliveries are down. Oncor is posting nearly 5% growth—which is quite fast for a regulated utility, a testament to the boom in Texas.

Aside from its traditional utility business, Sempra also offers exposure to LNG exports. It owns the Cameron LNG export hub, where phase one is operational. This unit distributed $339 million to Sempra Infrastructure this year. Phase 2 is under consideration with Sempra having 50% control of the fourth train. Additionally, Port Arthur Phase One is now under construction. Sempra sold a 42% stake in Port Arthur Phase One to KKR (KKR). This project is expected to begin commercial operations in 2027. Proceeds from the sale were $984 million. That would value the remainder of its stake at about $450 million. It also reduces its further capital requirements by about $6 billion on this $13 billion project. Sempra retains ownership of Phase 2, which would double capacity.

These incremental projects will not generate earnings for several years, but they provide long-term upside potential. According to the IEA, LNG demand is expected to surge in coming years. Europe will remain a major buyer as Russian gas exports are likely to remain closed off for the foreseeable future. Asia, led by China, Japan, and South Korea, are also large consumers. I would note that Sempra does not take material commodity risk in these projects, and they are supported by long-term supply and purchasing contracts.

One reason that utility stocks have suffered this year is the concern that these massive capital budgets are not as economical at higher rates (a reason shares have recovered as long-term rates have fallen in recent weeks). Sempra has seen its quarterly interest expense rise by $30 million to $312 million over the past year. While it carries $29.7 billion of debt, the parent company has no debt maturing until 2025.

Sempra is investing aggressively; it has spent $6.1 billion of cap-ex from $3.5 billion last year. However, it also generates substantial cash flow, with $5.7 billion of operating cash flow ex-working capital. Now, its dividend costs about $1.5 billion. Still, Sempra can self-fund about 2/3 of its capital budget and rely on debt financing for just one-third. It also can monetize noncontrolling stakes in its phase 2 LNG projects to raise cash and reduce the amount of capital it commits to building out these facilities, which can cost ~$13 billion. Sempra’s ability to self-fund most of its capital budget will help it manage through volatility in interest rates.

Overall, I expect California results to grow in-line with inflation or 0-2%. Conversely, Texas results should rise by at least 12% per year as the rate base doubles by 2030. These provide about 4% consolidated annual earnings growth. The incremental cash flow from Port Arthur when it is up and running by 2028, will boost annualized earnings by a further 3% annualized over the next four years, providing a 7% growth runway.

Now, over the past five years, SRE has delivered a 5-year dividend growth rate of 11% aided by the purchase of Oncor. Going forward, I expect dividend growth to track cash flow and earnings growth, or rise about 7%. I would note this growth rate does not account for any cash flow from Port Arthur or Cameron Phase 2.

If these projects are developed, they would offer further earnings growth, though that would unlikely to be generated until 2028-2030 at the soonest. Just based on existing operations and approved investments, SRE can grow its dividend by 7%, which combined with a 3% starting yield, provides a 10% total return potential. Even greater LNG exports provide upside optionality beyond this attractive base return, which is why I view shares as attractive for long-term income growth investors. I would be a buyer up to $82.