Sempra

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Sempra is a California-based energy infrastructure company, primarily focused on regulated utilities in North America, and develops and invests in energy infrastructure in both the U.S. and Mexico.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Sempra’s moat is rated a 2/5. It primarily stems from its regulated business model, providing some stability and predictable cash flows. However, this protection is limited because regulatory oversight can constrain profitability, and new entrants can sometimes obtain regulatory approvals. The lack of significant proprietary technology or brand recognition also limits Sempra’s moat. The energy industry is also a fairly competitive field.

Moat Analysis:

  • Sources of Moat: Sempra’s moat primarily comes from regulatory barriers to entry in the utilities space, creating a natural monopoly in its service areas. Their pipeline network and distribution infrastructure also provide a barrier to entry, as they are large scale and difficult and costly for a competitor to replicate. The company also benefits from long-term contracts that guarantee some level of profitability.

Despite the barriers, there is an open market for the sale of power so there is enough competition to create pressure on revenues and margins, which restricts SRE’s ability to make excess profits. Also, these contracts are largely predictable and there are very little opportunities for innovation or to beat the market.

  • Moat Durability: The durability of Sempra’s moat is moderate. While they have a stable base of customers and their regulated nature limits competitors from coming in to steal clients, they still need to abide by the regulation, meaning their profits are capped. Changes in regulation, government policies, and technological disruptions could all impact Sempra’s ability to maintain its competitive position.
  • Moat Rating: Given these factors, Sempra’s moat is classified as “Narrow”. Their business model is predictable and steady, but they lack the differentiation and barriers to entry needed to obtain a “wide moat” rating.

Risks to Moat and Business Resilience:

Sempra’s moat is threatened by the following key factors:

  • Regulatory Changes: As a heavily regulated utility, Sempra’s profitability and business decisions are heavily influenced by regulatory approvals and limitations. Unfavorable changes in regulatory rules, such as rate caps or changes in pricing methodologies, could seriously diminish its ability to generate high profits. Regulatory delays in obtaining approval from the California PUC have also hurt revenue growth.
  • Economic Conditions: As mentioned above, inflation and other economic factors can influence commodity costs and thereby affect its prices and ability to achieve profitable results. Also, a downturn in the economy would make it difficult for Sempra to raise capital or borrow funds for investments and operations, which are both capital intensive.
  • Commodity Price Volatility: The company is exposed to fluctuations in commodity costs, particularly natural gas. While these can be passed onto customers to an extent, they still could lead to lower profitability or lost sales if the price differences are too large, because customer demand could diminish.
  • Environmental Issues: Sempra is exposed to various environmental regulations regarding gas, oil, and emissions. Increasingly stringent environmental regulations could force the company to make more investments in pollution control and may force it to curtail certain aspects of its operations which increase their costs and thereby reduce margins.

Furthermore, increased frequency of extreme weather and wildfire incidents are presenting an increasing operational risk for all the california utilities, which may lead to material losses.

  • Technological Disruption: While unlikely to fundamentally change the industry, new technologies like battery storage, solar, and other renewable energy could affect Sempra’s market position and may erode its customer base. This is a lower level risk compared to other factors.
  • Political Instability in Mexico: Sempra has a significant presence in Mexico, and adverse changes in the political climate could lead to legal and regulatory challenges in that region.

Despite these risks, Sempra’s business is fairly resilient due to its regulated nature and the importance of its services. In addition to a good diversification and customer mix, management is taking action to mitigate these risks. They are focusing on operational excellence, innovation and reliability, diversification into more stable markets, and making necessary investments to improve its infrastructure.

Detailed Business Explanation:

Sempra operates in three main areas which can be further segregated into business lines.

  • Sempra California: This includes San Diego Gas & Electric (SDG&E) and Southern California Gas Company (SoCalGas). Both are regulated utilities in California. SDG&E serves approximately 3.7 million electricity and natural gas customers in the San Diego area, and SoCalGas delivers gas to 22 million customers in Central and Southern California. These two utilities are the main revenue generators for the corporation, accounting for over 70% of revenue.

  • Sempra Texas Utilities: This includes Oncor, a regulated electric transmission and distribution business, that serves about 10 million Texas residents. It is their only business outside of California and has a lot of future growth potential as Texas is a fast growing state. Oncor generates most revenue from distribution charges.

  • Sempra Infrastructure: This segment is made up of two sub-segments.

  • First is the Mexican subsidiary called IEnova, which includes assets in natural gas and refined products pipelines and storage, energy storage and generation assets, and wind power generation facilities. IEnova has a significant presence in Mexico.

  • Second segment consists of LNG and non-regulated assets, mainly in the US. This business involves developing and operating natural gas liquefaction facilities, as well as terminals and pipelines to store and transport natural gas and oil. This business is focused on creating long-term value and are highly capital intensive.

Revenue Distribution:

  • The main source of revenues for Sempra is its California utilities, specifically SDG&E, which contributed nearly 50% of the revenue in 2022.
  • Next comes Oncor which made roughly 25% of the overall revenue.
  • Finally the remaining 25% comes from the infrastructure business.

As can be seen, the revenue split is diversified between California utilities, Texas utilities, and infrastructure, but the profits largely come from California utilities, which are their most reliable and profitable business.

Trends in Industry:

  • The energy industry is undergoing a major transition towards renewable sources, due to environmental, political, and economic reasons.
  • There is an increased emphasis on technology to improve energy grid efficiency and security, as well as to integrate renewable energy into it. This also includes new storage technologies.
  • Decarbonization is playing an increasing role in the industry, pushing utilities towards more sustainable infrastructure.
  • Inflation and supply chain issues are impacting costs in the industry, however as mentioned, utilities are allowed to adjust their prices based on regulatory standards.
  • In California, utilities are starting to show more awareness to safety and mitigation, and this is driving significant capital investments to improve the infrastructure. This implies that those companies that do such investments will do better in the long run.

Competitive Landscape:

  • Sempra faces competition from other utilities in its service territories, however, the regulatory barriers provide an advantage over them.
  • In infrastructure, the competition varies, depending on the type of business (e.g., for LNG there are many global players).
  • In emerging markets, they compete with local and other international players, who might have different strengths and access to resources.

What makes Sempra different:

  • Sempra is a pure-play regulated utility compared to many of its competitors which has a very strong focus on returns in California, as such, it has to abide by the regulation framework that is already established, creating more predictability in returns. They tend to focus less on diversification.
  • Their exposure to Mexico gives them a foothold in a growing market for energy infrastructure. However, this comes with geopolitical risks that they have to manage.
  • A large emphasis on safety and modernizing its infrastructure in California. They are actively investing in various projects to maintain the reliability and efficiency of their system. They are also increasing their investments in technology.
  • Their infrastructure unit has a lot of growth potential with the increasing need to transport energy over long distances.

Financials:

Sempra’s financials show a large and predictable revenue stream, and a modest but stable profitability picture.

  • Revenue: The company has generated good growth in revenue over the past few years, largely driven by increase in customer base and an increase in the amount of energy use. The company generated 40.7 billion in 2023, a growth of more than 23% compared to 2022, due to a significant growth in their Mexican operations. Their total revenues for 2021 and 2020 was 14 and 11 billion dollars respectively, signifying a strong growth trajectory.

  • Profitability: Operating profit margins have remained steady, averaging 13% during this period. Net income was 3.8 Billion dollars in 2023, compared to 1.3 billion in 2022, mostly driven by increase in revenues. The company’s return on assets (ROA) was roughly 6% for 2022. The return on equity (ROE) is more around 10%. However, the numbers may look quite low, but they are largely stable.

The biggest problem for utilities and Sempra, as we saw in the 2021 and 2022 financials, is the rising input costs. Even if these costs can be passed on to customers, delays in approval or a change in pricing strategy could severely impact the bottom line.

  • Cash Flows: As a utility company, they have stable cash flows, with a fairly low CAPEX burden due to high regulatory scrutiny which dictates how their earnings can be used. The CFO was around $4.8 in 2022, compared to roughly 3.8 in the previous two years. Their free cash flow has largely trended positively over the last few years.

  • Debt: The company’s debt is quite high, which is expected of a utility. Total liabilities is at roughly 53 billion dollars, out of which more than 38 billion is long term debt, which provides a low-risk, predictable way of financing capital expenditure intensive business.

  • Dividends: Sempra is a dividend-paying stock and has historically provided a consistent stream of increasing dividends to its shareholders.

In terms of dividend payout ratio, that is, the percentage of earnings paid out as dividend, is relatively high at around 70-80%, signaling management’s willingness to share profits with shareholders. The company recently raised the dividend by roughly 10%.

Understandability:

Sempra’s business is rated a 3/5 on understandability. The basic business model is quite straightforward as a regulated utility, but some parts such as their LNG business are much more complex and subject to various international and regulatory complexities. The nature of their contracts is also complicated. The financials for utilities are also generally hard to understand for the common investor, which increases complexity. A financial investor may find this company to be easy to comprehend, however.

Balance Sheet Health:

The company’s balance sheet is rated a 3/5, with a significant amount of debt, as mentioned earlier. Due to high fixed costs of operating and the need for large infrastructure projects, utilities are normally heavily reliant on debt for financing their operations. The company’s current liabilities of around 7 billion are much lower than its current assets of roughly 12 Billion, indicating enough liquidity to meet short-term obligations. However, their overall equity of around 21 billion may be lower than most established companies. Even when compared to its liabilities, a large debt position puts pressure on their financial health.

The company is exposed to significant regulatory risks and large external economic factors that could affect the company’s business stability. For example, the recent Penn East Pipeline lawsuit led to a halt in operations, and further regulatory hurdles in Texas are also being faced by the company.

Recent Controversies and Problems:

  • The company has been subjected to scrutiny recently due to its increased rate hikes, which are tied to higher natural gas prices. Also, the company was forced to pay large compensation to various residents due to wildfire allegations, which are a negative for the company.

  • The largest current legal issue for the company is the Aliso Canyon natural gas storage leak, which happened in 2015. According to the latest reports and filings, the litigation from that incident is in progress and is in final stages. The financial implications of these lawsuits are unclear, which introduces more risk to the company.

  • Management has recently stated that while operating costs have increased, the margins are expected to remain at similar levels in the future. They also announced new investments in various projects and also in technology to make the infrastructure more efficient. However, given the volatile nature of the regulatory body in California, their expectations may not fully materialize.

  • In terms of the ongoing recession, Sempra management expects their core business to remain largely insulated and show stability. But they have indicated that their revenues may reduce in some sectors due to lower customer demand, as well as higher inflation may impact earnings.