Merrill recommends Sempra Energy mandatory on stock fundamentals, attractive level

By Ronda Fears

Nashville, Tenn., Aug. 30 - Merrill Lynch & Co. highlighted Sempra Energy's 8.5% mandatory convertible in its weekly analysis of risk/reward profiles, noting solid equity fundamentals and appealing valuation.

"Sempra is consistent with our overall market strategy. Our Chief U.S. Strategist, Richard Bernstein, continues to carry an overweight on the utilities sector, with a focus on distributors with safe yields," said Yaw Debrah, head of U.S. convertible research at Merrill Lynch, in a report Friday.

"Sempra's convert, along with all mandatories, should track very closely with Sempra's common stock, which is reflected in its high delta of 0.875. We believe that the convertible has a very attractive risk/reward profile over a one year horizon, offering total returns of 22.4%/-12.9% for a +/-25% price move in the underlying stock.

"This issue also offers significant yield advantage over its underlying equity. The current yield of 9.04% is 472 bps greater than its equity dividend yield of 4.32%. At $23.50 for the convert vs. $23.13, the issue is trading at a 2.21% discount to its theoretical value, assuming a volatility of 43.2% and spread of 221 bps."

Also, he noted the issue has a strong credit rating. Standard & Poor's rates it A- and Moody's Investors Service A2.

Merrill utility analyst Carl L. Kirst rates Sempra's stock an intermediate and long term strong buy with a target price of $28.50, noting the strong A rated balance sheet, solid base of utility earnings, increasing market share in energy trading and compelling valuation of 9.2 times earnings per share versus its historic average of 12.0 times.

With total assets of $17.1 billion, Sempra is the largest combined electric/natural gas utility in the U.S.

For second quarter, EPS was 71c, versus 66c in second quarter 2001 - very positive compared to other companies with significant energy merchant operations such as El Paso, Dynegy and Williams, whose results declined by 50% or more due to deteriorating market conditions and dilution from balance sheet strengthening moves.

"Sempra has no rating agency overhang in our opinion, and we expect no new equity will be required to maintain its composite A3 credit rating, although we note additional equity is possible in 2003 depending on capital spending," Krist said in a report.

"This puts Sempra in with a very elite few who are involved in merchant energy but heretofore have been relatively insulated against the havoc wreaked by a tightening credit environment.

"Having engaged in no wash sales and denying any involvement in Enron-like trading strategies, Sempra has managed to remain outside of the FERC focus and media headline risk. In our opinion, this has allowed Sempra to better maintain both investor and counterparty confidence in this tumultuous sector."

Furthermore, Kirst said that given its credit strength and relatively untarnished reputation, he believes Sempra is gaining market share in these challenging times and will be in a prime position to capture expanded earnings should the power market turn around.

Sempra Energy 8.5% mandatory convertible due 2005

Price: 23.50

Stock price: $23.13

Parity: 18.94

Percent premium: 24.06%

Payback period: 4.1 years

Current yield: 9.04%

Market value: $517 million

Equity market capitalization: $4.74 billion

Conversion price: $25.02/$30.525

Conversion ratio: 0.9992/0.819

Ratings: A2/A-

Theoretical value: 24.03

Investment value: 5.49

Investment premium: 328.05%

Parity delta: 0.875

Delta: 0.705

Implied volatility: 95.16%

Historical volatility: 43.1%

Volatility cap: 50%

Annual stock dividend yield: 4.32%

Credit spread: 221 basis points over 5-year Treasury

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