Description
The common equity of Companhia de Saneamento Basico do Estado de Sao Paulo (SABESP), the largest water utility in South America, offers a compelling risk-reward at its current price, in our opinion. Based on the stability of its core business, the strength of its balance sheet, its regulatory outlook, and its growth prospects, we believe the ADSs (NYSE: SBS, each ADS represents 2 ordinary shares) hold a potential upside of at least 30%. The current net dividend yield on the ADSs is 4.7%.
Disclaimer- we make no guarantees regarding the accuracy of the information contained herein. We currently hold a long position in SBS, but may change our holdings at any time.
Company Overview
SABESP was created through the combination of the Metropolitan Water Company of Sao Paulo, the Metropolitan Sanitation Company of Sao Paulo, and the Supervisory Authority of Water and Sewage Networks of the Capital, in 1973. The government retains significant influence over SABESP- the State of Sao Paulo is a 51% shareholder. SABESP distributes water to over 23 million people through 63,000 kilometers of water pipes and provides sewage services to 19 million people through 41,000 kilometers of sewer lines.
Not surprisingly, as a regulated water utility, SABESP’s financial performance has been quite stable over the past several years. It has also made progress managing costs, and has steadily been improving returns on capital ($R millions):
2003 2004 2005 2006 2007
Revenue 4131 4397 4953 5527 5971
EBIT 1512 1327 1689 1804 2076
EBIT % 36.6% 30.2% 34.1% 32.6% 34.8%
EPS (fd) 3.66 2.25 3.80 3.42 4.60
ROC 6.3% 5.6% 7.0% 7.4% 8.4%
Growth Outlook
SABESP has grown revenues by close to 10% annually over the past several years, driven by tariff hikes and increases in water and sewer connections. Given the current economic conditions, however, we believe that tariff increases should become increasingly difficult to obtain politically. Organic population growth of SABESP’s service areas remains strong, however, as the rural population continues to relocate to Brazil’s urban centers. Balancing these factors, we assume more modest revenue growth of 5% per annum for the next five years, then 3% per annum thereafter.
The Sewage division in particular offers strong growth potential, given that only three-quarters of the population has sewage coverage. SABESP’s sewer business holds 46% operating margins vs 22% for the drinking water business. SABESP is investing heavily to increase its penetration of sewer service, which should improve overall operating margins.
Balance Sheet
Operating a water utility is a highly capital intensive business, and SABESP needs continued access to capital. We are a comfortable with the credit, as EBITDA-Capex/Interest Expense is 3.2x (ttm), and Debt/Total Capitalization stands at 37%. SABESP issued two series of debt totaling $R220 million in early November 2008, rated A+ by S&P. The first series ($R 100 million) pays an annual rate of 275 bp over the local interbank rate. The second series ($R 120 million) pays an interest rate of 12.87% over the official inflation index.
Valuation
We employed two valuation approaches, detailed below. Choosing the lower of the two valuations- $29.96 per share- represents a 30% upside to the current ADS price.:
Discounted Cash Flows
($R millions) 2008E 2009E 2010E 2011E 2012E Assumption
Revenue 6269 6582 6912 7257 7620 3.0% terminal growth
EBIT 2069 2172 2281 2395 2514 31.0% terminal margin
Unlevered FCF 1116 1172 1231 1292 1357 3.1% terminal growth
Assumptions:
Equity risk premium: 8%
Cost of debt: 12%
5.0x terminal EBITDA multiple
FD Shares outstanding: 227.8 million
Impl. Value/Share $BR 40.30
Impl. ADS Value $US 35.20
Current ADS Price $US 23.03
EBITDA Multiple
(in R$000s)
2008E EBITDA 2695
Multiple 5.0x
Enterprise Value 13,475
Less: Net debt (5661)
Market Cap 7814
FD Shares 227.8 million
Impl. Value/Share $BR 34.30
Impl. ADS Value $US 29.96
Current ADS Price $US 23.03
SBS has traded in an EV/EBITDA range of 4.5x-6.5x over the past several years.
The table below compares SABESP with several other emerging market (and one U.S.) water utilities (as of 12/15/08, $US millions):
Company Market Cap EV/EBITDA(ttm) P/E (ttm)
SABESP 2,568 4.4x 6.3x
Eastern Water (Thailand) 119 5.7x 7.1x
Manila Water Co. 555 5.1x 11.4x
American Water Works 3,265 10.4x 15.9x (’09 Est.)
Risks
Government ownership- SABESP is subject to many restrictions given the state of Sao Paulo is a 51% shareholder, and this is a overhang on the stock, in our opinion. The State has the right to certain management appointments, and may influence tariff increases and capital spending.
Water supply- poor hydrological conditions (e.g., drought) are always a risk for utilities, but SABESP recently reached a settlement with the Sao Paulo state government in which SABESP obtained the rights the Ponte Nova, Paraitinga, Taiacupeba, and Jundiai reservoirs, which should strengthen its control over its water supply sources.
Catalyst
Catalysts
- State of Sao Paulo ceding majority control
- Continued strong operating performance
- Capital flows returning to Brazilian equities