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Overview:

Sabesp (NYSE:SBS) is a mixed capital company responsible for water supply, sewage collection and treatment in 363 municipalities in the state of São Paulo. It is one of the largest sanitation companies in the world in terms of population served. Over the last three months, the company's stock took a landslide, falling nearly 37% following its annual report.

(click to enlarge)

There is at least a 37% up-side potential in the company due to increasingly strong financials. The recent sell off seems unjustified when reviewing Sabesp's annual and quarterly reports.

Sabesp Is Underpriced

This water giant's shares are critically under priced at $8.50 per share. Sabesp's price per share at this level marks a new 52-week low that is critically oversold in my opinion.

(click to enlarge)Sabesp

Understanding where the opportunity exists is key to understanding why the company is a strong buy at these levels. Following the company's annual report, shares have been on a decline to where they are currently standing. Although after reading through the most recent annual report that was filed when the decline began, there is nothing that has popped out as justification for the steady three-month decline. The reason I looked to the annual report for answers is that it was filed around the time the steady decline in the shares began. After examining the annual report, many of the items are positive in nature.

2012 Annual Report Highlights (2012 compared to 2011)
Financial HighlightResult

Net Operating Revenues

Up 8.17%
Gross ProfitUp 9.68%
Operating ProfitUp 20.9%
Net IncomeUp 56.28%
Earnings Per Share - Basic and DilutedUp 56.42%
Dividends and Interest on Shareholders' equity per shareUp 53.49%

The inability to find a concrete reason for the recent, steady three-month decline, coupled with recent strong financials in Q2, provides investors with an excellent buying opportunity. The decline in Sabesp is unsupported. The only justification for the three-month decline is Sabesp's annual report which is mostly positive.

Sabesp's Q2 Financial Highlights (August 13, 2013)
Financial HighlightResult
Net Earnings23.5% Net Increase Year Over Year
Q2 Earnings$0.26 (ADR) versus $0.22 In The Year Ago Quarter
Net Revenue$1.357 Billion, Up 13% Year Over Year
Billed Water And Sewage VolumeUp 3.5% Year Over Year To 918.1 Million Cubic Meters
Water Loss Rate25.3% Versus 25.9% In The Prior Year's Quarter
Margins10.5% Year Over Year Increase in it's Cost of Sales and Services
Adjusted EBITDA$442 million, Up 14.1% Year Over Year
Operating ExpensesIncreased 22.9% YOY, 12.5% of Revenue
Cash and Equivalents$748.5 Million, down 21.5% from $1.053 Billion In The Previous Quarter
Net Cash GeneratedDecreased 12.4% to $369.7 Million
Capitals Spent On Property, Plant and EquipmentIncreased 71% to U.S. $1.8 Million
MiscellaneousWater volume decreased 1.1%, water connections increased 2.7% and sewage connections rose 3.4%. All Year Over Year from the prior quarter.

A quick glance at Sabesp's 2Q results shows no justification in a near 40% loss in the shares over the past three months. When reviewing Sabesp's Q2 financial statement, I see that Sabesp experienced a huge 23.5% increase in net earnings, a 13% increase in net revenue, a 10.5% increase in net margins, and a 14.1% increase in adjusted EBITDA, just to name a few.

The point of this article is not to boast the company's financial standings. More importantly it is meant to demonstrate how the near 40% drop in share price is not justified. Hence, an opportunity is provided to investors for a regain in the price per share. Also, strong and growing financials predicate a return of the share price to levels obtained before the sell off.

Scope:

The opportunity in Sabesp's stock price is apparent with regard to clear justification in its most recent three-month decline. The downside risk is limited as the company has not only maintained profitability and a strong balance sheet, but it is growing and remains stable.

Although the various factors affecting investing in the water market will not be covered here, I would mention that Sabesp provides an excellent play for its diverse business throughout the growing Brazilian economy.

What May Change Investor Perception?

As investors are aware of the company's balance sheet and most recent quarterly financial numbers, the march upward in the share price will not be caused by one binary event. Investors and managers will likely divulge the inexpensive share price and money will flow into the company in the coming months. This is because Sabesp has now become a value play now that the company's shares are nearly 40% cheaper than before. As the share price has become cheaper the value in the shares has increased. This can lead to investors buying the company's shares as they are now more valuable than before and have the potential to offer investors a nice return. I would not expect this to be immediate in nature. My opinion is that it will be a slow and steady rise back to where share price was before the three-month decline, near $11.65 per share. In the meantime, investors are able to enjoy a large dividend yield of 11.4%.

Why 37%

Picking a constant number that an investor can expect from an investment is a very hard game to play. Although I came to the conclusion that a gain of at least 37% can be made since Sabesp has declined for no apparent reason or justification. This arbitrary decline can offer investors value, value in the rebound of the company's share. This is because as the share price has become cheaper, the financials of the company have actually improved. Warren Buffett has always chanted:

"Be fearful when others are greedy and greedy when others are fearful"

... because when a value opportunity presents itself, you have to tackle it. Shares of Sabesp have become cheaper than before, sporting a price to book of nearly 1 while the water utilities industry has a price to book ratio of 14.4.

I further believe the rebound in the shares back to at least the levels before the steady decline will be achieved for a few main reasons that have already been discussed:

  • The company has declined 37% over the past three months with no justifiably factual reason. This has created a company that has significant value in its shares.
  • The company's financials have further improved when comparing the periods directly before the decline (2012 annual report released before the decline) to now (2Q earnings released last week).
  • The shares now have increased value and will be likely seen as a great value opportunity, thus the company will see increased investment by those looking for a great value play.
  • Increased financials from the period before and a price to book now extremely cheap compared to the industry as a whole brand the company with value.
  • Sabesp is a great long-term play for investment in the water theme with a high dividend yield.

Thirty-seven percent is actually quite simple when you think about it. Sabesp has declined that amount the last three months with no justifiable reason in the face of improved financials. Thus investors are granted with an extremely attractive value play that should return to at least the values seen before the decline since conditions have done nothing but improved.

Risk Factors

  1. The dividend yield is hard to calculate and paid on the ADR shares yearly. Be sure to hold the shares long enough to obtain the yearly dividend payout.
  2. The Brazilian government tends to intervene in its economic activity. It can change policy and regulations. The company attracts investors in the area and provides a necessity to nearly 22 million people. Increased earnings relate to increased taxes paid to the Brazilian government.
  3. Currency will fluctuate when the Brazilian real is compared to the U.S. dollar.

Other Exciting Water Opportunities:

Investors looking to capture the growing water investment story can invest in other exciting water companies to capture the growth in the water industry. Although an investor would have to look into the merits of investment in each of the companies below, they can offer a starting point.

CompanyExpertiseSymbol
PowerShares Global Water PortfolioETFPIO
Powershares Water Resource PortfolioETFPHO
CadizUnderground WaterCDZI
Calgon Carbon CorpPurification, Carbon, UVCCC
American Water WorksWater UtilityAWK
Aqua America IncWater UtilityWTR
Flowserve CorporationIndustrial Flow ManagementFLS
Consolidated Water Co. Ltd.DesalinationCWCO
GE and 3M CoAcquire many companies dealing with desalination and filtration, although they may be too large to be invested in for any pure water play ideas.GE, MMM

These companies can provide ideas to any investor trying to invest in the water sector. Although as an investor, always do your own due diligence before making any investments.

Conclusion

Sabesp will recover the 37% it lost over the past three months. Recent strong financials, both annually and quarterly, show no justification for the decline in Sabesp's price per share. As such, the company will recover as investors and managers realize the increased value in the shares and start investing in the company. This will take a few months as steady investment by investors and funds will increase the price per share of the company to at least $11.65 per share, or the amount before the unjustified decline.

Source: Sabesp: Steady Three Month Decline Provides 37% Upside Potential

Additional disclosure: Always do your own due diligence and contact a financial professional before executing any investments. All of the information provided in my articles are for informational uses only.