## Summary

- Drought leads to negative cash flow and increased financial leverage.
- Increased financial leverage may lead to reduced dividends.
- Risk reward valuation implies a significant downside risk to the share price.

When I first saw the consensus forecasts (source: 4-traders.com) for Companhia de Saneamento Basico do Estado de Sao Paulo, or Sabesp (NYSE:SBS), and the company's Q1 2014 presentation (source: Sabesp) I thought the company looked like an attractive investment.

However, during my research and analyzing the numbers, I grew more pessimistic.

The result is this analysis where I try to prove my pessimistic view wrong, by not using a too conservative forecast.

I have also included risk assumptions in order to analyze upside and downside potential.

My conclusion is that due to increased financial risk, and unfavorable risk reward valuation I do not believe Sabesp is an attractive investment.

## About Sabesp

Sabesp is one of the largest water and sewage service providers in the world based on the number of customers. It provides water to 24.6 million people and sewage services to 21.6 million people. It serves the city of Sao Paulo (largest city in Brazil) and 363 out of 645 municipalities in the State. It has long contract with the Municipality of Sao Paulo.

It has a natural monopoly, and low operating risk.

Ownership: 50.3% of the shares are owned by the state of Sao Paulo, 25.5% are traded on the Novo Mercado in Brazil, and roughly 24.2% are traded on NYSE. It is part of the utilities sector. It has a market cap of about $7.4 billion, and daily trading volume of about 2.7 million shares.

Forecast

a) Consensus forecast (source: 4-traders.com)

b) My forecast

The forecast is based on annualised Q1 2014 numbers (source: Sabesp), and the following assumptions.

- 4% yearly price and costs growth (source: BCB).

- 3% yearly volume (water/sewage connections) growth.

- 35% EBITDA margin.

- Yearly capex of M BRL 2.650.

- Assumed yearly effective tax rate of 35%.

The below table summarizes my forecast. The historic numbers are from the 2013 annual report (source: Sabesp)

Assumptions sources:

Price and cost growth assumptions are based on Brazilian inflation forecast, and assuming that prices and costs follows inflation (see below figures).

Inflation forecast (source BCB).

Annual price/tariff adjustments roughly follows inflation (source: Sabesp).

Volume growth (source: Sabesp).

EBITDA margin (source: Sabesp).

Capex (source: Sabesp).

In my forecast I have assumed capex of M BRL 2.650 per year.

Forecast assumptions:

Assumed EBITDA margin:

Forecasted EBITDA:

Forecasted earnings per share:

Forecasted increase in EBITDA, and earnings per share, are mainly due to volume growth.

Forecasted book value per share:

Increase in book value (book equity) is due to retained earnings.

Forecasted operating & investing cash flow:

Forecasted net debt:

Current share price relative to forecasted earnings per share:

Current share price relative to forecasted book value (equity)per share:

## Valuation (base case)

In the below valuation estimation I use 3 different valuation methods.

Valuation method 1, discounted cash flow (DCF) analysis:

Assuming a weighted average cost of capital (OTC:WACC) of 10%, and perpetual growth from 2020 of 5%. The assumptions implies a fair value of about 18 BRL per share, that is, about 8.2 USD per ADR.

## DCF valuation implies a fair value that is about 25% lower than current share price.

Valuation method 2, assuming a price earnings (P/E) multiple of 10 in 2020, and a weighted average cost of capital of 10%.

In this valuation method I am assuming that the fair value share price in 2020 shall be 10 times that years estimated earnings. That estimated fair value share price and dividends are discounted at 10% to get today's estimated fair value share price.

## Price earnings multiple valuation implies a fair value that is about 5% higher than current share price.

Valuation method 3, assuming a price book (P/B) multiple of 1 in 2020, and a weighted average cost of capital of 10%.

In this valuation method I am assuming that the fair value share price in 2020 shall be equal to book equity value per share in 2020. That estimated fair value share price and dividends are discounted at 10% to get today's estimated fair value share price.

## Price book multiple valuation implies a fair value that is about 8% lower than current share price.

## That is, based on the average of these 3 valuation methods, Sabesp's current share prices seems to be about 10% higher than estimated fair value.

## Forecast with risk assumptions

In order to analyze the risk-reward I have included the following risk assumptions:

- 0.25% yearly standard deviation in volume.

- 2% yearly standard deviation in prices.

- 1% yearly standard deviation in costs.

Risk assumptions:

Due to the natural monopoly the volume risk is assumed to be very low, and is mainly related to the expected volume growth.

The price risk assumption is mainly based on the assumed possible future inflation in Brazil (see earlier chart).

I have assumed that costs have a lower volatility than prices/inflation.

The calculations that includes these risk assumptions are based on the same base case as above, but there are in addition calculated multiple scenarios (using Monte Carlo and Cholesky decomposition) where volumes, prices, and costs are subject to potential changes (the above standard deviations).

The sum of all the potential outcomes from these multiple calculations can be summed up in e.g. fan charts and distribution charts.

The below fan chart shows the resulting assumed possible future EBITDA margins.

The fan chart shows the assumed possible development with included risk assumptions.

The black line shows the historic development, and then the base case forecast.

The darkest blue area shows the range estimated to contain about 75% of the assumed possible outcomes. The 2'nd darkest blue area, together with the darkest blue area is estimated to contain about 90% of the possible outcomes. The total blue area is estimated to contain about 95% of the possible outcomes.

It is estimated that there is about 2.5% probability that the future values will be above the blue shaded area, and about 2.5% probability that the future values will be below the blue shaded area.

The actual values can be both higher and lower than depicted in the fan chart.

The lower part of the EBITDA margin fan range occurs in the scenarios where the Monte Carlo generated prices are low, and the Monte Carlo generated costs are high.

The upper part of the EBITDA margin fan range occurs in the scenarios where the Monte Carlo generated prices are high, and the Monte Carlo generated costs are low.

Assumed possible future earnings per share:

The lower part of the earnings per share (NYSEARCA:EPS) fan range occurs in the scenarios where the Monte Carlo generated prices are low, and the Monte Carlo generated costs are high.

The upper part of the earnings per share fan range occurs in the scenarios where the Monte Carlo generated prices are high, and the Monte Carlo generated costs are low.

Assumed possible development in book value per share:

## Financial leverage

Assumed possible development in operating cash flow, without drought-effect:

Assumed possible development in net debt, without drought-effect:

Sabesp is expected to have a positive and increasing operating cash flow, but due to relatively high capital expenditures and dividends, net debt is expected to increase the next couple of years.

Assumed possible development in net debt relative to EBITDA, without drought-effect:

E.g. Sabesp has a loan covenant that says that total adjusted debt over EBITDA must be lower than or equal to 3.65. Please note that the above chart measures net debt over EBITDA.

Based on the simplified assumptions made in this analysis it does not seem very likely that Sabesp is in risk of breaching the loan covenants in the near future.

## Drought & financial leverage

However, due to the drought currently in Brazil and Sabesp's incentive program towards its customers (giving price reductions to customers that lowers their water consumption) the expected revenue and operating cash flow in 2014 is expected to be considerably lower than 2013. Fitch Ratings now expects Sabesp's net debt/EBITDA ratio to reach about 3.5 in 2014 (source: Fitch Ratings).

Assumed possible development in operating cash flow if 10% lower prices in 2014:

Assumed possible development in net debt if 10% lower prices in 2014:

Assumed possible development in net debt/EBITDA if 10% lower prices in 2014:

Please note that the above chart shows net debt over EBITDA whereas Sabesp loan covenant is total adjusted debt over EBITDA.

The drought in Brazil significantly increases the financial leverage of Sabesp. This may lead to higher financing costs, and possibly reduced dividends.

## Political & regulatory risk

There is a risk relating to Sabesp being controlled by the State of Sao Paulo.

In the past the State has directed Sabesp to engage in business activities and make expenditures that promoted political, economic or social goals but that did not necessarily enhance Sabesp business and operations.

Given the nature of the business there will also always be regulatory uncertainties.

Arsesp (the Sao Paulo State Sanitation and Energy Regulatory Agency, source: Arsesp) authorizes Sabesp's tariff/price adjustments.

However, Sabesp also enjoys having a natural monopoly which somewhat reduces the business risk.

## Valuation multiples with risk assumptions & drought

Assumed possible development in earnings per share with risk assumptions and 10% lower prices in 2014:

Assumed possible development in current share price over earnings per share (P/E) with risk assumptions and 10% lower prices in 2014:

## Valuation with risk assumptions & drought

Based on discounted cash flow (DCF) analysis, assuming a weighted average cost of capital of 10%, and perpetual growth from 2020 of 5%.

The distribution chart shows the assumed distribution of valuations per share (in BRL) based on all the calculated scenarios. The horizontal axis shows the assumed possible value distribution, and the vertical axis shows the assumed probability of each outcome.

The percentage shown on each bar is the accumulated probability, starting from the left.

Based on all the assumptions made there is an estimated 85.2% probability that the implied fair value per share is below BRL 23.9 (USD 10.9), and a 14.8% probability that the implied fair value per share is above BRL 23.9 (USD 10.9).

Sabesp's current share price is about BRL 23.8 (USD 10.8)

## Conclusion

Due to increased financial risk, political & regulatory uncertainty, and unfavorable risk reward valuation I do not believe Sabesp is an attractive investment.

If you want Brazilian exposure I would recommend Gerdau (NYSE:GGB) (source: GGB analysis)

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