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We recently downgraded our rating for Companhia de Saneamento Basico do Estado de São Paulo, or SABESP (SBS) from Outperform to Neutral.

The company is a public water and sewage services provider in the State of São Paulo, Brazil. As of fiscal year 2010, the company distributed water to approximately 23.6 million people and provided sewage services to more than 20.2 million people.

At fourth quarter end, SABESP’s water and sewage connections were approximately 7.3 million and 5.7 million, respectively. The company aims at maintaining its water coverage ratio at 100%, besides improving its sewage ratio to 90% from 80% by 2018.

In the near term, the company benefits from the September 2010 tariff adjustment, a more relaxed monetary policy in Brazil. The Sao Paulo State Sanitation & Energy Regulatory Agency reduced the tariff readjustment index to 4.05% over water and sewage tariffs as of September 11, 2010, from 4.43% in September 2009. The decrease in tariff is expected to have a positive impact on the company going forward.

Financial results for the fiscal year 2010 were rather impressive as earnings per share surged 8.2% year over year with a top-line increase of 7.6%. The company’s cash position improved as cash and cash equivalents at the end of fourth quarter shot up 45.5% sequentially.

The company’s aggressive investment policy and continuously increasing financial burden from higher debt levels, however, are posing a threat to SABESP’s margin and bottom line results in the quarters ahead. Exiting the fourth quarter, the company’s loans and financing, net of current portion soared 8.1% sequentially.

Moreover, the company’s over-dependence on weather conditions is disconcerting. SABESP’s principal shareholder is the São Paulo government, owning nearly 50.3% of the company, which bestows the power to control the election of the majority of members on the company’s board of directors and appoint senior management. The extent of political interference will directly influence SABESP’s future planning and growth prospects.

The company also faces stiff competition from its peers like Veolia Environnement S.A. (VE).

Source: Water Utility SABESP Facing Financially Draining Factors