SABESP Downgraded to Underperform

We recently downgraded our recommendation on Companhia de Saneamento Basico do Estado de São Paulo, or SABESP ( SBS - Analyst Report ) from Neutral to Underperform. SABESP is a public water and sewage services provider in the State of Sao Paulo, Brazil.

The company is one of the largest players in the industry having distributed water to approximately 23.6 million people and provided sewage services to more than 20.2 million people as of fiscal year 2010.

Long-term prospects of SABESP seems bright as the company targets to add roughly 1.3 million new water connections and 1.7 million new sewage connections, improving its sewage coverage to 90%, through 2019. Water loss ratio is expected to be 14% by December 2014 compared with 26% at the end of March 2011.

The company makes a constant effort to improve its services and coverage over time. Investments over 2009-2013 period would be roughly R$8.6 billion, with R$1,753 million targeted for 2011 and R$1,748 million for 2012.

Despite these positives, concerns over rising expenses and mounting debt levels have forced us to downgrade the stock. Higher cost of sales and services together with rising operating expenses were the prime reasons for a 39% decline in the company’s first quarter 2011 profit.

The company intends to fund 46.5% of its targeted investment through cash flow and the rest 53.5% via financing. With existing loans and financing of approximately R$7,207.1 million (US$4,341.6 million) at the end of the first quarter 2011, the burden of additional debts will increase the company’s financial expenses and hurt its performances over time.

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, SABESP’s over dependence on weather conditions and political interference on its affairs are disconcerting. Also, the company is in direct competition with peer companies like Veolia Environnement S.A. ( VE - Snapshot Report ) .