Companhia de Saneamento Basico: Infrastructure Play Positioned to Ride Burgeoning Need for Water in São Paulo

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By: Benjamin Shepherd

With a population of almost 11 million in the city proper and 19.9 million in the metropolitan area, São Paulo is the largest city in Brazil and one of the largest in the world.

With a history dating back to 1554, São Paulo has long served as one of Brazil’s most important commercial centers and has undergone major shifts in its primary businesses.

In the 1700s and into the 1800s, the city served as a major sugar cane and coffee bean trading center. Given its close proximity to the coast, European merchants used the city as a beachhead to establish commercial relationships with farmers in the country’s interior.

As agricultural commodity prices became increasingly volatile with the opening of new markets late in that period, São Paulo began a process of rapid industrialization that ran well into the mid-20th century. Attracting a huge influx of immigrants from the country’s rural areas in search of higher incomes, between 1920 and 1970 the city’s population grew by an average 10.3 percent annually.

But that halcyon period came to an end. In the 1970s and 1980s, other major Brazilian population centers began competing to attract manufacturers. At the same time, labor markets around the world, most notably China and Mexico, opened up to foreign trade. As a result, São Paulo underwent another major transformation by shifting its focus to become a base for the country’s growing services sector, attracting major banks, retailers, airlines and a diverse mix of other businesses. A growing number of multinational corporations have also come to call São Paulo home.

In its latest incarnation, São Paulo’s population growth has slowed, averaging just 3.5 percent annually over the past 40 years. Growth is expected to slow to just 1 percent annually over the coming decade as living conditions in the country’s urban and rural areas come to par, farm living becomes easier with continued mechanization, and the government’s programs to foster school construction and attract doctors to rural regions reduce the pressure to migrate to urban areas.

While slowing population growth might sound like a negative for the region’s water utility, Companhia de Saneamento Basico (NYSE: SBS), the company still faces plenty of expansion opportunities.

Locally known as Sabesp, it is one of the largest water utilities in the world, providing water services to 24 million people and sewage services to 20.6 million in 362 of the 645 municipalities in the state of São Paulo in addition to the city itself. In all, the company serves about 60 percent of the state’s urban population, with 100 percent water coverage across the state and 82 percent sewage coverage.

The state of São Paulo is the most populous in Brazil, with 41.2 million inhabitants and the second wealthiest with per capita gross domestic product (GDP) of BRL24,456 (USD12,032.18). About a third of the country’s GDP is generated in the state, which is widely considered the economic, technical and financial hub of Brazil.

Despite the state’s relative wealth and nearly universal coverage by a water distribution system, São Paulo faces major infrastructure challenges.

Poverty is still a major concern in the state, with about 16 percent of the population living below the poverty line. Most of those poor dwell in massive urban slums with insufficient access to either water or sewer services, so much of their waste finds its way into surface water which supplies 100 percent of the water in the region.

The quality of existing infrastructure is also a major issue; leaky pipes cause the utility a physical water loss of nearly 26 percent of its volume annually.

Sabesp is investing heavily to address those issues, with spending on track to reach BRL7.9 billion over the next three years to expand its services and minimize losses in its system. As a part of that program, the company recently closed a deal to borrow BRL884.3 million from the Japan International Cooperation Agency to continue to improve water efficiency—five years ago the loss rate was just over 34 percent. The company’s aim to have zero water loss by 2019.

Sabesp’s history of investing heavily in its distribution and treatment systems has greatly paid off over the past decade, for both the company and shareholders alike.

Revenues have risen from BRL3.7 billion in 2002 to BRL9.9 billion last year. By the same token, net income has shot up from a BRL651 million loss a decade ago to BRL1.2 billion last year, while net margin is currently averaging about 16 percent. Free cash flow also averages about BRL440 million annually, even as the company funds about half of its infrastructure investment from its own cash.

For shareholders, the company’s strong financial performance has translated into a steadily rising dividend that has nearly doubled since 2007. The stock’s yield is 4.9 percent, up from 3.4 percent in 2004. That solid growth should continue this year and beyond.

While organic population growth is slowing, its continued expansion will drive the company’s long-term prospects. With only 60 percent of the state of São Paulo’s population connected to the water system, potential growth opportunities abound. On that basis alone, management expects to be able to maintain its current growth rate in connections.

Additionally, São Paulo will also host soccer matches for both the 2016 Olympics and the 2014 FIFA World Cup competition. The city is eager to show its best face for the millions of people attending those events and is investing heavily in its infrastructure. An urban renewal project also is underway whereby slums are being systematically torn down and replaced with state constructed housing which has water and sewer connections. As the only water utility stock in the region, that directly benefits Sabesp.