Privatization And Expansion Will Drive Efficiency But Pose Financial Risks Ahead

Key Takeaways

• Transitioning to a private corporation aims to boost efficiency and margins through cost reductions and operational enhancements.
  
• Expanding operations and strategic M&A activities have potential for significant revenue growth and earnings diversification.
  
• The company's transition to privatization, ambitious investments, and tariff reviews pose challenges to margins, revenue stability, and financial predictability amidst litigation risks.

Catalysts

Provides basic and environmental sanitation services in the São Paulo State, Brazil.

• SABESP's ambitious investment program focused on accelerating the universalization of sanitation services with planned investments of over R$60 billion is expected to enhance future revenue streams through expansion into new consumer groups, including rural areas and informal communities.
  
• The transition from a state-owned entity to a private corporation is likely to improve efficiency by adopting private procurement models and breaking projects into smaller packages, which could lead to better net margins through cost reductions and heightened operational efficiencies.
  
• The renegotiation and termination of approximately 500 contracts to limit discounts to large clients should enhance revenue protection and increase the company's earnings by aligning with the new concession contract's regulatory requirements.
  
• Future plans for rigorous cost control and an efficient capital structure, supported by an organizational shift towards technology and process optimization, may free up resources for investments while positively impacting profit margins and potentially leading to better earnings performance.
  
• The potential for expanding operations into new municipalities in the State of São Paulo and exploring selected M&A activities may offer significant revenue growth and diversification possibilities, enhancing earnings through geographic and product line expansion.

Companhia de Saneamento Básico do Estado de São Paulo - SABESP Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Companhia de Saneamento Básico do Estado de São Paulo - SABESP's revenue will decrease by -3.7% annually over the next 3 years.
• Analysts assume that profit margins will shrink from 26.2% today to 21.4% in 3 years time.
• Analysts expect earnings to reach R$6.8 billion (and earnings per share of R$6.47) by about December 2027, down from R$9.3 billion today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as R$4.5 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 30.0x on those 2027 earnings, up from 6.8x today. This future PE is greater than the current PE for the US Water Utilities industry at 23.8x.
• Analysts expect the number of shares outstanding to grow by 15.3% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 16.64%, as per the Simply Wall St company report.

Companhia de Saneamento Básico do Estado de São Paulo - SABESP Future Earnings Per Share Growth

Risks

• The transition from a state-owned to a private company requires significant management adjustments, which include hiring a PMI consultancy and reassessing company assets. These transition costs and management challenges could impact net margins.
  
• Revenue is subject to deferred recognition due to required bifurcation of financial assets under IFRS 12. This could complicate future revenues and financial forecasting accuracy.
  
• The ambitious investment program aimed at universal sanitation requires R$60 billion, which could increase financial risk and impact earnings if the investments do not yield expected returns.
  
• The annual tariff reviews pose regulatory challenges and could introduce revenue volatility, as unlike the previous 4 to 5-year intervals, this could result in less predictable earnings.
  
• Discounts offered to industrial and commercial clients are being renegotiated, but there is a litigation risk associated with terminating approximately 500 contracts. This could affect revenue stability and lead to potential legal costs impacting the bottom line.

Valuation

• The analysts have a consensus price target of R$122.4 for Companhia de Saneamento Básico do Estado de São Paulo - SABESP based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of R$143.4, and the most bearish reporting a price target of just R$76.5.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be R$31.7 billion, earnings will come to R$6.8 billion, and it would be trading on a PE ratio of 30.0x, assuming you use a discount rate of 16.6%.
• Given the current share price of R$92.53, the analyst's price target of R$122.4 is 24.4% higher. Despite analysts expecting the underlying buisness to decline, they seem to believe it's more valuable than what the market thinks.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.