Victory belongs to the most persevering.
Napoléon Bonaparte
Companhia de Saneamento Básico do Estado de São Paulo – SABESP (BVMF:SBSP3: R$109.01/share), Brazil’s largest water and sanitation utility, serving 28.1 million people with clean water and 25.1 million with sanitation services in 375 municipalities in the state of São Paulo,, stands at the nexus of Brazil’s urgent infrastructure needs and an unprecedented wave of regulatory reform. Over nearly five decades it has operated as a publicly guaranteed regional monopoly, managing an R$ 80 billion asset base under long‑dated concessions, yet chronic underinvestment left service gaps, high water losses and mounting fiscal pressures on São Paulo’s state government. Privatisation has been the state’s answer to these problems, and with it an era of private‑sector discipline, enhanced governance and broader capital access. Traditionally, an investment that hinges upon an influx of capital is a thesis whose final outcome is shareholder value destruction, but the company’s existence as a monopoly whose essential profitability is protected, means that the investments-to-come will likely grow shareholder value, rather than destroy it, while achieving the state’s goals of universalisation of access to clean water and sanitation services. Management’s revamped incentive scheme and independent board, combined with a “strategic investor” privatization structure, have realigned leadership to profitability and service targets. Against a backdrop of rising sector margins, the country’s regulatory reforms and growing public-private partnerships (PPP) concessions nationwide set the stage for Sabesp to leverage scale, secure tenured assets until 2060 and navigate macro‑risks—be they tariff‑shielded inflation pass‑through or minimal exposure to trade‑war supply shocks. I believe Sabesp is a very attractive investment, whose economics, and a valuation that assumes a 36% decline in its core profitability, are hard to match.
The Road to Privatization
Privatization of Brazil’s water and sanitation sector began in 1996 under the government of Mr. Fernando Collor de Mello through the Programa Nacional de Desestatização, and by 2008, the private sector provided water for 4% of the country’s population. Today, ten of Brazil ‘s 26 states, São Paulo, Rio de Janeiro, Espírito Santo, Mato Grosso, Mato Grosso do Sul, Santa Catarina, Minas Gerais, Paraná, Pará and Amazonas, are now covered by 65 concessions contracts. Under concession contracts, the infrastructure is owned by the government and awarded by municipalities and states, but operated by concessionaries. This model has proven successful in expanding access to clean water and sanitation services. The private sector remains a small though growing player in water and sanitation, with private players such as AEGEA Saneamento e Participações S.A, enjoying higher-margins.
The drive toward privatization is a consequence of the need to address the infrastructure deficit the water and sanitation sector suffers. The government has attempted to spur added investment through legal mandates, most recently, the 2020 Sanitation Legal Framework (Law 14.026). The aim of this mandate is that, by March 2033, 99% of Brazil’s population will have access to drinking water, and 90% will have access to sewage collection and treatment services, a significant improvement from 2018, when, according to the National Sanitation Information System’s (SNIS), half of the population did not have access to sewage collection and treatment services and 16% did not have access to drinking water. This mandate envisages investments of around R$95 billion to achieve these twin goals, with a focus on underserved regions. Sector rules were standardised and private participation was incentivised through 30-year concessions and penalties for non-compliance. In the aftermath of the mandate, auctions surged, AEGEA, for instance, secured a R$15.2 billion contract in Pará state, demonstrating private appetite for long-term concessions.
Not only did the country witness a great demand for concessions, but, the Banco Nacional de Desenvolvimento Econômico e Social (BNDES) structured auctions and declared a financial capacity to finance as much as 80% of projects. For the 2019 to 2025 period, sanitation debentures are expected to reach R$43 billion, while multilateral institutions such as the International Finance Corporation (IFC) has also entered the fray, with João Carneiro, the IFC’s head of infrastructure investments, saying, “No other sector has a greater positive impact on society than sanitation.” The impact of this influx of capital will be to reduce the long-run cost of capital for concessionaires, an important point given high interest rates and residual regulatory uncertainty.
Sabesp, facing aging infrastructure with around 20% water loss due to leaks and underinvestment, long ago began the process of privatisation, but its operating structure, as a private-profit publicly guaranteed monopoly, proved a disincentive to investing in long-term infrastructure. During São Paulo’s 2014 Water Crisis, Messrs. Steffen Böhm and Rafael Kruter Flores explained that,
One of the world’s largest water utilities, Sabesp was founded as a public institution in 1973. Since part-privatisation in 1994 the state of São Paulo has maintained at least half of the company’s voting capital, though shares are also traded on the New York and São Paulo stock exchanges.While The Economist and others were keen to point out that Sabesp is “majority-owned by the state government”, this doesn’t tell the whole story. The utility is neither a public organisation concerned with providing a public service, nor a private company facing competition from other companies and controlled by regulatory agencies. Just like the “natural monopolies” enjoyed by water companies in the UK, Sabesp has a publicly guaranteed monopoly, yet its profits are part-privatised – earlier this year it paid out R$252m (US$83m) in dividends.
Sabesp pursued an alternative model to the private concession model in vogue, believing it a better way to resolve the incentive problems the previous model created. The company, like Companhia de Saneamento de Minas Gerais – COPASA MG (BVMF:CSMG3) in Minas Gerais and Companhia de Saneamento do Paraná – SANEPAR (BVMF:SAPR3) in Paraná, listed on the B3 S.A. – Brasil, Bolsa, Balcão. Sabesp is also listed on the New York Stock Exchange (NYSE). Sabesp also obtained loans from the Inter-American Development Bank and the Japan Bank for International Cooperation.
In 2019, São Paulo proposed to privatize Sabesp that very year in order to reduce fiscal burdens and align with federal pro-market reforms under President Jair Bolsonaro. Share prices rose 31% on privatization hopes. Privatisation, however, was only completed in July 2024 by the governor of São Paulo, Mr. Tarcísio de Freitas (Republicanos-SP). Under that agreement, São Paulo reduced its stake from 50.3% to 18.3%, while Equatorial Energia acquired 15% of Sabesp’s shares and became the new reference shareholder, and 17% of the shares were offered to minority shareholders, and another 40% of the shares are traded on B3 and 9.7% on the NYSE.
A Synergistic Relationship
Equatorial Energia, which owns power distribution companies in seven states, as well as a sanitation concession in Amapá, believes that its footprint in other states grants it the economies of scale and richness of expertise necessary to advance Sabesp’ expansion. According to Valor International, the firm’s focus is on improving Sabesp and its management, with the CEO, Mr. Augusto Miranda, envisaging a “long-term partnership”. Mr. Miranda believes that there are synergies between the two, given that not only is Equatorial Energia in energy and sanitation, but Sabesp itself not only serves 375 municipalities with water and sanitation services, it is also engaged in energy, paving and other sanitation-related services through six subsidiary companies:
Being a ‘multi-utility’ company is a differentiator – you’re already operating-, so these are complementary services, energy, and sanitation.
…
“We don’t need to grow for the sake of growth; we need to allocate resources efficiently.
In essence, what is promised is a blend of Equatorial Energia’s management model and Sabesp’s technical expertise. Noting that some municipalities in São Paulo are not covered by Sabesp, he said that,
If you look internally, there are municipalities that haven’t joined [the company] and are in neighboring areas. This is an opportunity. Sabesp’s reputation is an invitation for this.
New management, in place since October 1, 2024, and headed by CEO Mr. Carlos Leone Piani, who had previously served as chairman of Equatorial Energia, plans to invest R$70 billion by 2029 and R$260 billion by 2060 to fulfill its goal of achieving universal access to clean water and sanitation services. Piani is tasked with reducing the firm’s operating costs and optimally allocating capital without sacrificing service quality.
The company must abide by covenants which hold that at the end of every quarter, net debt/adjusted EBITDA must be lower than or equal to 3.50; and adjusted EBITDA/financial expenses must be equal to or higher than 1.5. Management expect to run at the limit of these restrictions, which are lower than other private-sector companies in the sector, with Equatorial Energia’s CFO, Mr. Leonardo Lucas, explaining that,
These are appropriate limits, especially in this interest rate environment. The company’s leverage is very low, and there is a significant opportunity to increase productivity. Additionally, the tariff review will be annual, so once the investment is made, there won’t be a long wait to receive the return.
An immediate benefit of privatisation is that, free from the shackles of state procurement policies, the firm will be able to act faster than it previously could.
Aligning Incentives
With privatization has come an additional lever for what Equatorial Energia’s CEO, Mr. Augusto Miranda calls, “engaging people”:
For example, Equatorial has a policy where there is a base salary, a medium-term salary with goals, and long-term incentives. With the company listed on the stock exchange, some people can even hold shares.
Although the role of reference shareholder lasts until 2029, the shareholder’s agreement can be renewed, which creates additional incentives for Equatorial Energia to deliver on its promises.
In tandem with the privatisation process, the company signed a new concession agreement with the Regional Unit of Drinking Water Supply and Sewage Services – URAE 1 – Southeast, covering 371 municipalities. It is in effect till 2060. Under this concession agreement ,the company is compensated based on its regulatory asset base, with annual tariff adjustments tied to how quickly the firm is accelerating its investments. In a field in which the firm faces no competition, this is a guarantee of profitability in the aftermath of the sought-out investments.
There are two five-year cycles whose asset base functions as a reference point for tariff adjustments: (i) 2024 to 2029 and (ii) 2030 to 2034. In the first, the goal is to achieve universalisation and quality improvement, for which significant investments are expected, enough to double the size of Sabesp’ regulatory asset base. All efficiencies with respect to the firm’s operating expenses are retained by it. In the second cycle, the goal is to improve operational efficiencies, for which there are loss reduction targets that will result in shared efficiencies with customers. The company will be remunerated based on the costs incurred and a predetermined weighted average cost of capital (WACC).
Tariff adjustments will, as aforementioned, be annual in the first two cycles, and quinquennial in the third cycle, subject to the company meeting universalisation and quality targets. The burden on customers is eased thanks to a Support Fund for the Universalization of Sanitation in the São Paulo State (FAUSP), which uses funds from Sabesp’ privatisation to keep tariffs at affordable rates, without hurting Sapesb’ profitability.
Improving Economic and Financial Performance
Even before these changes, Sabesp’ economic and financial performance was improving. The firm’s 5-year revenue CAGR for the 2019-2024 period was 14.98%, while its net operating profit after tax (NOPAT) compounded at a rate of 26.16%.
In that 2019-2024 period, Sabesp’s economic profit per share compounded from R$3.50 to R$11.47, at a rate of 26.79%, although the firm earned economic losses in 2021 and 2022, as its return on invested capital (ROIC) was lower than its WACC. At 23.2% in 2024, Sabesp’ ROIC is at its highest level ever.
In terms of operational efficiencies, it is noteworthy that Sabesp’ total operating costs and expenses as a share of total revenue, have fallen from 67.9% in 2019 to 55.94% in 2024, although the median value for the interim period was 77.11%. In other words, Sabesp was able to grow while keeping its operating costs under tight control.
Sabesp Is Priced for a 34% Decline in NOPAT
At its current price, Sabesp has a price-to-economic book value (PEBV) of 0.66, implying that the market expects its NOPAT to permanently fall by 34% from its 2024 levels. Using my reverse discounted cash flow (DCF) model, I teased out the expectations for future growth in cash flows implied by various scenarios for Sabesp.
In the first, I quantified the expectations implied by the current price, wherein:
- NOPAT margin remains at its 2024 level of 39.98%, and,
- Revenue declines by 20.55% in 2025, grows by 0.095% from 2025 onwards, in line with consensus estimates.
In this scenario, NOPAT falls to R$11.92 billion in 2028 -giving us a market-implied competitive advantage period (MICAP) of three years-, and the stock is worth R$110.93 today, approximately equal to the current price.
If, on the other hand, Sabesp’s
- NOPAT margin falls to its 3 -year average of 24.49%, and
- Revenue grows at 13.15% a year, it’s 3-year average, then,
the stock is worth R$123.69, an upside of 13.47% from the current price.
If, however, we assume that Sabesp’s
- NOPAT margins remains at 39.98%, and
- Revenue grows by its 5-year average of 14.98%, then,
the stock is worth R$255.69, a 135% upside from the current price.
Impact of Accounting Adjustments
I made numerous accounting adjustments to Sapesp’ 2024 financial statements, with the following impact:
Income Statement: I made R$4.87 billion in adjustments to calculate NOPAT, with the net effect of adding R$4.87 billion in non-operating expenses. The adjustments are equal to 50.84% of Sabesp’s IFRS net income.
Balance Sheet: I made R$11.54 billion in adjustments to calculate invested capital with a net decrease of R$11.07 billion. One of the largest of these adjustments was R$4.66 billion in excess cash, an adjustment which, on its own, is worth 5.75% of reported assets.
Valuation: I made R$32.58 billion in adjustments with the net effect of reducing shareholder value by R$23.26 billion. The largest of these adjustments was R$25.26 billion in adjusted total debt, representing 33.9% of Sabesp’ market cap.