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, On Tuesday October 4, 2011, 5:50 pm EDT

We recently upgraded our recommendation on Companhia de Saneamento Basico do Estado de São Paulo (NYSE: SBSNews) from Underperform to Neutral.

The upgraded rating is backed by the long-term prospects of SABESP’s target of providing roughly 1.3 million new water connections and 1.7 million new sewage connections, while improving its sewage coverage to 90%, through 2019. Water loss ratio is also expected to go down to 14% by December 2014.

Moreover, the Sao Paulo State Sanitation and Energy Regulatory Agency (ARSESP) recently approved a tariff readjustment index of 6.83% for SABESP, which the company can apply linearly to all categories of water and sewage consumers as of September 9, 2011.

Currently, the company is one of the largest players in the industry distributing water to approximately 23.6 million people and providing sewage services to more than 20.2 million people.

However, during the second quarter of 2011, SABESP’s cost of sales and services, as a percentage of revenue, soared to 61.5% boosting the gross margin by 4%. This has dampened our outlook on the company.

Among the cost components, rise in electric power cost appears detrimental to the stock as the company relies heavily on electricity as a source of energy for its pumping stations. The cost rise lowers our outlook on the stock.

Furthermore, SABESP is exposed to the risk of political interference, which may directly influence the company’s future planning and growth prospects. Regulatory uncertainty or delay in pension payments on behalf of the government remains a major cause of concern.

On this backdrop, the company continues to make a constant effort to improve its services and keeps formulating plans for strategic investments. Investments over 2009-2013 period have been estimated to be roughly around R$ 8.6 billion, with R$ 1,753 million targeted for 2011 and R$ 1,748 million for 2012.

Moreover, the company operates in a non-cyclical regulated utility market in Brazil. Therefore, the stock appears to be a relatively low-risk investment future opportunity.

The company, providing public water and sewage services in the State of SãoPaulo, Brazil, faces stiff competition from peer like Veolia Environnement S.A. (NYSE: VENews).

COMPANHIA DE SANEAMENTO BASI (SBS): Read the Full Research Report

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