ft 06.01.12

BRAZIL CONFIDENTIALJANUARY 6-18 201212

BLOO

MBERG

A Sanepar water treatment plant in Irai, Rio Grande do Sul. Brazil’s best sanitation companies are in the south and south-east

SUMMARY The water

and sanitation sector is badly managed and undercapitalised, but a process of transition is occurring.

Sabesp and Copasa, listed companies which hold concessions in the south-east, are the best suited for organic growth. They are turning to the bond markets and PPPs to ease capital pressures.

The private sector’s participation in the industry could increase from 10% to up to 40% within a decade. Firms owned by the major engineering contractors are expanding, in particular through combined water and sewerage contracts.

The better public providers are looking to expand, and private-sector companies are winning contracts.

BUILDING BRAZIL

SIGNS OF A CLEAN-UP IN THE SANITATION SECTOR

You don’t have to travel far in Brazil before you bump into the shortcomings of the sanitation sector. The sewerage network reaches less than half the population, and most of the waste it

does collect isn’t treated. One in five Brazilians lack access to piped water.

The sector is dominated by badly-managed publicly-owned utilities, which operate effective geographical monopolies without formal contracts or independent regulation.

However, the government has committed itself to re-form. It can take heart from good management seen in the south-east, where two state-controlled providers – Sabesp (SPSB3:SAO) and Copasa (CSMG3:SAO) – are in the process of formalising contracts and relationships with regulators. A small group of efficient privately-held firms are also gaining ground. The question is whether the sector as a whole will remain a laggard.

A new framework Ensuring universal access to piped water and sewerage collection in Brazil would cost an estimated R$270bn ($148bn, £95bn, !115bn). In 2010, the industry invested less than R$20bn, including both public and private sources. The federal government has pledged to invest a further R$35m by 2014, under the second phase of the Programme for Growth Acceleration (PAC 2). But that leaves a considerable shortfall. The hope is that sanita-tion could follow the example of the highways sector, which has benefited from greater private-sector involve-ment (through PPPs and concessions).

The federal government is trying to overhaul the institutional framework. In 2010 it passed a law obliging all municipalities to develop a sanitation plan by 2014 and create independent regulators. Other rules allow for differentiated tariffs for customers who consume and earn less, but indemnify utilities that cut off supplies to those who don’t pay at all.

Policy is set at the federal level by the Ministry of Cities, which together with the Ministry of Health and public banks such as BNDES and Caixa Econômi-ca Federal provides funding to utilities. Provision

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BRAZIL CONFIDENTIALJANUARY 6-18 201213

Sabesp serves 23.5m customers, making it one of the biggest sanitation companies by customer base in the world

BUILDING BRAZIL SIGNS OF A CLEAN-UP IN THE SANITATION SECTOR

Good management means that sector indicators are above average for public sector companies. They both had system losses of less than 30% in 2009, compared with a national average of 37%, and unpaid bills at Co-pasa were 1.32% in 2010, less than the national average of 7%. However, both companies face uncertainties in relation to regulation and future capital-raising.

The regulatory framework for both states is ex-pected to be announced later this year by the respec-tive state governments, although the process has

and regulation, however, is delegated to the regional level. Brazil has 27 publicly owned sanitation compa-nies – one per state – alongside a multitude of publicly

owned municipal sanitation companies. In most parts of the country geographical monopolies operate, but in recent years the south-east – and to a lesser extent the centre-west – has been opened up to competition.

As a result, a small number of private utili-ties, most of them subsidiaries of large engi-

neering contractors, have been gaining ground and now cover 10% of urban provision. Concessions are awarded by municipal governments and typically last for 30 years. However, the implementation of formal contracts via a public tender process is still at a very early stage.

Providers generally charge tariffs to customers for supply of water and, where offered, collection of sewer-age. In some cases they also charge for the use of water although water metering is still not widespread. Tariffs have traditionally been set by the utilities themselves based upon a calculation of operational cost and infla-tion. However, where they exist, independent regulators are in the process of defining new charging models. In São Paulo and Minas Gerais these will take into account capital expenditure when making tariff adjustments and this model may be repeated elsewhere.

Headway in the south-east The biggest beneficiaries of reform could be those ar-eas where the service is currently worst. For example, in the north-east, where just 80% of the population doesn’t have sewerage collection, companies have too many staff and too little monitoring capacity. Mean-while, because of fraud, leaking pipes and clandestine connections, the northern state of Amapá consumes as much water per person as São Paulo. Amápa’s state company, Caesa, cut half its jobs last year but still lacked the funds to pay for its phone lines.

In contrast, Brazil’s best sanitation companies are in the south and south-east, the regions which also have the best coverage. Santa Catarina’s Casan and the companies for Minas Gerais, São Paulo and Paraná (Copasa, Sabesp and Sanepar [SAPR3:SAO]) are all listed on the Bovespa, with the shares of Copasa and Sabesp trading on the Novo Mercado, the segment with standards for corporate governance.

However, the stocks lack liquidity. Only 0.002% of Casan’s stocks are traded, for example. This may change though, Santa Catarina state assembly recently passed legislation allowing for the state government to sell 49% of its stake in the company to a strategic investor, which may happen as early as 1Q12.

Sabesp, in which the São Paulo state government holds a 50.3% stake, serves 23.5m customers, making it one of the biggest sanitation companies by customer base in the world. The smaller Copasa, in which Minas Gerais state government has a 53% stake, serves 13.2m people. Both companies have significant potential for expansion of their customer bases. Source: SNIS

0

10

20

30

40

50

60

%

BrazilSouthCentre-west

South-east

Northeast

North

37.125.3

33.836.244.0

53.7

Efficiency is highest in the southWater losses as a share of water companies’ turnover, 2009

Source: SNIS

0

20

40

60

80

100Sewerage treatment

Sewerage collectionPiped Water

BrazilSouth-east

Centre-west

SouthNorth-east

North

%

Much still to be done – especially in the northAccess to water and sewerage services, 2009% of households

Financials of leading utilitiesNet revenues (R$m)

2005 2006 2007 2008 2009 2010 2011*

Copasa 4,953 5,527 5,971 6,352 6,731 9,230 7,226

Sabesp 1,477 1,682 1,863 2,060 2,202 2,323 1,872

Ebitda margins (%)

Copasa 39.7 39.0 40.2 28.9 39.6 45.6 42.5

Sabesp 46.1 44.3 45.2 44.7 40.7 34.9 31.1Notes: R$1=$0.5, £0.3, !0.4. *Jan-Sep Source: companies


BRAZIL CONFIDENTIALJANUARY 6-18 201214BUILDING BRAZIL SIGNS OF A CLEAN-UP

IN THE SANITATION SECTOR

INSIGHTSUPPLY CHAIN OPPORTUNITIES

Annual sales of water and wastewater treatment technology services in Latin America will rise by over 50% by 2020, to around $72bn, according to forecasts from consultancy Frost & Sulli-van. The vast majority of the market is in the residential and commercial sectors, although industry is seeing faster growth.

Within Brazil, around 85% of the market is dominated by multinational companies such as Nalco (NLC:NYSE), GE (GE:NYSE), Kurita (6370:TYO), Kemira (KRA1V:HEX), Veolia (VIE:PAR), Dow (DOW:NYSE), Buckman and Ashland (ASH:NYSE). Their distribution networks and technologies allow them to out-compete Brazilian rivals.

Advanced technologies can reduce the cost to the end user by 20-30%, according to Renato Ramos, head of re-search and development Dow Water & Process Solutions Latin America, because they consume less energy and chemicals.

There are legislative driv-ers, too, to the growth of such technology. Since 1997 some parts of the coun-

try have had committees – composed of representa-tives from industry, water companies and residential consumers – which manage water resources. The com-mittees have increased fees for water by about 10% per year. Industry can reduce its exposure to this increasing cost by re-using water. Tra-ditionally it has done this by treating water with coagu-lants such as iron chlorate and aluminium sulphate to aggregate pollutants. But the quality of the end product is not as good as that achieved with advanced technol-ogy such as ultra-filtration membranes and as a result cannot be used in sectors like the pharmaceutical industry, where purity is paramount.

Dow manufactures key parts in Europe, the US and Asia, which it then sells on to the large suppliers of utilities and industry in Brazil and elsewhere in Latin America. The company’s sales for the region are forecast to double in the three years to 2012, although it did not supply specific figures.

While much of the equip-ment used in the sector in Brazil currently is imported, Alessandra Lancellotti of Frost & Sullivan thinks that this will change as demand increases from large state-owned companies such as Petrobras (PETR4:SAO) and Vale (VALE5:SAO), which have significant local content rules for their respective sup-ply chains.

While legislation is increasingly rigorous, the sector would receive an even greater boost were laws to be better enforced, says Ms Lancellotti. “Many small and medium industries are not monitored,” she says. “Very often they don’t even have a system for the treatment of water.”

already been subject to delays. The new regulators are part of the state govern-

ments, which are the majority shareholder in the respective companies, Sabesp and Copasa.

One sticking point is adjustments to the tariff system, which will from this year take into account capital expenditure as well as the rate of inflation and operational cost. Sabesp invested R$2.5bn in 2010 out of net income of R$9.2bn, while Copasa has invested an average of R$870m per year since listing in 2006 and so both should stand to gain from linking tariff adjustments to investment. However, it is not known what basis the regulators will use to calculate the value of these companies’ respective asset bases.

Both companies are in the process of formalising their service contracts with municipalities. One uncertainty for Sabesp relates to a contract it was recently awarded to supply the municipality of São Paulo. The contract con-tains a service fee priced at 7.5% of gross revenues gener-ated from São Paulo. This is unusual in the public sector, and the company may seek to pass it on to consumers via higher tariffs. However, it is not certain that the state regulator would accept such a move.

Another issue for Sabesp and Copasa is financ-ing growth. Both have the opportunity to expand their customer bases significantly. Copasa currently provides water to around three-quarters and sewerage to a quarter of the 800 municipalities in Minas Gerais and has identified another 104 municipalities it wishes to target for sewerage contracts, while Sabesp provides water to 23.8m customers and collects sewerage from 20m, but still only covers half of São Paulo’s 645 municipalities. This expansion is likely to take place via organic growth rather than M&A activity, as other publicly owned companies are largely opposed to be-ing acquired and many don’t hold formal concessions for the services that they provide.

In the context of lacklustre equity markets, Sabesp and Copasa are likely to issue bonds, take loans from federal government agencies or enter into PPPs to fuel this expansion. Another option is multilateral agencies, such as the IFC, which recently provided

Source: SNIS

Rio Grande do SulR$359.7m

PernambucoR$440.5m

BahiaR$458.7m

Minas GeraisR$937.3m

São PauloR$2,712.9m

The states that invested most in sanitation2009


BRAZIL CONFIDENTIALJANUARY 6-18 201215BUILDING BRAZIL SIGNS OF A CLEAN-UP

IN THE SANITATION SECTOR

ACTIONPOINTS

01 Equipav, a private operator, has an ebitda margin of around 60%, 20pp higher than that enjoyed by the most efficient public sector companies. This is as a result of reduction of energy, labour and equipment costs and investments in metering.

02 In the supply chain, multinational companies import advanced technologies, offering improved water purity. However, increased demand for water from Brazilian corporations such as Vale and Petrobras, which operate local content rules, could stimulate the local supply chain.

R$59m to Casan and the state utility for Sergipe – Deso – to fund training, installing water meters and registering users.

Copasa has exhausted the capital available from its IPO and is looking for additional sources. It can’t issue new shares because the state government is at its shareholding limit, so it plans to issue R$400m in 2012. It has also obtained a !100m loan from the German development bank KfW but does not wish to increase its foreign currency exposure significantly beyond the current level of around 2% of gross debt. In contrast, around 35% of Sabesp’s debt is denominated in foreign currency, mainly US dollars. Net debt was 2.1x ebidta in 2009, 1.9x in 2010 and 2.0x ebidta in 3Q11.

State companies in the south-east of Brazil are increasingly entering into PPPs, which allow them to fund investment, while retaining direct contact with their customer bases. Sabesp established the R$300m CAB Spat PPP with CAB Ambiental (a small player in the sector owned by Galvão Engenharia and FIGTS) in Taiaçupeba, São Paulo in 2009. The 15-year contract covers the expansion of the capacity of water treat-ment by 50%.

Sabesp plans to launch two more PPPs in 2012, one for water treatment for the west of São Paulo city and one for sewerage on the northern coast of the state. Ce-dae, the Rio de Janeiro utility, also recently launched a major PPP for collection and treatment of sewerage in the deprived western zone of Rio de Janeiro city, which will require R$2bn investment over 30 years. Paula Bit-tencourt, Copasa’s head of investor relations, told Bra-zil Confidential that her firm is currently studying the possibility of a PPP to expand the distribution network for Belo Horizonte, although this is at an early stage.

Equipav’s efficiency Through a growth in the number of PPPs being ten-dered and also direct concessions, private companies, which currently hold about 10% of urban provision in Brazil, will increase their share to up to 40% by 2020, according to Paulo Oliveira, chief executive of the concessionaires organisation Abcon.

Infrastructure and services group Equipav moved into the sanitation field in 2005 through the acqui-sition of two companies – Águas Guariroba from Aigües de Barcelona, which has the contract for water and sewerage in Campo Grande, and Prolagos from Águas de Portugal, which covers five munici-palities in Rio de Janeiro.

The focus, according to finance director Flávio Crivellari, has been on making significant capital invest-ments to increase the number of clients and improve efficiency. Cuts have been made to the company’s three largest operational costs – labour, energy and chemi-cals. Automation reduced labour costs, while electric-ity costs have fallen 14% in the past four years, as the company now carries out distribution and collection during off-peak hours. Finally, chlorine costs have fallen by around one-third, following the construction of a

factory in Campo Grande, which allows the company to supply its local network and sell the surplus. As a result, ebitda margins for the two companies are expected to exceed 50% for 2011. That compares with a margin of 34% for Guariroba at the time of the acquisition and a negative margin for Prolagos and is up to 20pp higher than that of Copasa and Sabesp.

Long-term financing is provided by Caixa Econômi-ca Federal to Guariroba and BNDES to Prolagos. The business is looking for alternatives in capital markets. In 2007, Prolagos made a private placement of R$75m of seven-year bonds via HSBC (HBS:NYSE), rated A by Fitch. Mr Crivellari says that the business is also looking to external markets and has held conversa-tions with the IFC and IDB. He says that the business wishes to triple the number of users from the current level of 1.25m in the next five years, and may consider a partner.

The business recently had the Prolagos concession extended for another 18 years and is in the process of approaching municipalities with a view to winning combined water and sewerage contracts, which cre-ate better synergies and allow for lower tariffs than separate water or sewerage concessions. It recently competed for the AP-5 PPP, a project to collect and treat sewerage in western Rio de Janeiro city, but lost out to a consortium of Águas do Brasil and Foz do Brasil, which are owned by Developer, Queiroz Gal-vão, Trana and Cowan, and Odebrecht respectively. The consortium paid R$84.2m for the PPP contract.

Águas do Brasil has ten other concessions, covering 2m customers in eight municipalities in Rio de Janeiro and four in São Paulo. In 2011, net revenues were R$488m, while the ebitda margin grew 1pp to 135%. Leverage is low, just 20% of net revenue in 2011, and is entirely comprised of long-term financing provided by BNDES at a rate of around 8.5% per year. The company will look for further funding from the development bank, to finance the AP-5 programme. Claudio Ab-duche, Águas do Brasil’s director-general, says that the firm “has no interest” in a stock listing.

Foz do Brasil, meanwhile, has a strong footprint in the industrial sector. While this doesn’t offer the same scaleability as municipal contracts (which cover residential, commercial and public sanitation), it is a fast growing area as a result of the high demand from the oil and gas, mining, steel and paper and cellulose industries. One such contract is the agreement to treat water for the Franco-Japanese steel tubing joint ven-ture Vallourec Sumitomo Brasil (VSB), based 100km from Belo Horizonte in Minas Gerais.

Foz received a senior loan of R$361m from BNDES and R$74m in mezzanine financing from InfraBrasil, a $942m fund run by Santander (SANB4:SAO). In 2010, Foz also received a R$92m ten-year loan from the IFC to finance greenfield projects, improve existing assets and reinforce the existing capital base of the business with a view to making potential acquisitions. The IFC has the option of switching its loan into a 4% stake in Foz.


ft 06.01.12

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