It surely sound good! A Bossa Nova baby from Sao Paolo, not quite the girl from Ipanema, but we think it’s a very attractive stock nevertheless. Here is the chart, it doesn’t look to good, does it? And, to be honest, it’s not too easy to work out the figures. Looks can be deceptive..

Well, you could say that basically everything has a graph like that, these days, and you would actually have a point. But we have a feeling that underneath this nasty graph, a much more pretty picture is hiding. Compare it for instance to it’s three year graph, and things are put in a different perspective:

Basically, at least three years of steady progress has been wiped out in two months. The big question, of course, is whether there is any justification for this, or whether it is just collateral damage of the financial crisis buzzing around the world, with all its indiscriminate selling that accompanies it.

We think it’s clearly the latter, some important pointers:

1. The core business of this company is water and sewage management. Does seem a pretty stable business to us. We can’t detect any cycles, what’s more, it’s in Sao Paolo, a city that is steadily growing.
2. What’s more, with a stockprice of roughly $17 and average analyst profit forecast for 2008 of a whopping $5.16 per share, this trades at what seem to be a rather ridiculous p/e of 3.2 (although this turns out to be a rather common mistake, the share price is in dollars but the earnings per share in real, or if they are in dollar, they omit the 50.3% government stake, read on..)
3. Book value per share is, well, at $38.76 more than double that of at which the shares are trading
4. Mind you, analysts are not a whole lot more optimistic about next year, expecting on average a profit per share for 2009 of $5.28, at least at Yahoo. However, if you go over to MSN Finance the estimates get better, $5.72 per share for 2008 and $6.26 for per share for 2009 (and MSN clearly states that they are in US dollars, so they omit half the shares, those owned by the government, see below)
5. It gets hopelessly confusing when you then turn to the actual earnings page and see substantially smaller numbers, the first two quarters saw earnings of just $0.58 and $0.69 per share on MSN Finance. How are they going to get to the $5+ per share range with two quarters like that? It can’t be because these are in real, as they would be higher, not lower (unless there is really a dramatic profit drop, but the shares would have fallen much earlier if that was the case). Here they do count all the shares, apparently.
6. Things look even less attractive if you realize that analysts expect shrinking revenues, $4.19B in 2008 versus $3.22B in 2009, that’s a 23% expected fall. Pretty good job people expect profits per share to remain almost unchanged. There are not many companies which can deal with such a revenue shortfall and maintain profits per share. Margins must rise substantially to achieve that.
7. However, the recent change in those estimates leads us to think that what’s happening here (or rather, what’s expected by analyst) is mainly due to currency effects. Yes, these are tough times for the Brazilian real (as well as many other emerging market currencies), and these profit and revenue figures are expressed in ever stronger dollars..
8. We see nothing alarming in any of the key metrics (the market cap of 15. M can’t be right though). The debt is a bit high, but it doesn’t seem threatening with the operational results and margins they generate
9. There are 113,92M shares outstanding and curiously at first sight, according to MSN finance, the Brazilian government owns the lot, actually, even a little more at 114,508M. And indeed, according to a recent (30/6) SEC filing the company is ‘state owned’, but on p.58 the state (State Finance Dept.) owns only 50.3% of the shares, while the numbers are the same. It must be that the ‘outstanding’ shares refer only to the part that is non-government owned, and this can be the source of the confusion above (with the profit per share figures).
10. An interesting question with regard to this is whether the government eats up half the profit (and dividend)? We would expect so, because the government shares are just in common shares. Somewhat curious, this.
11. Another relevant question, although we realize privatizations are not so popular these days (to put it mildly), but could the Brazilian state sell some or all of its stake? It’s not likely that this will happen under the present government, but politicians rarely have eternal life, especially in democracies..
12. Actually, we cracked these problems. After a little bit of search, we found figures that make much more sense here. Indeed, the government is sharing and total shares are the sum of the government part and the shares outstanding, that is, 227.84M.
13. Earnings per share fluctuate quite a bit, without there being a clear upward trend: 4.6(07); 2.89(06); 3.63(05); 1.99(04); 3.19(03). In fact, there is a nice table with 10 year results. There were even two years with losses (1999 and 2002). Revenues are nicely growing though. There is a clear trend there.
14. As least as important, these figures are in Brazilian real, which leads us to conclude that these profit estimates for 2008 above in the 5 per share range cannot be true, they are either in Brazilian real or are based on half the share count, omitting the 50.3% stake of the government. MSN site say their estimates are in US dollars, so they omit half the shares. Yahoo’s estimates is not clear in what currency they are. Can analyst be that stupid?
15. Let’s double check. 2007 net earnings (in real) was 1048.7 divided by 227.84 = 4.6. That is indeed the figure that is provided. It also corroborates with figures in dollars on Yahoo, which show net income applicable to shares as $523,242, which is about right considering the exchange rate between dollars and real (roughly 2:1).
16. So the profit estimations for this year and next must be either in real (based on 227M shares), or if they are in dollars, they are disregarding the 50.3 stake of the Brazilian state. That spoils the picture considerably.
17. One risk is the legal and regulatory environment. Considering their business and the environment, this is hardly a surprise, but it makes it quite difficult to really analyse this company, unless you have a good command of the Portuguese language and Brazilian regulatory law and politics
18. The other risk is the exchange rate, and with the emerging market crisis at the moment we are far from certain that the worst has passed on this front.
19. Deeply buried in the latest SEC filing (p45.) we came across this sentence: “The loss of major consumers on the coast line and the discontinuity of invoicing to 3 municipalities in the interior.” The quarter was distinctly mediocre, and this was one of the reasons they provided. It does, at the minimum, suggest that their customers are not fully captive. Has the Brazilian government been embarking on excercises in ‘Reinventing Government’ and put tenders out for some of these contracts? It seems the case.

We promised to look into this company. Our preliminary conclusions:

• It is cheap, but not that cheap, in fact it’s twice as expensive as many people seem to think, and considering the lack of a strong upward trend in earnings, the p/e of 6-7 is hardly at bargain basement levels. In a normal market we would kind of recommend it, but this market has so many other cheap shares that we cannot go that distance
• One possible sweatner is dividend. In 2007, the dividend was 1.32 per share (which is almost 8% at current share prices), once again, in real. However, of the last five years, there were only two with a dividend pay-out (2007 and 2005), so we can’t be entirely sure whether they will pay dividends in 2008. We couldn’t find any decision, but that could be our fault.
• We have to admit that we cannot go to the core of this company. In our series ‘the economic analysis of stocks’ we were often able to point out at a couple of dynamics driving earnings. Here we’re pretty sure these dynamics are burried in the legal and regulatory environment (with labour negotiations as a joker thrown in), but this is beyond our competencies, so we have no real understanding where earnings go from here. If history is anything to go by, these could go anywhere though. Unlike revenue, which grows nicely year-on-year, there is no clear trend in earnings. That’s not too positive either.

So we started very enthusiastic, but that enthusiasm has waned considerably, we’re afraid.