3 States Forced to Invade Debt Reserve Funds, Moody’s Dramatically Alters Criteria & Ratings
Higher Payment Withholdings and Lower Debt Reserve Earnings Accelerate Projected Bond Defaults
A lot has transpired in the tobacco bond world since Part 1 of this report was issued in May 2011. To summarize that report:
Since that report, it was reported that two other issues, Virginia and the Ohio Buckeye Tobacco bonds, will be forced to invade debt reserve funds in order to meet minimum interest and serial bond repayment requirements this year. None of these three states are in a position to redeem turbo term bonds in 2011. In addition to the reduction of MSA payments, these issuers were forced to invest their debt reserves in low-yield securities after their Lehman Brothers guaranteed investment contracts were voided because of Lehman’s bankruptcy.
In June there were reports and the publication of a draft settlement proposal between the states and tobacco manufacturers to address the ongoing NPM dispute between the states and manufacturers, free up disputed funds in escrow, and revise future procedures to eliminate long and costly legal battles on the NPM adjustment. It was estimated that the states could have seen a one-time cash infusion of between $1 billion & $2 billion dollars next year, which would have improved cash flow for tobacco bonds. By the end of July, the proposed settlement had been scuttled because states couldn’t agree to the terms. Arbitration on the 2003 MSA payment dispute continues, with no expected decision date as yet.
Finally, on September 9th, Moody’s revised its tobacco bond rating criteria, incorporating more rating-by-maturity criteria and increasing its base-case shipment decline assumption from -3% annually to -4% annually. Moody’s upgraded about $3.5 billion of short-maturity tobacco bonds to as high as Aaa, reflecting the reduced risk that continued shipment declines would affect debt repayment in the next 5 years. However, they also downgraded about $3.5 billion of long-maturity tobacco bonds, with many maturities drastically downgraded from Baa3 to a range of B1 through Caa1.
The shortfalls in 2011 revenue continue to put a dent in cash flow that was expected to generate surplus revenue above bond interest costs and allow debt reduction through prepayments under the so-called “turbo” bond structure.
Turbo redemptions in 2011 again fell short of original expectations; the chart below depicts the cumulative shortfall in redemptions since issuance by some of the largest tobacco bond issuers. Over time, if shipments continue shrinking at a -4% decline rate (which had been the break-even rate of decline for most tobacco bonds structured after 2005), then eventually issuers will need to draw on debt reserves, and would come up short of paying the entire amount of bonds issued. That is because bond interest would remain high because fewer bonds were redeemed in the early years. The continuing shortfalls in turbo collections over the last few years are graphically depicted in the chart below.
Tobacco companies believe that they are due refunds of past MSA payments because of the NPM adjustment. This adjustment was written into the settlement to protect tobacco manufacturers from losing market share to companies that did not sign and pay into the MSA. Using this clause, the tobacco companies have disputed their payments since 2003, although the companies did not actually start withholding funds from the states until 2005 & 2006. Since 2005, the tobacco companies have frozen funds away from the states by about $3.5 billion; however, the potential amounts subject to challenge and refund has now accrued to $7.152 billion through 2011, as seen in the chart below.
These disputes are to be determined by arbitrators annually; the first arbitration for the 2003 sales year has yet to be completed. If the states won all of the arbitrations, the $3.5 billion of funds held in dispute would be freed, dramatically improving tobacco bond redemptions which have been well below expectations. However, if the tobacco companies were to win all of the arbitrations, they would get back the $3.5 billion of funds held in dispute, and could additionally withhold $3.6 billion from future payments. In that scenario, Philip Morris (Altria) would be the biggest beneficiary, because PM has not withheld any funds in dispute since 2005, instead choosing to wait for the results of arbitration. The $3.6 billion would also reduce future MSA payments, worsening bond redemptions and accelerating the date when tobacco bond issuers would need to use reserve funds and default because of insufficient cash flow.
One item of contention in this dispute is over the requirement that payments will only be reduced after it can be shown that a state has not diligently enforced laws enacted to force non-signing manufacturers to pay fees into escrow funds. Lax enforcement of these fees would allow non-MSA companies to sell their brands at a lower price, which could shift sales away from the MSA companies. Given the tobacco companies strong record in litigation, I believe that they probably have evidence of lax enforcement, although they have not disclosed any indications of states that may be guilty of lax enforcement.
In June, the Wall Street Journal reported that there was a draft agreement to settle the dispute. Although terms were never finalized in the draft, it was estimated that of the $7 billion in dispute, about $5-6 billion would revert back to the companies, allowing the states to free up between $1-2 billion. The proposal would have also streamlined and simplify the process of NPM disputes and adjudication for years after 2012.
By late July, it was reported that the proposal could not gather enough state support to proceed, and was therefore scuttled. The settlement would have improved tobacco bond cash flow significantly; however, as my analysis will show later in this report, the improvement would not have been enough to avoid future tobacco bond defaults.
In the first few years after the settlement, there was a major loss of cigarette market share from Participating Manufacturers (PMs) that signed and pay into the MSA, to Non-Participating Manufacturers (NPMs) that could charge lower prices by not having the MSA costs. The share of the market by NPMs reached a peak in 2003, when it reached 8.36%. Efforts to convince NPMs to join the settlement, and ostensibly the enforcement of NPM fees on lower cost manufacturers caused NPM share to decline from 2003 through 2007 to only 5.57% (which increases MSA payments to states). Because the NPM market share losses were declining, the amounts disputed under the adjustment shrank from, $1.15 billion in 2003 to only $703.7 million in 2006. NAAG is reporting that market share for NPMs increased in 2008, 2009 & 2010 with amounts in dispute also rising to $918 million in 2008, $843 million in 2009 and $905 million in 2010. While a 1 % shift of market share does not appear to be much, the payment reductions they cause, compounded over the 30 or 40 year life of bonds, result in significant revenue shortfalls as later bonds come due. It also fuels the fire for NPM disputes in future years.
Most tobacco bonds issued since 2005 were structured to have break-even cash flows if shipment declines averaged -4.0%. However, shipment declines have slightly exceeded those breakeven points over the last 12 years, and the shortfalls caused by the NPM dispute have weakened tobacco securitizations because issuers have not been able to reduce their debt through high turbo bond redemptions. If shipment trends continue at historical rates, many tobacco securitizations will have to use debt service reserves to meet full principal repayment requirements beginning as early as 2016 (in addition to those reserve invasions in 2011 by 3 states). In addition, principal defaults on term bonds could start occurring as early as 2024. Although not covered in these calculations, most issuers that issued subordinated capital appreciation (zero coupon) bonds with maturities after 2047 will likely see defaults on those bonds as well.
Issues before 2005 tended to be less leveraged, structured to pay in full even if shipment declines were higher than -4.0 % annually. As a result, issuers like Louisiana and the State of Washington should be able to continue making all payments on time, unless shipment declines rise to -5.0% or more annually.
The calculations below assume that current NPM withheld funds are not released, but further NPM reductions are not made by manufacturers after 2011. The biggest wild card for tobacco securitizations will be how current NPM disputes are resolved. If the states win the arbitrations (people expect the first arbitration decision for the 2003 NPM adjustment to take place later in 2011 or 2012), then all tobacco securitization cash flows will dramatically improve, although cash flows will still remain tight. If the manufacturers win however, and Philip Morris is permitted to withhold amounts that had originally been released to the states, then cash flows will demonstrably weaken further, with debt reserves being invaded earlier, and defaults occurring before 2024. Finally, all of my projections assume that the NPM withholdings are spread among all states; if the manufacturers win arbitration, and they rule that only several states were found to have less than diligent enforcement of the MSA statutes, the cash flow reductions could completely wipe out revenue in those states, accelerating debt reserve draws and bond defaults in the affected states, while improving cash flow for the remaining states. This creates a “Russian Roulette” risk to all tobacco bond issues because no one will know which states could lose their MSA payments until arbitration is completed.
This year’s default projections are far worse than those made in 2010, for two reasons: first, they include another year of NPM dispute withholdings which were not assumed in 2010. Additionally, most of my projections this year assume reduced debt service reserve fund earnings of only 1% annually, compared to earlier base case assumptions of reserve earnings of 4% or more (because many issuers had guaranteed investment contracts which expired in 2008 & 2009).
Finally, as seen in the comparison chart below, projections that would have been based on an NPM settlement according to the terms of the June 2011 draft proposal would have improved cash flows, but not enough to avoid defaults for the selected issues sold after 2005. That’s because the compounded effect of the NPM rebates to manufacturers, coupled with continued shipment declines of -4% and low debt reserve earnings, would not be sufficiently offset by the one-time cash infusion of $1-$2 billion that would have resulted from the 2011 proposal. It would, however, delay some expected defaults, and reduce amounts projected to default in the base case projections.
The material presented here is for information purposes only and is not to be considered an offer to buy or sell any security. This report was prepared from sources believed to be reliable but it is not guaranteed as to accuracy and it is not a complete summary of statement of all available data. Information and opinions are current up to the date of publication and are subject to change without notice. The purchase and sale of securities should be conducted on an individual basis considering the risk tolerance and investment objective of each investor and with the advice and counsel of a professional advisor.
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