Fitch Affirms Virgin Islands Matching Fund Rev Bond Ratings; Outlook Stable
--$804 million revenue bonds (Virgin Islands matching fund loan note) senior lien at 'BBB';
--$163 million revenue bonds (Virgin Islands matching fund loan note) subordinate lien at 'BBB-';
--$242 million subordinated revenue bonds (Virgin Islands matching fund loan note-Diageo project) series 2009A at 'BBB-';
--$36 million subordinated revenue bonds (Virgin Islands matching fund loan note-Cruzan project) series 2009A at 'BBB-'.
The Rating Outlook is Stable.
SECURITY
Special, limited obligations of VIPFA payable from and secured by a pledge of and lien on the trust estate of each respective indenture, primarily matching fund revenues associated with rum production at the Cruzan and Diageo facilities located on the U.S. Virgin Islands (USVI).
KEY RATING DRIVERS
ESTABLISHED PLEDGED REVENUE STREAM: Matching funds are an established revenue stream based on federal law derived from substantially all excise taxes imposed and collected on certain products produced and exported to the U.S.; primarily rum. The $13.50 federal excise tax rate provides revenue to the USVI at a $10.50 base 'cover-over' rate that has been periodically increased to a higher $13.25 rate.
PLEDGED REVENUES INSULATED FROM USVI OPERATIONS: Bond security is well-insulated from the financial operations of the USVI (implied general obligation bond rating of 'BB-' with a Negative Outlook by Fitch) as the U.S. Treasury transfers all matching fund revenue to a special escrow agent for payment of debt service on matching fund revenue bonds prior to being made available to the USVI for other purposes.
MATCHING FUND REVENUES DEPENDENT ON RUM PRODUCTION: Payment on the bonds, particularly the subordinate indentures linked to specific facilities, is ultimately dependent on ongoing rum production at the facilities and sales in the U.S. Additionally, production of rum in the territory itself is tied to continuation of the federal matching fund program and the availability of incentives and subsidies to producers from the USVI. Cruzan's loss of two bulk rum customers in fiscal 2014 (fiscal year beginning Oct. 1, 2013) and a shift in consumer tastes have reduced shipments from the USVI, impacting matching fund revenues and coverage.
COVERAGE OF DEBT SERVICE IN EXCESS OF THE ABT: Given variability in the revenue stream, the rating assumes a margin of coverage in excess of the bonds' additional bonds test (ABT). Maximum annual debt service (MADS) coverage from fiscal 2014 receipts for the senior indenture was 2.5x; MADS coverage for all debt service obligations in aggregate was almost 2x. Both ratios are down from fiscal 2013 when, incorporating the issues mentioned above, and Fitch believes a further decline in fiscal 2015 is likely.
RATING SENSITIVITIES
The ratings on the bonds are sensitive to adequate debt service coverage being provided by pledged revenues. Pledged revenues are affected by the continuation of rum production in the USVI and the maintenance of the matching fund program. These factors are influenced by shifts in consumption trends, which have recently resulted in reduced production. Fitch believes a continuation of these trends in fiscal 2015 has pressured debt service coverage and their continuation in fiscal 2016 could result in a downgrade.
CREDIT PROFILE
The rating on VIPFA's matching fund bonds is based on the revenue stream supporting bond payments, consisting of matching fund payments made annually by the U.S. government and transferred directly to escrow for payment of debt service prior to being made available to the government of the USVI. Offsetting factors include dependence of the revenues on ongoing rum production in the USVI and exposure to adverse trends in consumer demand for rum products.
Pledged revenues consist of matching fund revenues that are collected annually from federal excise taxes levied on rum shipments from the USVI to the U.S. and are based on proof (alcohol content) gallons, with a higher proof per gallon subject to a higher tax. The U.S. Treasury transfers all matching fund revenue directly to a special escrow agent, who deposits the funds for payment of annual debt service requirements.
ESTABLISHED PLEDGED REVENUE STREAM
Matching fund bonds are special, limited obligations of the VIPFA, issued under a senior indenture (1998 indenture) and two subordinate, parallel project indentures associated with the USVI's two distilleries (Cruzan indenture and Diageo indenture). The 1998 indenture bonds have been issued under senior and subordinate liens periodically by the USVI for capital purposes or to address operating deficits.
The project indentures, each established in 2009, funded facility improvements at the longstanding Cruzan distillery (the Cruzan indenture) and financed the construction of the new Diageo distillery (the Diageo indenture). The two project indentures are part of broader 30-year incentive agreements reached between the USVI and local affiliates of Suntory Holdings Ltd. (not rated by Fitch), owner of the Cruzan facility, and Diageo plc (rated 'A-', Negative Outlook), owner of the Diageo facility. A debt service reserve funded at MADS provides additional protection.
FLUCTUATIONS IN COVER-OVER RATE LOWERS AVAILABLE REVENUE
Matching funds have been paid annually to the USVI by the U.S. government since 1954 based on sales in the U.S. of USVI rum. Funds are paid at a base 'cover-over' rate of $10.50 per proof gallon (PG) in place since 1954, with periodically authorized increases in recent years to $13.25 per PG. The $13.25 rate expired most recently on Dec. 31, 2014 and its renewal has not yet been approved in the U.S. Senate or House of Representatives although it has been approved by the U.S. Senate Finance Committee. As the matching fund revenues are not an appropriated revenue source of the U.S. government, they did not fall under the provisions of the U.S. federal funding sequestration.
The annual, advanced payment made to the USVI is calculated from projected sales of USVI-produced rum in the U.S. in the following fiscal year (Oct. 1 fiscal year start), adjusted by an amount reflecting the difference between estimated and actual sales two fiscal years prior. The bonds include a covenant that if matching fund revenues are replaced with another federal funding stream, the USVI will use its best efforts to use the substitute revenues for bond repayment. The rating assumes the longstanding federal program will continue. Actual and forecast sales of USVI-produced rum are determined by market forces as well as the production capabilities of the two facilities.
Congressional authorization for an extension of the $13.25 rate is included in the larger federal tax extenders reauthorization; this larger process has been contentious in recent years and the approval of the higher rate for 2014 was solely for one year, rather than the historical two-year extension. Also differing from past practice, the U.S. government's advance to the USVI for fiscal 2015, and initially for fiscal 2014, was at the $10.50 rate rather than the higher rate, lowering the amounts deposited to the bond escrow account as well as revenue available to the USVI. The U.S. government later increased the full amount of the advance to the USVI for fiscal 2014 to $253.9 million. These actions have reduced the additional revenue cushion that was provided for annual debt service.
Rum shipments increased substantially in fiscal 2013 with a full-year production at the new Diageo facility, to almost 20 million PG. Despite some mid-year declines in shipments in fiscal 2014 that reflected Cruzan's loss of two large bulk customers to a competitor based in Puerto Rico, improved fourth-quarter shipments bolstered final results and total shipments were almost 20.5 million PG.
Shipments through the second quarter of fiscal 2015 are continuing to reflect competitive pressures as well as a recent consumer shift to other alcoholic spirits; shipments through March 31, 2015 were down 21.3% year over year (yoy). Matching fund revenues are also down yoy by 20.1%, incorporating this shipment decline as well as only one quarter of revenue received at the higher $13.25 rate. Fitch has encompassed these declines in expectations for revenues in fiscal 2015 and pledged revenues in fiscal 2016 are currently expected by Fitch to show some stabilization.
Based on current trends, Fitch believes shipments could approximate 16 million PG in fiscal 2015, providing approximately $180 million of matching fund revenue based largely on receiving the $10.50 rate for three-quarters of the year for the reduced amount of rum sales. The U.S. government's advance to the USVI for fiscal 2015 factored in these shipment trends based on the $10.50 rate for three-quarters of the year, and advanced $176.1 million for the year. These expectations are significantly reduced from fiscal 2014 collections of $214 million and the U.S. government advance of $253.9 million.
ADEQUATE COVERAGE OF DEBT SERVICE
Coverage of debt service in fiscal 2014 was still adequate despite the revenue fluctuations but this was due to a one-time drop in debt service expense for that year. Actual fiscal 2014 matching fund receipts covered 1998 indenture senior and subordinate debt service at 3.68x; coverage of debt service including both Cruzan and Diageo-related debt service was 2.62x. Coverage of combined MADS for the 1998 indenture and two project indentures occurs in fiscal 2016 and declined to 1.96x from 2.56x in fiscal 2013.
Based on the $176.1 million federal advance that was received in September 2014, actual debt service coverage on all bond requirements in fiscal 2015 shows a further decline to an approximate 1.7x with MADS coverage of 1.6x. Fitch's expectation of actual shipments in fiscal 2015 and derived revenue, largely at the $10.50 rate, provides essentially identical coverage levels. Under either scenario, coverage would be bolstered by a retroactive increase in the cover over rate, if enacted, but as the federal advance is set aside for debt service expense prior to the beginning of the USVI's fiscal year, providing the initial revenue set-aside for debt service payments, it is that deposit that should be looked to for coverage, in Fitch's view.
All matching fund receipts, including those generated by the new Diageo distillery, benefit 1998 indenture bonds first. After satisfying requirements under the 1998 indenture, excess receipts from Cruzan and Diageo-generated matching funds are transferred to separate special escrow accounts based on each facility's production. Receipts from Cruzan-related matching funds are not available to Diageo indenture bondholders after payment of 1998 indenture bonds, nor are Diageo-related matching fund receipts available to Cruzan indenture bondholders. Excess revenue following payment of debt service on all indentures is used to meet various incentives under the USVI's agreements with the distillers before being available to the USVI.
ADDITIONAL BONDS TEST PROVISIONS
While Fitch believes ABT provisions are adequate, Fitch has looked to annual coverage of obligations remaining comfortably above the ABT to maintain the current rating level due to variability in the revenue stream. Fitch believes current trends in fiscal 2015 are pressuring coverage and their continuation in fiscal 2016 is likely to lead to a downgrade.
New issuance under the 1998 indenture of senior or subordinate bonds requires pledged revenues sufficient to meet a three-year historical and two-year prospective MADS coverage test at 1.5x debt service for senior lien and 1.25x for subordinate lien after payment of senior lien debt service, and two-year prospective MADS coverage at 1.2x combined senior and subordinate liens. The ABT for 1998 indenture bonds excludes all matching fund receipts associated with the Diageo and Cruzan projects that are required to meet debt service, debt service reserve and certain other required payments under the Diageo and Cruzan indentures. Both Cruzan and Diageo must consent to 1998 indenture issuance which limits future borrowing; however, the USVI has indicated that it is considering undertaking a partial to full restructuring of these obligations as a means of providing budgetary relief beginning in fiscal 2016.
Cruzan and Diageo indenture issuance is limited by specific issuance caps and an ABT. For Cruzan, the maximum bonding is $105 million (plus 10% additional for project completion bonds), of which $39 million has been issued to date. For Diageo, the $250 million in maximum bonding was issued in 2009. The ABT for the Cruzan and Diageo indentures requires that new issuance meet a three-year historical and two-year prospective MADS coverage test at 1.5x debt service for senior lien and 1.5x for subordinate lien after payment of senior lien debt service, among other tests. Project completion bonds are not subject to the ABT.
STEADY GROWTH OF RUM CONSUMPTION
U.S. consumption of distilled spirits, including rum, has grown steadily in recent years based on shifting consumer tastes and the increasing attractiveness of premium products. However, rum consumption in the U.S. is subject to broader shifts in consumer demand and rum sales declined by 1.5% between 2013 and 2014. Diageo reports that its Captain Morgan sales (Captain Morgan is produced in the USVI) were down 10% between June 30, 2014 and June 30, 2015.
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