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Virgin Islands Snag Captain Morgan

JUL 28, 2008 1:00am ET
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One U.S. territory's loss is another's gain as spirits maker Diageo plans to switch production of its popular Captain Morgan rum from Puerto Rico to the U.S. Virgin Islands in 2012, thanks in part to a $250 million bond issue that will help finance a new distillery plant.

USVI governor John deJongh last week signed into law legislation that will give Diageo tax incentives and financing for a new facility that will produce up to 20 million gallons of rum per year in exchange for Diageo's guarantee that it will produce all its U.S. distribution of Captain Morgan from the new St. Croix distillery for 30 years.

Diageo currently produces all of its Captain Morgan rum for the U.S. in Puerto Rico, approximately nine million gallons per year manufactured from a third-party distiller, Destileria Serralles, in Ponce. Diageo's contract with Serralles will end in 2012 and the company now plans on moving its U.S. production to the Virgin Islands once the agreement with Serralles ends and the new 30-year contract with USVI begins.

To help entice Captain Morgan away from Puerto Rico, the Virgin Islands Public Finance Authority this fall will issue up to $250 million of 30-year Diageo project bonds backed by future rum tax revenues. Proceeds will support the construction and design of a new rum distillery on St. Croix. Diageo will own and operate the facility itself.

The legislation authorizing the authority to sell the bonds states that the debt shall not "bear interest at a federally tax exempt rate in excess of seven percent per annum or a federally taxable rate in excess of eight percent per annum."

"I am proud to say that this legislation represents a collective effort of the executive branch and the Legislature," deJongh said in a press release. "It enjoys the overwhelming support of the community. I am proud of, and grateful for, the tremendous effort of all who worked to bring us to this point. I look forward to working with you and your colleagues in the coming months and years as we continue in our efforts to build the economy of the territory so that we can provide real opportunities for all of our people to prosper and progress."

Bringing Captain Morgan onto St. Croix will help the USVI's overall economy. Officials estimate the additional rum tax receipts will bring in nearly $119 million of revenue beginning in 2012, with that yearly amount growing to $226.3 million in 2038, according to financial analysis data from Fiscal Strategies Group Inc. That's a dramatic boost compared to the anticipated $20.5 million of gross rum-tax receipts that officials anticipate receiving from the territory's sole rum maker, Pernod Ricard in fiscal 2009, which begins Oct. 1. Pernod Ricard manufactures Cruzan Rum.

JPMorgan and Citi will lead the underwriting syndicate on the transaction. Hawkins, Delafield & Wood LLP is bond counsel.

Of the rum tax revenues generated from the new distillery, each year the first $18.4 million of receipts will go towards paying principal and interest payments on the bonds. The USVI will then place 3% of gross rum-tax revenue into a community trust program, which will support local sports facilities and urban redevelopment projects on the territory's three islands, St. Croix, St. Thomas, and St. John. That 3% allocation will generate $3.5 million of revenue for the islands in 2012, with that amount growing annually to $6.7 million in 2038.

Diageo will also receive funds from the rum tax revenues through tax incentives, marketing campaigns, and molasses subsidies. That allocation totals $36.3 million for fiscal 2012, and will increase every year to $89.1 million for those programs in 2038, according to Fiscal Strategies data.

Even after debt service costs, the 3% allocation to local communities, and business incentives to Diageo, the territory expects its coffers will gain additional revenue, starting with $60.6 million of new funds in fiscal 2012 and increasing each year to $100 million in fiscal 2020 and $112 million in 2038.

When the governor filed the Diageo bill in late June, he cited infrastructure development, including improving energy and wastewater systems, and addressing USVI's $1.2 billion unfunded pension liability as possible candidates to receive the additional rum-tax receipts.

"While the project is being constructed, we will have ample opportunity to decide how best to use the new [rum tax] revenues once production commences," deJongh wrote in late June to the territory's Legislature. "As you are aware, there are numerous matters which require our attention and ultimate resolution. The need to implement a real capital projects program so that we can properly plan, implement, and manage our capital projects, avenues to systematically address the energy dilemma in the USVI, the unfunded liability of the Government Employees Retirement System, an effective maintenance program for government facilities, past wages to government employees, and our wastewater and solid-waste systems all are worthy of our attention."

Fitch Ratings analyst Douglas Offerman said Captain Morgan's move to the territory from Puerto Rico will help the territory's overall economy.

"The agreement, assuming it goes off as planned, is import for the USVI on a number of levels," Offerman said. "One is certainly on the level of revenues for the USVI and the flexibility that that revenue could provide it. And number two, economically it's a very small economy and has been in large part very tourism-centered, and to add a big player like this gives it a bit more diversity and a bit of a hedge against some of the cyclicality that it could face from tourism, which at this point in the broader economic cycle is very important."

Standard & Poor's and Fitch both assign BBB-minus ratings with stable outlooks to the USVI's roughly $590 million of outstanding general obligation bonds. Moody's Investors Service rates the credit Baa3.

Ratings for the Diageo bonds have not yet been obtained.

Meanwhile, Puerto Rico will need to absorb the loss of its second-biggest rum producer. Bacardi & Co. tops the commonwealth's list of rum makers with 20.7 million gallons consumed on the U.S. mainland in 2005, followed by the Captain Morgan brand with 11.2 million gallons sold in the U.S. in the same year.

Losing Captain Morgan to the USVI could decrease Puerto Rico's overall rum tax revenues if the commonwealth fails to bring other rum makers to the island, or boost its current production level. Puerto Rico collected $372.5 million of rum tax revenue in fiscal 2007, up from $320 million it received the year before, according to Horacio Aldrete, an analyst at Standard & Poor's.

The island has $2.1 billion of Puerto Rico Infrastructure Financing Authority debt secured by rum-tax revenue and commonwealth law stipulates that the first $90 million of rum tax receipts goes to pay down debt service costs on the bonds. That amount will increase to $117 million in 2010 and continue to maintain the bonds' strong debt-service coverage.

"Their maximum annual debt service on all of their bonds outstanding is about $113 million, so they have about 3.3 times coverage," Aldrete said. "So, even with Captain Morgan leaving, they have decent enough coverage to withstand the loss of that taxpayer."

Standard & Poor's rates the PRIFA bonds BBB-plus and Moody assigns its Baa3 rating. Fitch does not rate the bonds.

Still, analysts said they will be watching to see how Captain Morgan's departure could reduce Puerto Rico's gross rum-tax revenues once the distiller leaves the island in 2012.

"It's not an immediate concern for the PRIFA bonds that are backed by that, but it's a loss of revenue for them," said Moody's analyst Emily Raimes. "We haven't done a full analysis yet to see how much that is and what exactly that's going to amount to. That's going to be something to follow up on. It's a little bit of negative information for Puerto Rico, and certainly the Virgin Islands, I think, is very happy about it."

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