CHICAGO Positive cash flow developments from tobacco arbitration awards and settlement agreements this year may stave off the projected default dates for tobacco bonds issued by at least four states, but they are still likely, municipal bond analyst Richard Larkin warned
The new report from Larkin, director of credit analysis at Herbert J. Sims & Co., takes into consideration the latest arbitration rulings and settlement agreements reached with the major tobacco companies in a dispute over the enforcement of provisions in the 1998 Master Settlement Agreement with most states.
The report’s assessment of projected defaults is limited to just a handful of states Larkin has had the opportunity to review which take into account the latest developments.
“Of the projections I’ve done so far, the states that have tobacco bonds out and who settled in 2012/2013, are still going to eventually default on tobacco bonds,” Larkin wrote. “While I haven’t calculated the unenhanced Golden State tobaccos yet, my analysis of New Jersey and Virginia lead me to believe that California will follow in their footsteps. Defaults are pushed back to later maturities, but unless consumption declines improve, default will eventually occur.” Ohio faces a similar fate.
Approximately $7.1 billion in disputed payments had been withheld from 2003 to 2012 with tobacco companies arguing that states have failed to enforce provisions in the MSA designed to protect them from market share losses to non-participating tobacco manufacturers.
A total of 22 states and other jurisdictions previously settled the dispute in agreements struck in 2012 and this year. They include Alabama, Arizona, Arkansas, California, Georgia, Kansas, Louisiana, Michigan, Nebraska, Nevada, New Hampshire, New Jersey, North Carolina, Puerto Rico, Tennessee, Virginia, West Virginia, Wyoming, District of Columbia, Connecticut, Oklahoma, and South Carolina.
Others participated in arbitration and a first round of rulings that impact only the 2003 payment dispute came down last week. Challenges to payment refunds between 2004 to 2012 will be the subject of future arbitration.
The arbitration rulings favored 11 states found to have lived up to the escrow enforcement terms under the MSA. The winners included tobacco bond issuers Illinois, Iowa, New York, and Ohio, and Washington.
None of the six that saw adverse rulings have outstanding tobacco bonds, although some of the states have warned that the loss will hurt their budgets as they will collectively share in the loss of $642 million from their payment due in April.
Another 11 states and jurisdictions are subject to arbitration rulings that have yet to be released. They include tobacco bond issuers Alaska, Rhode Island, South Dakota, Guam, and the Virgin Islands. Any states found not to have diligently enforced the escrow rules will be required to share in the loss of $642 million in 2014.
The state and jurisdictions that settled the disagreement collectively shared in a windfall of $1.8 billion although it was reduced by credits granted to the manufacturers in 2013. They also will see a collective annual cut in their payments between 2014 and 2017 of about $212 million under the agreements.
The windfall, handed out to most in their 2013 payments, allowed “them to restore depleted reserve funds and accelerate debt retirement at the fastest rate since the start of the agreement,” Larkin wrote. “The net affect for settling states was to see only a slight increase in total cash flow over the life of the bonds, pushing back slightly my earlier forecasts of payment defaults.
“Unfortunately, it appears that the settling states of California, New Jersey & Virginia are now in a position where debt retirement will drop dramatically, debt reserves will be invaded, and the prospect for bond defaults accelerated, starting next year,” Larkin said.
While Ohio prevailed in its arbitration battle, Larkin warned: “The ultimate date of a cash default has been pushed back to later years, but not eliminated.”
The report’s projections are based on consumption and cigarette shipment declines continuing at a clip of 4% annually with inflation remaining at 3%. The projections also assume that states which won the arbitration over the 2003 payments will also prevail in disputes involving 2004-2012 payments. Challenges to post 2012 are not assumed. Any shift in those factors could alter projected defaults for the better or worse.
MSA payments are based on a complex formula with cigarette consumption factoring heavily in the equation. Under the settlement, the tobacco industry was expected to pay the states more than $200 billion over the first 25 years to settle disputes over state spending on healthcare tied smoking.
Consumption declines are driven by tax increases, anti-smoking efforts, and other issues. Inflation is also a factor. With the arbitration dispute over 2004-2012 payments still unsettled, Larkin said he expects tobacco companies will continue to withhold a portion of the payment due next April.
“States that lost arbitration and the states that settled NPM disputes will see larger revenue shortfalls of at least 12% or more. States that won arbitration will not see any payment increases unless arbitrations for the 2004 year are resolved in their favor, or if they choose to settle as 22 states did,” Larkin said.
A more accurate prediction of bond defaults for the settling states has proven difficult to reach due to a lack of disclosure over confidentiality agreements.
“For investors in tobacco bonds, this weakness should be factored into your decision to invest in this sector,” Larkin said.
Moody’s investors Service warned in a report last year that nearly 75% of the tobacco settlement-backed bonds it rates will default if consumption continues to decline at a rate of 3% to 4% annually. Moody’s rates a total of 32 tobacco settlement securitizations with a balance of $20.4 billion outstanding.
