NEW YORK--(BUSINESS WIRE)--Fitch Ratings affirms the following ratings on the Virgin Islands Public Finance Authority (VIPFA) revenue bonds and subordinated revenue bonds:
--$828.31 million revenue bonds (Virgin Islands matching fund loan note) senior lien at 'BBB';
--$177 million revenue bonds (Virgin Islands matching fund loan note) subordinate lien at 'BBB-';
--$250 million subordinated revenue bonds (Virgin Islands matching fund loan note-Diageo project) series 2009A at 'BBB-';
--$37.49 million subordinated revenue bonds (Virgin Islands matching fund loan note-Cruzan project) series 2009A at 'BBB-'.
The Rating Outlook is Stable.
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 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 (primarily rum) produced and exported to the U.S.
HIGHER COVER OVER RATE BOLSTERS PLEDGED REVENUES: The $10.50 base rate provides sufficient coverage of MADS under reasonable forecast assumptions. The higher, yet temporary $13.25 cover over rate provides additional cushion for meeting annual debt service requirements, but required biennial Congressional approval of the higher rate with frequent delays has added to revenue variability.
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 is expected to reduce shipments from that facility that year, with a likely impact on 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' ABT. Maximum annual debt service (MADS) coverage from fiscal 2013 pledged revenues for the senior indenture was 3.26x; MADS coverage for all debt service obligations in aggregate was 2.56x.
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. However, much of the leveraging of this revenue source has been to support General Fund operations of the USVI, and Fitch believes further leveraging is likely to absorb future excess matching fund revenues.
CONTINUED RUM PRODUCTION & MAINTENANCE OF MATCHING FUND PROGRAM: Interruption of rum production or U.S. support for the present cover over program could result in a downgrade;
SHIFTING CONSUMPTION TRENDS: Changes in consumer tastes or purchasing habits that significantly reduce rum consumption in the U.S. could pressure the rating;
WEAKENING OF COVERAGE: Additional issuance under this security to fund capital and operating needs of the USVI that significantly weakens debt service coverage could result in a downgrade.
The rating on VIPFA's matching fund bonds is based on the strength of 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 longer-term 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 prior to becoming available to the USVI for other purposes.
ESTABLISHED PLEDGED REVENUE STREAM
Matching fund bonds are special, limited obligations of the PFA, 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-', Stable Outlook), owner of the Diageo facility. A debt service reserve funded at MADS provides additional protection.
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 in place since 1954, with periodically authorized increases in recent years to $13.25 per proof gallon. The $13.25 rate expired most recently on Dec. 31, 2013 and its renewal has not yet been approved in the U.S. Senate or House of Representatives following its passage by the U.S. Senate Finance Committee earlier this year. 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 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), 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. Actual and forecast sales of USVI-produced rum are determined by market forces as well as the production capabilities of the two facilities. Shipments of Captain Morgan rum from the Diageo facility began in February 2012 and have bolstered pledged revenue sources over the past two fiscal years, though in tangent with an increase in debt service requirements.
Rum shipments totaled 9.17 million proof gallons (PG) in 2011 and increased substantially to almost 18.6 million PG in 2012 with a partial year of new production at Diageo. Shipments further increased in 2013, to almost 20 million PG, incorporating a full year of production at Diageo. Fitch expects a small decline in shipments in fiscal 2014 from 2013 due to a falloff in production at Cruzan, which has been affected by the loss of two customers to a competitor based in Puerto Rico; through the third quarter of 2014, total shipments (inclusive of shipments related to Diageo production) were down 1.3% from the same time period in fiscal 2013.
Expectations of matching fund revenues from the full year of production at Diageo were substantially reduced in August 2013 due to recognition of errors made in the revenue forecast. The lower than previously assumed alcohol content in the Captain Morgan brand rum lowered the amount of product manufactured that is subject to the excise tax. For fiscal 2013, the revised revenue forecast resulted in a projected $235.9 million receipt of matching fund revenue based on rum shipments, attributable to production at both Diageo and Cruzan. Actual collections in fiscal 2013 were $279.3 million based on actual rum sales and a $38.6 million retroactive payment related to the passage of the then-expired higher cover over rate by the U.S. Congress in Dec. 2013, which was partially related to rum sales in fiscal 2012.
ADEQUATE COVERAGE OF DEBT SERVICE
Coverage of debt service has been adequate, with actual fiscal 2013 matching fund receipts covering 1998 indenture senior and subordinate debt service at 3.59x; coverage of debt service including both Cruzan and Diageo-related debt service was 2.87x. Coverage of combined MADS for the 1998 indenture and two project indentures (occurs in fiscal 2016) from fiscal 2013 matching fund receipts is 2.56x. Fiscal 2014 receipts were most recently forecast (in August 2013) to provide coverage of combined MADS for the 1998 indenture and two project indentures together of 2.2x based on the $13.25 rate and 1.74x based on the $10.50 rate. Fitch believes this coverage level may be modestly reduced based on year to date production trends and the Cruzan facility's loss of bulk customers, noted earlier.
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.
ADEQUATE ADDITIONAL BONDS TEST PROVISIONS
While Fitch believes additional bonds test (ABT) provisions are adequate, annual coverage of obligations comfortably above the ABT is required to maintain the current rating level due to variability in the revenue stream. 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, additional leveraging of this revenue stream for cash flow and capital purposes of the USVI is expected by Fitch.
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 maximum bonding is $250 million (plus 10% additional for project completion bonds); the full $250 million 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. Rum consumption in the U.S. is subject to broader shifts in consumer demand; average demand declined by approximately 1.5% annually during the 1985-1995 periods but increased by 6.3% annually on average from 2000 to 2012. Based on forecasts by IHS Global Insights, annual rum consumption in the U.S. through the forecast period of 2041 is expected to increase 2.24% on average while the new Diageo plant on the USVI is expected to boost USVI market share for rum production to more than 35% from 15.5% in FY 2011.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria and U.S. State Government Tax-Supported Rating Criteria, this action was additionally informed by information from IHS Global Insights.
Applicable Criteria and Related Research:
--'Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).
Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
U.S. Local Government Tax-Supported Rating Criteria