Description

$750,000,000 6.5% series 2007A-2 Senior Current Interest Turbo Bonds due June 1, 2047.

CUSIP 118217AT5

In a yield starved world I believe the Buckeye Tobacco Settlement bonds represent an attractive risk reword opportunity. In the last four months these bonds have sold off substantially from a trading range in the mid-90s all the way down to the high-60s, and are now trading in the mid 70s.  Prices have not been this low since 2011.  The selloff has occurred partly because of the overall rise in treasury rates, uncertainty in future MSA payments as a result of higher than expected decreases in smoking, and the rise in popularity of e-cigarettes and alternative nicotine products which do not pay into Ohio’s Master Settlement Agreement (MSA) fund.  In risk and tax adjusted terms, I’m hard pressed to find more attractive yields.  With a current price around $80 for the 6.5% coupon maturing 2047 bonds, the after tax equivalent yield at the highest marginal federal rate of 39.6% is 15.55%.  However, given the current cigarette decline rates, I don’t believe these bonds will pay according to their full interest and principal payment schedules.  With that said, I intend to show why these still represent a good investment.

These bonds are backed solely by the state’s perpetual assignment of their cigarette consumption receipts and strategic payment by the cigarette companies as part of the MSA.  If cigarette consumption declines faster than expected there will not be enough funds to pay off interest or redeem maturing bonds.  Even with aggressive cigarette decline rates these bonds at their current price levels represent an attractive return.  Both retail and institutional investors fail to understand how to price these bonds.  In the event that there are not enough MSA payments to cover interest and principal payments, the senior bonds will continue in perpetuity until they have been fully redeemed or people stop smoking.  These bonds should be priced on the IRR of the MSA payments and not based on their ratings or some spread over treasuries. 

I’m recommending a position in the Series 2007A-2 Senior Current Interest Turbo Term Bonds.  I prefer the bonds with the highest coupons and the longest duration, however, I believe any within this series represent an attractive risk adjusted yield.

CUSIPs in the 2007A-2 Senior Current Interest Turbo Term Bonds

CUSIP                         Maturity                      Coupon

118217AP3                 June 1, 2024                5.125%

118217AN8                June 1, 2024                5.375%

118217AQ1                June 1, 2030                5.875%

118217AR9                 June 1, 2034                5.750%

118217AS7                 June 1, 2042                6.000%

118217AU2                June 1, 2047                6.070%

118217AT5                 June 1, 2047                6.500%

History:

Before we jump into the analysis of these bonds let me provide you with some quick background information on the Master Settlement Agreement (MSA) which is the genesis for all the state’s tobacco bonds.  In November of 1998 Philip Morris Inc., R. J. Reynolds, Brown and Wiliamson and Lorillard collectively known as the original participating manufacturers (OPMs), collectively representing 86.8% of the cigarette market share, arrived at an agreement with 46 States and territories (Settling States) to resolve cigarette smoking related litigation.  The agreement arrived at between these parties, known as the Master Settlement Agreement (MSA), released the OPMs from past and present smoking-related claims and provided for a continuing release of future smoking claims, in exchange for certain payments to be made to the Settling States in addition to certain strategic payments and advertising/marketing restrictions. 

Tobacco companies who did not join the MSA agreement at inception were invited to do so after the fact and are referred to as Subsequent Participating Manufacturers (SPMs), while the collective signers of the MSA agreement are known as Participating Manufactures (PMs).   Tobacco companies who have chosen not to join the MSA are referred to as Non-Participating Manufacturers (NPMs).  NPMs unlike PMs are subject to class action law suits from smokers who have been harmed by their products.  Some smaller tobacco firms and some new entrants into the space will choose not to join the MSA since they may view the risk of a class action law suit as minimal and believe they will benefit from not having to comply with marketing restrictions.  NPMs have been required by the state to pay into escrow accounts at a rate equivalent to the amount they would have had to have paid if they were a member of the MSA.  These funds are used in the event that the NPM is sued and is unable to pay.  These payments also act to counter balance any unfair competitive advantage NPMs would have obtained over PMs via price.

Subsequent to the creation of the MSA many states have elected to securitize the payment streams from the tobacco companies and issue bonds.  About $40 billion of tobacco bonds have been issued by states, counties, cities and territories.  These bonds have been backed by $200 billion in payments from the participating manufacturers. 

Disputes and Recent News:

Starting in 2003, participating manufacturers challenged 15 of the settling states over allegations that the settling states failed to adequately enforce the collection of payments from NPMs into the escrow accounts.  If this is proven it entitles participating manufactures to lower payments to the settling states.  A decision was reached on September 12^th of 2013 for the 2003 payments.  Of the 15 states that were challenged, nine won the arbitration, proving they had adequately enforced their end of the agreement.  This freed up $35 million for the State of Ohio and provides a needed boost for the Ohio Buckeye Tobacco bonds.  Moving forward this victory for the State of Ohio should greatly enhance its chances of winning arbitration over other disputed years, which have yet to be resolved.  Starting in 2004-2005 the settling states began to increase their enforcement of the escrow requirements of the NPM.  This should further increase the likeness that Ohio will win any future arbitration battles of the PMs. Trading on Friday the 13^th, 2013 seems to indicate the bond market has recognized the benefits of this settlement.  The Ohio Buckeye Bonds traded up from the previous days rising as much at $10 into Monday.

Evaluation

The decline rate of US Cigarette consumption has been higher than what was projected when these bonds were underwritten.  This has been caused by a number of factors.  The States have aggressively raised taxes on cigarettes and “TheTruth.Com” campaign and similar anti-smoking efforts have been effective in lowering tobacco consumption. Since the signing of the MSA cigarette smoking in restaurants, bars and public places has been restricted eroding tobacco sales even more.  The recession has also taken its toll on consumption.  Smoking is an expensive habit and a pack of cigarettes costs on average about $6.22 in the state of Ohio.  A pack a day adds up quickly to a $2,270 annual expense. Average discretionary income in the US ranges between $7,000 and $10,000, meaning a pack a day habit costs the average person between 23% and 32% of their discretionary income.  Contrary to popular belief, cigarette consumption is not price inelastic.  Most studies show that cigarettes have an elasticity of demand between -0.25 and -0.5 meaning a 10% increase in cigarette prices should yield a 2.5% and 5% decline in consumption.  Since this bond issuance in 2007, the Price of a pack of Cigarettes has increased 25%. 

Lastly new forms of nicotine delivery have entered the market.  E-Cigarette sales are exploding, growing from $500 million in 2012 to an expected level of $1.7 billion by year’s end 2013.  E-Cigarettes do not have to pay into the MSA and are not subject to the same marketing restrictions.  A refill package for an E-Cigarette sells for about $2 and are roughly equivalent to of a pack of cigarettes making them a relative bargain compared to traditional tobacco products.   Bonnie Herzog of Wells Fargo has predicted that E-Cigarettes sales will surpass regular cigarette sales by 2021.  Countering this explosive growth is the likelihood that the FDA will step in and add more oversight of the 200 plus e-cigarette manufacturers. 

Payments of the Bonds

The senior, Series A bonds are first in the payment waterfall.  In the event that tobacco settlement payments are less than the interest and or principal payments for a given year the reserve funds can be tapped to fill this hole.  The reserve fund cannot be used for the other bond series until the Series A bonds have been redeemed. 

“So long as no payment default has occurred, all payments of the bond obligation of the bonds made from collections will be credited against serial bond maturities and sinking fund installments and turbo term bond maturities in accordance with the payment priorities, within a priority in chronological order, and pro rata among bonds within the same payment priority as to which such payments are due on the same date, as more fully described in the indenture.  The senior liquidity reserve account is available to pay the principal if the senior bonds, including the series 2007A bonds, on their maturity dates.  Failure to pay the principal of the senior bonds on its maturity date will constitute a payment default, which is an event of a default under the indenture, in which case all future payments will be made on a pro rata basis subject to the payment priorities.”

The MSA payments to the Settling States is based on predetermined cash flow schedule and is annual adjusted based on a series of factors. The following are descriptions of the seven factors used for calculating the MSA Payments.

The Inflation Adjustment

Each year the MSA uses the greater of 3% or the actual Consumer Price Index for All Urban Consumer (CPI).  In the years 2000, 2004, 2005, the following actual CPI inflation numbers were used 3.4%, 3.256% and 3.416% respectively.

The Volume Adjustment

The following schedule shows the annual change in cigarette consumption in the US and is used when determining the MSA payments from the cigarette companies.

Total Net Market (RYO RYO @ 0.0325 ounces per cigarette conversion rate): Data MSAi

The Non-Settling States Reduction

The Non-Settling States Reduction was not applied to the annual payments and strategic contribution payment because such reduction has no effect on the amount of payments to be received by a State that remains a part to the MSA.  The Cash Flow Assumptions include an assumption that the state will remain a party to the MSA.

The NPM Adjustment

The NPM Adjustment has not been applied to date.  This adjustment comes into effect if the tobacco companies are able to prove that the State has failed to adequately enforce the escrow payment requirements of NPMs.  The dispute I discussed before that was settled on September 12^th 2013 is an example of this.  If the Tobacco companies where able to prove that the State had failed to live up to its enforcement requirement of the MSA they’d have been able to apply an adjustment on their MSA payments to lower them.

The Offset for Miscalculated or Disputed Payments

This adjustment allows for increases or decreases to be made in the MSA payments in the event of a miscalculation of a prior year’s payment (limited to 4 year look back).

The Litigating Releasing Parties Offset

This is an adjustment that allows for a dollar for dollar offset in MSA payments in the event that a Releasing State pursues litigation against a Participating Manufacturer for a claim that was released under the MSA agreement.  This adjustment is applied only to the MSA payments made to the State that has perused litigation against a Participating Manufacturer and is only applied if the Participating Manufacturer has taken all reasonable and ordinary actions to defend itself. 

The Offset for Claims-Over

In the event that a Releasing State pursues a claim against a NPM and the NPM in turn pursues a claim for contribution or indemnification against a Participating Manufacturer, this adjustment allows for a dollar for dollar offset against the Participating Manufacturer’s MSA payments.  This is a state specific adjustment and is only allocable on claims that were releases by the Participating Sates in the MSA agreement.

MSA Base case

Ohio is entitled to 5.0375098% of the each annual payment and 2.7819695% of each strategic fund payment.

Senior Liquidity Reserve

The series 2007 bonds were funded with a reserve account equal to $389,231,603.13.  The reserve account is supposed to be maintained at this level so long as the Series 2007A bonds are outstanding, however, the current balance of this reserve account is $383,159,831.90.  These funds can only be used to pay the Series 2007A bonds and not be used on the subordinate bonds until all the Series 2007A bonds have been redeemed.

Assumptions

For the purposes of modeling these bonds I held constant everything except the cigarette decline rates.  The decline rate for the 2011 was 2.67%, 1.98% for 2012 and the current decline rate is running around 5% for the first half of 2013, but should normalize back down to the 3% range.  I expect moving forward that declines rates will stay around 3% per year.  It’s important to remember when we talk about these decline rates, these are compounding annual rates.  Every year we are saying the cigarette consumption will fall by 3% meaning in 5 years consumption would have fallen by more than 15%.  Not an insignificant sum for a highly addictive product.  Counteracting declines in consumption is a minimum 3% annual increase for inflation.

Because of the number of adjustments and factors used in calculating these bonds it’s difficult to show my model.  I used the formula exactly as it its presented in the Buckeye Tobacco Settlement Financing Authority perspective and as it is described in the MSA agreement. I do my best to illustrate the MSA payments to show how this will affect the funding for the bonds.

To be conservative I’ve used a 5% decline rate.  This is significantly higher than the current 3% rate we have seen.

Bear Case

To price these bonds, I used the model illustrated above against the scheduled payments for a long duration 6.5% coupon maturing 2047 and a shorter duration 5.375% maturing 2024.  These should highlight the methodology I’m using and give an idea of what these bonds should actually yield over their life.  The big concept here is that an investor is unlikely to receive his principal payment at the end of these cash flows because the decline rate of the MSA payments will exceed the initial project.  However, because the current yield is high enough, an investor is more than compensated for this.

118217AT5 Coupon 6.5% due 2047

Assumed Purchase Price of $80

118217AN8 coupon 5.375% due 2024

Assumed Purchase Price of $80

*note that I cut off payments past 2055, but I expect these bonds to continue to pay well beyond this point. 

The other bonds in this series all trade roughly in line with these two bonds.  By using a 5% cigarette consumption decline rate, these are conservative yield projections.  Remember these are also tax free yields.  I don’t think it makes sense for these bonds to be trading at a taxable equivalent of a 12.5%.  While I do expect these bonds to default, they still represent an attractive investment and the market has mispriced them because of their complexity, institutional limitations and failure to price them based on IRR of the MSA payments which continue beyond a default.  If you want me to address a specific bond pricing within this series please let me know in the comments and I can run it through my model.

Catalyst