Download Crunch Time for the Commonwealth

Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
PUERTO RICO
Crunch Time for the Commonwealth
As the calendar turns to September, Puerto Rico (PR) enters a critical phase for debt and cash management. Over the
coming weeks, PREPA bondholders, a soon-to-be-named Chief Restructuring Officer (CRO), and the newly appointed
Puerto Rico Commission on Energy (CEPR) will be required to strike a deal to restructure PREPA’s operations.
Meanwhile, continued weakness in the real economy threatens to derail fiscal consolidation plans as Governor
Alejandro Garcia Padilla’s administration has had trouble executing some of the reforms essential to reductions in the
projected FY2015 deficit. Liquidity concerns continue to linger in the backdrop as negotiations with banks and
bondholders over short-term cash financing persist, but in our estimation, closing these transactions before the end of
Q1 (September 30) could be an important benchmark.
In this report, we recap some economic data that may be important to investors thinking about their investments in
general obligation (GO), Puerto Rico Sales Tax Revenue (COFINA), and Government Development Bank (GDB) bonds.
In light of last month’s Economic Activity Index (EAI) numbers, which were down an additional 0.7 percent year-overyear, we review our thesis about economic growth, revising down our projections for growth in the coming year to a
1.0 contraction. With this in mind, we highlight some execution risk in the 2015 budget, including yet-to-be-introduced
efforts to reform the tax code and make the teacher’s pension system more sustainable. Finally, we lay out a timeline
of key dates for PREPA’s bondholders, including the September 8 deadline to name a Chief Restructuring Officer. In
general, we believe that default at PREPA is a highly probable event, and that default at HTA and PRASA may follow.
At this stage, however, we continue to believe that the debt load of the general fund is sustainable under IMF debt
sustainability principles, and as such, we continue to place the odds of default at or below 30 percent.
Economic Data Softer But Steady; Slower Contraction But No Growth.
In earlier reports, we projected the PR economy would decline around 0.7 percent in FY2014 due to strong fiscal drag
weighing on growth. Now, we believe the decline in the economy will be steeper, with the annual contraction
registering at 1.0 percent. The decline in the real economy is driven principally from austerity, but a slowdown in the
growth of key industries – notably, financial services and tourism – has been compounded by a slowdown of capital
flow to the island. Since June, capital flows in Puerto Rico have fallen $350 million on a year-over-year basis, according
to our calculations using data from the Planning Board and Chamber of Commerce. In short, the economy is contracting
faster than expected, partially because of a slowdown in funds flowing from the United States. In our estimation, the
slowdown is reflective of the uncertainty engendered by continued fiscal turbulence on the island; with little certainty
about the path of the budget or the fate of public corporations, what little comparative competitive advantage PR may
have had is likely to have evaporated.
Figure 1. Real Gross National Product Projections.
4
3
2
1
0
-1
-2
-3
-4
-5
Planning Board Baseline
Height -- Baseline Case
Height -- Pessimistic Case
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: Puerto Rico Planning Board, Government Development Bank of Puerto Rico, Puerto Rico Office of Management
and Budget, and Height Securities LLC’s calculations.
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
EAI Continues Decline, Bears Watching as a Leading Indicator. The EAI is a better leading indicator than
coincident indicator, as its month-over-month volatility makes it a poor snapshot of economic activity. The R-squared
value of EAI’s 3-month lagged percentage change against real GNP is higher than its coincident R-squared by 3.2
percent, though both are well above 0.9. As a consequence, the laggard pace of the economy over the summer ought
to give investors pause. As we have written at length previously, however, the EAI does a poor job approximating the
growth the economy because of the way the economy has rebalanced and because of poor weighting in the EAI’s
underlying data. Height’s reweighted data also includes components for retail sales and hotel registrations, and while
the index continues to be sluggish, it looks somewhat better than the official index. We would note, however, that the
official index and Height’s version are both rather dismal, and for the first time since we began calculating our own
index, the strength of the retail sector and tourism sector are insufficient to pull the index upwards away from the
GDB’s original version. Three of four major components registered in negative territory in July 2014, and the pace of
private sector hirings has gone flat all across the PR economy. One key reason to watch the PR tourism sector is because
of its ability to reintegrate disenfranchised workers into the economy, but the sector’s hiring has slowed to effectively
zero in the past two months. Anecdotally, resorts, hotels, and casinos are all reporting a decrease in revenue over the
summer compared with their prior years, and in hearings before the Senate, some proprietors have asked to amend
their business hours to cut staff and cope with the slowdown. We would also note that credit contraction in PR has
continued unabated.
Figure 2. Comparative Economic Activity Indices.
160.0
155.0
GDB EAI
150.0
Height EAI
145.0
140.0
135.0
130.0
125.0
May-14
Jan-14
Sep-13
May-13
Jan-13
Sep-12
May-12
Jan-12
Sep-11
May-11
Jan-11
Sep-10
May-10
Jan-10
Sep-09
May-09
Jan-09
Sep-08
May-08
Jan-08
Sep-07
May-07
Jan-07
120.0
Source: Government Development Bank for Puerto Rico and Height Securities LLC’s calculations.
Legislative Changes Yet to Be Proposed by the Governor. The governor’s fiscal team has heavily telegraphed its
legislative priorities for the year, which include tax reform, reform of the teachers pension system, and an inquiry into
the health care system (Mi Salud). Tax reform is expected to be revenue neutral, and should be bolstered by a longawaited transition from a Sales and Use Tax (IVU) to a value-added tax (VAT). A VAT is a more flat tax to collect since
the tax applies broadly to all goods and services on the island, and while the VAT requires extensive maintenance to
ensure proper accounting and rebating, the current IVU system has so many loopholes, extensions, credits, and rebates
that the prospects for evasion and manipulation should drop alongside the cost of compliance as businesses and the
government work to adopt a new tax measure. The governor’s fiscal team would also like to pursue corporate income
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
Figure 3. Year-over-Year Percent Change 3-Month Moving Average, EAI Comparison.
0.03
0.02
0.01
0
-0.01
-0.02
-0.03
-0.04
-0.05
-0.06
Source: Government Development Bank for Puerto Rico and Height Securities LLC’s calculations.
Figure 4. Commercial Loans and Leases, Year-over-Year Percent Change
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
Source: Government Development Bank for Puerto Rico and Height Securities LLC’s calculations.
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Jul-14
Apr-14
Jan-14
Oct-13
Jul-13
Apr-13
Oct-12
Jul-12
Height EAI
Apr-12
Jan-12
Oct-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
Jul-09
Jul-11
GDB EAI
-0.08
Jan-13
-0.07
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
tax reform, but it is unclear how the administration would achieve income tax reform without losing revenue in the
process. Meanwhile, the prospects for reforming the teachers pensions system do not look bright, especially since the
governor recently reportedly struck an accord to cut teacher salaries by 6 percent in the next fiscal year. In our
estimation, the PR Supreme Court is unlikely to allow a reform to the teachers pension system to stand if it does not
create actuarial solvency, but the size of cuts required to create actuarial solvency are too politically difficult for the
governor to contemplate. Perhaps the administration will simply elect to work higher transfers from the general fund
into budgets through 2016 and punt reform until after the next election. Finally, requests to replace part of the
managed care provisions in Mi Salud in the spring did not go well, mostly because healthcare providers were unwilling
to renew the program at present rates. A new request for proposals (RFP) for Mi Salud should go active soon, as the
current arrangement expires on January 1. In our view, the cost of Mi Salud is likely dramatically understated for
FY2015 and beyond, as we expect the cost of care per recipient to increase by at least half for more than 40 percent of
Mi Salud’s care load. That implies the cost of PRHIA could be around $3.20 billion in this year, against a budgeted $2.67
billion. The incremental $534 million may need to come from the general fund, and the Commonwealth will need to
get a health provider to agree to even the 50 percent increase in order to effect this change. Reports from the initial
failed RFP in the spring are that the demand among health providers was for a nearly 100 percent increase in the
reimbursement rate for Mi Salud; Humana has cited this as a driving factor behind its reduction in PR activity.
Execution Risk Still Paramount; Liquidity Needs to Come Sooner Rather Than Later. With the government failing
to execute on a variety of reform efforts in the first 60 days of the new budget, liquidity needs are coming into focus.
This month, the implementation of the new port-collected IVU should bring about higher compliance, but relatively
abysmal tax collections in July should concern investors. While the headline figure ($663.2 million) was higher than
projected by $37.0 million, the only component that really had a strong showing was Act 154 revenues. As the months
draw on, 154 cannot be expected to make up the slack in revenue from other line items – especially corporations – if
the economy is not strong enough to meet projections. Moreover, the Commonwealth needs to move quickly to
implement changes, such as the closing of schools and the consolidation of agencies, in order to realize meaningful
savings from these measures. The fiscal year will be one-quarter gone by the end of September, and assuming the
governor fails to execute (and expenses are distributed as in prior years), the Commonwealth could be as much as
$390 million behind budget already. In this light, getting access to liquidity is a pressing concern; as we have
highlighted previously, the Commonwealth’s liquidity needs are acute in the coming year, and without a lifeline from
either bondholders or banks, the first half of the year may prove difficult from a financing perspective. While we
believe these incremental cash-flow funds should materialize, in our opinion, it is imperative that the Commonwealth
secure additional near-term liquidity before the end of September.
How much liquidity? While initial reports have indicated that the GO may receive as much as $1.6 billion in
incremental liquidity from a proposed bridge financing from investors, $1.6 billion may prove smaller than expected
if the current execution shortfalls remain. The Commonwealth may find itself more than $800 million behind budget
by the end of December, and while much of this can be made up in the back half of the fiscal year, investors should not
feel good about the inability of the Commonwealth to keep its fiscal promises. The governor has worked hard,
however, to ensure that other deals should fix the budget going forward, and has secured deals with more than 60
percent of union employees to take payroll cuts of up to 6 percent in FY2015. The bet being made by investors,
however, is that the FY2015 budget at least resembles balance, and with the disappointing first two months of the
fiscal year behind us, the governor faces a massive uphill battle in this regard. If investors are willing to provide bridge
financing, they should be leery of the black-box accounting areas of the budget – education and health care – where
unrestrained spending could easily derail well-formed plans. Without greater oversight, the path of the budget can
easily get out of hand, as it did in 2003, 2004, and 2005, when budget overruns from the health care and education
systems resulted in massive upwards revisions (in excess of $300 million) in budget deficits for the fiscal year.
A Calendar for PREPA.
CRO Headlines New Era at Utility. PREPA’s new world begins next week. According to the forbearance documents
signed by PREPA’s bondholders, the utility has until September 8 to name a Chief Restructuring Officer, and it is widely
believed that this new officer will be closely associated with FTI Consulting, which has been assisting the GDB with
liquidity analysis for public corporations in recent months. The naming of a restructuring officer is likely to be
politically motivated, but investors should watch for a new officer to be named who is distinct and independent of the
Garcia Padilla administration. The administration, which used the long weekend to wine-and-dine donors and union
interests, has begun to turn the page on PREPA, having ring-fenced the entity. Since the utility has grown hugely
unpopular, part of the PDP political strategy is to segregate PREPA’s problems politically as well as financially; in short,
if Utier is forced to absorb large payroll cuts, the governor wants to be clear that the other unions are safe and the
PREPA restructuring is outside his administration. As such, a CRO who is distinct from the governor’s administration
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
will be necessary; a truly independent CRO may have the added benefit of being acceptable to forbearing bondholders.
Likewise, PREPA will now become the focus of significant financial scrutiny never before placed on any entity in PR.
The new requirements are designed to indemnify investors against mismanagement by PREPA’s leadership and help
investors understand the severity of PREPA’s financial condition. Among the items that PREPA will need to provide
regularly are the following:






Monthly report of cash balances
Monthly breakdown of PREPA’s bank statements
Weekly statements of cash flow
Weekly disbursements from PREPA’s construction fund
Copies of the engineer’s report
Details of significant signed contracts (greater than $50 million annually, including fuel suppliers)
Additionally, PREPA will begin collecting on back accounts, and as of yesterday will use standard accounting for
municipalities. PREPA will also record Cash in Lieu of Taxes (CILTs) as receivables on a gross basis. On the next page,
we set out other important dates for bondholders.
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
Figure 5. PREPA Schedule
Date
Event
Explanation
September 1, 2014
PREPA Accounting
Shift
PREPA begins recording revenue from municipalities
and changes CILT procedures
September 1, 2014
First Reserve Fund
Installment
PREPA pays $34 million to a Reserve Fund special
defeasance account; four more installments must be paid
by January 1.
September 8, 2014
CRO Appointment
PREPA must have named a chief restructuring officer
October 1, 2014
Second Reserve
Fund Installment
PREPA pays $34 million to a Reserve Fund special
defeasance account in second installment
November 1, 2014
Third Reserve Fund PREPA pays $34 million to a Reserve Fund special
defeasance account in third installment
Installment
November 12, 2014
REAP Grants Close (REAP) grants close
Applications for FY2015 Rural Energy for America
November 15, 2014
FTI Report Due
FTI Consulting must have submitted a report laying out
‘best practices” for operations at PREPA
November 27, 2014
Comprehensive
CILT Plan
Comprehensive CILT plan must be effective
November 27, 2014
Interconnectedness
Standards Effective
Date
PREPA must release standards for using its grid that
meet IEEE Standard 1547 safety and performance
standards. Net metering must be allowed as part of this
transformation.
November 27, 2014
Rate Review begins
PREPA must begin a comprehensive review of rates to
determine what is “fair and reasonable”. It must
ascertain where loss might be occurring and how future
rate changes can be made more effectively
December 1, 2014
Fourth Reserve
Fund Installment
December 15, 2014
PREPA Long-Term
Plan
PREPA pays the fourth $34 million installment to its
Reserve Fund special defeasance account
PREPA must have a five-year plan approved by
bondholders and oversight board
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
December 15, 2014
FERC Releases
Environmental
Impact Statement
FERC EIS sets the clock ticking for approval of the
Excelerate Aguirre Off-Shore regasification facility.
January 1, 2015
Final Reserve Fund
Installment
PREPA pays the final $34 million installment to its
Reserve Fund special defeasance account
January 1, 2015
PREPA Pays
Bondholders
PREPA pays bondholders $214 million
January 15, 2015
Forbearance
Review
PREPA’s forbearing bondholders can vote to terminate
agreement after this date
March 2, 2015
PREPA Finalizes
Restructuring Plan
PREPA must have a finalized restructuring agreement in
place
March 31, 2015
Termination of
Forbearance
Agreement
PREPA’s forbearance agreement with bondholders, the
GDB, Scotiabank, and Citibank terminates
April 1, 2015
Projected Approval
Date for Aguirre
While we do not know when / if FERC and other
agencies will approval the facility, we believe a decision
will come around this time.
May 27, 2015
Rate Review Ends
PREPA must have completed the rate review begun in
November
July 1, 2015
Integrated
Resources Plan
Due
PREPA must submit a 20-year plan for meeting energy
demand using current and planned infrastructure that
reduces reliance on old technologies and increases the
use of renewables in the system. The plan must set
measurable yearly benchmarks for achievement.
July 1, 2015
Energy Price at
$0.22 per kWh
Per the existing capital plan.
July 1, 2017
High Efficiency
Standards
60 percent of PRPEA’s power generation must be from
“high efficiency sources”.
July 1, 2017
Energy Price at
$0.20 per kWh
Per the existing capital plan.
January 1, 2018
Major Plant
Conversion
Complete
January 1, 2019
Energy Price at
$0.16 per kWh
Per existing capital plan.
Per the existing capital plan.
Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com
Washington, DC – September 2, 2014
Daniel Hanson
(202) 629-0029
[email protected]
RISKS
The legislative and regulatory agendas are subject to change at the discretion of leadership. Unprecedented economic conditions
could instigate unanticipated and/or sweeping shifts in policy. Predicting the future is a hazardous endeavor and economic / market
forecasting is an imprecise science. Actual outcomes may differ substantially from our forecasts. The predictions and opinions
expressed herein are subject to change at any time.
ANALYST CERTIFICATION
I, Daniel Hanson, certify that (i) the recommendations and opinions expressed in this research report accurately reflect the research
analyst's personal views about any and all of the subject securities or issuers discussed herein and (ii) no part of the research analyst's
compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research
analyst in the research report.
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Height Securities, LLC
1775 Pennsylvania Avenue NW · Washington, DC 20006 · (202) 629-0000 · www.heightllc.com