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Q

Cigarette sales have dropped, and because industry payments to states are based to some extent on the number of cigarettes sold, the states’ settlement revenue has dropped. States that were part of the settlement initially expected about $6.5 billion this spring, for instance, but the tobacco companies have said that they may be entitled to cut their payments by as much as $1.2 billion this year. Some of that decline would be the result of dropping sales, and some could come from other adjustments allowed under the settlement. Since state obligations under the tobacco bonds is limited to settlement proceeds paid by the tobacco companies, how would declining receipts impact the credit worthiness of tobacco bonds?

A

James A. Klotz responds:

Declining sales have been factored into the structure of the bonds from the beginning. Each issue has been designed to expect a substantial decline in annual shipments up to, and including, the current 4% range. Since the bonds are expected to have a shorter average life than actual maturity dates would indicate, we would expect that any declines in sales in excess of that originally projected would mean that advance (“turbo”) redemptions would either be reduced or, in the worst case, eliminated. In that situation, the bonds would be paid on time according to the actual maturity schedule of each issue.

In the case of the NPM (Non-Participating Manufacturer) Adjustment, it is possible that up to the $1.2 billion figure you quote may, indeed, be withheld by tobacco companies claiming the Master Settlement Agreement (MSA) cost them market share. However, this will not go uncontested by the states. Further, the NPM Adjustment can only be invoked if the companies can prove that the states failed to adequately enforce the MSA. This may be difficult to prove. States have repeatedly passed legislation tightening up holes in the MSA, slowing the growth of small, non-participating companies. Some experts actually believe that the states and tobacco manufacturers have so much at stake here that a new, stronger agreement may yet be developed to solve the problems that have arisen to date. The next few weeks should reveal how this plays out. In any case, the withheld funds would be segregated into an escrow account and we believe cash flows, in the worst case, could be tight this year, although we expect all debt service to be paid. In the longer run, it will be in the interest of all parties to iron out differences to ensure that the MSA remains viable.