muscleman Posted July 17, 2014 Share Posted July 17, 2014 Note: this thesis is in an application that I submitted to VIC. Note: 1. I normally invest in stocks, but this one is a municipal bond idea. I have never invested in municipal bonds before. 2. The liquidity of these bonds are very low, so anyone interested will have to look at the bond ladder from 2015 expiration to 2030 expiration. CUSIP: 745190TR9 is the 2030 expiration and relatively liquid. Now here we begin: Summary: The recent passage of Puerto Rico Public Corporation Debt Enforcement and Recovery Act (http://www.gdb-pur.com/documents/FactsAboutDebtEnforcementAndRecoveryAct.pdf) truly shed blood onto the PR municipal market. Although this act only enables debt restructuring for PRHTA, PREPA and PRASA, all PR bonds are on fire sale, but PRHTA and PREPA's bonds experienced the biggest drop. Has Mr. Market rationally priced in the risks for these bonds, or is he totally maniac right now? My research below will show you why I believe PRHTA's bonds should be worth 60 to 100 cents on the dollar, reflecting an upside of 100-300% over the next 2 years. Details: 1. Background Puerto Rico debt has been a hot topic amoung the media since last year. The total debt is 70bn and they have a deficit since decades ago. Due to the triple tax exempt status, PR government and its agencies can keep selling more bonds and include selling of these bonds as part of their annual "balanced" budget proposal. Eventually, the debt load has become so high that it is much harder to find lenders. The new governor Alejandro García Padilla has enacted an impressive number of Acts in order to turn around this situation. While there are signs of improvement, the market did not seem to believe the story. As the market remained temporarily closed, Puerto Rico Development Bank (GDB) had to provide liquidity to various government agencies and carry the entire PR onto its back since last November. The market relieved this April as a successful $3.5 bn General Obligation bonds were issued and GDB got $1.9 bn to restore its liquidity position. The GO bonds jumped from over 60 cents on the dollar to 73 and everything seem to be peaceful again. However, in late June, the announcement of Puerto Rico Public Corporation Debt Enforcement and Recovery Act totally shocked the market and caused panic selling. These three agencies' bonds were consider safe and had investment grade just 12 months ago, as they use their revenue as the collateral to pay the bonds first, and any remaining money will pay the operating expenses and worker's payroll, and also PR does not allow debt restructuring. But the passage of this effectively bankruptcy law reminds people that PR's willingness to pay its debt has limits, and perhaps these three agencies will just be the tip of the iceberg and pave the way for additional restructuring of other PR bonds in the future. 2. Brief analysis of the three involved agencies. Right now PREPA has the worst shape of the three. Its 672 Million line of credit from two commercial banks are due now, but it is unable to get them renew the lines of credit. It also has ran out of cash to purchase fuel. In addition, its charges customers 3 times the price of electricity per kilowatt compared to mainland US utilities, as it is using oil instead of natural gas to generate electricity. It needs to spend 8-9 bn in order to upgrade its facilities to use natural gas, but it neither has the money nor can find more lenders to get this money for upgrades. PRASA and PRHTA are in a better shape. Their interest coverage ratio on the debt is about 1.13x and 1.45x separately. PRASA needs to upgrade its facilities to meet new environmental regulations, but it does not seem to have the urgent need to do so now. Also PRASA's president just talked to journalists and said it has no need to restructure right now. (http://www.reuters.com/article/2014/06/27/puertorico-debt-prasa-idUSL2N0P81ME20140627) PRHTA is on the suspicion of the restructuring candidate according to some jounarlists "because it is facing large operating losses every year". However, I believe this concern is overblown, given the following aspects: A. PR GDB has a 2 bn loan lent to PRHTA, which amounts to 14% of its total assets and 85% of its equity. Given the role GDB plays so far in the crisis, if PRHTA gets restructured, there is a good chance to cause a domino chain effects on the entire PR financial system. B. The willingness to pay remains strong, as implied from the following (Open the pdf, the first two paragraphs of page 19. ) "http://emma.msrb.org/EP810215-EP627537-EP1029317.pdf". Note that these actions will likely bring $250 mn additional revenue to PRHTA. C. PRHTA's interest coverage ratio remains strong at 1.45x. D. PRHTA will not have cash flow problems even without government grants support every year, as I will show you in the next section. 3. Detailed analysis of PRHTA's financial reports. This is the financial report for the year end 6/30/2013. http://emma.msrb.org/EP810215-EP627537-EP1029317.pdf I would like to point out some important accounting rules in this report (page 27). A. Maintanence capex is expensed, and these items are included in its operating expenses section. B. Roads and highways depreciate over 40 years and bridges and transporation systems depreciate over 50 years. These two items tell us that the D&A figure running at $500 mn per year can all be added back to the cash flow, because it will be unrealistic to say that after a road is built and Maintanence capex is spent every year, the road will still be useless after 40 years. One limitation is that I do not know if the Maintanence capex is sufficient at current levels, without a visit to all the PR roads and highways. Let's look at page 22, which is the financial report for 2013 and 2012. Assuming the additional actions mentioned in 2.B can successfully bring in 250 mn extra revenue, and assuming that the government will no longer be willing to give grants to PRHTA, then its adjusted annual loss will be 318 mn. This is sustainable if we add back the $438 mn D&A figure. This gives us a positive cash flow of 120 mn per year, which provides a nice buffer if the current maintenance capex is insufficient as I pointed out in the above paragraph. Therefore, I believe PRHTA's current debt level is sustainable. 4. Worst case analysis. Assuming that Assuming the additional actions mentioned in 2.B cannot bring in 250 mn extra revenue, due to various factors. Maybe the austerity measure in PR caused too much economic contraction and causing the overall revenue to drop, I assume a 20% haircut on the total revenues for PRHTA. Then its total revenue will be (250+476) * 80% = 580 mn. I also assume that the current maintenance capex is too low and it actually needs 200 mn more per year. This brings the cash flow from a positive 120mn to a negative 225 mn. In this case, a haircut of 20% of the bonds with a interest cut from 5% coupon to 3% coupon will make the debt sustainable again. In this case, I expect the bonds to trade at the 60 cents level prior to the debt restructure, which implies a good MoS if purchased at 36 cents now. 5. Additional notes. A .Moody's downgrade comments: https://www.moodys.com/research/Moodys-downgrades-Puerto-Rico-Aqueduct-Sewer-Highway-Transportation-authorities-to--PR_302949 "Moody's acknowledges that PRHTA and PRASA have taken steps toward self-sufficiency by raising revenues, and that while their internal liquidity is weak, they do not face immediate liquidity needs that would force them to seek near-term debt restructuring." B. Right now the senior transportation bonds of PRHTA (745190TR9 and others) trade at the same price level as the subordinated bonds, a sign that Mr. Market is totally maniac depressive right now. C. http://www.bloomberg.com/news/2014-06-27/bulk-of-puerto-rico-electric-debt-without-lifeline-for-investors.html "With its liquidity problems and electricity costs that are double that on the U.S. mainland, Prepa may offer repayment below 10 cents on the dollar, Fabian said. At least 75 percent of investors would need to approve any restructuring, which would be difficult, he said." (I view this as a cheap way to become famous for an analyst, just like Meredith Whiteney's Trillion dollar muni market default comment.) D. 40% of PRHTA bonds are insured by AGO, MBI, AMBC etc, so there is substantial interest for these companies to fight for you for free. E. Given the worst case scenario outlined here, I think MBI shareholders may consider to switch to PRHTA bonds, because the outcome of these PRHTA, PREPA and PRASA bonds will directly affect MBI's future. Link to comment Share on other sites More sharing options...
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