We recently returned from a research trip to the Dominican Republic, where we met with officials from various multilateral and government agencies, as well as representatives of several private sector companies. We highlight our key sovereign and corporate takeaways.
Sovereign Takeaways
Franco Uccelli – (561) 672-4780 – [email protected]
DomRep’s recent fundamental performance has been impressive...
By most measures, 2006 was an extraordinary year for DomRep. Driven by the communications (+26%), construction (+23%) and financial services (+22%) sectors, the US$35-billion Dominican economy grew by 10.7% in real terms, its highest rate of expansion in almost two decades. The country’s impressive growth was underpinned by remarkable monetary stability, with inflation declining to 5.0% in 2006 from 7.4% the previous year, benchmark interest rates on 12-month Central Bank CDs dropping from 17.0% to 12.5%, the currency appreciating by 3% and net international reserves (IMF methodology) climbing by 33% to an all-time high of more than US$1.1 billion. Meanwhile, an 8% upsurge in tourism revenues to US$3.8 billion and a 13% rise in remittances to US$2.75 billion helped to offset a 14% increase in DomRep’s oil import bill, which reached almost US$2.8 billion, and to contain the size of the country’s current account deficit to less than US$800 million, equivalent to only 2.5% of GDP. The current account shortcoming was more than fully covered by foreign direct investment (FDI) inflows, which soared by 16% last year to some US$1.2 billion. The economy’s positive growth, monetary and external performance was accompanied by a moderate deviation from 2006’s non-financial public sector target, which called for a balanced result (i.e. a zero-deficit), but recorded a 0.9% of GDP deficit instead, as increased expenditure levels outpaced revenue growth. Despite such deviation, however, DomRep’s consolidated fiscal deficit for 2006 (3.4% of GDP) was roughly in line with that of 2005 (3.3%), as a greater-than-expected decline in the Central Bank’s quasi-fiscal deficit, which dropped from 3.0% of GDP in 2005 to 2.5% last year, neutralized part of the NFPS slippage.

...and its prospects remain quite promising...
After a very favorable fundamental performance in 2006, DomRep’s prospects for 2007 remain quite encouraging, in our view. Indeed, the key official forecasts for this year call for real GDP to expand by 6%, inflation to stay within 4%-6%, the quasi-fiscal deficit to total 2.3% of GDP, a non-financial public sector surplus of 0.5% of GDP, a current account deficit of 1.8%-2.3% of GDP and a US$150 million increase in net international reserves. Except for a moderation in growth (the combination of negative base effects and mean reversion), all of 2007’s projections, which we view as reasonable and attainable, imply an improvement on last year’s results. But, as we have noted earlier, positive macroeconomic performance is not the only thing going for this credit. In addition to securing more permanent preferential access to the US market for most of its export products, DomRep’s accession to DR-CAFTA as of March 1st should make it a more attractive investment destination for foreign and domestic investors alike. Moreover, the country’s positive outlook from S&P and Fitch and its placement on review for a possible upgrade by Moody’s make it a good candidate for ratings upgrades.

...despite some near-term challenges...
DomRep’s near-term outlook will be influenced by the way in which it handles three fundamental challenges: (1) keeping the level of political noise related to the upcoming presidential election within tolerable levels, (2) finding a definitive resolution to the country’s electricity crisis, and (3) staying the fiscal course. Although DomRep’s presidential election is not due until May 2008, campaigning for party nominations and in some cases for the country’s top executive office is already in full swing. The challenge for DomRep here will be to ensure that any instability related to the election does not translate into undue pressures/distortions on the country’s economic processes. Meanwhile, an electricity crisis that results in periodic blackouts and cost the government some US$530 million (equivalent to 1.5% of GDP) in subsidies last year continues to plague the country. With power outages affecting productivity and subsidies representing a sizeable fiscal burden, the situation is clearly unsustainable, making prompt resolution to the ongoing electricity crisis one of DomRep’s key challenges. Lastly, having missed its fiscal deficit target for 2006 by almost one percentage point of GDP, the Fernandez administration is under some pressure to show that it can indeed follow its fiscal blueprint and meet its targets for 2007, particularly in the context of an electoral race that may generate calls to increase public spending for political gain.

...leading us to reaffirm our outperform recommendation on the credit.
We view DomRep as an improving credit story, supported by its relatively strong economic performance and promising prospects. While next year’s presidential election is apt to generate some uncertainty, the ongoing electricity crisis is unlikely to wane any time soon and sticking to the fiscal plan will not be easy (after all, it implies a 1.4% of GDP fiscal adjustment this year), we believe that DomRep’s renewed economic strength and proven resilience will allow it to keep pressures related to these challenges generally contained, keeping them from having a significant impact on its overall economic performance. Against this backdrop, we recently upgraded our recommendation on the credit to outperform.

Corporate Takeaways
Alex Monroy – (212) 272-3545 – [email protected]
Sarah Leshner – (212) 272-1382 – [email protected]
We visited with several of the country’s corporate issuers on this trip, including Cap Cana, AES Dominicana, Itabo and Autopistas del Nordeste. As we further elaborate below, we view the outlook of Dominican corporates as mixed. On one hand, we came away impressed with the performance and future prospects for those corporates directly tied into the country’s impressive growth story (Cap Cana, Autopistas de Nordeste). On the other hand, we returned with heightened concerns regarding the prospects for the country’s electricity sector (AES Dominicana, Itabo).

Cap Cana – An Enclave of Luxury – Project Moving Ahead At or Above Expectations
Cap Cana is very well positioned in a sector which is one of the country’s key drivers of growth: tourism and leisure. To enter the threshold of this giant real estate development (the entire property measures about 46 square miles – roughly twice the size of Manhattan) is to leave the unpleasant aspects of the third world behind while retaining the level of personalized service and attention that only a third world country can provide – all within a 10 minute drive of Punta Cana international airport.

While construction is still taking place in every direction the eye can see (much of it on a 24-hour schedule), the areas that are already completed provide a very good idea of what the finished product will look like: breathtaking vistas no-expenses-spared luxury, the latest cutting-edge technology and excellent infrastructure. While there, we had a chance to tour the marina (expected to be one of the largest, if not the largest in the Caribbean) and the surrounding founders’ package condos, as well as the Green Village units, Farallón lots, completed golf course and associated club house and completed beach club, all of which were extraordinary in their beauty and in the attention paid to detail in their design. Construction seems to be going according to, or ahead of, schedule.

We also visited much of the supporting facilities such as administrative offices, schools (including an international school) and employee housing and entertainment – all of which seemed to be progressing briskly (administrative offices had been completed). There are also two hotel sites under construction, one of which we expect to be completed by the summer of this year. We expect that the entire portion of the Cap Cana project that was financed via the recent bond issue will be completed and handed over to the new owners by around August of 2008.

Official figures with updated sales data have not been released yet – we expect them to come out early to mid next week. For now, we can share management’s indication that sales across the different units have been progressing at or above initial expectations, including the Farallón lots which will be branded under the mark “Trump Farallón Estates at Cap Cana”. We note that the agreement that Cap Cana reached with Trump is purely a licensing agreement intended to increase the project’s profile on a global basis, while also adding the Trump distribution network to the sales effort. Cap Cana remains the developer.

It is further important to note that interest in the Farallón lots seems to have been strong even prior to the agreement with Trump, as about 40 indications of interest (ie. people paying a US$100,000 for the privilege of participating in the official Farallón sales events) out of 68 lots had already been received at the time the agreement was signed. We also note that the portion of Cap Cana that will be developed in conjunction with the Trump brand is only a small part of the entire property. So there will be plenty of opportunities for potentially interested buyers who are not fans of Trump. To summarize, we came away encouraged from our Cap Cana site visit. It would be difficult to envision being worried about the notes, given the significant amount of collateral backing them, while still trading 250+ bps wide of the sovereign – especially since the project will be providing regular financial and operational updates to the market.

Autopistas del Nordeste – Expect Early Completion – Additional Project in the Pipeline
Our meeting with Autopistas del Nordeste (AdN) was very encouraging and featured some interesting updates. AdN is responsible for constructing a 106-km toll road between Santo Domingo and the peninsula of Samaná under a 33-year concession granted by the Dominican government. The primary source of funds for the project is toll revenue collected at two toll plazas near the north and south ends of the highway, and there is also a minimum revenue guarantee from the government in case toll revenues fall below a certain level. Project construction is funded in part by the US$163 million 20-year 9.3825% bonds issued in February of last year. The bonds have several sweeteners attached, including a partial guarantee from the World Bank’s Multilateral Investment Guarantee Agency (MIGA) which covers 51% of the face value of any loss attributable to specific factors including civil disturbance and breach of contract.

We were pleased to hear from management that the project is moving ahead of schedule and the company expects that construction will be finished three months early (January 2008 vs. May as originally projected). Additionally, tourism-based development in the northern end of the highway in Samaná is expected to spur an increase of traffic flows on the highway, and therefore higher revenues. Finally, we expect that AdN will be contracted to upgrade and develop an additional section of highway – this is just awaiting governmental approval, expected in the first or second week of March. The cost of the additional project is expected to be around US$60 million. Final financing plans have not been drawn up yet, pending final adjudication of the new additional project. While intricately linked with the Dominican economy (traffic on toll roads tends to be highly correlated to GDP), AdN’s notes continue trading about 200 bps wide of the sovereign, leading us to continue viewing them as an excellent proxy.

AES Dominicana and Itabo – Power Sector Remains a Strong Area of Concern
The Dominican power sector is a clear-cut example of what happens when you privatize a sector under weak structural and legislative underpinnings, combined with a lack of political will to enforce regulations. The result is one of the shabbiest electricity systems we have ever seen, where lengthy daily power outages are the norm, causing households and businesses to do what they can to mitigate the impact of the outages. This often implies bypassing the country’s electricity system altogether, via small generators and ingenious contraptions involving racks of car batteries connected in series. We are somewhat surprised by the valuations of AES Dominicana’s and Itabo’s notes, given the sector’s woes and the potential difficulties that lie ahead.

The central problem lies within the government-owned electricity distribution segment and, more specifically, with collections (ie. electricity theft). Basically, while distributors’ technical electricity losses are around 8%, perhaps somewhat higher than desirable but nothing to cause too much concern, total electricity losses are between 40% and 50% - a very alarming and almost unbelievable amount. The difference between total and technical losses stems from electricity theft, either outright via illegal connections to the grid or from customers who receive power from the distributors but do not pay, and are not cut off due to lacking and ineffective enforcement.

This, in turn, follows a longstanding Dominican culture of nonpayment for electricity which, in a way, is perfectly understandable given that the duration of the daily power outages can range from 6 hours for the wealthier parts of Santo Domingo to over 20 for the poorer ones. Ironically, the main reason behind the outages is the fact that distributors don’t have enough money to pay generators for more power. This is despite the significant cash that the government has been paying into the sector on a yearly basis (about US$530 million for 2006), trying to bridge the gap between what distributors receive from customers and what generators (which are mostly privately owned) require to send power into the grid.

The good news is that we will probably see a new sector agreement signed within the next few weeks, whereby the government, distributors and generators will agree to freeze certain past debts and continue canceling liabilities between themselves, and the government agrees to continue putting money into the system. In addition, we are also expecting a new law to come out over the coming weeks or months which moves significantly closer to criminalizing electricity theft. Lastly, we expect both AES Dominicana and Itabo to report results next week, which could provide favorable year over year comparisons of the companies’ results.

The bad news is that the country will hold presidential elections next year and, as our sovereign research colleagues mention in the country section above, the air seems to be becoming significantly politically charged. This, in turn, leads us to expect that it is unlikely that there will be sufficient political will to enforce the new more severe regulations, at least until after the presidential elections have been decided.

We also continue to be worried about the potential renegotiation of AES Dominicana’s and Itabo’s power purchase agreements (PPAs), which we view as having been instrumental in the launch of the companies’ respective bond issues. Thus far, only Itabo has received a formal renegotiation request from the government, after having learned about the government’s stance in a 2 page spread taken out in El Diaro Libre newspaper in January. We remind investors that the government’s stance seems to be to either: 1) drastically reduce the capacity on the PPAs, 2) change the indexation formulas to drastically reduce the price paid to generators, or 3) leave the capacity and formulas intact, but have the contracts end around 2009. No definitive steps have been taken and this could well turn out to be a drawn-out negotiation process. However, we believe that in the end, it is unlikely that the companies’ PPAs will survive this process entirely unscathed.

More medium-term, we’re also concerned about government plans to build two new coal generators with a total capacity of about 1,200 MW. These plants could have serious negative impact on gas-fired generators’ economics since the coal plants’ lower marginal costs would mean that they would likely be dispatched before gas-fired plants (ie. AES Dominicana). This would be particularly dangerous if AES Dominicana’s PPA is changed. Though we understand that the government is still negotiating with potential builders, there seems to be a generalized belief that a deal will be reached shortly. We estimate that it would take about 3 years to build the plants if all goes well.

The research analysts who prepared this research report hereby certify that the views expressed in this research report accurately reflect the analysts' personal views about the subject companies and their securities. The research analysts also certify that the analysts have not been, are not, and will not be receiving direct or indirect compensation for expressing the specific recommendation(s) or view(s) in this report.
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