CARNIVAL CORP/PLC (USA) CCL
June 22, 2015 - 11:59am EST by
wjv
2015 2016
Price: 48.00 EPS 2.45 3.36
Shares Out. (in M): 778 P/E 19 14
Market Cap (in $M): 37,288 P/FCF 0 0
Net Debt (in $M): 8,757 EBIT 2,419 3,034
TEV ($): 46,045 TEV/EBIT 19 15

Sign up for free guest access to view investment idea with a 45 days delay.

  • FCF yield
  • Cruises
  • Leisure
  • Industry Consolidation
  • Consolidation
  • Travel
 

Description

FCF set to grow fivefold, investor fatigue no longer justified, 50-70% upside in base/bull case
 
 
Investment Case Summary
 
Carnival has gone through the perfect storm in recent years. They not only faced a subdued European recovery and FX pressure, they also had to deal with elevated fuel costs and yield growth being held back by some high profile ship accidents, most notably the Costa Concordia. The tide now seems to be turning, with fuel costs coming down, yield growth catching up and the Euro bottoming. Together, these factors should lead to earnings more than doubling over the coming years.
 
 
Most investors dislike the cruise companies, and for good reasons. Business strategies over the past 2 decades have been designed to accomodate management egos rather than shareholder interests and I have avoided the names for the past 15 years. But a few things are genuinely changing now - the industry has consolidated to the point where 3 players control 90%, the 2 largest had a change in management, and both are taking steps to maximise returns rather than the size of their ships. The number of ships on order has been scaled back, the operators are now happy to leave some cabins empty if it means they can scale back the discounts on offer, there is an increased focus on increasing on-board spending, etc. And the emergence of the EM consumer is helping, with the re-routing of some ships to Asia restricting capacity growth in existing markets. Adding everything together, FCF is expected to grow fivefold over the coming years.
 
 
The current valuation of 14x FY16 P/E, 9.5x EV/EBITDA is at the lower end of the historical trading range, suggestion that the market is not fully aware of all the changes impacting Carnival and the cruise industry. It also compares favourably to other consumer stocks, while the expected growth is substantially higher.
 
 
 
Company
 
- Carnival is the world’s largest cruise company with 100 ships sailing under 9 brands – Carnival Cruise Lines, Holland America, Princess Cruises and Seabourn in North America; P&O Cruises and Cunard Line in the UK/Australia; AIDA in Germany; and Costa Cruises in Southern Europe. The total passenger capacity of its ships is 200,000 and Carnival attracts over 10 million guests annually, giving it a 50% market share of the global cruise industry.
 
- Roughly 40% of passengers are American, 35% are European and 25% come from the RoW (including Canada).
 
- In revenue terms, roughly 40% of revenues come from Europe, 40% come from the US and 10% from RoW.
 
 
 
Industry structure
 
- The cruise industry has been gradually consolidating over the past 30 years. The top 3 players – Carnival, Royal Caribbean and Norwegian – controlled 30% of the North American cruise market in the early 90s, 50% in the early 00s and 90% today.
 
- The consolidation is leading to a more rational pricing environment, provides the remaining players with better access to capital and is producing the traditional operating efficiencies that come with scale.
 
- The biggest industry moat is the fact that a new ship easily costs $500mn-$1bn and that operating cash flow covers this for the large existing players. The other moat is the brand – people know what they get when they book a Carnival cruise.
 
- The remaining 10% of North American capacity is focused on niche markets such as ultra-luxury, low end, adventureor kid friendly cruises (Disney has a 3% market share).
 
- There are more smaller players outside North America, but the top 3 still have roughly the same market share – 84% in the UK, 90% in Germany, 87% in Southern Europe and 90% in Asia. Globally, Carnival has a 50% market share.
 
- Cruise operators do compete with alternative holidays. The secular growth drivers of an ageing population and emerging EM consumer work in the cruise industry’s favour here.
 
- The bigger picture growth drivers for the industry are the ageing population, the emerging EM consumer, and economic growth / consumer confidence.
 
- The key top line drivers are capacity and yield growth.
 
        o Industry capacity has grown by 5% per year over the past 15 years and is scheduled to grow by around 3% per year for the coming 3 years and around 5% from FY18 to FY20. Carnival is scheduled to grow its capacity by 2-3% per year.
 
        o The industry yield has grown by 1% per year on average over the past 15 years and is scheduled to grow at a 1-2% pace over the coming years. Carnival is scheduled to outgrow the industry and should deliver 2-3% yield growth per year, potentially more (I'll come back to this).
 
- The delivery time for a ship is 3 years, so any pick up in ship orders would only impact the industry from FY18 onwards. Therefore the swing factor for the investment case is yield.
 
 
 
Industry/company changes, not fully appreciated by the market
 
Headwinds turning into tailwinds
 
- Carnival has gone through the perfect storm in recent years – fuel costs were elevated on the back of high oil prices, a subdued European economy and the Euro weighed on both the business and the stock, and yield growth was held back further by some high profile ship accidents. The tide now seems to be turning.
 
 
- Fuel costs are coming down rapidly
 
        o Brent was $97 last year and I model it coming down to $60 this year. For FY16/17 I model $65 and $70, which then remains the oil price in the model longer-term.
 
        o The bunker multiple – the multiple of bunker fuel over Brent – has gone up from 4.5x in 2005 to 7x in-line with refining margins. Simply put, refineries were trying to squeeze everything out of oil at high prices, leaving less residual bunker fuel. At lower oil prices, we should see this pressure ease. I model 7x this year, 6.5x next year and 6x thereafter.
 
        o Added together, the cost of bunker fuel falls from 636 last year to 420 this year and the coming years. The lower bunker fuel cost boosts EPS by 60% in FY15.
 
 
- Revenue yield is a function of ticket prices and on-board spending
 
        o Ships tend to sail full 50 weeks per year (leaving 2 weeks for maintenance/repair). Occupancy rates are typically 104-106% and stayed above 105% throughout the financial crisis (100% occupancy equals 2 people in every cabin, the part above 100% is driven by children sleeping in the parents room on extra beds). Cruise costs are mostly fixed, the incremental expanse of carrying a passenger is easily covered by his/her on-board spending. So it makes sense to sail at full capacity, even if you have to discount tickets.
 
        o Therefore changes to ticket revenues are driven the level of discounting. Cruise ships typically offer attractive discounts at the start of the season with prices moving up in the middle and then falling again immediately before departure.
 
        o Ticket revenues typically drive 75% of the total  yield (net revenues per average lower berth day). The remaining 25% comes from on-board spending. Mostly alcohol and gambling and to a lesser extent dining, the spa, excursions, shopping, internet access, etc. On-board spending has been growing at a 3-4% pace for the industry in recent years on the back of improving consumer confidence, an increased focus of the industry on offering things that boost on-board spending, and the fact that bigger ships allow for more things to do.
 
 
- Carnival’s total yield growth has lagged peers and is due for a catch up
 
        o Royal Caribbean’s total yield is back at 2007 levels, Norwegian’s yields are 10% above the previous peak (had more of a mix shift to bigger ships, from a smaller base), while Carnival’s yield is still 15% below 2007.
 
        o Some of the lag is structural and therefore I don’t expect Carnival to catch up entirely with peers (which is the lazy pitch of some equity analysts). Carnival ‘s yield growth has been below Royal Caribbean’s for 8 of the past 10 years due to a combination of mix (more smaller and older ships) and regional exposure (more Europe).
 
        o However, there is also an element of Carnival’s yields having suffered from a series of high profile accidents. The Costa Concordia (which sank in 2012 off the coast of Italy), Costa Allegra (which was adrift in the middle of the Indian ocean in 2012 after an engine fire) and the Carnival Triumph (also adrift after an engine fire, in the Gulf of Mexico in 2013. In this case, faulty pumps also led to raw sewage streaming onto the decks, leading to the media jumping on the incident and calling it ‘the poop cruise’).
 
        o I don’t really expect to see a big reversal in ticket yields now that these accidents are far enough in the past, just growth in-line with peers. But there has been a secondary effect in that management has spend a lot of time taking measures to reduce the chances of another accident, leaving less time to focus on things like improving on-board spending. Carnival has lagged its peers substantially in this area and is due for a catch-up.
 
        o We indeed seem to have turned a corner now, with on-board spending growing by 8% in Q1, far ahead of consensus expectations and peers. Also, the company has installed a public relations office which is now creating positive headlines for the company. Eg, the Queen has attended the naming ceremony of the new P&O Britannia in Southampton, Carnival made headlines with its Super Bowl Commercial, and Princess Cruises headed the Rose Bowl parade.
 
        o I’ll come back on the potential for further accidents in the risk section, but it is important to know that Carnival does not have a worse track record than peers. 2012/2013 was just really bad luck. Eg the company only had 4 engine fires in its entire career, so having 2 of them in 2012 was exceptional (the company has since installed back-up generators on every ship which should prevent another ship being adrift going forward). And I bet no captain will ever try to sail close to an island again to impress their mistress.
 
 
- So Carnival should finally be able to generate some reasonable yield growth again after 3 meagre years (-10% between 2012 and 2014). And yield growth counts given the fixed cost nature of the business
 
        o Even though 25% of revenues are variable, the cost base of a cruise ship is almost entirely fixed. Unlike a hotel which can shut down a floor and reduce staff when demand is low, cruise costs are dominated by depreciation, fuel and a largely fixed crew and provisions base.
 
        o So yield matters and my model show that every 1 percentage point in yield adds roughly $0.18c in EPS or 6-7% (broker models show a similar sensitivity).
 
        o While yields have grown 1% throughout the cycle historically, they are able to expand at a mid- to high-single-digit pace in a cyclical recovery. I model 3-3.5% yield growth per year for the coming 3 years. This is similar to what competitors have generated in recent years (excluding FX).
 
        o Carnival delivered 2% net yield growth in Q1 (1% pricing and 8% onboard spending) and increased its FY net yield guidance from 2-3% to 3-4%. Management talked about a strong wave season, meaning that cumulative bookings in Q1 were ahead of expectations, leaving fewer tickets to be sold later in the season and therefore less potential discounting. Additionally, industry capacity in the Caribbean is scheduled to decline double-digit in H2, which should be another tailwind for discounting. The company has a poor track record of yield guidance at the start of the year, but a strong track record of guidance once they know the Q1 results (because over 50% of bookings are done in Q1).
 
 
- A European economic recovery could increase yield growth. Similarly, a stronger EUR would benefit the company.
 
        o The company says that roughly 40% of its revenues come from the European brands (2/3rds EUR and 1/3rd GBP). Additionally there is an impact of USD strength on the cost base, as fuel is priced in USD, although that is often offset by the negative correlation of oil prices and the USD.
 
        o The company guides for a $0.25-0.30 impact on EPS for a 10% swing in the USD in 2013, or 10-12%.
 
 
- Also, both Carnival and Royal Caribbean are experimenting with giving up some occupancy in return for less discounting. Ultimately they want  to end the image that it pays off to book cruises last minute because you will get substantial discounts. Also, they hope it will lower the main frustration of customers - discovering that other guests paid half of what you paid. It's hard to say how much this will add to revenue yield, both companies say that last year's tests were surprisingly positive, but overall I see it as another sign that the industry is effectively changing for the better
 
 
 
Changing competitive landscape
 
- Similar to most investors, my initial reaction to a cruise industry pitch is a sceptical one. Some industry history helps explain the investor reaction.
 
        o Cruises strongly gained in popularity at the end of the 1970s and during the 1980s. It’s no coincidence that this the ‘Love Boat’ series aired between 1977 and 1987 (the boat that featured in the series was a Carnival one). Demand attracted capacity and ended up with several underfinanced small players purchasing second-hand ships. Most of these players went bankrupt in a challenging pricing environment in the early 90s (Royal Cruise, Royal Viking, Regency).
 
        o The industry had a second growth spurt at the end of the 90s. Once again the media mighthave played a role as the Titanic movie launched in 1997, but I’m sure the robust economy played a bigger role. It once again led to overcapacity and a series of bankruptcies as the economy turned in 2000 (Premier Cruise Lines and Commodore Cruise Lines). 9/11 created further pressure on the industry and led to Renaissance and American Classic Voyages going into Chapter 11.
 
        o 2004-2008 was characterised by the remaining players spending a lot of money on bigger and brighter ships, leading to the sector going into the financial recession with substantial leverage and the stocks underperforming heavily. From a business point of view the recession led to pricing pressure and a collapse in on-board spending.
 
        o The post-recession recovery has been marked by some severe headwinds for the stocks, such as the earlier discussed rise in oil prices, geopolitical events like the Arab spring, and for Carnival specifically the accidents of 2012/2013.
 
        o So there have been an exceptional amount of opportunities for investors to burn their fingers.
 
 
- The cruise industry continues to carry risks that are typical for the travel industry (economic cyclicality, geopolitics, weather, accidents, FX, commodity trends) and I will come back to this. But the competitive environment is improving.
 
        o The main players seem to be moving away from the ‘bigger is better’ mentality of the past decade. While the amenities and technology on the ships continue to improve, the industry has hit critical mass in terms of ship size and new ships no longer set new records. A good example is Royal Caribbean’s newest generation of flagship ships. The Quantum Class has an average of 4,100 berths compared to the previous Oasis class with 5,400 berths.
 
        o The big players are also building fewer ships, not just smaller ones, with the different managements talking about a focus on returns. The average fleet age has doubled from 6 years in 2005 to 12 years today and is scheduled to go to 17 years by the end of the decade. The track record indicates that we can’t blindly trust these managements, but we can take comfort from the fact that they can’t change tactics quickly even if they want to given the long lead times to build and deliver a ship. Also, the ship builders are running at maximum capacity.
 
        o China is emerging as a new source of demand and a local destination. The number of passengers is expected to surpass 1mn in 2015 with half of them travelling on a Carnival ship. So volumes benefit, but the bigger effect will likely be on yields. With an increasing number of ships being deployed in Asia (eg 2 of the 3 new Royal Caribbean Quantum ships will be positioned there), there is a substantial reduction in the capacity expansion in existing markets, which should help pricing and yields. There will be a big repositioning effort in the second half of this year, with the key Caribbean market scheduled to see a double-digit decline in capacity. Some analysts are calling it a ‘game-changing shift in supply’.
 
        o China isn’t the only new driver. Latam is also emerging as a new market. And the opening of Cuba should lead to further capacity being re-routed from the Caribbean market. Parking a cruise ship outside Havana when the market opens is a lot easier and quicker than building a new Four Seasons hotel.
 
 
 
Improving FCFs and capital returns
 
- The reduced pace of ship orders will not only help yields, it should also lead to improving free cash flows and capital returns.
 
- Capex is scheduled to come down from $3bn this year to $2bn in 2017 and beyond for Carnival. Coupled with lower oil prices, rising yields and high OP leverage this leads to an expected fivefold increase in FCF from $600mn this year to $3bn in 2017.
 
- Carnival is guiding for a net-debt / EBITDA ratio around 2x longer-term and capital returns once we reach this level (buybacks and dividends). The company will reach 2x at the end of the year and therefore I expect an increase in share buybacks and dividends going forward. We can trust them on this as they have done this in the past. I model the dividend to increase by 10% a year (current yield 2.2%) and $500mn in buybacks in FY16 going to $2bn per year thereafter (5% per year on the current mcap of $36bn).
 
 
 
Improved efficiency
 
- Together with the increased focus on returns comes an increased focus on costs. Carnival has for example appointed its first procurement officer for the company as a whole. So far, brands have organised procurements separately and fuel is purchased on a ship by ship, port by port basis.
 
- So there seems to be an opportunity here, but we have little insight into the potential scope. Given that most costs remain fixed and that any cost savings will be dwarfed by the change in fuel prices shorter-term, I have not spend too much time modelling this in detail. Neither have analysts, so this could be a smaller source of margin upside surprises.
 
- Costs excluding fuel declined 1.9% in Q1 versus consensus expectations of a 2-3% increase. FX explains most of the beat, but a small part indicates that we are seeing some progress on the cost front.
 
 
What do I expect in numbers and how does this compare to consensus?
 
Base case
 
- We have a good 3 year visibility on capacity, so yield is the swing factor. Consensus is modelling a similar 3.0-3.5% growth in yield over the coming years as I do, so my revenues are in-line with analysts.
 
- I model margins 150bp higher than consensus over the coming 3 years (EBITDA margin of 29.8%), which takes EBITDA 5% ahead of the street. 2/3rds of the difference comes from modelling a slight decline in the bunker multiple (which consensus keeps stable) and 1/3rd comes from the company’s cost savings efforts.
 
- Modelling buybacks as of FY16 takes the EPS further out to 10% ahead of consensus in FY17. My base case is for Carnival to deliver $4.03 in EPS by FY17, which compares to $1.59 in FY14.
 
 
Bull case
 
- We could very well see a bit more yield growth on the back of a European economic recovery, a bigger effect of EM demand absorbing industry capacity and Carnival catching up with the industry after three lost years. In a bull case I model an extra 2.5% yield growth spread over the coming 3 years.
 
- I also model the bunker multiple to come down further to 5.5x, still comfortably above the 4.5x of 2005. And an extra 1% improvement in cost growth per ALBD. That leads to margins that are 350bp ahead of consensus.
 
- The extra cash flow allows for an extra $1bn buyback spread over FY16 and FY17.
 
- The EPS expands to $4.70 in FY17, 30% ahead of consensus
 
 
Earnings revisions
 
- 2013 marked the bottom for earnings expectations, we’ve seen a gradual increase since.
 
- Q1 results were substantially ahead of expectations on an FX adjusted basis ($0.20 in EPS versus $0.00 expected), but the average FY analyst estimate was revised down on EUR weakness (this has reversed since).
 
- My numbers are ahead of consensus, so I expect further upgrades going forward. The USD running out of steam increases the chances of that. The real swing factor would be a reduction in the bunker multiple.
 
 
 
Some more details on the model
 
Tax
 
- Carnival’s tax rate is below 1%. Section 883 of the Internal Revenue Code states that foreign corporations do not pay tax on income earned from the international operation of a ship. Carnival ticks the boxes as the corporation is dual registered in Panama and the UK. The small tax in the P&L comes from the ‘other’ operations, such as on shore excursions and transfers.
 
- Paying less than 1% tax doesn’t feel right, but the situation is unlikely to change going forward. For the US government, trying to tax Carnival is the same as trying to tax US tourists for spending the night at a Paris hotel.
 
- Senator Rockefeller has looked at taxing the shipping industry in the past, but he has given up on there no longer seems to be any political pressure on the subject. The only viable option was a ‘boarding tax’ for the cruises that leave from Miami, but that would shift the boarding to the Caribbean which would hurt the Florida economy.
 
- Carnival has additional protection through its dual-listed company status, which was established when they acquired P&O Princess in 2003. If any regime would try to tax them, they could collapse the structure into 1 company. The highest tax would be if they move 100% to the UK, where the tax regime is based on a ship’s weight. If that would happen today, the tax rate would increase to 5%. But again, the risk of anything changing in the near term is small.
 
 
 
Balance sheet
 
- Compared to its peers, Carnival is the non-levered company. The net-debt / EBITDA falls to 2.2x at the end of FY15. Management guidance is for this ratio to remain at 2x going forward and for any excess cash to be used for buybacks and (special) dividends.
 
- The maturity profile is spread over the coming years. $200-500mn expires per year and $1.9bn in 2020. This is comfortably covered by FCF generation, but should be refinanced.
 
- And Carnival’s debt is cheap. Cruise companies receive ‘export credit agency guarantees’ from the countries in which the ships are build. The guarantees are designed to ensure the ship builders that they will get paid, but they come with the added advantage that the cruise companies can use them to raise debt with the rating of the shipbuilder country.
 
- There are no off balance sheet liabilities.
 
- And we don’t have to worry about the pension. There are a few individual defined benefit plans for key personnel in the US and 2 wider defined benefit plans for employees in the UK. They are 10-20% underfunded and the company is gradually trying to close the gap. Total defined benefit expenses were $69/62mn in FY14/13 or 3.5% of total payroll expenses. The FY14 number was split as $45mn ongoing contributions and $24mn to close the deficit. The company guides for ‘no material’ changes to the funding pace going forward.
 
 
 
FCF and WC
 
- This is a negative working capital business. Customers pay a few months in advance and suppliers are paid after the cruise. The ratio to sales has been a steady -25% over the years and I expect it to remain at this level going forward.
 
- Capex is scheduled to decline as Carnival has reduced its ship orders for the coming 5 years. The capex / depreciation ratio is scheduled to come down from 1.8x to 1.2x. Even if they would change their mind, it would take a few years to see a meaningful impact to the cash flow.
 
- Rising yields, operating leverage, a decline in fuel prices and a reduction in capex all contribute to FCF growing more than fivefold over the coming 3 years. And not paying taxes helps to keep cash flows positive in economic downturns.
 
 
 
Capital Returns
 
- Spending on new ships is scheduled to go down. We should also see a peak in refurbishment/upgrade capex this year, after a few years of elevated spending following the 2012 accidents.
 
- Excess cash has been used to reduce debt in previous years, but will increasingly be used for share buybacks and (special dividends) as we approach the target leverage of 2x net debt / EBITDA.
 
- Management is clearly guiding for this without being explicit about the buyback/dividend split, and has a track record of buybacks and special dividends historically.
 
- All in all, I expect that Carnival will return $5bn to shareholders over the coming 3 years, equally split between buybacks and dividends. This equals 14% of the current mcap.
 
 
 
Valuation
 
Excluding the peak of the financial crisis, Carnival has been trading at a fairly stable 11x EV/TBIDA multiple over the past 10 years. The P/E has been a bit more volatile, with an average and median multiple of 16x.
 
Listed peers Royal Caribbean and Norwegian Cruise (the latter is a US domestic player with a misleading name) are expected to grow at a roughly similar pace over the coming years (because oil is the dominant growth driver). Carnival is cheaper on an EV/EBITDA basis but trades in-line with peers on other multiples. This reflects that Carnival has a much better balance sheet, which also translates in higher capital returns.
 
Other hospitality peers like hotels trade at a substantial premium and are expected to deliver lower growth.Higher returns explains the valuation gap for some hotels, although Carnival is expected to return to a double-digit ROIC within our investment horizon, thereby closing the return gap with many hotel stocks (management also guides for a double-digit ROIC).
 
For my base case I keep the historical average multiples of 11x EV/EBITDA and 16x P/E on FY17 numbers. This leads to a target price of $67 or 45% upside. Adding dividends gets us to just over 50% upside.
 
Keeping the same multiples but using the bull case numbers gets us to a target price of $76 (65% upside, 70% including dividends).
 
 
 
Risks
 
An economic downturn
 
- Carnival’s ships sailed at 100%+ capacity throughout the recession and the company benefited from some trading down as an all-in cruise tends to be cheaper than a traditional ‘flight + hotel’ holiday. The demographics of the customer base provides another layer of downside protection (60% of passengers earn over $75k a year and the average age is 55).
 
- However, the share price chart on the previous page illustrates that this remains a cyclical company/stock. Pricing is used to fill capacity and together with a reduction in on-board spending this led to a 15% fall in yields in the financial crisis. High operating leverage means that earnings fall substantially more, somewhat compensated by a fall in fuel prices (although we went into the previous cycle with exceptionally high oil prices and therefore more room for them to fall).
 
- In short, you don’t want to own Carnival in a downturn.
 
 
One off events
 
- The cruise industry carries risks that are typical for the travel industry – geopolitics, weather, accidents, FX, commodity trends. Next to the Costa Concordia / Costa Allegra / Carnival Triumph disasters in 2012/2013, the company has recently suffered from the Tsunami in Indonesia, the Arab spring impacting the Mediterranean region, and various virus outbreaks on-board ships. Carnival does not have more disease outbreaks than the competition, but all ships look alike and the combination of smart phones with cameras and social media / the Daily Mail loving the pictures have led to us being more aware that these incidents happen.
 
- Unlike hotels or airlines, the cruise industry has to report illnesses if they affect more than 3% of a ship. However, the cruise industry also has an advantage when it comes to one off events, and that is that they can move their boats to another region in the case of geopolitical or weather disasters.
 
- The insurance policy covers all liabilities in the case of an accident/disaster, even if Carnival has been negligent (the clean-up bill for the Costa Concordia is estimated to be $1.5bn and fully covered).
 
- We can’t rule out one off events going forward, if anything we know they will happen. But I take comfort from the fact that we are starting from a low point (we are only just leaving 2012/2013 behind us), and that history has shown that it would actually be a good strategy to pick up these stocks in the case of a one-off event. So if one were to happen, I would consider this a buying opportunity.
 
 
 
Seasonality
 
- Over 50% of cruise bookings happen in Jan-Feb. So Q1 often makes or breaks the year as a successful early bookings season lowers the chance of heavy discounting to fill the final capacity of the ship.
 
- Therefore visibility is highest in the first quarters of the year and lowest in the final quarters of the year.
 
 
 
Saturation point
 
- Ships always sail at full capacity and therefore passenger growth equals capacity growth. One of the frequent discussion on the industry is when do we reach the saturation point, when do yields need to come down to fill additional capacity.
 
- Various brokers make a poor attempt at tackling this question. The reasoning often being the Marriott has more hotel rooms in the US than the entire cruise industry combined, or that Vegas has 41mn visitors per year compared to only 12mn North Americans taking a cruise. I don’t think most people going to Vegas for a weekend consider a 7 day cruise as an alternative, so I struggle to follow most of these comparisons. The truth is that we will probably only know the saturation point once we hit it. However, the capacity additions scheduled over the 3 year investment horizon of our investment case seem reasonable, especially with markets like Asia opening up at the same time. So I am not too worried about the saturation point today.
 
 
 
Fuel
 
- Fuel is the biggest swing factor of the model. Customers generally do not pay fuel surcharges.
 
- I believe it is unlikely that we will move back to a $100 oil price, so a somewhat higher oil price doesn’t change the investment case. However, it can lower the target price / upside in the stock.And recent industry reports suggest that I might actually be too conservative on the oil price.
 
 
 
Relative positioning
 
- Some analysts prefer Royal Caribbean because the stock is cheaper on a P/E basis, it will deliver roughly similar growth over the coming 2 years, and that growth is more reliable as it is driven by the launch of new ships and less dependent on the European economy and the Euro.
 
- I believe the valuation difference is purely driven by the higher leverage (Royal Caribbean has 5x net-debt / EBITDA), but I fully appreciate that the growth of RCL is more reliable. The flip side of that is that there is less chance to surprise positive versus consensus expectations. If Carnival delivers on the yield improvement or Europe and the Euro do recover, Carnival offers more upside, which is why I chose to write this one up.
 
 
 

Disclaimer

Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to whether a particular security or financial instrument is appropriate. I, my employer and/or others we advise hold a material investment in the issuer's securities.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Quarterly results confirming the investment case

- The bunker fuel multiple coming down later in the year

- Better Euro(pe) sentiment

    sort by    

    Description

    FCF set to grow fivefold, investor fatigue no longer justified, 50-70% upside in base/bull case
     
     
    Investment Case Summary
     
    Carnival has gone through the perfect storm in recent years. They not only faced a subdued European recovery and FX pressure, they also had to deal with elevated fuel costs and yield growth being held back by some high profile ship accidents, most notably the Costa Concordia. The tide now seems to be turning, with fuel costs coming down, yield growth catching up and the Euro bottoming. Together, these factors should lead to earnings more than doubling over the coming years.
     
     
    Most investors dislike the cruise companies, and for good reasons. Business strategies over the past 2 decades have been designed to accomodate management egos rather than shareholder interests and I have avoided the names for the past 15 years. But a few things are genuinely changing now - the industry has consolidated to the point where 3 players control 90%, the 2 largest had a change in management, and both are taking steps to maximise returns rather than the size of their ships. The number of ships on order has been scaled back, the operators are now happy to leave some cabins empty if it means they can scale back the discounts on offer, there is an increased focus on increasing on-board spending, etc. And the emergence of the EM consumer is helping, with the re-routing of some ships to Asia restricting capacity growth in existing markets. Adding everything together, FCF is expected to grow fivefold over the coming years.
     
     
    The current valuation of 14x FY16 P/E, 9.5x EV/EBITDA is at the lower end of the historical trading range, suggestion that the market is not fully aware of all the changes impacting Carnival and the cruise industry. It also compares favourably to other consumer stocks, while the expected growth is substantially higher.
     
     
     
    Company
     
    - Carnival is the world’s largest cruise company with 100 ships sailing under 9 brands – Carnival Cruise Lines, Holland America, Princess Cruises and Seabourn in North America; P&O Cruises and Cunard Line in the UK/Australia; AIDA in Germany; and Costa Cruises in Southern Europe. The total passenger capacity of its ships is 200,000 and Carnival attracts over 10 million guests annually, giving it a 50% market share of the global cruise industry.
     
    - Roughly 40% of passengers are American, 35% are European and 25% come from the RoW (including Canada).
     
    - In revenue terms, roughly 40% of revenues come from Europe, 40% come from the US and 10% from RoW.
     
     
     
    Industry structure
     
    - The cruise industry has been gradually consolidating over the past 30 years. The top 3 players – Carnival, Royal Caribbean and Norwegian – controlled 30% of the North American cruise market in the early 90s, 50% in the early 00s and 90% today.
     
    - The consolidation is leading to a more rational pricing environment, provides the remaining players with better access to capital and is producing the traditional operating efficiencies that come with scale.
     
    - The biggest industry moat is the fact that a new ship easily costs $500mn-$1bn and that operating cash flow covers this for the large existing players. The other moat is the brand – people know what they get when they book a Carnival cruise.
     
    - The remaining 10% of North American capacity is focused on niche markets such as ultra-luxury, low end, adventureor kid friendly cruises (Disney has a 3% market share).
     
    - There are more smaller players outside North America, but the top 3 still have roughly the same market share – 84% in the UK, 90% in Germany, 87% in Southern Europe and 90% in Asia. Globally, Carnival has a 50% market share.
     
    - Cruise operators do compete with alternative holidays. The secular growth drivers of an ageing population and emerging EM consumer work in the cruise industry’s favour here.
     
    - The bigger picture growth drivers for the industry are the ageing population, the emerging EM consumer, and economic growth / consumer confidence.
     
    - The key top line drivers are capacity and yield growth.
     
            o Industry capacity has grown by 5% per year over the past 15 years and is scheduled to grow by around 3% per year for the coming 3 years and around 5% from FY18 to FY20. Carnival is scheduled to grow its capacity by 2-3% per year.
     
            o The industry yield has grown by 1% per year on average over the past 15 years and is scheduled to grow at a 1-2% pace over the coming years. Carnival is scheduled to outgrow the industry and should deliver 2-3% yield growth per year, potentially more (I'll come back to this).
     
    - The delivery time for a ship is 3 years, so any pick up in ship orders would only impact the industry from FY18 onwards. Therefore the swing factor for the investment case is yield.
     
     
     
    Industry/company changes, not fully appreciated by the market
     
    Headwinds turning into tailwinds
     
    - Carnival has gone through the perfect storm in recent years – fuel costs were elevated on the back of high oil prices, a subdued European economy and the Euro weighed on both the business and the stock, and yield growth was held back further by some high profile ship accidents. The tide now seems to be turning.
     
     
    - Fuel costs are coming down rapidly
     
            o Brent was $97 last year and I model it coming down to $60 this year. For FY16/17 I model $65 and $70, which then remains the oil price in the model longer-term.
     
            o The bunker multiple – the multiple of bunker fuel over Brent – has gone up from 4.5x in 2005 to 7x in-line with refining margins. Simply put, refineries were trying to squeeze everything out of oil at high prices, leaving less residual bunker fuel. At lower oil prices, we should see this pressure ease. I model 7x this year, 6.5x next year and 6x thereafter.
     
            o Added together, the cost of bunker fuel falls from 636 last year to 420 this year and the coming years. The lower bunker fuel cost boosts EPS by 60% in FY15.
     
     
    - Revenue yield is a function of ticket prices and on-board spending
     
            o Ships tend to sail full 50 weeks per year (leaving 2 weeks for maintenance/repair). Occupancy rates are typically 104-106% and stayed above 105% throughout the financial crisis (100% occupancy equals 2 people in every cabin, the part above 100% is driven by children sleeping in the parents room on extra beds). Cruise costs are mostly fixed, the incremental expanse of carrying a passenger is easily covered by his/her on-board spending. So it makes sense to sail at full capacity, even if you have to discount tickets.
     
            o Therefore changes to ticket revenues are driven the level of discounting. Cruise ships typically offer attractive discounts at the start of the season with prices moving up in the middle and then falling again immediately before departure.
     
            o Ticket revenues typically drive 75% of the total  yield (net revenues per average lower berth day). The remaining 25% comes from on-board spending. Mostly alcohol and gambling and to a lesser extent dining, the spa, excursions, shopping, internet access, etc. On-board spending has been growing at a 3-4% pace for the industry in recent years on the back of improving consumer confidence, an increased focus of the industry on offering things that boost on-board spending, and the fact that bigger ships allow for more things to do.
     
     
    - Carnival’s total yield growth has lagged peers and is due for a catch up
     
            o Royal Caribbean’s total yield is back at 2007 levels, Norwegian’s yields are 10% above the previous peak (had more of a mix shift to bigger ships, from a smaller base), while Carnival’s yield is still 15% below 2007.
     
            o Some of the lag is structural and therefore I don’t expect Carnival to catch up entirely with peers (which is the lazy pitch of some equity analysts). Carnival ‘s yield growth has been below Royal Caribbean’s for 8 of the past 10 years due to a combination of mix (more smaller and older ships) and regional exposure (more Europe).
     
            o However, there is also an element of Carnival’s yields having suffered from a series of high profile accidents. The Costa Concordia (which sank in 2012 off the coast of Italy), Costa Allegra (which was adrift in the middle of the Indian ocean in 2012 after an engine fire) and the Carnival Triumph (also adrift after an engine fire, in the Gulf of Mexico in 2013. In this case, faulty pumps also led to raw sewage streaming onto the decks, leading to the media jumping on the incident and calling it ‘the poop cruise’).
     
            o I don’t really expect to see a big reversal in ticket yields now that these accidents are far enough in the past, just growth in-line with peers. But there has been a secondary effect in that management has spend a lot of time taking measures to reduce the chances of another accident, leaving less time to focus on things like improving on-board spending. Carnival has lagged its peers substantially in this area and is due for a catch-up.
     
            o We indeed seem to have turned a corner now, with on-board spending growing by 8% in Q1, far ahead of consensus expectations and peers. Also, the company has installed a public relations office which is now creating positive headlines for the company. Eg, the Queen has attended the naming ceremony of the new P&O Britannia in Southampton, Carnival made headlines with its Super Bowl Commercial, and Princess Cruises headed the Rose Bowl parade.
     
            o I’ll come back on the potential for further accidents in the risk section, but it is important to know that Carnival does not have a worse track record than peers. 2012/2013 was just really bad luck. Eg the company only had 4 engine fires in its entire career, so having 2 of them in 2012 was exceptional (the company has since installed back-up generators on every ship which should prevent another ship being adrift going forward). And I bet no captain will ever try to sail close to an island again to impress their mistress.
     
     
    - So Carnival should finally be able to generate some reasonable yield growth again after 3 meagre years (-10% between 2012 and 2014). And yield growth counts given the fixed cost nature of the business
     
            o Even though 25% of revenues are variable, the cost base of a cruise ship is almost entirely fixed. Unlike a hotel which can shut down a floor and reduce staff when demand is low, cruise costs are dominated by depreciation, fuel and a largely fixed crew and provisions base.
     
            o So yield matters and my model show that every 1 percentage point in yield adds roughly $0.18c in EPS or 6-7% (broker models show a similar sensitivity).
     
            o While yields have grown 1% throughout the cycle historically, they are able to expand at a mid- to high-single-digit pace in a cyclical recovery. I model 3-3.5% yield growth per year for the coming 3 years. This is similar to what competitors have generated in recent years (excluding FX).
     
            o Carnival delivered 2% net yield growth in Q1 (1% pricing and 8% onboard spending) and increased its FY net yield guidance from 2-3% to 3-4%. Management talked about a strong wave season, meaning that cumulative bookings in Q1 were ahead of expectations, leaving fewer tickets to be sold later in the season and therefore less potential discounting. Additionally, industry capacity in the Caribbean is scheduled to decline double-digit in H2, which should be another tailwind for discounting. The company has a poor track record of yield guidance at the start of the year, but a strong track record of guidance once they know the Q1 results (because over 50% of bookings are done in Q1).
     
     
    - A European economic recovery could increase yield growth. Similarly, a stronger EUR would benefit the company.
     
            o The company says that roughly 40% of its revenues come from the European brands (2/3rds EUR and 1/3rd GBP). Additionally there is an impact of USD strength on the cost base, as fuel is priced in USD, although that is often offset by the negative correlation of oil prices and the USD.
     
            o The company guides for a $0.25-0.30 impact on EPS for a 10% swing in the USD in 2013, or 10-12%.
     
     
    - Also, both Carnival and Royal Caribbean are experimenting with giving up some occupancy in return for less discounting. Ultimately they want  to end the image that it pays off to book cruises last minute because you will get substantial discounts. Also, they hope it will lower the main frustration of customers - discovering that other guests paid half of what you paid. It's hard to say how much this will add to revenue yield, both companies say that last year's tests were surprisingly positive, but overall I see it as another sign that the industry is effectively changing for the better
     
     
     
    Changing competitive landscape
     
    - Similar to most investors, my initial reaction to a cruise industry pitch is a sceptical one. Some industry history helps explain the investor reaction.
     
            o Cruises strongly gained in popularity at the end of the 1970s and during the 1980s. It’s no coincidence that this the ‘Love Boat’ series aired between 1977 and 1987 (the boat that featured in the series was a Carnival one). Demand attracted capacity and ended up with several underfinanced small players purchasing second-hand ships. Most of these players went bankrupt in a challenging pricing environment in the early 90s (Royal Cruise, Royal Viking, Regency).
     
            o The industry had a second growth spurt at the end of the 90s. Once again the media mighthave played a role as the Titanic movie launched in 1997, but I’m sure the robust economy played a bigger role. It once again led to overcapacity and a series of bankruptcies as the economy turned in 2000 (Premier Cruise Lines and Commodore Cruise Lines). 9/11 created further pressure on the industry and led to Renaissance and American Classic Voyages going into Chapter 11.
     
            o 2004-2008 was characterised by the remaining players spending a lot of money on bigger and brighter ships, leading to the sector going into the financial recession with substantial leverage and the stocks underperforming heavily. From a business point of view the recession led to pricing pressure and a collapse in on-board spending.
     
            o The post-recession recovery has been marked by some severe headwinds for the stocks, such as the earlier discussed rise in oil prices, geopolitical events like the Arab spring, and for Carnival specifically the accidents of 2012/2013.
     
            o So there have been an exceptional amount of opportunities for investors to burn their fingers.
     
     
    - The cruise industry continues to carry risks that are typical for the travel industry (economic cyclicality, geopolitics, weather, accidents, FX, commodity trends) and I will come back to this. But the competitive environment is improving.
     
            o The main players seem to be moving away from the ‘bigger is better’ mentality of the past decade. While the amenities and technology on the ships continue to improve, the industry has hit critical mass in terms of ship size and new ships no longer set new records. A good example is Royal Caribbean’s newest generation of flagship ships. The Quantum Class has an average of 4,100 berths compared to the previous Oasis class with 5,400 berths.
     
            o The big players are also building fewer ships, not just smaller ones, with the different managements talking about a focus on returns. The average fleet age has doubled from 6 years in 2005 to 12 years today and is scheduled to go to 17 years by the end of the decade. The track record indicates that we can’t blindly trust these managements, but we can take comfort from the fact that they can’t change tactics quickly even if they want to given the long lead times to build and deliver a ship. Also, the ship builders are running at maximum capacity.
     
            o China is emerging as a new source of demand and a local destination. The number of passengers is expected to surpass 1mn in 2015 with half of them travelling on a Carnival ship. So volumes benefit, but the bigger effect will likely be on yields. With an increasing number of ships being deployed in Asia (eg 2 of the 3 new Royal Caribbean Quantum ships will be positioned there), there is a substantial reduction in the capacity expansion in existing markets, which should help pricing and yields. There will be a big repositioning effort in the second half of this year, with the key Caribbean market scheduled to see a double-digit decline in capacity. Some analysts are calling it a ‘game-changing shift in supply’.
     
            o China isn’t the only new driver. Latam is also emerging as a new market. And the opening of Cuba should lead to further capacity being re-routed from the Caribbean market. Parking a cruise ship outside Havana when the market opens is a lot easier and quicker than building a new Four Seasons hotel.
     
     
     
    Improving FCFs and capital returns
     
    - The reduced pace of ship orders will not only help yields, it should also lead to improving free cash flows and capital returns.
     
    - Capex is scheduled to come down from $3bn this year to $2bn in 2017 and beyond for Carnival. Coupled with lower oil prices, rising yields and high OP leverage this leads to an expected fivefold increase in FCF from $600mn this year to $3bn in 2017.
     
    - Carnival is guiding for a net-debt / EBITDA ratio around 2x longer-term and capital returns once we reach this level (buybacks and dividends). The company will reach 2x at the end of the year and therefore I expect an increase in share buybacks and dividends going forward. We can trust them on this as they have done this in the past. I model the dividend to increase by 10% a year (current yield 2.2%) and $500mn in buybacks in FY16 going to $2bn per year thereafter (5% per year on the current mcap of $36bn).
     
     
     
    Improved efficiency
     
    - Together with the increased focus on returns comes an increased focus on costs. Carnival has for example appointed its first procurement officer for the company as a whole. So far, brands have organised procurements separately and fuel is purchased on a ship by ship, port by port basis.
     
    - So there seems to be an opportunity here, but we have little insight into the potential scope. Given that most costs remain fixed and that any cost savings will be dwarfed by the change in fuel prices shorter-term, I have not spend too much time modelling this in detail. Neither have analysts, so this could be a smaller source of margin upside surprises.
     
    - Costs excluding fuel declined 1.9% in Q1 versus consensus expectations of a 2-3% increase. FX explains most of the beat, but a small part indicates that we are seeing some progress on the cost front.
     
     
    What do I expect in numbers and how does this compare to consensus?
     
    Base case
     
    - We have a good 3 year visibility on capacity, so yield is the swing factor. Consensus is modelling a similar 3.0-3.5% growth in yield over the coming years as I do, so my revenues are in-line with analysts.
     
    - I model margins 150bp higher than consensus over the coming 3 years (EBITDA margin of 29.8%), which takes EBITDA 5% ahead of the street. 2/3rds of the difference comes from modelling a slight decline in the bunker multiple (which consensus keeps stable) and 1/3rd comes from the company’s cost savings efforts.
     
    - Modelling buybacks as of FY16 takes the EPS further out to 10% ahead of consensus in FY17. My base case is for Carnival to deliver $4.03 in EPS by FY17, which compares to $1.59 in FY14.
     
     
    Bull case
     
    - We could very well see a bit more yield growth on the back of a European economic recovery, a bigger effect of EM demand absorbing industry capacity and Carnival catching up with the industry after three lost years. In a bull case I model an extra 2.5% yield growth spread over the coming 3 years.
     
    - I also model the bunker multiple to come down further to 5.5x, still comfortably above the 4.5x of 2005. And an extra 1% improvement in cost growth per ALBD. That leads to margins that are 350bp ahead of consensus.
     
    - The extra cash flow allows for an extra $1bn buyback spread over FY16 and FY17.
     
    - The EPS expands to $4.70 in FY17, 30% ahead of consensus
     
     
    Earnings revisions
     
    - 2013 marked the bottom for earnings expectations, we’ve seen a gradual increase since.
     
    - Q1 results were substantially ahead of expectations on an FX adjusted basis ($0.20 in EPS versus $0.00 expected), but the average FY analyst estimate was revised down on EUR weakness (this has reversed since).
     
    - My numbers are ahead of consensus, so I expect further upgrades going forward. The USD running out of steam increases the chances of that. The real swing factor would be a reduction in the bunker multiple.
     
     
     
    Some more details on the model
     
    Tax
     
    - Carnival’s tax rate is below 1%. Section 883 of the Internal Revenue Code states that foreign corporations do not pay tax on income earned from the international operation of a ship. Carnival ticks the boxes as the corporation is dual registered in Panama and the UK. The small tax in the P&L comes from the ‘other’ operations, such as on shore excursions and transfers.
     
    - Paying less than 1% tax doesn’t feel right, but the situation is unlikely to change going forward. For the US government, trying to tax Carnival is the same as trying to tax US tourists for spending the night at a Paris hotel.
     
    - Senator Rockefeller has looked at taxing the shipping industry in the past, but he has given up on there no longer seems to be any political pressure on the subject. The only viable option was a ‘boarding tax’ for the cruises that leave from Miami, but that would shift the boarding to the Caribbean which would hurt the Florida economy.
     
    - Carnival has additional protection through its dual-listed company status, which was established when they acquired P&O Princess in 2003. If any regime would try to tax them, they could collapse the structure into 1 company. The highest tax would be if they move 100% to the UK, where the tax regime is based on a ship’s weight. If that would happen today, the tax rate would increase to 5%. But again, the risk of anything changing in the near term is small.
     
     
     
    Balance sheet
     
    - Compared to its peers, Carnival is the non-levered company. The net-debt / EBITDA falls to 2.2x at the end of FY15. Management guidance is for this ratio to remain at 2x going forward and for any excess cash to be used for buybacks and (special) dividends.
     
    - The maturity profile is spread over the coming years. $200-500mn expires per year and $1.9bn in 2020. This is comfortably covered by FCF generation, but should be refinanced.
     
    - And Carnival’s debt is cheap. Cruise companies receive ‘export credit agency guarantees’ from the countries in which the ships are build. The guarantees are designed to ensure the ship builders that they will get paid, but they come with the added advantage that the cruise companies can use them to raise debt with the rating of the shipbuilder country.
     
    - There are no off balance sheet liabilities.
     
    - And we don’t have to worry about the pension. There are a few individual defined benefit plans for key personnel in the US and 2 wider defined benefit plans for employees in the UK. They are 10-20% underfunded and the company is gradually trying to close the gap. Total defined benefit expenses were $69/62mn in FY14/13 or 3.5% of total payroll expenses. The FY14 number was split as $45mn ongoing contributions and $24mn to close the deficit. The company guides for ‘no material’ changes to the funding pace going forward.
     
     
     
    FCF and WC
     
    - This is a negative working capital business. Customers pay a few months in advance and suppliers are paid after the cruise. The ratio to sales has been a steady -25% over the years and I expect it to remain at this level going forward.
     
    - Capex is scheduled to decline as Carnival has reduced its ship orders for the coming 5 years. The capex / depreciation ratio is scheduled to come down from 1.8x to 1.2x. Even if they would change their mind, it would take a few years to see a meaningful impact to the cash flow.
     
    - Rising yields, operating leverage, a decline in fuel prices and a reduction in capex all contribute to FCF growing more than fivefold over the coming 3 years. And not paying taxes helps to keep cash flows positive in economic downturns.
     
     
     
    Capital Returns
     
    - Spending on new ships is scheduled to go down. We should also see a peak in refurbishment/upgrade capex this year, after a few years of elevated spending following the 2012 accidents.
     
    - Excess cash has been used to reduce debt in previous years, but will increasingly be used for share buybacks and (special dividends) as we approach the target leverage of 2x net debt / EBITDA.
     
    - Management is clearly guiding for this without being explicit about the buyback/dividend split, and has a track record of buybacks and special dividends historically.
     
    - All in all, I expect that Carnival will return $5bn to shareholders over the coming 3 years, equally split between buybacks and dividends. This equals 14% of the current mcap.
     
     
     
    Valuation
     
    Excluding the peak of the financial crisis, Carnival has been trading at a fairly stable 11x EV/TBIDA multiple over the past 10 years. The P/E has been a bit more volatile, with an average and median multiple of 16x.
     
    Listed peers Royal Caribbean and Norwegian Cruise (the latter is a US domestic player with a misleading name) are expected to grow at a roughly similar pace over the coming years (because oil is the dominant growth driver). Carnival is cheaper on an EV/EBITDA basis but trades in-line with peers on other multiples. This reflects that Carnival has a much better balance sheet, which also translates in higher capital returns.
     
    Other hospitality peers like hotels trade at a substantial premium and are expected to deliver lower growth.Higher returns explains the valuation gap for some hotels, although Carnival is expected to return to a double-digit ROIC within our investment horizon, thereby closing the return gap with many hotel stocks (management also guides for a double-digit ROIC).
     
    For my base case I keep the historical average multiples of 11x EV/EBITDA and 16x P/E on FY17 numbers. This leads to a target price of $67 or 45% upside. Adding dividends gets us to just over 50% upside.
     
    Keeping the same multiples but using the bull case numbers gets us to a target price of $76 (65% upside, 70% including dividends).
     
     
     
    Risks
     
    An economic downturn
     
    - Carnival’s ships sailed at 100%+ capacity throughout the recession and the company benefited from some trading down as an all-in cruise tends to be cheaper than a traditional ‘flight + hotel’ holiday. The demographics of the customer base provides another layer of downside protection (60% of passengers earn over $75k a year and the average age is 55).
     
    - However, the share price chart on the previous page illustrates that this remains a cyclical company/stock. Pricing is used to fill capacity and together with a reduction in on-board spending this led to a 15% fall in yields in the financial crisis. High operating leverage means that earnings fall substantially more, somewhat compensated by a fall in fuel prices (although we went into the previous cycle with exceptionally high oil prices and therefore more room for them to fall).
     
    - In short, you don’t want to own Carnival in a downturn.
     
     
    One off events
     
    - The cruise industry carries risks that are typical for the travel industry – geopolitics, weather, accidents, FX, commodity trends. Next to the Costa Concordia / Costa Allegra / Carnival Triumph disasters in 2012/2013, the company has recently suffered from the Tsunami in Indonesia, the Arab spring impacting the Mediterranean region, and various virus outbreaks on-board ships. Carnival does not have more disease outbreaks than the competition, but all ships look alike and the combination of smart phones with cameras and social media / the Daily Mail loving the pictures have led to us being more aware that these incidents happen.
     
    - Unlike hotels or airlines, the cruise industry has to report illnesses if they affect more than 3% of a ship. However, the cruise industry also has an advantage when it comes to one off events, and that is that they can move their boats to another region in the case of geopolitical or weather disasters.
     
    - The insurance policy covers all liabilities in the case of an accident/disaster, even if Carnival has been negligent (the clean-up bill for the Costa Concordia is estimated to be $1.5bn and fully covered).
     
    - We can’t rule out one off events going forward, if anything we know they will happen. But I take comfort from the fact that we are starting from a low point (we are only just leaving 2012/2013 behind us), and that history has shown that it would actually be a good strategy to pick up these stocks in the case of a one-off event. So if one were to happen, I would consider this a buying opportunity.
     
     
     
    Seasonality
     
    - Over 50% of cruise bookings happen in Jan-Feb. So Q1 often makes or breaks the year as a successful early bookings season lowers the chance of heavy discounting to fill the final capacity of the ship.
     
    - Therefore visibility is highest in the first quarters of the year and lowest in the final quarters of the year.
     
     
     
    Saturation point
     
    - Ships always sail at full capacity and therefore passenger growth equals capacity growth. One of the frequent discussion on the industry is when do we reach the saturation point, when do yields need to come down to fill additional capacity.
     
    - Various brokers make a poor attempt at tackling this question. The reasoning often being the Marriott has more hotel rooms in the US than the entire cruise industry combined, or that Vegas has 41mn visitors per year compared to only 12mn North Americans taking a cruise. I don’t think most people going to Vegas for a weekend consider a 7 day cruise as an alternative, so I struggle to follow most of these comparisons. The truth is that we will probably only know the saturation point once we hit it. However, the capacity additions scheduled over the 3 year investment horizon of our investment case seem reasonable, especially with markets like Asia opening up at the same time. So I am not too worried about the saturation point today.
     
     
     
    Fuel
     
    - Fuel is the biggest swing factor of the model. Customers generally do not pay fuel surcharges.
     
    - I believe it is unlikely that we will move back to a $100 oil price, so a somewhat higher oil price doesn’t change the investment case. However, it can lower the target price / upside in the stock.And recent industry reports suggest that I might actually be too conservative on the oil price.
     
     
     
    Relative positioning
     
    - Some analysts prefer Royal Caribbean because the stock is cheaper on a P/E basis, it will deliver roughly similar growth over the coming 2 years, and that growth is more reliable as it is driven by the launch of new ships and less dependent on the European economy and the Euro.
     
    - I believe the valuation difference is purely driven by the higher leverage (Royal Caribbean has 5x net-debt / EBITDA), but I fully appreciate that the growth of RCL is more reliable. The flip side of that is that there is less chance to surprise positive versus consensus expectations. If Carnival delivers on the yield improvement or Europe and the Euro do recover, Carnival offers more upside, which is why I chose to write this one up.
     
     
     

    Disclaimer

    Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise. Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to whether a particular security or financial instrument is appropriate. I, my employer and/or others we advise hold a material investment in the issuer's securities.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.
    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    - Quarterly results confirming the investment case

    - The bunker fuel multiple coming down later in the year

    - Better Euro(pe) sentiment

    Messages


    SubjectRe: Agree with Thesis but Have a Different Angle
    Entry06/25/2015 04:35 PM
    MemberSlackTide

    Thanks for the write-up. A few comments from a human who is generally less sanguine...

    CapEx has exceeded Depreciation expense every singe year, I believe, therefore your focus on P/E as a valuation metric is fundamentally flawed as it is manipulated and is overstated relative to cash flow. 

    If a company that is asset intensive achieves a double digit ROIC (right around its WACC) shouldn't it trade right around book value as there is then no economic value added? 

    The double-digit ROIC target has no set timeframe ("within 3-4 years"), so does not strike me as a ringing endorsement of management's confidence--they don't want to get nailed down on it. These firms have always emphasized that they are trying to cut costs so that message is not new. 

    If everything goes according to management's/wjv's expectations, you are paying 15x EV/2017 FCF, which is not very attractive and is also probably a cyclical peak if everything goes right (can't delay maintenance forever and then also won't grow and could get multiple compression). RCL has negative FCF since inception. CCL cumulative FCF since 1996 is just $8.1b on a $50b EV. RCL is clearly more expensive and has worse economics, but CCL is just the "tallest midget" or "cleanest dirty shirt" as Gross says. 

    I am wondering if you or CCL is under estimating mCapEx. At $2b of CapEx along with 2016 sales estimates this would put them at the lowest Capex as % of sales in company history by a wide degree (11.8% versus 25.7% 20 year average), so again it is probably closer to a cyclical peak and not sustainable. 

    Also, when I was looking around I found several operators in China who are testing the waters with operating only one cruise ship but have publicly expressed a desire to grow to 10-15 in a hurry (e.g. HNA Cruises 15 ships within ten years, but this is just one example). Capacity in China is supposed to grow high-teens CAGR for the next several years. The seasonality in China is worse than the US which will be bad for asset utilization. Any thoughts on this? When they started expanding into Europe it was also at the time hyped and highlighted as game changing but the economics did not structurally improve...same with larger, more efficient ships. So, same song and dance, different cycle, IMO.  


    SubjectRe: Re: Re: Re: Re: Agree with Thesis but Have a Different Angle
    Entry06/26/2015 12:51 PM
    MemberSlackTide

    Let me try to frame an investment in these names a different way.

    What do you think maintainence capex is in a normal year if they don't build any new ships? Are there any other 2-year periods in history when CCL has not built any new ships? This should give you some idea of what mCapex level is realistic. From there what is the normalized FCF with the current fleet assuming minimal top-line growth, and what multiple are you willing to pay for that "normalized" FCF?

    I wouldn't pay more than 10x. 

      Back to top