|Shares Out. (in M):||216||P/E||17||16|
|Market Cap (in $M):||26,329||P/FCF||0||0|
|Net Debt (in $M):||7,697||EBIT||0||0|
|Borrow Cost:||General Collateral|
Having waited patiently we now believe it’s time to short RCL. Thesis suggests RCL is materially mispriced as investors are a) confusing an abnormally elongated cruise pricing cycle with a secular trend; b) anchored on current favorable fund’ls while ignoring record multi-year supply growth; c) inappropriately using a multiple on extrapolated estimates to value a cyclical with material operating and fin’l leverage and d) underestimating the extent to which RCL over-earned to reach its Double Double targets. Part of the attractiveness of this short is a temporary favorable shift in cyclical dynamics has shifted focus away from a dramatic structural headwind – record supply growth. And absorption is predicated on unprecedented cont’d growth in China despite cont’d troubling signs of supply indigestion in this non-trad’l market already. On any increased visibility on demand weakness, especially in China, investors are likely to quickly re-focus on this multi-year fund’l headwind. RCL is the preferred short because achievement of its Double Double fin’l targets in 2017 is now fully reflected in the stock while both sustainability of levers pulled to achieve them and diminishing earnings quality are largely ignored. Similar to NCLH last year, even without a negative cyclical inflection downward revisions to extrapolated 2018 consensus appear likely given historically difficult compares, mean reversion from stretch to reach Double Double (estimate $0.55 EPS headwind or ~175bps NRY growth needed to offset drydock catch up, new vessel intro spend and roll off of 1x gains alone), competitive inroads from heavier-spending peers unburdened by LT fin’l targets and lessening of 1st-mover new-tonnage advantage in China.
RCL’s stock is +49% YTD and sentiment appears particularly ebullient – the opposite of a year ago and a warning sign in and of itself in a name that’s largely a sentiment-driven trading vehicle. Short interest has also come down to just 3% vs 3Q 2016 peak near 10%. We don’t believe there’s any add’l upside to 2017 guide and 2018 consensus appears too high even if another year of positive NRY change materializes. Recent multiple re-expansion also appears largely done given a) re-expansion back to high end of trailing two-year NTM range; b) forecast material EPS growth deceleration (2H +LSD); c) normalized tough 2018 booking, NRY and cost compares; d) fuel shifting back to neutral from multi-year tailwind; e) benefit from 20-yr records for monthly SPX gains/lack of drawdowns unlikely to repeat; f) above-avg geopolitical uncertainty/risk; and g) lack of any tax change/regulatory benefit given RCL’s un-taxed status/use of low-cost foreign labor.
Catalysts include a) 2H shift in investor focus to what’s next after Double Double incl mean reversion following 3 years of EBITDA flowthrough >100% and drydock, ship intro and 1x Legend sale gain that represent est ~$130M y/y NI headwind; b) indications of weaker booked occ’y and/or pricing on tougher booking compares as ability to sustain “better booked/higher pricing” rhetoric historically limited (sources suggest discounting already starting to ratchet back up); c) indications of weaker close-in demand on negative price elasticity and/or lower onboard per caps esp as add’l occ’y gains limited given recent advance beyond prior peak; d) increased visibility on cont’d China demand weakness/pricing erosion esp in seasonally key 4Q; e) re-emergence of geopolitical/terror incidents, ship incidents, equity market weakness, etc. that would negatively impact elongated booking curve; and/or f) any indication US corporate tax reform could impact cruise operators’ taxpaying exemption.
Risks include a) consensus “this time is different” narrative on shift to experiential spend and Millennial interest continues to dominate as booking curve remains historically elongated, close-in demand isn’t impacted by negative price elasticity and external backdrop incl equity market remains completely benign; b) investors are willing to further expand multiple above high end of historical range and/or further upside to 2017 EPS guide is realized; c) RCL is able to offset difficult 2018 compares and achieve 2018 consensus; and d) recent Chinese weakness is transitory and this market is able to absorb unprecedented new supply growth w/out any periods of material supply indigestion.
Since basis of bearish thesis is cyclical pricing and RCL doesn't earn its cost of capital, eventual negative NRY inflection brings book value (low $40s) back into play. Moreover, cruise companies already benefited in 2015-16 from collapse in fuel prices and on any downward revisions investors re-focus on hefty op and fin’l leverage so the stocks tend to overshoot to the downside (hence RCL has traded at discount to book ~1/3 of its history as a public company vs current 2.6x). Even in the event the cruise cycle is sustained, expected company-specific downward revisions taking 2018 consensus sub-$8/share would likely take the stock back into the $70s-80s.
Cruise Cycle in Extra Innings
RCL’s massive cumulative negative FCF, its inability to generate economic profit given its history of sub-WACC ROIC and subsequently the extent to which the equity has traded below book value have all been well documented. And while bearish views based on these dynamics are valid they are largely ignored when NRYs are trending positive as they have been for a record eight consecutive years including 2017 guide. To think these dynamics won’t take center stage again when NRYs eventually inflect negatively again is a mistake and the cruise category is already exhibiting signs of a peak.
Recent demand trends appear particularly strong on easy compares with the impact of terror attacks, a sharp equity correction and lingering Zika concerns during last year’s wave and the booking curve has elongated to a peak on lack of ship incidents, benign geopolitical backdrop, ebullient equity market, etc. Like 1999 and 2006, current cruise fundamentals have the latter-cycle feel of “this is as good as it gets” with the last negative inflection point in NRYs mostly forgotten. Distributor optimism, consumer confidence and central bank-driven wealth effects are at cycle highs. The booking curve has fully lengthened, booked occ’y is at record highs and ticket pricing is well above prior peak (especially for NCLH and RCL). High-profile ship incidents in 2012 and 2013 are a distant memory and the prior 12-month period has been devoid of geopolitical events, terror attacks, pandemics, negative press and multi-decade records for equity market strength/lack of volatility. A record-high $60B new ship order book equivalent to more than 50% of the industry’s existing capacity is deemed “rational” because an emerging third cruise sphere in Asia (in addition to existing North American and Europe spheres) will expand to seamlessly absorb an unprecedented ramp in new supply. And still-valid China concerns of a year ago are now dismissed as overblown.
Given the length of the current cycle and complacency bred by 9-year bull market, investors are mistaking cruise NRY growth as secular not cyclical. Thus, the stocks continue to appear relatively cheap on extrapolated estimates that assume cont’d +LSD NRY growth and against an unprecedented liquidity backdrop and the recurring wreckage in brisk-and-mortar retail. The reality is that cruise pricing is cyclical and it’s different this time only in terms of the extended duration of the current cycle. Historically NRYs show little correlation to capacity growth owing to the industry’s unique book-to-fill strategy so the bullish “rational supply growth” argument holds little sway. The cycle typically rolls every three years as an external event (war, terror attack, recession, ship incident, etc.) causes the booking curve to shrink and necessitates heavier close-in discounting to drive fill (typically takes two years to re-establish a normal lengthening booking curve). With the current elongated curve and ATH ticket pricing, demand has grown particularly susceptible to external dynamics because of strong price elasticity created by operators essentially giving away the product in periods of slack demand.
RCL’s EPS progression shown below exhibits clear cyclical pattern that has completely diverged from historical trend over the last couple of years both in terms of duration and magnitude of EPS growth. Bulls attribute the divergence to tailwinds including increasing cruise popularity (Millennials, aging Boomers), benefits from China’s emergence as a third sphere of cruising, a shift toward experiential spending and mgmt (finally) delivering cost/ROIC improvements. The counter view suggests abnormally long cycle can be partially attributed to the extended length of the current US economic expansion/wealth effects as well as transitory factors including a) positive impact of competitor CCL’s 2013-14 retrenchment following two heavily publicized ship incidents; b) benefits from onboard refurb initiatives for both RCI and Celebrity completed in 2014; c) initial pricing and especially onboard revenue gains from its new hardware 1st-mover advantage in China; d) a collapse in fuel prices while NRYs are still positive; and e) combo of unsustainable cost dynamics, aggressive accounting, etc. to reach Double Double targets.
Notably the current cycle is in its 5th year vs historical avg of 3 and the cumulative EPS gain is ~+250% vs +30% avg. Both duration and magnitude of the EPS gain in current cycle has diminished cyclical concerns in favor of a secular rationale for such a dramatic increase in peak EPS power. Nonetheless we’re not convinced that cyclical cruise NRY dynamics have changed vs prior cycles nor that sources of positive company-specific change are sustainable especially beyond 2017 achievement of mgmt’s Double Double targets.
The booking curve has fully extended and this is confirmed by healthy recovery in customer deposits following a period of transitory Caribbean-led weakness in 2015. Each of the major cruise operators is citing peak “higher booked load factor at higher pricing.” Historically this favorable dynamic changes quickly as either load factor and/or pricing weakens. In fact, distribution sources already indicate slower recent call volumes on heightened geopolitical uncertainty. And as 2015 illustrates, individual markets often experience demand weakness and/or periods of supply imbalance that impact the booking curve and the status of a cruise operator’s booked load and rate.
Per cruise industry execs and distributors favorable demand dynamics began in early 2016 and gained momentum throughout the year, culminating in a wave season characterized as “the strongest in years” by many industry insiders and distributors alike. This further extension of the booking curve came against a backdrop characterized by steadily rising asset values including a low-volatility advance in the US equity market off Jan 2016 lows and a lack of publicized terror attacks, ship incidents, outbreaks, etc. As shown below RCL’s compares get sequentially tougher throughout the year especially into the 2H and through the 1H of next year. And booking compares also likely bottom in 1Q and get sequentially more challenging throughout 2017. Look for a sequential deceleration in NRYs following that becomes even more pronounced in 2H with benefits from new vessel premiums and Pullmantur de-consolidation rolling off and increasing seasonal importance of China market in 4Q. Extrapolating cont’d above-trend NRY growth on compares this challenging appears extremely aggressive vs historical trend.
As shown below RCL’s occupancy has recently recovered beyond prior peak (in part owing to Pullmantur deconsolidation). This has facilitated outsized onboard revenue gains – which RCL mgmt has incorporated into its 2017 forecast per the 10-K. With occ’y overhead limited, onboards will require greater per-capita spend as the incremental benefits of broader points of sale, telecom initiatives and 1st-mover advantage in China (including out-sized gaming benefits) become less impactful. Maintaining peak occ’y at peak NRYs has also historically proven challenging as close-in demand becomes highly sensitive to price. And higher close-in pricing will be increasingly challenging to get.
Over-Earning to Reach Double Double
Like NCLH a year ago, a combo of potential industry and company-specific catalysts point to RCL being the most attractive short candidate among the major cruise operators. RCL happens to be the operator most leveraged to a downturn and unlike CCL or NCLH is still on track to deliver against its LT fin’l targets (the EPS piece at least). We question the sustainability of moves taken to reach Double Double and suspect focus will shift sometime in the 2H of this year to tough company-specific 2018 compares.
After more than two years of pulling various levers (accounting changes, deconsolidation, etc), likely unsustainably holding costs down, benefitting from both a new-hardware 1st-mover advantage in China and materially lower fuel costs, it appears quite likely RCL has reached a fund’l peak in 1H 2017. Booking comparisons have been easy for over a year now on anniversary of European terror attacks in late 2015 and last US equity market drawdown in early 2016 but will get increasingly more difficult each month through the 2018 wave season. NRY benefits from both Pullmantur deconsolidation and new ships (Ovation and Harmony) roll off into 2H and unlike recent years RCL won’t generate onboard benefit from incremental vessel in China in 2H. Cost dynamics are also favorable with mgmt indicating lower 1H NCC ex fuel costs turning higher in 2H (estimated -50% fewer drydock days in 2017 vs 2016).
In our view, RCL mgmt has also pulled a lot of levers to achieve (the EPS piece of) its Double Double targets or doubling EPS off 2014 base (implied $6.78 target) and achieving double-digit ROIC by 2017. This includes opportunistic initial timing of Double Double in mid-2014 after completion of existing vessel refurb programs at both RCI and Celebrity (lower maintenance spend; initial pickup from onboard revenue initiatives) and while CCL was retrenching after publicized ship incidents. RCL also had the 1st-mover benefit from Quantum and Anthem intros in China in 2015 after nearly two years without a new vessel introduction. Benefits in 2015 from new hardware strategy in China included “double-digit NRY growth” paced by both record ticket and onboard NRYs (“record-setting onboards in summer 2015”). These benefits continued throughout 2016 with record onboard PC increases cited including call outs each quarter on positive casino gaming impacts.
As shown above 4 years of EBITDA flowthrough above 100% appears unsustainable (cycle avg is 14% and typical years have run mid-20s to mid-40s). While FX is one piece, levers mgmt has pulled including explicit efforts to shift op ex to D&A appear to account for the remainder. These levers include reducing exposure to value-destroying Pullmantur acquisition through non-core asset sale in early 2014 and write down/deconsolidation in mid-2016. Believe an under-appreciated offset to deconsolidating Pullmantur is that it impairs RCL’s prior vessel transfer strategy. And the Achilles heel of single-brand RCI strategy is the challenge of maintaining a consistent brand image across vessels that are 30 years apart in age. The ability to sell off older hardware at a gain will also likely become an increasing challenge owing to the decision to use state-of-the-art new hardware to pioneer the emerging China cruise market.
Royal Caribbean’s cap ex has consistently run well ahead of its initial guide and well beyond the impact of incremental new vessel stage payments. This points to the potential for maintenance or other spending being capitalized to boost reported EPS. In 2014 initial cap ex guide was $1.2B, raised to $1.4B and then came in at $1.8B (even after adjusting for purchase of Brilliance lease actual cap ex was +27% vs. original guide). In 2015 actual cap ex was $400M or +34% above initial guide and in 2016 was also $400M higher or +19%). Already up from original levels, 2018 cap ex guide was again revised higher at 2Q.
As shown below D&A per berth has also been on the rise since the introduction of the Double Double targets in 2014 (2017 based on guide). RCL has made several moves impacting D&A including a) bought Brilliance lease (Dec 2014) shifting $19M from op ex to D&A; b) extended vessel useful life on 5 ships at YE14 to 35 years w/ 10% residual vs standard 30-years/15% residual (not disclosed but assume subsequent newbuilds Anthem, Ovation and Harmony are all 35 years); c) right-sized (Mar 2014) and deconsolidated (Aug 2016) underperforming Pullmantur business; and d) sold Splendour (Apr 2016) and Legend (Apr 2017). And unlike CCL and NCLH RCL capitalizes a portion of its drydock expense over 30-60 months. Recently rising D&A per berth suggests extended amortization of drydock R&M costs which is in line with consistently higher cap ex vs guide.
Meanwhile other op ex per ALBD – the line item that includes repairs and maintenance expensed as incurred has found a lower plateau in recent years. This appears unsustainable especially in 2018 as mgmt has indicated 2017 drydock days are -50% y/y. And the 1x $31M Legend gain was netted against other op ex per ALBD in 1Q 2017 and thus included in operating EPS even though CCL sells ships far more consistently yet nets gains/losses from operating earnings.
Like analysis of EBITDA flowthrough overall net cruise cost performance appears unsustainable despite Street’s belief that RCL mgmt has finally attained cost religion. Industry an company sources suggest unsustainable belt-tightening to achieve Double Double targets with pressure increasing owing primarily to heavy competitor spend as CCL and NCLH aren’t burdened with achieving LT fin’l targets. CCL has been investing heavily across its brand portfolio and the NCL brand - which had gone through a period of under-investment – has also been getting materially more spend against both hardware/onboard product and brand. Sources also suggest heavier investment is required to enhance distribution and improve marketing in China especially as new entry will now be in form of competitive new ships.
Looking at 2018, we estimate drydocks, launch costs and a 1x ship gain in 2017 represent $118M tailwind or $0.55/share that will become a headwind requiring ~+175bps of NRY growth next year to offset.
Estimate annual drydocks avg ~150 w/ slightly higher number (~170) in 2016 and much lower number in 2017. At $1.5M/day and assuming 35% is expensed this equates to $50M tailwind in 2017 or $0.23/share. Assuming avg 150 days next year this equates to a $42M or $0.20/share headwind (disclosure indicates drydock costs were -8.1M lower in 1Q 2017).
RCL has indicated costs associated with new ship intros can run as much as $20-25M per. Since there are no new intros this year vs 2 last year that’s up to a $40-50M ($0.20/share) cost tailwind that will revert in 2018 on the 2H launches of Qasis and Edge class vessels.
RCL took a 1x $31M ($0.14/share) gain in 1Q 2017 on the sale of Legend of the Seas that is essentially a non-recurring cost tailwind that will need to be made up next year.
Beyond these dynamics sources suggest cost reduction opp’ys have already been harvested, maintenance costs are rising as tail on refurb programs at both RCI and Celebrity run off and messaging becoming more challenging in a crowded market characterized by new supply including new entrants.
Lastly, as shown below accelerating EPS growth in 2015-16 was driven by a collapse in fuel prices that only occurred after NRYs rolled over in the last cycle.
Elongated Cycle Plus China Exuberance = Record New Supply
One predictable consequence of an elongated pricing cycle and enthusiasm for China’s potential is a record new cruise ship orderbook. While currently largely dismissed, the overhang from record new supply makes sentiment appear extremely fragile since on any emergence of demand weakness and/or increased visibility on ongoing supply indigestion in China the bullish narrative could quickly shift to a negative one characterized by the space being uninvestable for years.
142K new berths or $34B total commitment through 2020;
+29% gross supply or +6.5% CAGR; less than 0.5% annual relief from withdrawals in recent years;
249K new berths or $60B total commitment through 2026 and plenty of yard capacity from 2021 onward;
China market being developed with new hardware so not a material outlet for older tonnage;
Unlike prior cycles potentially weaker hands are building aggressively including MSC and new entrants Viking, Virgin and Asia-centric operator Dream Cruises;
Demand dynamics ebb and flow on market-by-market basis and 1/3rd of global cruise industry is still deployed in Caribbean and winter/shoulder capacity an issue;
Belief that China can absorb sustained double-digit annual supply increases without material periods of supply indigestion despite lack of any precedent; and
Indications that 2017 wholesale pricing in China -20% or more and wholesalers no longer willing to operate at a loss (seasonally key in 4Q); RCL indicated China demand weakness in 10-K.
Sentiment backdrop appears fragile given record supply growth including new entry and high expectations for China cruise market development. Specific catalysts include the following:
Shift in 2H investor focus to what comes after Double Double – Tailwinds have been 1H loaded with 2H more challenging on a) anniversary of both new ship benefits and Pullmantur consolidation; b) stiffening booking compares as distance increases from terror attacks and Jan 2016 equity market drawdown; c) lack of onboard benefit from incremental China capacity; d) impact of APac issues incl supply indigestion in both China and Australia markets in seasonally important 4Q; and e) impact of China bookings made after charter agreements re-negotiated in late 2016. And investor focus should begin to shift to the 2018 outlook including extremely challenging Sep through Feb booking comparisons and very difficult 2018 NRY and cost (normalized dry dock spend, renewed new ship intro costs, op ex catch up from Double Double stretch) comparisons.
Realization 2018 estimates are too high – Based on compares, extrapolated estimates, mgmt caution and initial indications of slowing call volumes 2018 consensus appears too high. And with the bulk of 2017 inventory on the books the focus will soon shift to 2018. Some point to aggressive share repurchase given the company’s one-year cap ex honeymoon but with the stock well above $100/share that expectation is unlikely to be met. And even if mgmt wants to engage in self-help program like share repurchase at ATH prices it would just make the downturn that much more severe when it comes ($500M repurchased at $100/share would add <2% or $0.10 to NTM EPS; and that assumes 150bps yield on cash which appears well below realized rates).
Indications of slower booking volumes/shrinking booking curve – Distributor sources indicate hefty correlation between call volumes and both geopolitical uncertainty and equity market dynamics. They also note materially more challenging compares essentially starting now. RCL mgmt also acknowledged booking curve has likely elongated to peak duration and forward bookings improved consistently off late 2015/early 2016 levels on easing compares. With a peak curve and more challenging compares the potential for mgmt commentary to reflect weaker “booked occ’y and/or pricing” commentary is high.