Description

Operational mishaps and heavy spending during 2007 have created uncertainty regarding the recently acquired cruise business at AMIE.  This uncertainty has created an opportunity to buy into an attractive business (good demographics and market position) at 5-7x after-tax FCF assuming management does what it says it will, implying a potential double or more from today’s price. 

Downside is limited by the fact that AMIE’s acquisitions have left it in control of 92% of the river cruise capacity in the country.  AMIE can restrict supply to restore pricing discipline to this sector (which was lacking under prior owners), and new entrants are highly unlikely due to high replacement costs (AMIE is trading at a 50% discount to replacement cost, and profits have to improve to what AMIE is projecting in order to justify a return on current replacement costs).

In a meltdown, AMIE’s balance sheet provides further protection.  $73m of its $160m in debt is secured by two of its ships.  AMIE can return 45% of its debt to the government at the cost of losing 30% of its berth capacity.  And the debt left behind would be a long dated convertible with a 3.75% fixed yield and a $56 strike price.

In addition, an investment in AMIE means partnering with a shareholder-friendly family with a long track record of outstanding capital allocation.  It is likely over time that the Ueberroths will create value through their capital allocation skills and contacts throughout the travel industry.

THE UEBERROTH FAMILY

AMIE is controlled by the Ueberroth family, which owns 23% of the shares outstanding.  Peter Ueberroth (70) is a director and former chairman, and his son Joe (37) is chairman and CEO.  Peter’s career has been filled with achievements, including building and selling First Travel, fixing and selling Doubletree to Hilton (his basis in the sale to Blackstone is maybe 15 cents/share), running the LA Olympics, as a commissioner turning around Major League Baseball, and making a bundle investing in Pebble Beach. 

By all accounts, Peter is a highly honorable man who is relentlessly focused on getting value for money.  See this story for some background:  www.golfbusiness.com/pageview.asp?doc=1555

The Ueberroth family’s primary business interests are Ambassadors International (AMIE), Ambassadors Group (EPAX), Pebble Beach, and the Contrarian Group, which is a privately held investment firm.  EPAX runs a student exchange program in partnership with the US Government, and has had a very strong run, as the stock chart will show.

EPAX was spun-off from AMIE in 2002, leaving behind $100m in cash and a corporate travel business.  Joe Ueberroth became CEO, and has spent the last four years looking for cheap travel assets to buy. 

Reviewing the family’s business dealings gives a sense of conservatism, shareholder-friendly actions, and extraordinary access to people in the travel industry.  Over any long period of time, the Ueberroth family seems likely to allocate capital intelligently in the travel business, and owning AMIE is a way to partner with them.

AMIE’S CRUISE SHIPS

AMIE has some smaller businesses – a marina construction company, a small reinsurer that is being wound down, and a small corporate travel and events company – but the main event is the ten cruise ships acquired during the last 18 months.

These ships are organized into the Majestic America Line, which operates paddle wheelers on America’s Northwestern and Southern rivers, and Windstar Cruises, which operates sail-powered ships in the Caribbean and Mediterranean. 

Here are the capacities, build costs per berth, and AMIE’s purchase cost per berth for each of the ten ships (costs are per berth, and are in thousands of 2007 dollars – I have inflated the build costs at 3% annually from build date, which seems conservative given what has happened to the price of steel):

Frommers has descriptions and reviews of both lines that are great background – see www.frommers.com/trip_ideas/cruise/category.cfm?catcd=ADV.  Both lines are intimate experiences (150-450 berths, rather than thousands) and have highly loyal customer bases.  On my trip on the American Queen this summer, they had a party for repeat passengers.  About 120 passengers of the 340 on board showed up.  Two dozen had been on 5 or more cruises, a dozen on 10 or more, and one man had been on 40.  All talked about coming back to see friends from prior cruises, and to explore additional rivers.  The historical content and laid back atmosphere seem to be big draws.

I haven’t been on the Windstar ships, but they also get strong reviews for their relaxed atmosphere, and ability (due to their small size) to get into hard-to-access ports in interesting places.

The paddle wheelers are also unique in the cruise business because they are US-flagged.  Under US law, cruise ships cannot travel directly between US ports unless they are US-flagged and US-crewed.  This makes it impossible for foreign cruise lines to compete on the rivers that make up most of Majestic America’s itineraries, and is why Majestic America has no competitors (other than a single 198 berth ship run by River Barge Excursions).

Being US-flagged also allows financing of ships with MARAD debt.  We can thank Trent Lott and other southern senators for this ridiculous subsidy by the US government, which provides a federal guarantee of long dated fixed rate borrowings to finance ships built in US shipyards.  As a result, AMIE has $73m of fixed-rate, long term debt at an average interest rate of 5.5%, and this debt is secured by two of the paddle wheelers (American Queen and Empress of the North) with no recourse to AMIE.  If things ever got really bad, AMIE could just hand these two boats back to the US government along with the $73m of debt.

HOW DID AMIE BUY THE SHIPS?

The prior owner of the Northwestern and Alaskan ships was the Oregon Rail Corporation.  Their initial success with Queen of the West (which was operated by the father of David Giersdorf, who now runs AMIE’s cruise business) led them to order a new ship, Empress of the North.  Unfortunately, construction costs came in above budget, and this clobbered their bottom line.

The prior owners of the Southern ships were the Delaware North Company.  They purchased the boats from Sam Zell’s bankrupted American Classic Voyages in October 2001.  Under ACV, the paddle wheelers had made ~$30K of EBITDA per berth from 1995-2000.  Sam used the paddle wheeler cash flow (and MARAD debt) to finance the construction of two huge (1000 berth) cruise ships in Louisiana in order to cruise in Hawaii.  Trent’s shipyards are good at cost-plus Navy contracts but not so good at for-profit business.  Their overruns levered ACV, and it filed for bankruptcy a month after 9/11.

The Delaware North people bought the boats thinking that they could persuade Congress to allow them to become casinos.  When this didn’t work, they resorted to discounting in order to fill the boats.  Average per diem rates fell from $290 under Zell to $180-200 under Delaware North.  Plus, many customers were angry that Zell’s bankruptcy had lost them their deposits.

My conversations with people at Oregon Rail and Delaware North suggest that the idea of combining the two operations was obvious due to the ability to cross-market and reduce central overheads, plus pricing power from becoming the only operator of river cruises in the country.  But neither company wanted to be a buyer.

So AMIE bought both lines in early 2006 (plus the Columbia Queen, which ACV had sold to a third party) for the assumption of $73m MARAD debt outstanding on the two ships plus $35m of cash and AMIE shares.

This $108m price was $70K per berth.  To get a sense of the Ueberroths as capital allocaters, note that after four years of looking for something to buy, they managed the following:

• $73m of debt could be returned to the government along with two ships, leaving AMIE in control of 880 berths at a cost of $40K per berth.
• The last ship built (Empress of the North) cost $260K per berth in 2003, and that was before the jump in the price of steel.
• Profit for the two lines during 1995-2000 was ~$30K of EBITDA per berth.

And then in April 2007, AMIE bought the Windstar cruise line from Carnival.  Windstar’s profits had been reduced after 9/11 from $40K/berth to $18K/berth in 2006.  Windstar’s demographics are very different from Carnival’s, and the boats were in need of $10-15m of capital upgrades.  AMIE bought them for $100m, or $164K/berth, and financed the deal with $60m of debt and $40m of cash.

The Windstar ships are internationally flagged, which means they cannot easily serve US ports.  But unlike the paddle wheelers, which pay full US tax rates, the Windstar ships pay de minimis taxes – say, 5%.

If you assume that Windstar can be returned to $30K/berth of profit (and it is on track to do $29K/berth during 2007), then the cash-on-cash return on the equity and additional investment that the Ueberroths put into the deal will be >25%.  This is further evidence of great capital allocation and strong contacts within the travel business.

For sake of comparison, recently announced new builds by the Oceania line (purchased this year by Apollo for $414K/berth) are $398K per berth.  Given the historic and unique nature of the Majestic and Windstar ships, and the ability to keep these ships going over time (the American Queen’s engines date from 1932), it looks as though AMIE got a good deal.

SO WHY IS THE STOCK OFF SO MUCH?

The cruise business is all about filling ships to 85-90% occupancy at the highest per diems possible.  Below 85%, it does not pay to have the ship sail.  It is no accident that the mass market for cruising is dominated by Carnival and Royal Caribbean – their ability to spread marketing dollars and agent commissions over a large base enables them to keep the boats full and avoid price wars.

AMIE began 2007 believing that its pricing was at least $100/day below the competition, and made it a key objective is to close this gap.  This was to be accomplished by refitting ships aggressively during 2007, and by shifting more marketing spend to direct mail and internet.  If a $50/day price hike could be implemented and brought to the bottom line, EBITDA per berth would rise by $14K (this assumes 300 sailing days per year, and 90% occupancy).

Also, in 2006 and 2007, Majestic America began the year with 25-30% of its bookings sold.  This resulted in 83% occupancy during 2006, which is not good enough.  So Giersdorf has targeted 60% booking for the beginning of 2008.  By front-loading spending, he is looking to break the cycle of under-booking followed by discounting that plagued Oregon Rail and Delaware North.  This front-loading and more emphasis on direct contact is the strategy employed by his father successfully prior to 2000, and he also has the advantage of cross-marketing between the two companies’ databases.

So AMIE is spending big time during 2007:  $15m on improving the boats’ physical condition, and $20m on marketing (double last year, and forecasted to drop to $12m next year).  Almost all of this is being expensed, and it is hurting current earnings.  But it has rejuvenated the boats’ physical condition – the engineers on the American Queen told me that no major maintenance spending is necessary on any of the paddle wheelers for at least 5 years.  And on the Q2 call, Joe Ueberroth forecasted just $1m of capital spending on the boats during 2008, compared with $13m of depreciation.

The biggest question is whether the big marketing spend will be effective.  In Q2, occupancy rates on Windstar were 93%, and per diems were an excellent $390/day.  So far, 30% of 2008 has been sold, and at prices 10% above 2007.  Windstar looks very well-positioned for 2008.

In the Northwest, occupancy rates are 96% on the Columbia River with decent per diems.  But Empress of the North hit a rock in May, and had to have all of her passengers evacuated.  While no one was hurt, AMIE lost $7m in missed sailings and other expenses.

Finally, on the Mississippi, management admitted on the Q2 call that they had underestimated the difficulty of winning back customers after the Zell bankruptcy and Delaware North discounting.  Occupancy on the American Queen is in the mid-70s, and per diems are not strong.  Getting American Queen from loss-making to her historical $14m of EBITDA (last achieved in 2000) requires 90 more passengers a week at decent prices.

The investment thesis boils down to some basic questions.  How likely is AMIE management to be able to return the boats to their 2000 level of profitability?  How long will it take them?  And across how many berths?  Currently the market is assuming that AMIE management is likely to fail.

One final blow to the stock is the announcement this summer that the Delta Queen – the company’s oldest and most authentic paddle wheeler – will have to be retired at the end of 2008.  This ship has an all-wood superstructure, and has operated despite violating Coast Guard regulations for decades due to periodic Congressional exemptions.  Renewal of this exemption at the end of 2008 appears unlikely.  While upsetting to some of her fans, this is an economic non-event.  The boat is just 8% of AMIE’s berth capacity, and over the years has made just $0.5-2m of profit, compared to up to $14m for a larger ship like American Queen, and management guidance for 2008 of cruise EBITDA of $45-50m.  I suspect that AMIE management is secretly relieved, as a fire killing dozens of passengers would have been terrible, and phasing the ship out can now be blamed on Congress.

VALUATION

Free cash flow during 2006 was negative $3.6m, and for the first two quarters of 2007 has been negative $1.1m.  Note that 2006’s results were impacted by discounted bookings made by the prior owners, and 2007’s results are impacted by the spending and Empress grounding discussed above – roughly $30m pretax in total ($15m refurbishment spending on the boats, $8m increased marketing, and $7m lost revenues from the grounding).

Management has repeatedly stated that the paddle wheelers made historical EBITDA of $30K+ per berth, and asking around the cruise industry confirms these numbers.

We can assume three cases for profitability during the 2008-2010 years.  In the low case, AMIE gets EBITDA to half of 2000’s levels of $30K/berth.  In the middle case, AMIE gets to $25K/berth, which is what management has given as 2008 guidance.  In the high case, AMIE uses pricing power and cross-marketing to get to $35K/berth, slightly in excess of 2000’s profitability.

I assume $4m of maintenance cap ex, compared with guidance of $2m for 2008 (Joe’s $1m for the cruise business, and an estimated $1m for the marina business).  I am also backing out of the $22.75 share price the the $3/share of cash (net of customer deposits, which show up as restricted cash) on the balance sheet.  And the Windstar operations are taxed at 5%, whereas everything else is taxed at 38%.  Note that I am also assuming that Mississippi Queen is back in service, and Delta Queen and Contessa have been sold (for no proceeds).

Note that Carnival and Royal Caribbean are trading at a 15x p/e, and at maintenance FCF yields (backing out spending on new ships) of 7% and 9%, respectively.  The middle and high cases above would translate to $35-50/share at an 8% FCF yield.

And the demographic picture for AMIE is brighter than for the big players.  AMIE customers tend to be older, more affluent people.  These are groups that are growing in size.  It is likely that AMIE’s customer base is growing at least 5% annually – the cruise industry talks about growth in the high single digits for all demographics.

WHAT’S THE DOWNSIDE?

Obviously this can be a cyclical business, as the impact of 9/11 shows. 

But AMIE has several levers that it can use to minimize downside:

1. Restrict supply.  Now that AMIE owns all of the paddle wheelers, it can simply remove capacity from the rivers.  That is why Mississippi Queen is sitting out all the rest of 2007 and 2008 – to restore pricing power on the Mississippi.
2. Liquid balance sheet.  AMIE’s debt is fixed rate and low cost.  Even if you assume no profitability from the cruise business, a cash flow projection will take you through 2011 before interest and principal payments use up AMIE’s unrestricted cash.
3. Cash flow generation.  Even with all of the spending and issues in 2007, AMIE is essentially cash flow breakeven.  The company spent $1.5m on share repurchase during Q2, and may spend more.
4. MARAD debt.  In a crunch, AMIE can cut its debt by 45% by sending the MARAD debt back to the government at the cost of 30% of its berths.  The convertible debt left behind has a 3.75% coupon.

Finally, at $22.75/share, AMIE is trading at half of replacement cost, which is at least $300K/berth given the cost of recent builds and the subsequent rise in the price of steel.  Note that US law requires that ships cruising the US rivers be built in US shipyards, so you can’t shop around for the Korea or China price.

Another way to think about downside is that the primary problem in this high fixed cost business is attracting enough demand at good prices to get above 85% occupancy.  It looks as though AMIE’s occupancies are good everywhere but the Mississippi.  2008 will be the farewell year for the Delta Queen, and this is likely to improve demand.  But if demand in 2009 is not strong, AMIE can just leave Mississippi Queen in dry dock, retire Delta Queen, and try to transfer Delta Queen’s business to American Queen.  Moving American Queen’s occupancy from mid 70s to mid 90s will require an additional 87 passengers each cruise, which is just 50% of Delta Queen’s capacity.

If AMIE did this, total berth capacity would fall to 1,607.  If restricting supply got EBITDA to $30K/berth, total cruise EBITDA would be $48m, which is the same as the mid case FCF yield of 14% above.

And it is highly unlikely that restricting supply in this manner would result in new entrants.  Construction costs of $300+K/berth make new entrants unlikely unless they could be assured of at least $30K/berth EBITDA.

POSSIBLE UPSIDE

The Ueberroths may continue to deploy cash on an intelligent basis.  If you do a cash flow model out assuming $30K of EBITDA per berth and cash redeployed at a 15% return, you get $50-60/share in 4-5 years.

THE BIG QUESTION

Will the Ueberroths and David Giersdorf manage to return the cruise operations to historical levels of profitability?  2007 has been a tough year, but a lot of the pain has resulted from spending to maximize results going forward.  And management has several levers to pull to influence the outcome that were unavailable to prior owners (cross-marketing, holding back supply, relationships within the travel business).

Catalyst