Description

Recommend long Carnival Cruise Lines – CCL. Key points:

• Carnival stock trades at ~8x NTM EV/Ebitda with an EV of ~$50bn (~$28bn of net debt). Management guidance is for ~$5.8bn of adj. Ebitda in FY24.
• Forecast is for moderate industry capacity growth over the next few years due to a slowdown in ship orders during the pandemic.
• Elevated cash flow in 2025 & 2026 due to only 1 new ship entering CCL’s fleet – cumulative free cash flow should be ~$6bn due to low capex intensity.
• Capital allocation – management is focused on reducing debt and regaining an investment grade credit rating; all cash flow will be used to reduce leverage.
• Solid demand due to continued revenge spending, demographic shifts (retiring baby boomers) and the increasing popularity/quality of cruises.
• Improved execution from management – switch in focus to larger (more profitable) ships and more efficient operations.

Background

By the end of 2024, the cruise industry is expected to have ~360 ships in operation with a passenger capacity of ~675k; the big four cruise lines (Carnival, Royal Caribbean, Norwegian, and MSC) make up ~80% of the market. From 2003-2019, the industry has grown global passenger volumes from ~12mn to ~30mn (~5.6% CAGR). The pandemic put a stop to that, but growth has returned and CLIA forecasts ~38mn passengers by 2026.

Carnival makes up ~40% of the industry’s capacity and operates under 9 brands (will be 8 soon as the Carnival brand will absorb P&O Cruises Australia) and across all segments of the cruise market; from contemporary with Carnival, to luxury with Seabourn/Cunard. ~70% of Carnival’s capacity is evenly split between the Caribbean and Europe, with the remaining in locations like Alaska, Australia, and Asia.

The business is still recovering from the pandemic, where it was forced to cancel sailings and issue ~$25bn in debt and >$5bn in equity. The core business has rebounded, and they’ve made progress, with leverage now ~4.8x (net debt to adj. 2024 Ebitda). The key concern is current demand isn’t sustainable due to delayed revenge spending. Comcast pointed to cruises as a reason that their parks business saw a slowdown. From Comcast earnings:

“Going back to 2022 and 2023, parks were clearly the early beneficiaries of substantial rebounds in tourism and travel after the pandemic, resulting in a surge in demand that contributed to us reaching record results for both of those years. More recently, other travel options, including cruises and international tourism given the strength of the dollar, have experienced their own surge in demand, which cause visitation rates at our parks to normalize.”

I think demand for cruises will hold up better than expected; even if pricing does soften, moderate capacity growth and low capex requirements will still allow Carnival to repair their balance sheet over the next few years. Long-term there are tailwinds from demographic shifts (baby boomers), overall cruise quality, and larger ships producing more attractive economics.

Capacity

The CLIA projects capacity will grow ~3% annually through 2028, which is ~2-3% lower than the historical growth in demand. Ships orders were halted during the pandemic as cruise lines focused on preserving cash, and megaships like Royal Caribbean’s Icon of the Seas take at least 5 years to design and build.

Fincantieri, the biggest shipbuilder with ~40% market share in the cruise market, agrees and is forecasting a supply shortfall as cruise demand returns but capacity lags due to a halt in orders during the pandemic.

Ship orders have started to come back with Norwegian recently ordering 8 ships (~25k berths), Carnival announcing 3 230,000-ton ships, but new capacity is skewed towards megaships that have better economics and won’t be ready to sail for 5-10 years.

Cash Flow & Capital Allocation

Carnival is only taking delivery of 1 new ship in 2025 & 2026. This translates to ~$5.3bn in capex combined in 2025 and 2026, with analysts forecasting >$13bn in Ebitda. Take away ~$2.8bn for interest expense and add ~$1.5bn working capital benefit (mainly increase in customer deposits), and CCL should generate >$6bn in free cash flow over in just two years (~12% of CCL’s current EV). This will reduce net debt to ~$22bn, or ~3x leverage depending on Ebitda growth.

Even after two low capex intensity years, CCL is only expecting to add 1-2 ships a year; once their debt is more manageable, new ships will allow CCL to refinance their remaining high-rate debt with attractive export credit financing; export credit financing is usually at a rate of ~3% and amortizes over 12 years.

Management is laser focused on reducing debt. Analysts have been starting to ask about a potential dividend given the recent performance, but management continues to commit to using all free cash flow to reduce debt and get back to an investment grade credit rating by 2026.

Industry Tailwinds

Gen X & Baby Boomers are all getting closer to retirement and make up ~50% of cruise passengers, with ~84% of this cohort planning to cruise again; add in their significant wealth, increasing leisure time and this should translate to solid growth in the industry’s core demographic. Cruising is also becoming more popular among younger generations, with Gen Z and Millennials making up ~35% of cruisers, with most planning to cruise again.

Similar to onshore vacations, cruise goers have noticed a decline in the quality-of-service post-pandemic (less services included, smaller food portions etc.); overall though, the quality of cruises has increased over the last few decades as tech & design improvements have created “floating cities”. Megaships create more room for activities like waterparks, adult only areas, specialty restaurants, as well as the typical shows and casino that people expect on a cruise.

Guests usually have to pay extra for these new amenities, but this has increased the amount of non-ticket revenue generated per guest, which is now ~1/3^rd of CCL’s total revenue. Additionally, cruise lines have launched apps that reduce the friction to pay for these add-ons; it also allows them to collect data on guests’ interests and then offer specific products based on their preferences.

Cruise prices have jumped over the last 12 months, but a cruise is still cheaper than a land-based vacation; Morgan Stanley estimates a cruise is ~25% cheaper than a land-based vacation, up from ~35% in 2023, but still lower than the average ~20% discount in the decade before the pandemic.

Bottom line, cruise lines’ core demographic should continue to grow, the quality of a cruise continues to improve relative to a land based vacation, cruises are getting better at extracting more non-ticket revenue from guests, and a cruise is still cheaper, historically, than a land-based alternative. Cruises aren’t for everyone but it’s a niche with room to grow.

Better Execution

Royal Caribbean is the undisputed best in class operator and is already back to pre-pandemic margins. CCL has historically been the low-cost operator, matched with lower revenue per berth; one of the key reasons RCL has been able to return to pre-pandemic margins is they have embraced the megaship trend, launching megaships such as Icon of the Seas & Utopia of the Seas. These ships are currently generating a significant premium vs older style vessels.

Carnival was late to the megaship game, with previous management avoiding the class over concerns that guests didn’t want ships with >5,000 berths. They changed course after RCL & MSC Cruises showed the strategy was highly profitable; CCL launched their Excel class, which are >180,000 tons and carry >5,000 passengers. These are smaller than RCL’s Icon & Oasis class, but Carnival fits in more guests per ton of ship (~35 tons per guest for Carnival vs ~40 tons per guest at RCL).

Management is also focused on improving operations and cutting costs; they recently announced they will sunset the P&O Australia brand and fold it into Carnival. This will simplify operations, reduce costs, and allow CCL to take advantage of the global Carnival brand. Management has a goal to increase the Carnival brand to ~37% of total capacity by 2028 (up from ~29% today).

Other operational improvements include:

• Booking curve – A change in the booking curve, where tickets are sold further in advance, has created a better pricing environment. Historically, Carnival would enter the year with ~50% of the years’ capacity sold; now, this number is closer to ~65%. They continue to report solid 2025 bookings with pricing and occupancy ahead of 2024.
• Fuel-efficiency – Larger and more fuel-efficient ships have reduced the amount of fuel needed per Available Lower Berth Day. Since 2015, CCL has lowered the amount of fuel used per ALBD by ~22%. Fuel makes up ~10% of CCL’s total operating costs and should continue improving.
• Private islands – CCL plans to launch their own private island in 2025, Celebration Key. The cost is expected to be ~$500mn and will see ~4mn guests visit the island by 2028. RCL has seen a 15% price jump in tickets that sail to CocoCay (their recently opened private island), and guests spend on average ~$100-150 a day while there. Another added benefit is Celebration Key is located close to Miami, which helps keep fuel costs down.

Risks

Demand

Demand is clearly a risk with a business that relies on the strength of the consumer. A demand shock like the pandemic destroys this thesis, but moderately softer pricing will not kill the investment. CCL is set up nicely with low capex requirements in 2025 & 2026; this will allow them to work through a soft demand/pricing environment, while still paying down debt. Consumers also cut back in other areas before axing their vacation.

Premium competition

Cruise lines held back on new ships during the pandemic, but there is a certain niche within the industry that is seeing increased competition. Luxury offerings have seen new entrants such as the Ritz-Carlton and the Four Seasons, who have both launched luxury yachts.

Viking, which recently went public, focuses on river cruises but also plans to grow their ocean cruise business. Cruise Industry News has Viking making up ~42% of new luxury capacity through 2030. Luxury and river cruises aren’t CCL’s core customer, Seabourn & Cunard make up ~4% of CCL’s capacity, but luxury customers bring in significantly higher revenue per berth and an increase in capacity could pressure pricing and lower margins.

This should have a relatively small impact overall but does create a potential banana skin for management.

Tax regulation

OECD issued proposed rules for a 15% global minimum tax rate. CCL and other cruise lines currently pay very little tax as they are able to incorporate overseas and avoid any significant tax liability. CCL disclosed in their 10K that they currently estimate the impact of the 15% minimum tax rate will be ~$200mn (annually).

Valuation

Ebitda estimates are for ~$5.8bn in 2024, but management guidance has proven very conservative in recent quarters. A bull case would be demand holds through 2026, revenue grows ~4%, Ebitda ~7% as margins expand to ~25% (close to pre-pandemic margins).

$6.7bn of Ebitda in 2026 at a 9x multiple would be ~$60bn EV; debt will be ~$20bn with debt paydown and conversion of convertible notes (~$1.6bn principal debt converted avg. ~$12 a share). This is a market cap of ~$38bn on ~1.4bn shares, a share price of ~$27 (~20%+ CAGR).

What I like about this bet is even if we see softer pricing due to a weakening consumer, low near-term capex requirements mean CCL will still be able to reduce debt and clean up their balance sheet anyway. Permanent capital loss will come from a significant demand shock, not a slight weakening of the consumer.

Catalyst

Continued debt paydown, continued positive pricing, cash flow in 2025 & 2026