Certain statements contained herein reflect the opinion of the author as of the date written. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Pitch:

I am bullish on the cruise industry over the long run because of the good value I consider cruising provides to its customers. I believe cruising is a secularly growing industry evident by the continued increase in global demand coupled with rising net yields. Global penetration rates are still low and even in the most developed regions like North America, penetration is still low-double digits.[1] In a world where technology is disrupting industries left and right, putting into question the terminal value of various businesses, cruise lines do not appear to have this risk.

The key question is whether growth in supply over the long-term will exceed demand growth and hurt pricing. Over the short-term, this is a risk and that is the current market fear. However, over the long-term, some mitigating factors are that there is only so much supply that can be generated in a given year due to the natural constraints from available shipyards; the industry operates largely as an oligopoly with Carnival Corporate (NYSE: CCL), Royal Caribbean Cruises, Ltd. (NYSE: RCL) and Norwegian Cruise Lines Holdings Ltd (NASDAQ: NCLH”), collectively, “the Big 3”, controlling ~80% of capacity[2]; and the ability for the Big 3 to reallocate capacity geographically to better meet demand (see NCLH’s recent move of the Norwegian Joy from China to Alaska). CCL currently trades at an undemanding valuation of ~13x 2019E EPS and barring a recession, in my view, should be able to grow revenue and EPS at a mid-high single and low-mid double-digit rate, respectively, over the next several years.

Business Description:

Carnival Corporation is the largest cruise company in the world. In 2017, CCL carried 46.5% of all global cruise guests.[3] CCL operates over 100 cruise ships across several brands and has global operations in North America, Europe, Australia, and Asia.[4] As the largest cruise operator in the world, CCL caters predominately to the contemporary cruise market. CCL’s closest competitors, Royal Caribbean and Norwegian Cruise Lines, serve the contemporary and premium/luxury market segments, respectively.

Investment Thesis:

The cruise industry is currently out-of-favor. CCL, RCL, and NCLH collectively trade on average at ~12x 2019E EPS, which represents a ~1x P/E discount to their ten-year average and a ~2x P/E discount to their fifteen-year average. Relative to the S&P 500, the Big 3 trades at a ~5x P/E discount on 2019E consensus estimates.[5] I believe the P/E multiples for the Big 3 should re-rate higher over time if these companies continue to grow their earnings at an above average rate relative to the market.

Concerns over capacity growth, tepid Chinese demand, rising oil prices, and unfavorable FX have weighed on the Big 3’s multiples. Yet despite these concerns, I believe CCL remains an attractive investment opportunity because it has the ability to earn incremental ROIC in excess of its cost of capital; the company is disciplined in its fleet expansion, and it has, in my opinion, an attractive valuation.

Expectations for CCL are low. Next year the market expects CCL to generate constant currency net yield growth of just ~1.5%-2.0%,[6] which may prove too conservative. In my view, CCL should be able to drive ~100bps of net yield growth next year by introducing new ships. In addition, net yield performance should potentially benefit from the full-year rollout of the Company’s new revenue management system (“Yoda”). Yoda will allow CCL to improve yields by optimizing pricing across the Company’s fleet. Aside from self-help drivers, the economic backdrop remains healthy and as noted in CCL’s Q2’18 results press release, CCL’s cumulative advanced bookings for the next three quarters are in line with the prior year at higher prices.[7] Further, based on my experience, CCL’s management team has a reputation for providing conservative guidance.  

The cruise industry is relatively straightforward to model because of the visibility into future capacity. It takes between 3-4 years for a new ship to be constructed and there are only three major shipyards (i.e., Meyer Werft, STX France, and Fincantieri), which places a cap on future capacity growth. Together these shipyards have a maximum capacity of 12 ships per annum. With future volume growth given (while exact timing can vary), to model CCL one primarily needs to make assumptions regarding pricing and expenses. CCL expects to grow its fleet at a 5.6% CAGR from 2017-2021, which is slightly below the industry average of ~6.1%, but in line with historical norms (e.g. ~5.7% from 2000-2017).[8]

If overall macro environment remains healthy over the next few years and fuel prices remain relatively stable, CCL will potentially be able to grow its EPS by a mid-double digits CAGR.[9] If this scenario unfolds, CCL’s shares may be extremely attractive on an absolute and relative basis. I believe shares could trade at $75 over the next 12-18 months, which represents ~20% upside including dividends.

Major assumptions for this scenario include: 1) capacity comes online as the company has forecasted; 2) CCL realizes net yield growth of ~2% in each of the next two years; 3) fuel prices remain stable at current levels; 4) CCL uses its excess free cash flow to repurchase ~$5B worth of its stock cumulatively from 2018-2020 at an average price of ~$70; and 5) the stock trades at 13x 2020E EPS exiting 2019.

Industry Analysis:

Relative to other industries, I believe the attractiveness of the cruise industry is above average. From a financial perspective, cruise operators pay almost no taxes, have generally low cost of capital and collect cash upfront from bookings, which helps with general liquidity and free cash flow.

§  Low Taxes: CCL pays very low corporate taxes due to favorable international tax laws for shipping income. The Company’s historical tax rate has ranged between 0%-2%[10]. 

§  Low Cost of Debt Financing: Cruise operators typically use export credit agencies (“ECA”) to obtain financing for new builds at relatively low interest rates. Before a new ship is ordered, cruise operators can usually obtain an 80% financing commitment from an ECA[11]. In terms of payment timing, approximately 80% of the total purchase price is due at delivery.

§  Negative Working Capital: Cruise operators typically try to (and often do) book cruises at least six months in advance of the actual departure date. This helps not only from a pricing perspective, but also from a cash flow perspective. Over the last year, cruise operators have extended their upfront booking windows beyond six months to take advantage of strong demand.[12]  

Complementing the cruise industry’s potential financial advantages are what I believe to be positive secular trends. Cruising has been the fastest growing category in the leisure travel market for many years. Growth in passengers carried has compounded at 5% per annum over the last decade[13]. Looking forward, economic and market factors such as demographic tailwinds (particularly the baby-boomers), growth in Chinese demand from nascent levels, constrained capacity, and the value proposition of cruising over land-based vacations may continue to benefit the cruise industry.

§  Demographics: Approximately 50% of North American (NAm) cruisers are 50+ years of age.[14] I expect the utilization from this age group to continue to grow moving forward. In addition, millennials’ desire to spend discretionary income on travel/experiences may also benefit the cruise industry.

§  Growth in Chinese Demand: The Chinese market is estimated to grow at a 20%+ CAGR over the next decade[15]. Chinese customers spend significantly more than Americans on international cruises, which improves net yields. However, over the last year, Chinese passenger growth has slowed[16] because China imposed a travel ban to South Korea.[17] If China can return to its 20%+ growth, then the Chinese market could potentially absorb nearly 33% of industry supply growth through 2022[18].   

§  Constrained Capacity Growth: Historically, capacity has grown in line with passenger growth at 5%[19]. If every shipyard produces at maximum capacity (without going bankrupt or experiencing any significant delays during construction), capacity could theoretically grow at ~7%. While this is unlikely to happen, even if capacity does grow too rapidly in one region without requisite passenger growth, operators could potentially move their ships to a region where demand is greater and thus returns are more attractive.

§  Value Proposition of Cruising over Land-based Vacations: Cruising allows passengers to “sample” a number of different destinations within a short time span at a comparatively low cost. U.S. resorts are ~20% more expensive than cruises on a relative basis[20]. According to industry publications, it’s not unusual for cruisers to subsequently plan a land-based vacation at one of the sites they visited on their cruise. The main factors influencing an individual’s decision to cruise are as follows: 1) cost; 2) destination; 3) overall experience; 4) quality of the ship (including rooms and common areas).[21]

Why CCL?

§  Largest and Most Diversified Cruise Line Mitigates Risk: While the top three cruise lines make up ~80% of the industry’s capacity, CCL (~45% of capacity) is far larger than RCL (~25% of capacity) and NCLH (~10% of capacity)[22]. Due to its industry position, CCL sources passengers from a more diverse range of geographies than RCL and NCLH, which reduces its reliance on any one region and may mitigate the impact from potential economic weakness and/or terrorism in any specific area. CCL’s size and diversity of regions also helps increase its brand awareness globally. This helps to position the company for future growth as is expands its fleet and associated footprint.

Another advantage of having the largest fleet is that each ship is less meaningful to the Company’s financial results. Therefore, if one of CCL’s ships experiences a technical problem for an extended period of time the impact to CCL’s financial results is likely less than it would be for RCL or NCLH.

§  Measured Capacity Growth: Because cruising remains underpenetrated, CCL can add capacity at a mid-single digit rate to grow revenue. CCL expects to add capacity at a 5.6% CAGR through 2021, which is in line with historical averages[23]. The Company is committed to maintaining an attractive fleet profile and has shown discipline selling older vessels. Over the last twelve years, CCL has sold 22 ships into the secondary market, including two ships last quarter. Moving forward, CCL plans to continue to sell, on average, one to two ships annually[24].

§  Benefits from New Revenue Management System: Prior to Yoda, CCL used a decentralized pricing strategy by brand. Yoda was launched in 2016 and rolled out across six of CCL’s brands to help the company optimize close in pricing across its fleet. By having the largest global fleet, CCL has more data points in more geographies to optimize pricing relative to its closest competitors. By the end of 2018, 90% of the six brands’ inventory will be utilizing the revenue management system.

Management has opted not to provide estimates for Yoda’s impact on future net yields[25]; however, by leveraging its large data sets, CCL could improve net yields next year by 50bps or more.[26] In nominal terms, CCL’s net revenue yield per capacity day is still 6% below the 2008 peak of $192.[27] Given the wealth effect from rising markets and assets over the years, there may be room for price increases. The combination of Yoda (~50bps positive impact to net yields) and new ships (~100bps positive impact to net yields[28]) alone could result in CCL meeting implied net revenue yield guidance for next year.

§  Onboard Spending Growth: CCL has been rolling out its Ocean Medallion™ program over the last year. The Ocean Medallion™ is a wearable device that allows CCL to track its guests’ position on the ship. Through this device, guests can order items (e.g., food, drinks, etc.) and have them delivered to their precise location. CCL employees delivering the ordered item can see what items the customer has previously ordered, which allows for better customer service. The device may also be used to purchase goods at the point of sale.

§  Strong Fundamentals: While management did lower the mid-point of FY18 EPS guidance by $0.10 to be in the range of $4.15 to $4.25 on the Q2’18 call,[29] the downward revision was related to a $0.19 unfavorable impact from fuel and FX. Management has done a solid job managing the aspects of the business it can control.

§  Balance Sheet Strength/Capital Allocation: I believe CCL has room to return cash to shareholders via share repurchases given that is has significantly lower leverage (1.8x net debt to EBITDA) than RCL and NCLH which are levered ~3x and 4x, respectively.[30] CCL’s leverage target is 2.0x-2.5x. CCL may have the capacity to return at least $2B to shareholders in 2019 and 2020.[31]

Inputs & Assumptions for Valuation:

In my view, CCL may potentially be able to grow revenue by 8%-9% in 2019/2020 through increased capacity and modest pricing growth. If this happens, net cruise costs excluding fuel should scale modestly as they have in the past. Assuming fuel prices remain relatively stable and CCL uses its free cash flow to repurchase shares, then the Company may be able to earn EPS of ~$5.80 in 2020. Applying a 13x multiple to 2020E earnings, CCL’s shares could possibly trade at $75 in the next 12-18 months. This ~20% upside represents a potentially attractive risk/reward tradeoff relative to other opportunities in the market.

Risks:

§  Industry capacity growth results in negative net yield growth, causing multiples to contract

§  A shipwreck such as the one (Costa Concordia) that occurred in 2012, which hurt Carnival’s reputation

§  Reduced desire to travel due to terrorism

§  A deep and prolonged global recession

§  Fuel prices continue to rise, which impacts demand due to cost based price increases and therefore impacts earnings growth

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is not indicative of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.