Description

Thesis:

Carnival (CCL) offers a good risk/reward at current prices.  The stock is cheap because of the shadow from the Costa ship sinking in 2012, the “Poop Cruise” in 2013, and more recently - fears about Ebola.  With the stock near Book Value (which it effectively held during 2008/2009) and earnings power of near $4 - $4.50, this is an under-earning company with valuation support.  We think the stock could trade to $60 as earnings improve, with minimal downside.

Industry:

• The top two companies (CCL and RCL) control 70% of global supply and while capacity can be added by anyone, we believe an established brand provides a barrier to entry and ability to better balance supply within markets.  Note: NCLH controls another 7% of industry capacity. 
• We believe that the industry is less commoditized than one might initially think.  While simple supply/demand analysis suggests there may be overcapacity (if you believe demand should grow with population longer-term), there are ways to either segregate the market or stimulate new demand.  For example, older ships can be moved to 3^rd tier cities (or 3^rd tier providers) such as Charleston, SC or Galveston, TX – creating new alternatives for vacation – or move to emerging markets (such as China), allowing pricing to recover in more established markets (like the Caribbean, where demand per population shouldn’t increase meaningfully). 
• CCL and RCL are finally starting to put appropriate incentives in place.  Historically, managements were focused (and compensated) on growth-oriented metrics.  In 2014, CCL changed its short-term compensation scheme and is now 25% tied to ROIC and 75% operating profit (previously was all OP).  And, brand executives are now 50% tied to corporate level operating profit, compared with 25% previously (which could have encouraged competitive behavior between different company brands).  Both CCL and RCL have established goals of 10% ROIC (v. 5% and 6%, respectively, today). 

Earnings Power:

• We think earnings power should be based off a 10% return on capital or about $4 -$4.50 v. current earnings of about $2. 
• In the year ending November 2014, CCL should earn about $23 of Operating Profit per Available Lower Berth Day (ALBD).  Longer-term, we think they should be able to earn near $45 (compared to an average of ~$47 from 2003 – 2008). 
• While some folks think that costs at CCL are bloated, we think the expense reduction opportunity is rather limited (maybe they can offset normal inflation pressures).  The improvement will need to come from sales (mostly ticket prices, with some possible increase in onboard revenues).  In nominal terms, net revenue per ALBD averaged about $180 from 2003 – 2008, compared with $170 today.  We think an increase of ~$20 per ALBD over the next few years is reasonable. 
• Part of this should be made up for by a rebound in the Carnival brand.  From 2011 – 2013, Carnival net passenger ticket prices were down from $142 per ALBD to $127, while RCL and NCL were both up a bit.   

Industry Capacity:

• From 2005 through 2013, industry capacity has grown from 321k berths to 470k berths (according to the CCL 10K).  Over the next few years, industry growth is expected to be ~4%. 
• For North America, there are about 274k berths in the industry fleet and growth is expected to be +1-2%.  It’s tough to know how oversupplied the NA market is, but by segmenting the market better and moving newer ships to other destinations (RCL is sailing one of its newbuilds to China in 2015), the market should start to absorb capacity and rates should firm. 
• Europe has about 155k berths in its fleet and also is expected to grow low-single-digits. 
• A key for the industry is either growth in Asia or other emerging markets, which should be able to support double-digit growth over the next few years. 
• Understandably, history suggests that the cruise operators have lacked any discipline on ordering – and we think that’s part of the reason the opportunity exists. 
• With three players controlling near 80% of the industry capacity and the push from investors (and willingness from the management teams) to move towards return-based compensation, it’s possible that they get a better control of capacity (and thus pricing).  If that happens, Carnival provides an asymmetric risk/reward at current prices.   
• In fact, Carnival has begun to show discipline with only one vessel ordered for 2017 (or about 1% gross capacity growth) v. two-to-three ships historically.

 New v. Old:

• One common misconception, we think, is that CCL has an old fleet.  It’s true that CCL has an older fleet than Norwegian or MSC (a private, smaller competitor), but just looking at the number of ships is misleading.  60% of CCL’s ships were built before 2004.  But, because the newer ships are larger, only 50% of the capacity is pre-2004.  This compares to 60% of RCL capacity which was built before 2004, 35% at NCLH, and 15% at MSC. 
• We also consider the returns for new ships versus older ships (based on lower fuel and maintenance expenses) when thinking about earnings power.  Both CCL and RCL have said it costs about 20% less to run a newer ship than an older ship (I believe this is on a per capacity basis).  Using this logic, it seems that newer ships are about $24 per passenger day cheaper to operate.  Also, assuming that a newer ship gets a premium price of about $10-15, suggests that newer ships have an approximate advantage of ~$35-40 per day in Operating Profit, compared with old ships.
• On an unlevered basis, to get about a 10% return would imply an operating profit of about $65 in early years for a ship.  (It costs ~$600 per available berth day). Assuming $65 of OP for its new ships (per day) and $25 for its older ships, gets us back to the $45 per day assumption we used for earnings power.   

 Valuation:

• 15x earnings power of $4 seems reasonable for a value of $60, especially against book value of $32.34 (as of 2Q14).  CCL basically held $20 in 2008/2009, when its book value was $24 and only traded below book value in 4Q08/1Q09. 
• We have a full position here and would add on any additional weakness. 

Risks:

• Real risk is chronic overcapacity.  With 4% gross capacity additions in 2015 – 2017, the industry will need to segment the market more effectively or scrap old ships.  With three major players and cruise lines not a pure commodity industry, we think it could be managed more efficiently than just looking at the overall numbers.   

Other Notes:

• Street is “relatively” negative on the stock with 54% buys versus 72% and 63% for RCL and NCLH, respectively. 
• CCL has most scale in industry with a $6 lower opex per passenger day than RCL, in 2013.     

Catalyst