Description

Idea: Long Fincantieri which, pending its acquisition of Chantiers (fka STX France), controls 60% of shipyard capacity capable of fabricating large cruise ships and trades for little above the value of backlog alone. Fincantieri is being mischaracterized as a low-quality, cyclical, shipbuilder when – in-reality – it possesses inimitable Cruise fabrication assets that over the next decade should accrue significant value as cruise demand continues to secularly grow in the MSD range. Large cruise ship-building capacity (>90k tons) has not grown and will remain relatively fixed over the next decade. This dynamic will manifest significant pricing power for this financially and operationally leveraged Italian shipbuilder. Further, Fincantieri’s current margin profile is obfuscated by its low-quality O&G business and VARD expedition-vessel business; over the next five years we will see sustained HSD revenue growth as the Company takes pricing on its cruise services while EBITDA will CAGR in the low-teens as it experiences a positive mix-shift in margins from its cruise business. This is a multi-bagger. 

Put very simply, Fincantieri trades for 5x 2020 EBITDA, and I expect EBITDA to grow 50% by 2023 driven by higher incremental margins on cruise fabrication borne from pricing on orders that are already in the backlog. As the Company is levered and capex is relatively fixed, this will produce a windfall of FCF to equity (I estimate a 28% IRR to 2023 assuming essentially no multiple expansion). Nearly all of the current market cap will be generated in cash by 2023. 

The opportunity is afforded by near-term focus by the investor community on losses in the O&G & VARD expedition cruise business as well as a complete lack of appreciation for the long-term cruise supply/demand dynamics.

Business

Fincantieri is the leading cruise and naval ship fabricator with over 230 years of history and more than 7,000 vessels built to-date. It controls 20 shipyards spanning four continents. Fincantieri was a 2014-vintage privatization by the Italian government (listed on the Milan stock exchange in 2014 and still 59% owned by the Italian Ministry of the Economy). In 2018, it acquired an additional stake in VARD (a mostly offshore shipyard group that makes expedition cruise-ships) and signed an agreement to purchase a 50% stake in Chantiers (number three large-cruise fabricator; I detail this in the appendix).

Its operations today are segmented as: shipbuilding (cruise and naval vessels), offshore & specialized vessels (high-end offshore support vessels and other specialized ships), and equipment & services (propulsion and automation systems, repair, and after-sales services). Shipbuilding is the largest segment by far – contributing 84% of total revenue and I estimate nearly all of EBITDA (due to losses in offshore).

Shipbuilding encompasses really three different businesses: core Fincantieri cruise fabrication (these are large cruise-ships and the best business of the group by far), VARD expedition-cruise (recently acquired and loss-generative; I believe this is misunderstood), and Naval vessel construction (a stable business levered to defense spending). I estimate core cruise fabrication generates ~80% of Company EBITDA with ~10-11% EBITDA margins (compared to corp avg. 6-7% estimated for 2019). Due to its contribution and growth prospects, core large cruise fabrication is the focus of the writeup. 

Large Cruise Fabrication Industry

Large cruise ship fabrication is a complex task – taking around three years to design, plan, and construct as well as thousands of skilled workers and the shipyard capacity to house such large vessels. 

To put a frame of reference to the complexity of large cruise fabrication – these ships are typically in the 140k ton range (a 140k ton cruise ship corresponds to a capacity of about 4k passengers). That is, they rival the tonnage of some of the largest tankers or container ships – but the fabrication is extraordinarily more complex compared with a simple metal-box that holds oil or containers. These are essentially horizontal skyscrapers that house thousands of people. As a result, without the proper experience (learning curve) and network of suppliers, large cruise ship fabrication is an extremely daunting and unprofitable task. For this reason, there are only three shipyard groups, globally, that dominate the fabrication of >90k ton cruise ships. Within the >90k backlog (to 2027) Fincantieri has about 35% share, Germany’s Meyer Werft is second (29%), and Chantiers comes in third at 26% share (all from total ship-backlog numbers). If Fincantieri’s acquisition of Chantiers is successful, it will hold 61% market share. The remaining 10% share comes from two players who are not active in the market today – MV Werften and CSSC – though we are skeptical these will be successful ventures:  

Further, the number of cruise-liners (operators) has expanded over the years (while the shipyard groups are consolidating). If you go back to when the cruise industry was relatively nascent – the early 2000s – Fincantieri only had two major customers: Carnival and Disney Cruise Line. Today, their potential customers span the majors (Carnival, Royal Caribbean, Norwegian) as well as four new entrants – MSC, Viking, Virgin, and Ritz-Carlton. 

Suffice to say, the large cruise-ship fabrication industry is very consolidated with an expanding customer list. 

Thesis
This is a very simple thesis. As the demand for large cruise ships has steadily grown and supply has remained relatively fixed, beginning in 2019, shipyard utilization has come to ~100%. Unlike other shipbuilding industries, three players dominate the large cruise ship fabrication industry which means that significant pricing power will manifest when operating at these levels of asset utilization. We think the large cruise fabrication industry is about to enter a long-term period of increasing supplier power (it will act more like a true oligopoly going forward with pricing going up over-time for all units as the marginal unit is not being heavily competed for). Fincantieri is best positioned given it has the largest scale (and is in the process of buying the #3 player). 

Demand

Cruise demand is secularly growing within the total pool of tourism growth. Tourism grows at around a 3% CAGR; cruise-demand is taking share within this pool due to its superior value proposition for a total growth rate in the 5-6% range per annum (Source: World Tourism Organization / Fincantieri estimates).

There is a long run-way for cruise to take share. I calculate penetration at only ~4% in the U.S. (~12mm passengers per annum), 1.5% in China (~3mm passengers, grossed up due to a lower GDP/Capita), and between 1-4% for major Western European countries (same methodology). 

So how has this played out in practice?

Below, I show the number of total gross berths (sleeping space) of cruise capacity added per year (blue) vs. total industry berths (gray line). Note, all data is from Cruise Industry News / direct press releases (and forward-looking figures are placed orders). We can see that the existing industry backlog is strong and that for year-end 2020, we expect about 648k berths of capacity. What is perhaps most noteworthy here is the historically slow periods of gross adds in ’05-’06 and ’11 to ’15 (I believe this is a lagging consequence of recessions experienced in 2001 and 2008). As we have not experienced a significant global slow-down in over 10 years and cruise fabrication capacity has remained relatively constant, the demand and order book for cruise capacity has grown commensurately:  

Further, cruise book-to-bill is still well over 1x for Fincantieri (EUR 7.1bn of orders vs. EUR 4.7bn of revenue for 9M19; 1.5x), so we expect 2024 and 2025+ to sustain the strong growth already in the backlog through ’23.  

What’s more, due to the prior order patterns, we should have an extended period of outsized demand growth (to catch up to prior low deliveries). The fundamental reason this will happen is basic economics. As cruise deliveries were lower than underlying demand between ’11 and ’17 (explained below), cruise operators saw expanding returns on capital! As we do not view the cruise industry as a “Buffett oligopoly” – especially with the new entrants – returns will come down for the industry (through adding capacity that outpaces underlying cruise demand). The shipyards will benefit from this dynamic. 

To better illustrate this, if we use 6% as a normalized demand level, the industry undershot this target between 2011 and 2017. From 2018 (realized) to 2023 (expected, from orders in backlog), we are now entering a long-term upcycle growing above this 6% rate:

note: I use the upper end of this range, 6%, for a gross capacity add figure since ~0.50% of capacity is withdrawn per year 

So to distill this, from 2011 to 2017, industry fleet additions undershot underlying demand by a cumulative 34k berths. The industry will deliver more than underlying demand by a cumulative 22k berths between 2018 and 2023 (still a 12k gap). So the backlog should still be growing commensurate with underlying cruise demand (6% growth) post 2023; it should even outpace underlying demand (eating into that 12k gap). 

All this is to say – due to the backlog dynamics and prior order patterns – this is a much less cyclical market than other industries that ship-builders commonly supply to. Realized cruise-demand itself will not exhibit much signs of cyclicality as the cruise-liners always manage to full occupancy (they will lower prices to fill ships and their new ship order backlog stretches 5+ years). 

To be very clear, in the absence of a multi-year recession, Fincantieri should be immune to any cyclical swing due to its 5-years of revenue backlog (more on this in the valuation section); this seems like a strong margin of safety.  This dynamic is more akin to dominant suppliers in the aerospace industry rather than shipbuilding. 

Further, two other factors help support strong demand for new cruise-ships: 1) new cruise ships are technologically superior in various ways that support cruise pricing and lower-costs (larger/newer ships can house better attractions – like large amphitheaters, pools, and even go-kart tracks; larger cruise ships offer operators economies of scale; new ships even are LNG powered) and 2) there have been new entrants in the cruise industry which likely means in the medium-term, capacity outgrows underlying cruise demand (currently elevated return on capital of low-teens for cruise operators will come down to a more normalized level or even below prior normalized levels given more players). 

Supply

The large cruise (>90k ton) cruise fabrication industry is sold out through 2023 – 100% of which is being supplied by Fincantieri, Meyer Werft, and Chantiers (STX France) combined. While it is difficult to say with confidence, we believe Fincantieri and Meyer Werft both possess capacity and supplier networks that can construct around 15k berths of supply / year (in periods, below, where they are above 15k – this is due to timing of deliveries). Chantiers has the ability to construct two large cruise-ships per annum (this translates to a max of around 10k berths of supply). Combined, we believe the existing industry capacity is ~40k berths. Shown below are the scheduled deliveries by shipyard (represented in berths):

What supports 40k berths as the top-3 players’ capacity, very simply, is that none of these players are adding new near-term orders to their backlog (i.e. new orders are added to the book in the 2024+ time-frame); they are sold out in the medium term. 

We do not envision capacity expansion by the existing players. Even if they wanted to, they do not (to our understanding) possess an ability to expand the large shipyard locations they operate in (these locations are huge already and take up swaths of the coast). On the margin, they may be able to complete construction at a faster pace by incrementally employing smaller shipyards to pre-fabricate certain sections. 

There are two potential new entrants of note -- MV Werften and CSSC/SWS:

• MV Werften
  
  • MV Werften (subsidiary of Genting) has focused on smaller expedition-class cruise ships historically. In 2016, MV Werften purchased three shipyards from Nordic Yards for EUR 231mm (Wismar, Warnemunde and Stralsund). We believe these shipyards (based on press releases) can produce 150k tons of cruise capacity (a ~4k berth ship). 
    • Their stated goal is as follows: “Ownership of the yards provides certainty that we can build a fleet of high quality cruise ships at a pace dictated by our growth rather than constrained by supply as cruise ship order book continues to reach an all-time high, with orders placed out as far as 2026.” 
  • Based on expected deliveries, MV Werften is due to deliver a 5k berth ship (Dream Cruises) and an 0.8k berth ship in 2022, so we estimate around 6k of total capacity for them (starting to hit the market in 2021). 
• CSSC / SWS
  • In late 2018, CSSC (Chinese shipbuilder) launched a JV with Carnival called CSSC Carnival Cruise Shipping which plans to operate its own fleet of cruise-ships to serve Chinese guests (this is a new cruise-liner entrant). The JV has purchased existing ships to supply the Chinese market and has placed on order two new cruise ships to be constructed by Shanghai Waigaoqiao Shipbuilding Co (“SWS” – expected delivery date in 2023). 
  • SWS is not capable of fabricating large cruise ships itself. They have employed the help of Fincantieri (in a separate JV with CSSC) to provide “technical and project service support to SWS throughout the shipbuilding process.” We do not know the full extent of this arrangement but note that Fincantieri is unlikely to have engaged in this business if it did not get an appropriate share of the pie (or if it thought SWS would steal their technology and displace them somehow). 
    
    • My sense is that this move is more to appease the Chinese government (allowing foreign cruise-liners to operate in the region only if they attempt to foster local ship construction). 
  • As the only ship confirmed in the order book in our data is a 5k berth ship, we use this as the capacity figure for the CSSC complex. 

It is not a given that MV Werften or the CSSC complex are successful in their ambitions. The last time an eastern player attempted to enter the market, they lost billions of dollars. This was Mitsubishi Heavy, an otherwise successful shipbuilder (Japan’s #4), which announced its exit from the cruise market in 2016 after booking a cumulative $2.3bn loss over the prior three years from cost overruns and delays in construction of two 100k ton cruise-ships (customer was Carnival). “The construction of the vessels for Carnival was plagued by faulty engines, late design changes and onboard fires that delayed delivery by more than a year and increased construction costs by almost 4x … in the future Mitsubishi Heavy will build smaller vessels that it can manage.” This bodes poorly for the even Chinese players’ limited ambitions to be fruitful. 

Assuming these new players are successful, I arrive at total industry capacity of 40k from ’11 to ’20 (could be off) which will grow to 51k by 2023 – which will still result in a tight market. Utilization is flexing from a 50% rate historically to 90%+ for the foreseeable future (for 2024/2025 I use the normalized 6% demand figure discussed above); therefore I expect the currently favorable s/d environment to last for years to come. As I calculate the market to have only started getting tight in the 2018/2019 time-frame (and due to the POC accounting discussed later), the bulk of pricing growth will not flow through until the 2021-2023 time-frame (3-4 yr lead-time):

Pricing

Most importantly, Fincantieri accruing pricing power from this supply/demand environment is not just my conjecture based on common business & economic sense. If one carefully looks at the press releases reported by the major cruise liners, we can see that pricing has already come up for ships in Fincantieri’s backlog. No one seems to be paying attention to this, despite it being obvious.

Please see the appendix for a full list of ships; below one can see that pricing / berth for >90k ton ships grows significantly (a cumulative 30%) through 2023 (we expect 2024+ to be growth years as well once new orders flow in). This will lead to expanding margins. >90k ton pricing is the key metric as it represents the majority of their revenue: 

Valuation

So we basically have confirmation that pricing is coming up significantly for Fincantieri’s large cruise ship fabrication (on orders already in the backlog). Fincantieri discloses that its POC schedule for cruise fabrication is as follows: 3-5% (first 12 months, for design), 50-55% (the next 10-17 months, hull assembly), and 40-45% (the last 8-12 months, outfitting/sea trials/delivery).   

This means that pricing flowing through reporting financials is ~45% constituted of 3-4 year old market dynamics. Resultantly, we should see natural progression of higher pricing from 1) this accounting effect and 2) further like-for-like pricing that flows through from the backlog. My calculation of this effect is somewhat complex, so I have put it in the appendix – happy to answer questions on it. 

I estimate that the 30% pricing growth per berth from 2019 to 2023 will only partially flow through to Fincantieri’s bottom line. As ~70% of their construction is done through a supplier network (which would share benefits from increased pricing / tight capacity), I assume only 30% of the increased pricing flows through directly through to EBITDA.

Here is what the effect of this looks like on large (>90k ton) cruise EBITDA margin; we are going from 10.5% in 2019 to 14.1% by 2023:

In addition to the growth expected in the core cruise segment, I expect losses to abate in the expedition-cruise vessel business and O&G. I do not want to belabor the points here (happy to discuss further in Q&A), but they are losing about EUR 75mm in their offshore segment currently and I estimate EUR 25mm in their expedition business (not disclosed). The Company has already taken steps to solve these issues – they are shutting down some offshore shipyards in the Nordic region (to rationalize the cost structure) and noted that they are progressing along the learning curve for their expedition-cruise business (which I estimate has better go-forward pricing, anyway, in the backlog). 

The result is – over the next four years, I expect Cruise EBITDA to double (cruise EBITDA goes from EUR 265mm in 2019 to EUR 515mm in 2023). I hold the navy business flat, slightly grow the services business, and assume offshore losses stabilize by 2023:

Capitalizing 2023 FCF (excl. working cap effects) at 8x results in a 28% IRR (or a 3x). 

I believe the current valuation is ~80% covered by the current backlog. Below I NPV the cash thrown off by the cruise and naval backlog (attributing four years worth of services EBITDA and WholeCo capex and interest). So giving no terminal value, the worst case is a down 23%: 

Appendix:

POC Schedule

Backlog and Pricing Detailed

RCL Return on Equity

STX France Acquisition

In February of 2018, Fincantieri signed a purchase agreement for 50% of STX France from the French State (the Agence des Partisipations de l’Etat). Further, Fincantieri is “borrowing” an additional 1% of shares from the French State (so Fincantieri will effectively have majority control). This acquisition is pending regulatory review; to the extent it is approved this will consolidate the current three player market to two players. We do not include this in our base-case, but the benefit of this transaction is fairly obvious (and would support much greater pricing on a go-forward basis). 

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation. This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Pricing flowing through backlog into revenue

Realized higher cruise fabrication margins