Summary

NCLH is a short because it is:

- overvalued on a relative and absolute basis

- highly indebted

- misperceived as a superior operation and ongoing turnaround

- cash flow negative (at least over the next two years)

- subject to its private equity sponsors cashing out

In my opinion, the best risk/reward is to short it against CCL.

Discussion

In a nutshell, NCLH is a low ROI, capital intensive, cyclical, and highly indebted enterprise whose private equity sponsor is most likely looking to cash out trading at 16.5x 2012 and 14.4x 2013 Ebitda.  It peers, CCL and RCL trade at 10x, which is already pretty rich.

On top of the unfavorable characteristics mentioned above, the company is highly vulnerable to a number of risks.  Perhaps the most significant, an increase in interest rates would kill their earnings, cash flow and ability to grow.  An accident or epidemic would most likely put a severe dent in the stock.  Similarly, albeit a remote possibility, a change in tax laws making what is aUSbusiness payUSincome tax would also be quite detrimental.  Finally, their target customer seems to be under pressure to maintain purchasing power.

NCLH trades well above replacement value despite a weak ROI profile.  CCL and RCL trade well below replacement value, which makes sense given the relatively low ROIs.  Based on the information I have, NCLH trades at 150% of replacement value, while CCL and RCL trade at 90% and 80% respectively.

There is no good reason for the valuation premium.  First, NCLH lacks a competitive advantage.  Despite the prospectus enumerating several competitive advantages, including “Freestyle cruising”, slightly younger fleet with 48% of rooms with balcony, and great service, objective metrics tell a different story.  In reality, these “competitive advantages” are meaningless/easy-to-copy.  Second, NCLH is not a better operation (as will be shown below).  Third, it has the weakest balance sheet and cash generation profile in the foreseeable future.

On all relevant operating metrics NCLH is below or at best on-par with its peers:

As can be seen, CCL is the best operator.  It also has the strongest balance sheet and the best cash flow profile.  It pays a regular dividend (~2.6% yield) and in late 2012 paid a special dividend.  Net debt to 2012 Ebitda stands at 2.6x, while RCL and NCLH show 5.5x and 5.0x respectively.

CCL has been able to grow and update its fleet while generating cash (cash from ops-capex>0).  On their part, NCLH and RCL are only able to grow or update their fleet by borrowing heavily.

Over the next two years, 2013 and 2014, NCLH will significantly add capacity.  Consequently its cash flow will be negative.

It seems to me that the market is giving NCLH an undue premium because of its near term growth prospects.  Its top line will probably grow 14-15% in each of 2013 and 2014.  On top of this growth, the company will also benefit from lower interest expense as a result of reducing debt with its IPO proceeds and a recent refinancing of high coupon debt.  By my calculations, cash flow from operations will grow in the same range.

Even accounting for this growth, the valuation would still be quite rich a year from now.  On my estimates of end of fy13 net debt and fy14 Ebitda, NCLH still trades at 13x.

In the mean time, the private equity sponsors are most likely looking to cash out.  This investment is over five years old and shows a nice IRR on a significant amount of capital.  The IPO lock up expires in mid-July of this year.

It seems to me that the story has been sold as that of huge improvement since 2008, which needless to say was a trough year for the whole industry.  From my perspective, NCLH has already achieved its optimal operating metrics.  And thus, the value of the improvements made since 2008 has accrued to the private equity sponsors.  And so has the value associated to the near term growth and refinancing initiatives.

In terms of catalyst, while I can’t foresee a specific event that will eliminate the valuation premium, I like the idea of NCLH having negative cash flow while CCL generates substantial amount of cash and distributes a portion of it to its shareholders.