Description

Summary

I am recommending a long position in Norwegian Cruise Line Holdings (NCLH). I believe the company is worth ~$75 one year from now, or ~30% upside to the current stock price. NCLH has a market capitalization of $13.9 billion and enterprise value of $19.4 billion. There is a short (thesis) write-up on the company in 2013 by Coyote05, which I believe to be outdated at this point but worth reading to get a balanced view. While the write-up is a bit longer, I will try to cover the key drivers of the long thesis in the summery section (below). 

NCLH is a diversified cruise line operator that operates 3 brands spanning market segments from contemporary to luxury. Norwegian brand owns and operates 13 ships in contemporary end market; Oceania brand owns and operates 5 ships in upper premium end market; Regent Seven Seas brand owns and operates 3 ships in luxury end market. These three brands operate a combined 21 ships with approximately 40,000 lower berths (beds). NCLH is planning on introducing 6 new ships through 2019, thereby growing the fleet to 27 ships.

The thesis here is that the cruise line industry is at an inflection point, and that NCLH is best positioned to benefit from it as well as from other company specific initiatives. 

As background, historically the cruise line industry was led by CEOs that were building empires and not putting enough focus on profitability. As such, over last 20 years the capacity grew at ~5% CAGR while the ROIC declined from low-to-mid teens in 1990s to mid-single digits today. Some of this ROIC decline was offset by the fact that ship financing became very cheap over time (big cruise lines get 2.5-3.5% fixed cost financing packages on a new ship from Export-Import agencies), which also fueled capacity growth (circular). As such, the cruise lines have not been great investments historically (as a reference, CCL’s share price has been flattish over last 10 years). Over time, especially more recently, there have been couple of changes in the industry that should create an attractive opportunity as the industry is approaching an inflection point at which time the focus is shifting to profitability from capacity growth (discussed in more detail below). 

One big change happened in 2013, when Arnold Donald replaced Micky Arison (empire builder) as the CEO of Carnival (CCL). Following two well publicized incidents (2012 ship wreckage and 2013 adrift of a ship), Arnold Donald was brought in from the agriculture biotech sector to run CCL (where he sat on its Board for 12 years prior to becoming a CEO). His big focus has been on reaching double digit ROIC over next 3-4 years through increased yields, better cost management and disciplined capex spending. Accordingly, CCL has achieved strong progress on this front since the goal was communicated to the market.  Obviously, this is very encouraging for the entire cruise industry since CCL is the largest cruise line operator with 100+ ships, more than double the size of its nearest competitor Royal Caribbean (RCL) and 5x the size of NCLH. 

Within an improving industry backdrop, I believe that NCLH is the most attractive due to its size and management. NCLH has a much smaller and younger fleet, and as a result enjoys much better operating and financial metrics compared to RCL and CCL. NCLH’s Investor Day materials cover this benchmarking quite well, so I suggest you review it. As a result of its fleet size, each new ship will be a significant contributor to NCLH’s top line and earnings growth. Note that these new ships have superior economics (higher yields, higher occupancy and lower costs) and thus meaningfully contribute to the bottom line. Also, the cruise line penetration (of the entire population) continues to increase which results in very little cannibalization of older ships.  If that’s a concern of yours there’s a quite a bit of sell-side data out there on this matter, and China expansion serves as a “release valve” for all the new capacity coming to the market. 

The other reason why I prefer NCLH over its peers is Frank Del Rio (FDR), recently appointed CEO and former CEO of Prestige Group. Following NCLH’s acquisition of Prestige Group (Oceania and Regen Seven Seas), FDR replaced Kevin Sheehan as the CEO. FDR has an impressive track record in the cruise line industry, and thus appears to be an upgrade to the previous CEO Kevin Sheehan. Several months after his arrival, FDR outlined his “New Deal” which is incremental to Sheehan’s $5.00 EPS goal by 2017-end, though the long-term guidance of $5.00 EPS by 2017 remains unchanged. In essence, FDR’s New Deal focuses on improving yields and cutting costs through reorganizing the management team, changing the go-to-market strategy, changing itineraries, increasing pricing, cutting costs (beyond transaction synergies), etc. Therefore I believe that $5.00 EPS goal in 2017 is overly conservative, and even FDR suggested that if one gives credit to his initiatives the 2017 EPS should be in excess of $5.00 (though he hasn’t quantified it). 

When valuing NCLH, I focus on EPS as EBITDA multiple might be slightly inflated since cruise lines pay almost no taxes. Conservatively, I’m arriving at $5.15 EPS in 2017. Assuming 15x NTM PE multiple at exit, which is where cruise lines are trading today, I arrive at $77 per share at 2016-end or 30% premium to current share price. My assumptions reflect NCLH’s initial long-term guidance, which I believe to be very achievable based on my work to date. To put it in perspective, I’m not assuming any improvements arising from the FDR’s New Deal and I’m still assuming $80p/bbl for the unhedged portion of fuel cost in 2016 and 2017. So I believe I’m fairly conservative in my approach. 

Key Assumptions

Since NCLH is performing in line with its guidance for 1H2015, I’m assuming that 2015 ends up lower end of guidance range of $2.80-2.90EPS. Below, I discuss the key drivers of my model for 2016 and 2017. 

New ship deployment is in line with NCLH’s forward ship order (covered in 10K) 

Occupancy in line with historical performance (109% for Norwegian and 95% for Prestige brands).  

Net Yield growth of 3.5% (on constant currency basis): existing fleet should generate ~2% yields and new builds would account for the remaining difference – as previously discussed new ships have better economics. This assumption is consistent with historical trends for the all three NCLH brands.

Net Cruise cost excluding fuel growth of 1.5% (on constant currency basis). This is in line with historical performance, though historical costs ex-fuel have been volatile. 

Fuel costs are based on the hedged prices for hedged fuel volumes (per 2Q2015 data) and $80p/bbl for the unhedged fuel. Note that 54% and 44% of 2016 and 2017 fuel has been hedged. 

I assume to de-lever quite quickly and assume share buybacks to hold the leverage at 3.5x.  

Capex and other assumptions are based on long-term guidance.

Investment Highlights

Below is a more detailed discussion of favorable changes and trends in the cruise line industry: 

(i) The cruise line industry has undergone significant consolidation over last several decades – top 3 players (CCL, RCL and NCLH) hold over 90% market share in the North America today vs. ~30% in 1990s. 

(ii) Since 2013, two out of the three biggest cruise lines (CCL and NCLH) changed leadership. With these leadership changes, all three operators committed to significantly growing earnings and achieving double digit ROIC over next 3-4 years. NCLH is hoping to double EPS by 2017 and double (or reach 14%) ROIC by 2018; RCL announced its goal of doubling 2014 EPS and achieving double digit ROIC by 2017; CCL management is targeting double digit ROIC over next 3 to 4 years.

(iii) To achieve double digit ROIC the cruise lines are looking to drive net yield growth by (a) eliminating the last minute discounting, (b) introducing new ships and (c) recovering lost pricing. Cruise ships are managed to full capacity (over 100%) so the ticket pricing tends to drop significantly during last 30 days in order to achieve target boat capacity. Recently, cruise lines have indicated that they’ll stop the heavy discounting that occurs 30 days prior to the actual trip, and to achieve this they’re willing to give up some capacity utilization. This should increase pricing over time. Also, new ships are quite popular with cruise line passengers as they have the latest and greatest entertainment venues, and as such they enjoy better pricing / higher yields. As the new ships replace the old ships, the overall net yields are expected to improve. Lastly, the general pricing over last two years has been weak due to two incidents, one ship sank and another had an engine fire, which put pressure on the overall industry pricing. Since these incidents are behind us, the cruise line industry is hoping to recover some of the pricing growth lost over last couple of years (during which lodging and entertainment parks enjoyed much healthier pricing growth). 

(iv) Probably the biggest swing factor for this industry is development of Chinese cruise market. Thus far the pace of cruising development in China continues to be impressive (even in the current environment). Both CCL and RCL continue to post impressive results in China, frequently mentioning that Chinese ships are the highest yielding ships in their fleet. Majority of CCL’s and RCL’s new capacity coming online is intended for China, meanwhile NCLH is still evaluating if it should enter Chinese market. 

(v) The other tailwind for the industry is the fuel expense saving that should arise in the current oil price environment. Fuel costs represent ~20% of cruise line’s operating costs or 9-12% of revenue. Historically, the fuel price has been a headwind, but the recent drop in oil prices / forward oil curve suggest that there could be upside to the near term goals of doubling the EPS. As a reference, I’m modeling in $80p/bbl oil price in 2016 and 2017 for unhedged portion, which is above the forward oil curve cost. 

Aside from the favorable industry trends, I like NCLH due to its scale and leadership.

(i) With 21 ships, NCLH is substantially smaller than its peers CCL and RCL that have ~100 and ~40 ships, respectively. Given its smaller scale each new ship has a larger mix impact on NCLH’s top line and earnings, especially since the new ships are ~2x the size of older ships and more economical. Another reason to like NCLH is because it’s a better operator – NCLH enjoys superior operating and financial metrics when benchmarked against its competitors. 

(ii) Recently appointed CEO, Frank Del Rio, has quite an impressive track record in this sector. He started Oceania cruise line in 2002 with $14M equity investment, sold 50% equity stake to Apollo in 2007 valued at $475M. With Apollo, he acquired Regent Seven Seas, a luxury cruise line, in 2008 to create Prestige. Prestige was sold to Norwegian in November 2014 for $3B (EV value). While at Prestige, FDR has pursued a unique go-to-market strategy of “marketing-to-fill” as opposed to “discounting-to-fill” that the rest of the industry implements. This has resulted in Prestige enjoying highest per diem ticket prices in the entire cruise line industry. In January 2015, FDR was promoted to be NCLH’s new CEO, following departure of Kevin Sheehan (which didn’t seem to be voluntary but that’s my speculation). Few months later, FDR introduced a new strategic plan called FDR’s New Deal. The plan focuses on driving growth in yields and cutting costs, with specific initiatives outlined in the investor day materials. Since FDR was promoted to CEO, NCLH has already surpassed synergy goals outlined by the previous CEO, the booking trends are the best they’ve ever been, and he’s making solid progress on FDR’s New Deal. But it’s important to note that the overall trends in the sector are improving across all 3 major players so it’s difficult to differentiate FDR’s impact from the overall market.  

Concerns / Risks

My biggest concern for this investment is that the capacity outgrows the demand – thus my reference to China being the swing factor. The capacity growth over next 2-3 years is pretty certain (within a narrow range) given that there is a small number of ship yards that can produce these large cruise ships, which are booked at full capacity. But one might find it difficult to get comfort around capacity absorption and its effect on future pricing (net yield). Furthermore, the incentives don’t seemed to be aligned properly just yet – every cruise line wants to introduce new ships as they’re earning higher yields, and ship financing costs are at all-time lows. In the meantime, there’s been very little capacity taken-out over the years and older ships (which are passed down to smaller cruise lines) put pressure on pricing. So if China doesn’t absorb the new capacity these assets are movable and they’ll be moved to more attractive markets where they’ll compete down the pricing which directly impacts the earnings profile of these businesses. My work to date suggests that Chinese market is significantly underpenetrated with only ~0.25% penetration of the middle class vs. 3.5% penetration rate in the US. More importantly, all the relevant indicators are suggesting that China is growing, as both RCL and CCL are showing very strong bookings and pricing trends on increased deployments in China over last couple of quarters. Therefore, I’m quite comfortable that China can absorb majority of new capacity coming online over next 2-3 years. Also, since cruising is so underdeveloped in China, I do not expect it to be impacted by recent events in China (at least not on the same scale) and thus far the commentary from earnings calls has been positive, unlike for some other sectors. 

By investing in NCLH you are also indirectly betting on success of CCL and RCL. CCL and RCL are much larger with 100+ and 40+ ships, respectively, compared to NCLH which has 13 contemporary ships and 8 luxury/premium ships. When CCL and RCL discount their trips, NCLH must follow as they cannot differentiate too much on pricing. Given the recent commentary during earnings calls I’m increasingly more confident that all cruise lines are looking to improve yields and profitability. However, the real concern arises if a particular cruise line has an incident that would put pricing pressure on the entire industry. The good news is that cruise industry always recovers from these incidents, but the bad news is that these “one-time” events happen frequently: Norwalk-like virus (2002), oil price spike (2007), Arab Spring (2011), Italy cruise ship sinking (2012), engine fire/ship adrift (2013), Ebola scare (2014), etc.

Management initiatives on aggressively growing EPS and improving ROIC are nothing new, these promises have been made before. While I dislike “this time it’s different” arguments, the recent management changes as well as commentary around disciplined pricing over last couple of quarters are indicators of tangible changes in the industry. So compared to prior instances, there are more data points today to support my “this time it’s different” thesis. 

With 47% of its debt having variable interest rate, NCLH has some exposure to interest rate hikes. As a reference, the 10-K notes that 1% increase in interest rate would result in $29 million of incremental interest cost, which would results in ~$0.13 hit on EPS in 2014, which should decrease in 2015 and 2016 as the business de-levers.

Conclusion

In summary, I believe NCLH presents an attractive short-term investment opportunity. While it’s difficult to argue that this is a great business due to its capital intensity and other factors outlined above, one should really focus on the earnings growth opportunity over the near term arising largely from capacity growth, but also from pricing increase, lower fuel costs and deleveraging.

Catalyst

NCLH should de-lever to target leverage range by the 2016-end, at which time I expect management to start returning capital to shareholders. Management has indicated that they’ll look to return capital to shareholders once they reach the 3-4x target leverage range, at which time they’ll look to repurchase shares. Additionally, management has already indicated that “it’s a matter of time before a dividend is implemented” as they’re looking to “broaden the investor base”.