Variant Thesis:

Near-universal bullish consensus suggests NCLH is poised to benefit from uninterrupted favorable industry cyclical/secular trends including current ATH booked load factor (occ’y) on record booking curve length, “more rational” supply growth and an emerging third cruise sphere in Asia (in addition to existing N American and Europe spheres). These dynamics are expected to support rapid earnings growth ($5.00 EPS guide in ’17 or +32% CAGR) driven by +3-4% net revenue yield (NRY) growth and +1.0-2.0% net cruise costs ex fuel (NCC ex fuel) growth per available berth day (ALBD) driven by heightened ROIC focus, lower oil (bunker fuel) prices and synergies from the acquisition of upscale operator Prestige Cruises in late ‘14. This contrasts with the variant view that NCLH faces under-appreciated category and company-specific risks that when combined with peak valuation metrics applied to extrapolated EPS estimates deep into the cruise-pricing cycle create asymmetric risk/reward. In fact, NCLH exhibits several attractive short-side characteristics including potentially forced M&A, peaking cyclical demand metrics, material management turnover, massive insider selling and bullish consensus that leaves significant room for downside dynamics relative to lofty expectations.

The negative thesis rests on the premise that unique cyclical cruise pricing dynamics are not well understood by the Street and that recent checks suggest the cruise industry’s key fund’l and sentiment indicator – NRYs – may be peaking. Should this “it’s not different this time” cyclical call prove correct then all three cruise pure plays (CCL, RCL and NCLH) will trade materially lower with RCL and NCLH exhibiting the most downside owing largely to heavier financial and operating leverage characteristics.

NCLH appears particularly compelling owing to significant company-specific risks including recent forced M&A that brought heavy exposure to the capital-intensive and highly volatile upscale/luxury segment, significant management turnover, a shift toward unproven revenue-driven operating strategies at the core NCL brand, exposure to the resurgence of category-leader CCL and $2.9B of YTD insider selling all set against a recent re-rating to a premium relative valuation (vs historical discount) and extrapolated consensus expectations for outsized +32% EPS CAGR through 2017 that appear wildly optimistic.

Target is $38/share or 12x (vs trailing two-year NTM range of 13.3x-19.2x) 2016 EPS of $3.20 vs consensus of $3.87 on flattish NRYs (implies negative inflection in 2H 2016 owing to lag driven by healthy current fill) vs +3-4% implied in consensus and corresponds to ~39% downside. The lower 12x multiple is warranted because during periods when NRY declines are anticipated cruise multiples tends to compress materially below ranges set during periods of NRY growth. Moreover, further downside can be expected as the cycle takes hold and a forecast -3% decline in 2017 NRYs suggests EPS of $2.55 vs mgmt guide of $5 and Street consensus of $4.89. Realistically, this is a six to nine-month TP as multiple catalysts illuminating the potential for our well below-consensus expectations and undermining the bullish belief set should materialize by the end of the heavy cruise selling period – wave season – which runs from mid-Jan through mid-Mar.   

Under-Appreciated Category Risks:

• Cyclical cruise pricing again being mistaken for being secular – With six years of NRY improvement, China as a new source market and Cuba opening up, investors are mistaking cruise NRY growth as secular not cyclical. So despite trading at ATHs the stocks continue to “look cheap” on extrapolated estimates that assume cont’d +LSD NRY growth. The reality is that cruise pricing is cyclical and it’s “different this time” only in terms of the extended duration of the current cycle which may be coming to an end. Historically NRYs show little correlation to capacity growth owing to the industry’s unique “book-to-fill” strategy so the bullish “rational supply growth” argument holds little sway. The cycle typically rolls every three years as an external event (war, terror attack, recession, ship incident, etc) causes the booking curve to shrink and necessitates heavy close-in discounting to drive fill (typically takes two years to re-establish a normal lengthening booking curve). With the current elongated curve and ATH ticket pricing, demand has grown particularly susceptible to external dynamics because of strong price elasticity created by operators “giving away” the product in periods of slack demand. Checks indicating sequentially weakening N. American-source booking volume throughout August suggests the current EM/Chinese crisis and resultant US equity market weakness represents the catalyst to drive an inflection in the cruise booking curve.

• Evidence of a top in peak booking curve and booked load factor metrics – Recent distributor checks suggest weaker call volume and sub-par conversion albeit in a seasonally slow booking period. Recent equity market volatility is cited as the cause of this weakness and while operators have yet to respond with incremental tactical incentives there is a heightened sense of “nervousness.” Given an already elongated booking curve incremental efforts to extend the curve into 2016 appear to be meeting with limited efficacy. In addition, per CCL’s recent segment disclosure and commentary the European market is already softer y/y on macro and currency impacts. And while the bullish counter is that the major operators are well booked into 1Q 2016, the last 10% of fill and onboard spend typically determines performance vs guidance.

• High sensitivity to NRY change cuts both ways – Given cruise is a leverage-driven, high fixed-cost, capital-intensive business with heavy sensitivity to changes in NRYs (100bps change in 2016 NRYs equals $0.16/share for NCLH), negative inflections are met with multiple compression. In fact, cruise equities tend to have entirely different ranges for periods of improving (higher) and declining (lower) NRYs. So negative NRYs are met with trough multiples as extrapolation of highly sensitive NRY changes works both ways. And the Street has consistently over-estimated both NRY upside and downside (seemingly under-estimating heavy price elasticity i.e. consumers don’t pay up for a highly discretionary product that has not infrequent “fire-sales” but they will seemingly come out of nowhere when the price is “right” which can be as low as $50/night).

• Increasing visibility on negative implications from burgeoning “sharing” and “on-demand” trends – The rise of alternative accommodations providers such as AirBnB, HomeAway and Villas.com, etc. presents a long-term threat through increased access to competitive leisure travel supply through increasingly seamless consumer APIs and at prices that erode the trad’l “unbeatable relative value proposition” in cruise especially for families. Look for more sell-side analysts to focus on this sea change especially since distributors appear to already be concerned. Moreover, the proliferation of heavily discounted last-minute “on-demand” lodging inventory through OTAs such as Booking.com and specific distributors such as HotelTonight may also begin weighing on cruise operators’ ability to offset weaker close-in demand with discounting in the next downturn.     

Under-Appreciated Company-Specific Risks:

• Prestige as forced M&A near the top of the cycle – NCLH closed on the acquisition of upscale/luxury cruise operator Prestige Cruises in Nov ’14 for total consideration of $3.1B including the assumption of $1.8B in debt or 12x a TTM EBITDA figure that was 58% higher vs 2011. Having benefitted from share shift away from CCL in 2013-14, NCL’s passenger ticket yield ~10% above prior peak and operating income per berth approaching CCL’s mid-$50s historical high-water mark suggest potential for negative price elasticity and limited incremental margin opp’y at NCL stand-alone. This could have been behind the rationale and timing of the Prestige buy that had Apollo Mgmt on both sides (Prestige was 80%-owned by Apollo which owned 20% of NCLH at time and controls NCLH’s BoD).

• Highly cyclical/volatile upscale/luxury segment exposure - Despite benefitting from an elongated booking curve and high per diems, the upscale/luxury segment is characterized by heavy capital and service intensity, greater operating volatility/cyclical exposure and lower-margins. The luxury segment also benefited from the combination of virtually no net supply growth in 2013-14 and strong wealth effects on the heels of 2013 equity market gains that increased HH net worth by ~$10T. At 15% of NCLH’s berth capacity (highest upscale exposure among peers by far), Prestige brings material incremental operating volatility and cyclicality (less price elasticity thus loss of load factor in weak demand environment creates large swings in NRYs). There is precedent for 10-20% swings in up-scale/luxury NRYs even in periods of relative demand strength in the broader cruise category. Moreover, the upscale space has been known to have wider swings in profitability given the narrower margins associated with maintaining a competitive, largely all-inclusive product characterized by high service levels and far-flung exotic itineraries.

• Outsized luxury segment supply growth – While bulls cite “more rational” +LSD annual supply growth in the broader cruise category, Prestige faces a +40% increase in total luxury berth capacity in 2016 (although Oceania is defined as “upper-premium” discounting tends to blur segment definition to the downside as small-ship upper-premium becomes more competitive with luxury, etc.). And mounting evidence such as Prestige’s recently missed earn-out targets, lagging pro forma customer deposits growth and travel agent feedback (“reduced interest,” “evidence of deferrals,” “need for more compelling promotional activity”) suggest upscale demand may already be slowing ahead of this substantial increase in supply. While equity market volatility was cited by nearly every luxury-focused distributor, we also heard feedback about near-term deferrals in front of several new vessel intros in ’16 including NCLH’s highly touted Regent Seven Seas Explorer.  

• Mgmt turnover subsequent to Prestige acquisition – The Street appears enamoured with new CEO F Del Rio and the promise of his articulated “FDR’s New Deal” strategy. But the strong track record of value creation driven by former CEO K Sheehan who resigned after the Prestige closing should hold more sway – at least until there’s evidence FDR’s New Deal can actually drive sustainable shareholder value. Coming from outside the category, K Sheehan built an impressive track record of cash flow and ROIC growth (timing of his tenure was also cyclically favourable). Should NCLH have difficulty meeting the lofty goals set out in FDR’s New Deal, investors may yearn for the “good-old days” with K Sheehan at the helm. In addition, NCL’s brand president & COO departed post the acquisition along with a number of additional and less-visible lower-level executives down through the organization and across multiple functional areas.

• Applying upscale revenue-driven strategies to NCL’s already strong contemporary brand – Under former CEO K Sheehan’s leadership the NCL brand flourished and transformed from category laggard to category leader. Under “FDR’s New Deal” NCL is investing to improve the onboard product (i.e. food) to drive brand loyalty (historically a challenge in the category). To offset the higher costs the strategy calls for new upcharges and increased pricing across various onboard products/services – changes that have been well documented by the cruise blogging and travel agent communities. These changes are consistent with a revenue-driven approach more suited to up-market brands and top-of-market “promote to fill” strategies will likely quickly degrade back to “discount-to-fill” when operators are faced with a shrinking booking curve and the potential for material loss of load factor. History in cruise suggests there’s a long list of items the consumer wants but a much shorter list of items they’re willing to pay for. And already blogs and industry forums suggest consumers – even “loyal” NCL customers – recognize and are concerned about being “nickel and dimed” by recent revenue actions.

• Tailwind from CCL retrenchment now a headwind owing to competitive resurgence – We believe the pricing cycle was elongated/boosted for NCLH and RCL owing to high-profile ship incidents suffered by industry bellwether CCL (Costa Concordia in 1Q ‘12 and Carnival Triumph in 1Q ‘13). Costa and Carnival Cruise Lines’ immediate brand impairment and subsequent retrenchment drove share shift to other brands including NCL throughout 2013-14 as both brands lost significant relevancy/support from both consumers and travel agents. CCL’s response was to heavily re-invest in both capital (hardware re-furbs/upgrades) and op ex (soft product/service) to re-establish consumer and travel agent relevancy particularly at the CCL brand. CCL’s fin’l results and distributor feedback both suggest these initiatives have met with considerable success especially at the CCL brand which has become significantly more relevant in the core short-cruise and seven-day Caribbean market. Thus a prior tailwind is increasingly a headwind for the NCL brand as Carnival in particular continues to regain consumer and travel agent relevancy especially in the Caribbean.

• Aggressive extrapolated consensus estimates based off mgmt targets – Sell-side forecasts embed cont’d +3-4% NRY improvement (vs +1.2% avg annual industry NRY growth since 1990) six years into a cycle that normally runs three years on avg. These extrapolated expectations show little room for error (+34% EPS growth in ’16 and +26% in ’17 or seven and eight years into cycle, respectively). Moreover, visibility on the primary variable – NRY growth – even one year out is limited and the currently elongated booking curve is highly susceptible to external “shocks” and in fact already appears to be shrinking owing to the recent Chinese meltdown and subsequent US equity market correction.

Street consensus shows NCLH as a mid-teens top-line grower (+LDD unit growth plus +3-4% NRYs), mid-20s EBITDA grower on modest op leverage and a low-30s EPS grower on deleveraging. Not surprisingly, consensus expectations are roughly in line with mgmt’s LT targets. A base case scenario suggests much lower growth in 2016 on a 2H inflection in NRYs and a steep decline in 2017 EPS as the company cycles through a likely period of lower passenger ticket pricing, occupancy (more pronounced at Prestige) and onboard spend.

Long-Term Mgmt/Street Targets

Mgmt’s 2017 $5 EPS target is highly dependent on its +3-4% NRY growth target. This implies acceleration vs trailing four-year NRY CAGR of +3% and 2015 guide of +3% six years into the cycle while the cruise category has grown at a cyclical +1% CAGR since 1990. In addition, adj EBITDA margins above 30% compare with flat 2015E (consensus) of 28.1% and would be unprecedented in the cruise category.

Valuation Considerations:

At $62.50/share NCLH’s current EV is $20.0B including net debt of $5.6B (4.3x net leverage). Using consensus estimates, EV is 15.4x NTM adj EBITDA or high end of trailing two-year NTM range of 10.0-15.5x and avg of 12.6x (every turn is ~$5.30/share).

P/E is typically utilized as primary valuation metric by Street vs EV/EBITDA (latter is really an after-tax CF figure since foreign-flagged cruise companies aren’t subject to US-source income tax under an exemption provided in section 883). Current NTM P/E is 19.1x (consensus) or high end of trailing two-year NTM range of 13.3-19.2x and avg of 15.8x.

NCLH’s 19.1x P/E compares with CCL at 19.9x and RCL at 17.4x (consensus); NCLH had historically traded at a discount to peers but this reversed in 2015 as NCLH’s NTM P/E expanded from 13x in 3Q of 2014 to its current 19x. This is seemingly largely driven by excitement about the merits/benefits of the Prestige combination and despite the fact that NCLH is operating with above-peak NRYs and ATH margins while CCL’s multiple likely reflects both well below-peak NRYs (-12% vs prior peak) and depressed margins (‘15E operating margins ~10ppts off historical highs).

Sentiment is nearly universally bullish with stock price is +34% YTD virtually entirely driven by multiple expansion and +78% vs $35.17 share value established as consideration in Prestige acquisition that closed in Nov. 2014. Short interest is modest 4.5M shares or <3% of float and borrow is readily available.

Sponsors Apollo, Genting and TPG have sold 52.5M shares YTD and still own 75M shares or 33% less than the 114M shares (56%) prior to the Prestige buy (and Apollo received 16.2M NCLH shares for its 80% ownership in Prestige).

Potential Catalysts:

• Indications of slower booking volumes/shrinking booking curve – Equity volatility has shown correlation w/ NT booking volumes (other examples that have materially shrunk the curve and brought heavy discounting include Sep 11, ’98 fin’l crisis/recession, Concordia grounding, etc). The current equity market weakness is already having an impact as checks suggest N American source market booking volumes slowed materially in Aug. despite articulated heavier marketing spend by major operators to continue to elongate booking curve. At previous cycle peaks demand weakness was dismissed and we expect the same especially given duration of this cycle. But sell-side surveys should pick up weakness and indications of heavier discounting and mgmt commentary beginning with CCL 3Q in late Sep. also represents a potential catalyst.

• Increased visibility on upscale/luxury segment demand weakness – There is already mounting evidence that the upscale/luxury segment of the cruise industry is weakening including direct distributor feedback indicating slower booking volumes, unusually heavy tactical discounting of remaining ’15 inventory and increased consumer deferrals in front of unprecedented ’16 new ship intros. In addition, NCLH recently indicated Prestige will not hit its revenue-driven earn-out targets ($50M initially) and Genting HK disclosed earlier this month that it would pay 23% less for luxury operator Crystal Cruises owing to post-closing adjustments despite the deal having just closed in May.

• Potential 4Q guide down – There appears to be little-to-no upside to ’15 EPS guide as low end has been raised <2% on unchanged NRY and despite lower fuel and interest inputs. Mgmt has articulated the need for heavier 2H marketing spend while distracting with raises in “net” synergy targets after both 1Q and 2Q. And the implied EPS ramp in 4Q is daunting as 1H EPS growth of+26% y/y on basically in-line prints and implied 3Q EPS guide +22% y/y implies 4Q growth +50% y/y to reach 2015 consensus.

• Additional aggressive insider selling – Owners Genting, Apollo and TPG have sold 52.5M shares YTD at a weighted avg price of $55.51 or $2.9B of stock in three separate transactions following each quarterly report this year (the latter two highlighted by token $0.05 increases to lower end of initial $2.70-2.90 EPS guide taking it to $2.80-2.90 or mid-point +2% on unchanged NRY guide). Meanwhile the multiple has expanded on increases in “net” synergy targets at both 1Q (from $40M to $55M in ’15 and $50M to $75M in ’16) and 2Q prints (’15 unch and ’16 from $75M to $85M) thus driving the stock +24% YTD and facilitating 20ppts of ownership drawdown from 52% (post Prestige) to 33% currently.

In August Apollo sold 8M shares (~50% of shares received in the Prestige deal) at $59.25 or -6% off ATHs and a 69% premium to the value set at the time of closing in Nov ’14. Genting, Apollo and TPG still own 75M shares or ~33% of the shares out with a 45-day lock up from the most recent Aug 10th offering.

YTD Selling Shareholder Activity

Thesis Risks:

• Continued +LSD NRY growth in ‘16 supports consensus EPS target – Recent demand weakness proves transitory and continued healthy global consumer spending and category positives (modest penetration, relative value, exciting new supply, China) allow operators to maintain record booking curve length and drive +LSD improvement in passenger ticket yields and onboard spend in 2016. And this NRY improvement combined with effective cost control, lower fuel costs and realization of articulated synergies support consensus +34% 2016 EPS growth which would likely drive another material leg up in NCLH’s share price.

• Uncertain timing on visibility in demand weakness – A significant amount of forward cruise volume is already on the books and cruise mgmt teams tend to emphasize positives since travels agents are also keen to determine if heavier discounting is in the cards in the future (agents are paid by cruise lines but have shown they’re loyal to the consumer). Thus it can be difficult to forecast timing of when weaker demand becomes visible enough to impact the bullish narrative. At the top of the last cycle weakness was visible for several months (sell-side checks, high-profile downgrade) before CCL acknowledged the weakness and even then the stocks took two years to eventually bottom in early 2009. Given the potential magnitude of the “bust” portion of the cycle, it’s more likely survey work, directional metrics (the sell-side now recognizes the customer deposits line on the BS can be useful directionally) and qualitative mgmt commentary (CCL is most open and frank – has no lofty “$5.00 EPS in 2017” or “Double-Double by 2017” expectations) will be enough to catalyze material downside.

• Lower oil (bunker fuel) prices as an offset to demand weakness – Incremental fuel cost declines (and to a lesser extent USD weakness) could have a supportive impact on NT EPS estimates. History shows however that demand trumps any favourable cost variability. Model incorporates current bunker pricing and NCLH’s bunker fuel requirements are 54% hedged for 2016 at $468/Mtn equivalent and 44% hedged at $409/Mtn equivalent in 2017 vs. actual 2015 guide of $450/Mtn (excl. hedges) with Brent Crude at $49/bbl as of latest guide.

• Incremental revenue and/or cost synergies – Street has seemingly responded well to recent increases in net synergy targets and there could be more in the offing. However, it appears that nearly a year after closing the any opp’ys to be realized by ’16 would have been articulated by now.   

Cyclical Not Secular Cruise Pricing:

Central to our bearish thesis is the Street is viewing cruise pricing as secular rather than cyclical and that we are deep into the cycle which makes demand (and the all-important length of the booking curve) increasingly sensitive to external dynamics. In the past events including vessel incidents, terror attacks, recessions and equity market weakness have negatively impacted demand for cruises. Historically, negative net yield change inflection points are largely created by external dynamics that cause the industry to get “behind the demand curve” rather than by the more commonly perceived drivers such as supply growth (+HSD NRY growth in ’05-06 was accompanied by +LDD net supply growth) or economic variables (negative NRYs have often led recessions). It appears three particular dynamics cause the industry to roll in a secular pricing cycle including (1) material demand elasticity exacerbated by heavy discounting at bottoms; (2) the major cruise operators’ strategic decision to sail at full 100% occupancy; and (3) the industry’s heavy intermediary dependency. When combined, these dynamics place great pressure on the cruise lines to stay in front of the demand curve and avoid widespread close-in discounting. Transparent last-minute discounting to fill inventory churns the book of business and causes both travel agents and consumers to engage in the practice of waiting until the last minute to book, which is not yield friendly behavior. This business reality is set against challenging broader leisure travel pricing dynamics influenced by the following:

• General perceived lack of scarcity of leisure travel inventory – Consumers feel there is significant availability of leisure travel inventory, such that the purchase decision can be made closer to departure date. While the cruise industry operates at 100% load factor, competing land-based leisure travel alternatives have significant structural excess capacity. Roughly a quarter to a third of resort rooms go unsold every night and that number can climb during the shoulder periods. This can diminish the relative value proposition of a cruise and make yield improvement challenging.

• No shortage of substitutes – Cruising competes with a multitude of land-based vacation alternatives as well as many other activities that vie for share of the consumer’s scarce leisure time. Substitutes limit the potential returns in an industry by placing a ceiling on the prices firms in an industry can profitably charge. Longer term, the rise of seamless access to alternative leisure travel accommodation’s driven by players including AirBnB, HomeAway, Booking.com will increasingly become part of the leisure travel inventory narrative particularly in a weaker demand environment.

• Democratization of leisure travel information – The proliferation of travel information on the Internet has opened up the number of leisure travel alternatives available to the consumer and increased the ability to comparison shop within and across leisure travel alternatives. Consumers have become increasingly comfortable booking complex travel on the Internet as content (virtual tours, reviews, testimonials) and functionality (cruise wizard functions, customizable dynamic packaging) has become increasingly sophisticated and familiarity with complex products has increased.

• Operating model characterized by high fixed costs – High fixed costs (and high incremental returns) create strong pressures for all firms in any industry to operate at capacity. Within the cruise space, this pressure is even more intense as the major operators have strategically decided to operate at 100% utilization. This is driven by low variable costs, potential high-margin onboard revenue capture (now 20-25% of revenues) and the gratuity-driven compensation structure of the hospitality staff (US minimum-wage standards don’t apply to foreign-flagged cruise vessels).

• Capacity augmented in large increments – While a single 3,000 or 4,000-berth cruise ship no longer has the same impact on overall supply growth that it did 10 years ago, individual markets can experience tremendous increases in capacity due to new build introductions and/or vessel transfers.

• Perceived lack of differentiation among brands – This is not uncommon in the broader leisure travel category and is very much the case in cruise despite mgmt rhetoric to the contrary. Strong cyclical results are attributed to “brand strength” and “differentiation initiatives” while inevitable demand weakness is attributed to any number of dynamics including economic weakness, vessel incidents, supply indigestion, etc. Based on the way the product is sold—on the price or the discount—there is relatively little brand differentiation among similarly positioned offerings in the cruise marketplace. This can be attributed in part to the distribution channel’s strong predilection to selling price versus value. Recent attempts to alter this behaviour won’t stick in a weaker demand environment despite bullish views that “This Time Is Different.”

• Proven demand elasticity cuts both ways – High elasticity of demand for the cruise product suggests that lower pricing dramatically expands the addressable market opportunity while higher pricing does exactly the opposite. And historically the Street underestimates the negative elasticity at tops – “booked load will remain higher at higher pricing forever” - and over-estimates it at bottoms – “no one’s going to get on a cruise ship so occ’y is going to get destroyed.” In fact, occ’y for at the trough in 2009 was 105.5%, 102.5% and 109.4% for CCL, RCL and NCLH, respectively.

• Drawbacks of strategic decision to sail at 100% occupancy – In response to dynamics including a high fixed-cost structure, minimal variable costs associated with incremental passengers, increasing importance of high-margin ancillary onboard revenue streams, and gratuity-driven hospitality staff compensation, the major cruise operators have made the strategic decision to sail at 100% load factor. This strategic decision to fill every cabin makes managing the demand curve for cruises a significant challenge. Unlike a hotel operator that will sacrifice incremental occupancy to preserve rate integrity, a cruise line’s revenue management department is charged with filling every cabin. Therefore, it is crucial that a cruise line stays well ahead of the demand curve to avoid having large amounts of inventory left for sale close to the sailing date, which would require transparent heavy discounting. And that’s why CCL, RCL and NCLH each indicated higher 2H marketing spend targeted toward maintaining the current elongated booking curve.

• Heavy intermediary dependency – Owing to the product’s complexity, the cruise industry is the most intermediary-dependent segment of the broader leisure travel category as travel agents book roughly 65-70% of all cruises. (Cruise execs put the number at closer to 80%). Lodging, on the other hand, generates roughly 70% of its distribution either direct to the property or to the property management system primarily through call centers. This high intermediary dependency creates a unique transparency challenge, as travel agents are in the market every day monitoring pricing.

As the graphic illustrates cruise NRYs have shown consistent cyclicality historically. The extended length of the current cycle may be attributable to some combination of factors including the magnitude of the ’08-09 NRY, material Fed-induced wealth effects, benefits to RCL and NCLH from CCL ship incidents in ’12 and ’13, a lull shipbuilding post the Great Recession and significant recent efforts to continue to elongate the booking curve. Nonetheless, extrapolating NRY growth out through ’17-18 when the industry is already six years into a cycle that normally lasts three appears aggressive even without mounting and increasingly visible evidence that the cycle is topping.   

Prestige Acquisition Analysis:

Both industry sources and fin’l data suggest NCL’s NRY and margin-enhancement opportunities may have been becoming more challenging to exploit thus providing the impetus to pursue the Prestige acquisition which was completed in November ‘14. Former CEO K Sheehan initiated the process by consulting fin’l advisors in the spring and subsequently contacting Prestige CEO F Del Rio (notably F Del Rio’s initial value expectation was $3.5B vs realized $3.1B). There is no indication Prestige was shopped despite both CCL and RCL having a history of being consolidators in the space. We suspect there may have been little interest from CCL and/or RCL anyway since both companies have experienced the limited profitability and heavy volatility associated with operating in the small-ship upscale/luxury niche.

There is evidence of negative price elasticity and limited incremental margin opp’y at NCL stand-alone prior to Prestige deal in late 2014 including passenger ticket yield ~10% above prior peak, an inflection in early 2014 whereby customer deposits began lagging forward capacity growth and operating income per berth that approaching CCL’s mid-$50s historical high-water mark. This could have been behind the rationale and timing of the Prestige buy that had Apollo Mgmt on both sides (Prestige was 80%-owned by Apollo which owned 20% of NCLH at time and controls NCLH’s BoD).

Directionally customer deposits vs forward six-month capacity growth can be a helpful indicator. Although it can be skewed by various dynamics including promotions that reduce deposits, in periods of healthy NRY improvement deposits growth typically outpaces forward capacity growth. Also recall that cruise line managements are loathe to acknowledge demand weakness until it’s absolutely necessary because travel agents often key on this commentary, anticipate forthcoming heavier discounting and subsequently lose the urgency to book in advance which exacerbates the downturn. So any directional or channel feedback is important in being early to define an inflection point. The chart below suggests that in late 2013 NCLH’s customer deposits began running behind its next six months capacity growth despite fairly consistent outperformance for the prior four years.

NCLH closed on Prestige in Nov ’14 for total consideration of $3.1B including the assumption of $1.8B in debt or 12x a TTM EBITDA figure that was 58% higher vs 2011. The luxury segment benefited from the combination of virtually no net supply growth in 2013-14 and strong wealth effects on the heels of 2013 equity market gains that increased HH net worth by ~$10T.

Prestige Acquisition Details

Interestingly the contingent consideration of up to $50M was recently reduced to zero based on probability-weighted assumptions that targets would not be met (<98% of target = zero payout). This is despite the fact the deal closed in Nov. and Prestige has among the highest visibility into future revenue of any cruise brand (>50% of revenue booked 25 weeks in advance; per NCLH 20-30% better than industry peers).

Another piece of evidence that luxury may be weakening is provided by NCLH’s pro forma customer deposits as of June 30. The major cruise operators have been touting record-long booking curves and higher booked load factor at higher prices y/y. Yet pro forma deposits for NCLH highlighted below shows a material lag vs forward capacity growth which suggests either a shrinking booking curve or heavier discounting in order to sustain the curve into 2016.

NCLH Pro Forma Customer Deposits June 30, 2015

It also may not be a coincidence that Genting HK (a 13% owner of NCLH that has sold 26.25M shares YTD) recently ann’d it acquired luxury cruise operator Crystal Cruises for adjusted consideration of $421.4M or 23% lower than the previous $550M value (May 15th closing). The original amount was subject to a post-completion adjustment based on a number of financial matrices at the completion date including the difference between working capital and target working capital, cash and equivalents and unearned revenue from customer deposits.

Mgmt Turnover/Up-Market Strategy Shift:

Contrary to narrative that new mgmt is a positive, NCLH’s strong track record as a public company suggests the loss of former CEO K Sheehan is a negative. Sheehan – who became President in Aug 2008 and CEO that Nov 2008 – transformed the company with Freestyle Cruising, took it public @ $19/share, oversaw ordering and launch of Epic and two Breakaway-class vessels and contracted for Breakaway-plus ships, and acquired Prestige. NCLH swung to strong profit in 2009 and subsequently generated 25 qtrs of TTM adj EBITDA growth. While F Del Rio has a strong track record of value creation in the upscale/luxury space, he has never faced public company scrutiny and his expertise is rooted in niche cruise operations and revenue-driven strategies that may have limited efficacy at a large-ship contemporary brand especially in a weaker demand environment.

Under “FDR’s New Deal” NCL is investing to improve the onboard product (i.e. food) to drive brand loyalty (historically a challenge in the category). To offset the higher costs the strategy calls for new upcharges and increased pricing across various onboard products/services – changes that have been well documented by the cruise blogging and travel agent communities. These changes are consistent with a revenue-driven approach more suited to up-market brands than contemporary brands such as NCL. In fact, the “This Time Is Different” narrative includes belief that providing more for the consumer will engender incremental loyalty. However, precedent in cruise suggests there’s a long list of items the consumer wants but a much shorter list of items they’re willing to pay for. And already blogs and industry forums suggest consumers – even “loyal” NCL customers – recognize and are concerned about being “nickel and dimed” by recent revenue actions.

Moreover top-of-market “promote-to-fill” and “market-to-fill” strategies may generate benefits in the upscale market but will likely quickly degrade back to “discount-to-fill” in the premium/contemporary segments when operators are faced with a shrinking booking curve and the potential for material loss of load factor. This appears especially true when contemporary operators are faced with CCL brands that continue to emphasize an ongoing cost-driven operating model despite recent heavier spend to refresh the customer experience. And for upscale brands pricing integrity is much more important and as such will typically forego occ’y in downturns which does lead to significantly greater peak-to-trough cyclicality in NRYs.

Material Upscale Operating Model Differences:

The Street is nearly universally bullish on the complementary nature of the NCL/Prestige combo but historical precedent and fin’l disclosure suggests these are different businesses. Bulls appear enamored with the potential for the core NCL brand to achieve higher per diems and higher NRYs but the luxury business is much lower margin owing to lack of shipboard scale and high cost to deliver the product. As shown below, Prestige is more all-inclusive and thus a passenger ticket-driven business vs NCL (85% vs 71% of total revenues) which exhibits nearly 30% onboard revenue mix. This is reflected in occ’y which is among the highest in the industry above 109% while Prestige in the current ebullient environment runs closer to 95%. Owing to the high cost and relative complexity, Prestige also has much heavier intermediary dependency and owing to a global itinerary mix much higher transport costs with NCL’s commissions/transport costs per ALBD nearly 74% lower. It appears unlikely luxury-focused intermediaries will provide incremental distribution heft to the NCL brand owing to the differences in the products, core customers and relative commission opp’y. Prestige also exhibits much higher per diems and NRYs but much higher cost to deliver product and thus generates materially lower margins.   

Massive Luxury Segment Supply Growth:

It’s surprising the Street isn’t more concerned about the 40% increase in total luxury segment berth capacity in 2016. Historically the luxury segment has been prone to supply indigestion given the relative small size of the segment (many operators refer to the space as a niche). While upscale brands will sacrifice load to maintain pricing integrity to a much greater degree than mass-market brands, in past periods of supply-driven weakness discounting has blurred the segmentation between small-ship luxury and upper-premium. Moreover, in a weaker demand environment consumers tend to trade down in cruise and there are myriad small and large-vessel alternatives to traditional luxury product

Category Leader Carnival’s Resurgence:

We believe the pricing cycle was elongated/boosted for NCLH and RCL owing to high-profile ship incidents suffered by CCL (Costa Concordia in 1Q 2012 and Carnival Triumph in 1Q 2013). The subsequent brand impairment and retrenchment drove share shift to other brands including NCL throughout 2013 and into 2014. CCL’s response was to heavily re-invest in both capital (hardware re-furbs/upgrades) and op ex (soft product/service) to re-establish consumer and travel agent relevancy particularly at the CCL brand. CCL’s fin’l results and distributor feedback both suggest these initiatives have met with considerable success especially at the CCL brand which has become significantly more relevant in the core short and seven-day Caribbean market.

As shown below Carnival has significantly increased its non-newbuild spend in large part to make older hardware more relevant. Moreover, CCL’s historically tight cost op ex focus was loosened in part to re-build the Costa and Carnival Cruise Lines brands and in part to refresh the soft product. For example, net cruise costs ex fuel were +4% in constant USD in 2013 vs historical of +/100bps.

The charts below highlight how NCLH and RCL seemingly benefitted in the wake of Carnival’s high-profile incidents. NCLH in particular seemed to accelerate its NRY outperformance vs the industry and Carnival in 2013-14. With CCL re-establishing itself and demonstrating material improvement in brand image across both consumers and travel agents we expect this tailwind to abate and potentially reverse.

Note also the CCL mgmt is relatively unencumbered by aggressive LT EPS targets predicated on continued strong NRY improvement. For 2017 NCLH has targeted $5 in EPS and RCL has likewise put a $7 target out there. And despite significant incremental product investment in recent years, Carnival also appears likely to continue to pursue its cost-driven approach and aggressively book to fill during periods of weaker demand.  

Conclusion:

NCLH appears to offer asymmetric risk/reward based on under-appreciated category and/or company-specific risks becoming more visible and destroying the bullish belief structure that underpins sell-side/investor forecasts for extrapolated NRY and EPS growth for the foreseeable future. The primary risk is the timing of this increased visibility owing to the naturally elongated booking curve at the peak of the cycle and the time it takes for weakening demand to begin to attract attention especially in the current complacent equity market environment.

Seemingly largely ignored fundamental headwinds include (a) recent equity market volatility/weakness negatively impacting North American-source cruise demand as measured by call volumes; (b) increasingly challenging negative price elasticity given ATH NRYs and more intense competition facing the NCL brand; and (c) evidence of already weakening luxury demand and a massive 40% increase in 2016 total luxury berth capacity facing the recently acquired Prestige brand. And with the stock up 78% since the Prestige deal, mgmt promising $5/share in 2017 and 52.5M shares dumped by insiders YTD well above $50/share there appears to be very small margin for error/disappointment.

NCLH’s 19.1x NTM P/E compares with CCL at 19.9x and RCL at 17.4x (consensus); NCLH had historically traded at a material discount to peers but this reversed in 2015 as NCLH’s NTM P/E expanded from 13x in 3Q of 2014 to its current 19x. This is seemingly largely driven by excitement about the merits/benefits of the Prestige combination and despite the fact that NCLH is operating with above-peak NRYs and ATH margins while CCL’s multiple likely reflects both well below-peak NRYs (-12% vs prior peak) and depressed margins (‘15E operating margins ~10ppts off historical highs).

TP is $38/share or 12x (vs trailing two-year NTM range of 13.3x-19.2x) 2016 EPS of $3.20 vs consensus of $3.83 on flat NRYs (implies negative inflection in 2H 2016 owing to healthy current fill) vs +3-4% implied in consensus and corresponds to ~36% downside. The 12x multiple appears appropriate because during periods when NRY declines are anticipated cruise multiples tends to compress materially below ranges set during periods of NRY growth. This is a six-month TP as multiple catalysts illuminating the potential for our below-consensus expectations should materialize by the end of the heavy cruise selling season – wave season – which runs from mid-Jan. through mid-Mar.

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.

NCLH Trading Multiple Valuation Summary

Prestige Cruises Historical Financials