Description

Company: Norwegian Cruise Line Holdings, Ltd.

Security: $565MM 3.625% Senior Notes ‘24 (unsecured bonds)

Price: 69 Cents / ~13.5% YTM 

Recommendation: Long

Executive Summary/Summary Thesis

At 69c / ~13.5% YTM, the 3.625% Senior Notes ‘24 (“the Bonds”) present an attractive risk/reward to play the ‘recovery’ trade for NCLH. Notwithstanding the +100% move off the March lows in the equity, the Bonds are only up ~15% and I believe have much more room to go. Understandably NCLH has raised significant secured debt in recent months to shore up liquidity ahead of the Bonds but there is still ~$4.5bn in subordinate equity cushion (~30% of TEV pre-conversion of the exchangeables), and the TEV is still +30% below 2019 levels. Ultimately I think the Bonds have ~10pts downside (back to March lows) and ~40 points upside (appreciation + yield). 

As special situations-oriented investors we look for companies and industries undergoing transition and disruption, and cruise lines fall squarely in that context. While cruise operators are not for the faint of heart - capital-intensive businesses, cyclical in nature, benefitted from super-cycle pricing in the last 4-5 years, hit particularly hard the CDC’s 8 month no-sail order (which will expire on 10/31 and sailing in US waters can resume under a less restrictive “conditional sailing order”) and unclear demand trajectory over the next 12-18 months - and sentiment for the Bonds remains awful, I am less bearish than the market and believe the Bonds will be paid par at maturity for the following reasons: 

(1) Strong liquidity - the company has raised over $4bn in capital this year, has $2.8bn in cash on b/s at Q2-20 and is burning $160MM per month compared to $350MM during normal conditions.This would enable NCLH to withstand +16 months of cash burn assuming no revenue. Under my conservative base case, NCLH makes it through 2022 without requiring additional liquidity. While there is no incremental secured debt capacity permissible under various credit indentures, the company has some unsecured debt capacity to raise pari passu capital with the Bonds ( practically unlikely at the current cost of capital in the near term) but is more likely to tap the equity markets given its ~$4.5bn market cap if the situation appears worse than expected. The company has been successful in issuing exchangeable notes (convertibles) in recent months.  

(2) Sustainable business model - I believe there is significant pent up demand for NCLH’s cruise product which offers a solid value proposition and attractive unit economics but don’t need to make herculean pricing, capacity day and load factor assumptions to get back to net yield growth inflection, positive corporate-level EBITDA (both 2022 events), positive net free cash flow (2023) and ultimately a refinancing event in 2024 (at which point I expect EBITDA to revert back close to 2019 levels) when +40% of the debt stack is scheduled to mature. 

(3) Undervalued creation multiple - the Bonds are trading at ~5.4x ‘19 Adj. EBITDA at market, well below the 9-10x the cruise industry has historically traded for, and ~8.7x my base case of ‘22E Adj. EBITDA, (for reference my estimate of ‘22E Adj. EBITDA is slightly below 2015 Adj. EBITDA when capacity days were 25% lower than they are expected to be in 2022) and meaningfully below the company’s normalized earnings power (~20% EBITDA margins assumed in 2022 vs ~30% normalized). Note: trading multiples exclude cash on b/s given no revenue/level of cash burn.  

(4) Attractive position in the capital structure - the unsecureds are sandwiched between the secureds that are yielding ~8.5% (4.6x leverage on ‘19 Adj. EBITDA) and a ~$4.5bn equity market cap (~30% of TEV). For an incremental 0.8x in ‘at market’ leverage, the yield pick up is ~450bps. Also, as aforementioned, there is no more liens/secured debt capacity to prime the  Bonds outside bankruptcy.     

Risks - clearly there are several in the post-COVID world, but here are the two most relevant in my view:

(1) Timing - given the recent spike in cases, a quick return to normal is unlikely absent a vaccine notwithstanding the CDC no-sail order expiration. The risk is that the company doesn’t have sufficient liquidity to withstand a depressed level of activity and may have to restructure which could impair the Bonds. While I believe this is a low likelihood scenario, with the Bonds at 69c the market is assigning a higher probability to a ‘stress’ scenario.  

(2) Pricing/Demand - also absent a vaccine, the outlook for demand and pricing will remain somewhat unclear. Companies are incentivized to get back to load factor break-even and may use pricing as a lever to stimulate demand. While this is certainly possible and in-line with action taken during prior recessions, the industry has more levers at its disposal now, namely supply.

Catalysts: 

(1) Return to ‘normalized’ sailing / lift of CDC ban - The CDC had extended its no-sail order to October 31, 2020 but wanted to extend it to February 2021 (that decision was overruled by Mike Pence). Following the extension, the cruise lines have largely suspended sailing through end November. A near-term catalyst is the expiration of the no sail order and a return to sailing in US waters under less restrictive conditions - this occurred today. Over the medium-term this should stimulate the industry’s marketing engine which has essentially been inactive since March. Clearly the release of a viable vaccine would be the ultimate catalyst.

(2) Supply shrinkage - unlike in prior recessions, capacity is exiting the market both by default (bankruptcies) and by desire (scaled ramp based on demand). The ability to ‘control’ supply gives the industry a strategic lever to stimulate demand which may alleviate the pressure to offer significant promotions.  

The Business / Industry:

Participants in the cruise industry have been written up many times on VIC and are reasonably well covered by the street so it is definitely worthwhile reviewing prior write-ups and sell-side research for background information. Briefly, NCLH is a cruise line operator with a global fleet of 28 ships, ~59k berths and three distinct brands (NCL, Oceana, Regent) spanning the major market categories - luxury, premium and contemporary. In 2019, the company carried ~2.7MM passengers and had ~36k employees. The top three players (NCLH together with Carnival (CCL) and Royal Caribbean (RCL)) hold ~80% market share, generate net yields in the $200-250 range and EBITDA per capacity day margins in the 35-40% range. NCLH is the smallest of the three with a TEV of ~$15bn vs ~$30-35bn for RCL/CCL but is typically at the higher end of the KPI range. It also has the lowest weighted average fleet age at ~10 years vs 12-13 years for the others.

Thesis:

(1) Strong liquidity

Monthly Cash Burn: NCLH seems to have the strongest liquidity from a runway standpoint in the industry: with ~$2.8bn in pro forma net cash at Q2-2020, the company should have 16-17 months of liquidity assuming no revenue, recurring cash refunds on advance ticket sales (deferred revenue) and no additional capital raises. This would get them to Q4-2021, at which point I expect NCLH to have good visibility into bookings and itineraries for 2022. Importantly, 70% of bookings for 2021 are new cash bookings vs 30% future credits implying meaningful pent up demand.

Capital Structure: In the last six months the company has raised significant capital largely in the form of secured and unsecured debt (some equity). As such total debt has increased from $6.8bn at the end of 2019 to $11.1bn at the end of Q2-2020 (pro forma for the July financings and inclusive of ship-level export credit agency debt). Currently the company has $2.8bn of cash, secured debt of $8.8bn, unsecured debt (including exchangeables) of $2.3bn and an equity market cap of ~$4.5bn. Given the lack of secured debt capacity, I believe the company will continue to raise capital opportunistically via the equity and quasi-equity markets. Additionally, the company’s maturity schedule is very manageable with only 4% of the debt stack due before 2024 (~$450MM due in 2022).   

Incremental Debt Capacity: NCLH has virtually no secured debt capacity and about ~$500MM of unsecured debt capacity which would be pari passu with the Bonds. At +13% cost of capital for unsecured debt, however, I view a straight unsecured raise as unlikely, particularly given the existence of a sizable equity cushion. What is more likely is an exchangeable (which would be pari until converted) or straight equity. 

(2) Sustainable business model

Rate of bookings/Pent up demand: Recent commentary/data points suggest there is pent up demand for cruising not only from repeat-cruisers but also from new customers to the category and the older demographic leisure traveler (two areas historically assumed to be lackluster participants in the recovery cycle). On recent earnings calls and at (virtual) trade conferences, all three large operators have sounded upbeat about bookings. On its Q2 call, CCL noted meaningful bookings from new cruisers, which is positive given the depressed level of marketing spend for the industry. NCLH noted that cumulative bookings and pricing for 2021 are within ‘historical ranges’ and added that one of its brands that skews towards the older demographic has seen a significant increase in bookings for the 2023 world cruise. Separately, cruises have recommenced in Germany and Italy with no reports in COVID incidents suggesting that operators are employing necessary and effective protocols to mitigate transmission. 

I would expect the CDC ‘greenlight’ to have a positive impact on forward cruise bookings. While the major operators appear optimistic about a resumption in US sailing in 2020, I believe it would be more impactful from a sentiment and process standpoint (restart marketing, ramp up bookings) than revenue / cash flow contribution.    

Capacity Breakeven: Pricing appears down HSD on average y/y in Q3 so far for bookings made a year out (Q3-21). In general, Caribbean and Alaska-bound cruises are holding up pretty well, down MSD-HSD while European cruises are the softest, down LDD. Assuming 2019 pricing, load factor breakeven is ~38% for ship-level EBITDA (unadjusted) and ~62% for corporate level EBITDA (also unadjusted and assumes 2019 level marketing/SG&A spend). Assuming a 10% decline in prices (relative to 2019), load factor break-even is ~45% for ship-level EBITDA (which I believe is very attainable) and +70% for corporate level. My expectation is that NCLH will achieve 70% by Q4-2021. Naturally, NCLH can flex its marketing spend in the event liquidity is tighter than expected in 2H2021 and 2022.

Operating Model/Free Cash Flow: The business model typically generates significant free cash flow with high revenue visibility. The industry is typically disciplined about using promotions to pre-sell tickets, receive customer deposits and sell onboard activities well in advance of sailing in order to get to capacity breakeven. Notwithstanding the increase in annual supply (average berths), NCLH has been able to improve load factor while increasing net yields. This is a testament to the value proposition of the company’s vacation package. For the remainder of 2020 and full year 2021, I have made conservation assumptions (vs consensus) regarding the reopening process:

• Ramp: Slow ramp starting in Q2-2021 with 50% load factor increasing to 70% in Q4-2021 and 90% after nine months (slower than the 5-6 months cited by management and below ~105% normalized load factor). 

• KPIs: Significantly lower net yields, capacity days and load factor for 2021 and 2022 compared to 2019

• Advance ticket sales (ATS): The decline in ATS has been a meaningful drag on cash flow this year with balances dropping from ~$2bn at year end 2019 to $1.2bn in Q2-2020. Of the $1.2bn, $800MM is future cruise credits where customers have elected to postpone their trip (in lieu of receiving a cash refund) and $400MM reflects bookings for 2h-2020, 2021 and 2022. I assume ATS balances will continue to decline Q3/Q4-2020 due to 2h-2020 booking cancellations, stabilize in Q1-2021 and start picking up in Q2-2021. My base case expectation could prove conservative given the pending expiration of the no-sail order. 

• Margins/EBITDA: Due to my (more conservative) estimate of load factor ramp, I continue to expect elevated cruise operating costs per passenger and lower margins in 2022 relative to consensus and historicals. My base case Adj. EBITDA for 2022 is ~25% below consensus.

• Liquidity: I expect the company to have sufficient liquidity to get through 2022. As load load factor continues to ‘normalize’, I expect NCLH  to generate significant FCF and take delivery of a newbuild on schedule in 2h-2022 for which it has secured export financing. As aforementioned, in the event the company believes it requires a larger cash cushion, equity investors appear willing and able (for now).

(3) Undervalued Creation Multiple 

As aforementioned, I believe the Bonds offer the most attractive risk/reward in the capital structure. In my base case, they are worth par. In my downside case, they are effectively the fulcrum which is what I believe the market is discounting. At 69c / ~13.5% yield, the market seems to view a refinancing event in 2024 as low probability. The Bonds are currently trading at ~5.4x ‘19 Adj. EBITDA and 8.7x (my meaningfully depressed) ‘22E Adj. EBITDA, both below the 9-10x historical multiple range. The Bonds are trading at $165k /Berth (‘22E) vs a historical intrinsic value range of $230-250k EV/Berth. Additionally, given that the Bonds are trading in ‘stressed’ land, they currently have ‘equity-upside characteristics’ and should be viewed in that context - through that lens, the Bonds are cheap relative to the equity of the comps (CCL and RCL) which trade at ~11.5x EV / ‘22E Adj. EBITDA. As such the Bonds are undervalued both on an absolute basis and relative to the comps.  

(4) Attractive Position in the Capital Structure with solid covenant protection

The Bonds are a ‘sliver’ between $8.8bn of secured debt and ~$4.5bn of equity. The secured debt is trading at 4.6x ‘19 Adj. EBITDA / 7.4x ‘22E Adj. EBITDA and is yielding ~8.5%, that equates to 186bps per turn of leverage. For an additional 0.8x / 1.3x turns of leverage (5.4x / 8.7x), the yield pick up is ~450bps which seems mispriced to me. Admittedly the secureds are secured and guaranteed by the operating subsidiaries while the Bonds (and the other unsecured notes) are unsecured and unguaranteed. Importantly (and as aforementioned), the company has no collateral capacity to issue secured debt capacity that could layer the Bonds implying that the market is either (i) crystallizing the value break between the secureds and the unsecureds at a ~1x multiple differential (unlikely), (ii) believes the company will need more liquidity which will dilute the unsecureds disproportionately (possible but less likely given the opportunity to tap the subordinate equity layer in the event of additional liquidity needs), or (iii) has mispriced the risk/reward in the capital stack (most likely).   

Risks:

(1) Timing - given the recent spike in cases in the US and Europe, a quick return to normalcy is unlikely absent a vaccine, notwithstanding the pending CDC no-sail order expiration. As such, many questions remain including: when will NCLH return to occupancy breakeven? and how much cash will the company  burn in the interim? I have conservatively assumed that bookings will stabilize and resume growth in Q1-21, sailing will slowly recommence in Q2-21 and the company’s 1st full year of operation post-COVID will be 2022. In the event we see weaker than expected demand, then Q4-21 will be crunch time from a liquidity standpoint. Between now and then, however, the  ~$4.5bn equity market value (raise capital) and the pending expiration of the no-sail order (restart the marketing engine / revitalize the bookings curve / generate cash flow from advance ticket sales) offer the company multiple tools to improve liquidity opportunistically and if necessary.

(2) Pricing/Demand - also absent a vaccine, I assume demand from new cruisers (~40-50% of annual demand) will be depressed. What is encouraging however, is the bookings data/commentary from the larger incumbents which indicates pent up demand largely  from the engagement from repeat customers (50-60% of demand). Customers appear to have responded favorably to the industry’s commitment to stringent safety protocols such as pre-on boarding temperature checks, time slot arrival check in, capacity caps, social distancing mandates, upgraded ventilation systems and other health measures. Sailings in Europe provide a useful case study. There is a risk, however, that operators become less disciplined and revert to aggressive promotional pricing to kickstart the bookings curve for outer years particularly if liquidity is tight but there is little evidence of this thus far. My fundamental view is that demand will be impacted over the next 12 months but start reverting to normalized levels in 2-3 years, within the context of historical crises - cruise passengers are notoriously loyal and have returned after recessions, the GFC, terrorist attacks and at-sea disasters.

Catalysts:

(1) Return to 'normalized' sailing / lift of CDC ban - The expiration of the no-sail order will enable the marketing engine to restart and ultimately lead to positive net bookings growth and cash flow generation from advance ticket sales. The cruise lines have also committed to a comprehensive, multi-layered safety approach such as 100% testing pre-embarkation which, while not fail-proof, has the potential to improve confidence of both repeat and new cruisers. A medium-term catalyst (next 6 months) would be the release of a commercially viable vaccine, more effective treatments and/or herd immunity - that is my base case: I am assuming a slow ramp where business will start returning in Q2-2021 with phased-in capacity (five ships added per month in line with management’s comments that it would take 5-6 months to get the entire fleet back into utilization) and full year of operation in 2022. While NCLH’s stock price has already responded positively to the vaccine newsflow over the last several months, I would expect the Bonds to move up markedly on an announcement as it would crystalize timing, firm up bookings/demand and generally mitigate the downside. 

(2) Supply shrinkage - given the fixed cost and capital-intensive nature of the cruise business, the industry is naturally dominated by scale. Smaller players simply don’t have the financial resources, asset value and access to capital to withstand a prolonged period of cash burn and will file for bankruptcy/exit the market. It is estimated that close to 10% of industry capacity will exit the industry in the next 12 months with several smaller cruise lines having already permanently shut down operations and larger incumbents like CCL announcing ship disposals (12% of fleet). The industry has also negotiated deferrals with the ship yards for ships that have yet to begin construction, pushing out some deliveries by 6-18 months. There is also an expectation that some orders may be cancelled altogether if the shipyards fail to meet their milestones (increasingly the case given their limited resources). Ultimately, the cruise operators and the shipyards need a robust supply chain - industrial logic would suggest that they are working together to ensure the market doesn’t get flooded with excess capacity and to preserve a solvent shipyard vendor base. Industry estimates for ‘20-24E supply CAGR have already begun to come down from ~6.5% prior to COVID to 3-4% post-COVID. Additionally, unlike prior downturns where cruise operators were pressured to use price to fill capacity and meet load factor breakeven (as the ships were already sailing), this time the ships are laid up. So the industry could strategically bring back capacity to meet demand without materially adjusting price. Collectively, these actions would help (i) control supply/demand in near-/medium-term and (ii) recalibrate/absorb the new supply schedule over the next 7-8 years.

Catalyst

1. Return to normalized sailing / lift of CDC ban

2. Supply shrinkage