Description

As a result of massive indebtedness, the cruise operator RCL has become a form of a Ponzi scheme:

It needs an ever larger fleet to service its ever growing mountain of debt.  For this purpose, it needs ever increasing access to cheap financing to pay for its larger fleet and refinance upcoming maturities.  However, it seems like lenders are not as enthusiastic as they once were...

The macro themes of this idea are similar to todd1123's posting of CCL on 11/3/08.  The reader is advised to review that idea as I have chosen not to repeat what was well written there.  I believe, however, that RCL is a weaker player, with a much weaker financial position.

Thesis

-RCL is priced for more than perfection

-The dynamics of the market are such that it will not be able to fill large capacity increases without sacrificing margins

-It is highly levered with $6.5b of net debt, growing to $9b by the end of 2010; even under generous assumptions

-RCL will not generate positive free cash flow until 2011 at the earliest

-Its cost of debt is and will most likely continue to increase as it has to refinance substantial amounts of debt

-Insiders at CCL are selling stock

-Any threat of a flu or similar event could put a lot of pressure

The industry is plagued by overcapacity and getting worse

Cruise operators serving the mass market seem to be engaged in an expensive and ever increasing "arms race".  Over the past few years, these operators have grown capacity in the high single digits, on average.  Going forward, RCL is growing capacity by 7% in '09. 13% in '10, and 9% in '11.  Concurrently, CCL is growing capacity by 5.5% in '09, 8% in '10, and 6% in '11.  RCL and CCL are simply adding too much capacity.  Their model seems to be: build it and they'll come.  This does not make sense.

Given the long lead times for delivery of new vessels, it seems to me that cruise operators got too far ahead of themselves when they committed to their new build schedule.  As we know now, throughout the rest of the travel industry (and many others) too much capacity was added and excessive future commitments were made.  As the economy soured, cruise operators were left deep in debt and with few alternatives but to put a brave face.

It is well known that airlines continue to cut capacity and postpone/cancel deliveries for fleet additions.  This is a clear sign that demand is simply not there; let alone huge additional demand to fill up the new RCL and CCL vessels.  Is one expected to believe that cruise operators have "THE crystal ball" and everyone else in the industry has made the wrong forecast?  More plausibly, cruise operators can not get out of their commitments to increase capacity.  Further, to survive, they need their lenders and the market to believe that demand will be there to fill their new vessels.

The new vessels will save the day, or so they hope

I understand that the bull thesis revolves around growth coming from additional capacity and margin expansion from more efficient vessels.  RCL clearly committed to the new vessels under a very different consumer environment.  If all it takes to grow the top line is to bring new capacity to the market, then we would be witnessing all leisure travel providers adding capacity.  As mentioned above, this simply not the case.  Actually, leisure operators are cutting everywhere they can.

Let's first examine how much margin expansion RCL can derive from more efficient vessels.  The answer is: very little.  RCL is adding 7% capacity in 2009 and 13% in 2010.  It claims that these vessels are up to 40% more fuel efficient.  Current net cost per APCD is $122.5: fuel $21, payroll $25, food $13, other op $36, sg&a $27.5.  A 40% more fuel efficient would have a total net cost per APCD of $114.  Thus, for the year 2010 the mix would be close to 90% existing fleet and 10% new more efficient vessels.  Assuming occupancy remains north of 105%, the weighted average net cost per APCD would be $121.65; a decrease of less than 1% on the total.

It seems pretty heroic to assume that occupancy will remain at these levels; especially in the context of flat to increasing revenue yields.  This seems almost impossible to happen in a depressed consumer environment.

Reason points to pressure on revenue yield and margins

How can one believe that revenue yield will increase at the same time that massive amounts of capacity are coming on line and the consumer has not only lost substantial purchasing power but also has learnt that cruises are now on sale?  Is there anyone who really thinks that consumers will be outbidding each other to get on these boats?  Doesn't the fact that there has been huge compression in the booking to sailing lead time say anything about the dynamics of this market?  Cruise operators are heavily discounting their prices to avoid a collapse in occupancy.  In recent reports, both RCL and CCL show a drop in revenue yield, occupancy, and lead time.  Think about it, consumers are now aware that cruises are on sale; just like very much every other travel alternative.  Thus, those who booked a long time ago and paid non-sale prices hate the idea that others who waited got much better deals.  Those who waited, and got a good deal, will wait again for a bargain.  This dynamic is here to stay; especially in the face of huge additional capacity that has to be filled.

My guess is that, ceteris paribus, cruise aficionados will desert the old boats in favor of the new, more exciting vessels.  This will necessarily put pressure on industry pricing; as operators further discount old vessels.

I can not see a reasonable scenario where pricing and occupancy recover in the foreseeable future.  Cruise operators will have to be very aggressive to fill massive amounts of additional capacity.  Even absent brutal competition within the sector, discounts throughout the rest of the leisure sector will have a substantial negative effect on it.  Although cruise companies would probably want you to believe that they are not just one more vacation option, this is precisely the case.  Consumers considering a vacation are finding huge discounts across the whole spectrum; and it does not seem like this will change in the foreseeable future.

Even under assumptions favorable to RCL, it will consume $2.5 billion

RCL has guided net revenue yield to decrease by 14% and capacity to increase by 6.7% in 2009.  Thus, $6b in 09 revenue looks reasonable.  For 2010, capacity is scheduled to increase by 12.7%.  Assuming a modest net revenue yield decrease of 3%, revenue would be close to $6.65b.  It is difficult to see how there could be a rebound in margins under these circumstances.  However, to be conservative in the analysis, let's assume favorable conditions for the operator allowing for a 21% ebitda margin:

*FCF=cash from ops-capex+net proceeds from disposals ($247 in '08, and $150 in '09)

RCL is priced for more than perfection

At $19/shr one will be paying $13.1b for $800m of Ebit; a multiple of 16.5x on 2010 figures (Ebit and debt).  Even with the nearly 0% income tax rate that it has, such a rich valuation does not make sense for a business with very poor ROIC.

RCL has a poor ROIC profile both in absolute and relative terms.  Over the last three years, when operating metrics were much stronger than they currently are, the company's average ROIC was below 8%.  Over the same period, CCL had an average ROIC of 12%.  Further, the cash flow profile of RCL is much weaker than that of CCL.  Over the last five years, RCL shows ($242) of cumulative negative FCF.  During the same period, CCL generated a cumulative $3b of FCF.  Despite consuming a lot more cash, RCL has not much to show for it; as it did not grow faster or became more profitable than CCL.  Going forward, while CCL will probably be cash flow break even in 2009-2010, RCL will consume no less than $2.45b.

The above estimates do not include an increase in the average interest rate RCL has to pay on its debt.  It looks very likely, however, that its cost of borrowing will significantly increase.  For example, the interest rate on it most recent ship financing by an export financing bank was well above previous levels (variable portion @ LIBOR+300 vs LIBOR +100 or less previously).  Similarly, in July RCL issued $300 million of 11.875% senior unsecured notes due 2015 at a price of 97.399% of par; an effective interest rate of 12.2%.

RCL has a mountain of debt to refinance over the next few years.  This last senior notes transaction serves as an indication of the company's real cost of capital.  Isn't it reasonable to see this last transaction as the new standard for RCL?  Would you lend to this company at a lower rate just after it agreed to pay someone else 12%?  As RCL refinances sub 5% debt with ~12% debt, its cash flow profile will deteriorate in tandem.

It is interesting to note that for at least one of its new vessels, the financing (for 80% of the vessel price) will be secured by the vessel if the credit rating of senior debt falls below BB-, its current rating.  This is a new development, and a clear indicator that lenders are not as bullish on the company.

In a nutshell, RCL is a:

-consumer discretionary,

-low ROIC,

-high capital intensity,

-highly levered,

-cash flow negative,

-priced for perfection stock, trading at a wild absolute and relative multiple.

Catalyst

Further deterioration in occupancy, revenue yield

Additional debt re-financings at 10%+