Summary Thesis:

The cruise industry is going through an inflection point.  The growth in cruiseship capacity is declining over the next three years to levels not seen in two decades. Meanwhile, market penetration is rising and customer sourcing is broadening on a global basis. The declining supply, coupled with widening demand should provide pricing power to this oligopolistic industry.   Managements’ attitudes appear to be changing towards a greater focus on generating higher return on capital and strengthening of the balance sheet, which marks a strategy reversal from the last few years. Despite the rise in oil prices, newer energy efficient ships should help the flow of top-line growth to the bottom line.  Lastly, the recent tragic Costa Concordia accident and European economic woes are depressing valuations and outlook, providing an attractive entry for a longer-term investor.  Royal Caribbean, has lesser exposure to Europe, no liabilities related to recent accidents and is enjoying improving relative performance with respect to its key competitor Carnival.  In addition, its attractive valuation and company-specific catalysts offer further risk/reward support to the investment thesis.

Company Description

Royal Caribbean Cruises Ltd. (RCL) operates in the cruise vacation industry in North America and internationally. RCL is the second-largest company in the industry, operating global brands that include Royal Caribbean International, Celebrity Cruises, and Azamara. The company also operates the Pullmantur brand, which is tailored to serve the cruise markets in Spain, Portugal, and Latin America; the CDF Croisières de France brand, which provides a tailored product targeted at the French market; and its joint venture TUI Cruises, which focuses on the German market. Currently, RCL has the largest ships, albeit a smaller fleet than its closest rival Carnival Cruise Lines (CCL). As of the end of 2011, the company has 40 ships with 95,000 available berths, with three additional ships on order in Germany. The company carried 4.9 mm guests in 2011 and generated revenues of $7.5bn. The company was founded in 1968 and is based in Miami, Florida.

The “Bear” Thesis

The sell-side analyst community has been, in general, favorably predisposed towards RCL and the cruise industry.  However, during the ‘08-’09 financial crisis, RCL and its peers, were a relatively popular “short” among some buy-side investors for a number of reasons: 1) alleged “ill-advised” strategic focus on growth through acquisitions and new-build capacity with lesser concern for profitability, cash flows and returns; 2) excessive leverage with net debt/EBITDA reaching 7.7x in 2009; 3) spiking oil prices; 4) weak consumer taking fewer vacations; 5) rising geopolitical risks.  This write-up will focus primarily on points 1) and 2) and will provide some hedges for ameliorating the potential impact of factors 3)-5).

Industry Dynamics – an Inflection Point

The cruise industry has an attractive structure, relatively high barriers to entry and secular growth characteristics. It is also undergoing an inflection point whereby supply is slowing down to nearly unprecedented levels while the demand base is broadening. The following paragraphs illustrate in further detail these points relying on industry statistics from CruiseMarketWatch.com, RCL company presentations and research analyst reports.

• Favorable Industry Structure: The cruise industry has a fairly oligopolistic structure. The top two players in the industry, CCL with 49% market share, and RCL with 24% market share, control nearly three-quarters of the world-wide passenger capacity. Barriers to entry are high, as substantial capital requirements (a new ship costs in excess of $500mm) and the ownership of well-known, reputable brands are necessary to achieve success.

• Secular Growth Characteristics: The cruise industry is estimated to generate revenues of approximately $33.5 billion in 2012, with 20.3 million annualized passengers carried, a 5.6% increase over 2011. Over the last two decades the industry has grown at a rate of c. 8% and is estimated to continue its expansion at similar levels. Growth strategies have been driven by new mega-ship launches, shorter cruises, more local ports, more destinations and innovative on-board/on-shore activities that match consumer demands.

• Cruising - a Cheaper and more Resilient Form of Tourism: Historically, cruise industry fundamentals have been generally less volatile and more quickly to rebound than those of the lodging and gaming industries due to (1) lodging being skewed to business/convention related travel, and (2) the attractive price/value relationship to land-based vacation/holiday alternatives for the consumer. Cruising offers affordable pricing relative to other forms of tourism as it combines lodging, food, travel and entertainment into an attractive all-inclusive package.  Cruise operators have managed to fill up ships even in the depth of the financial crisis through promotions. Adverse geopolitical events seem to have a bigger impact on cruising demand than economic ones.

• Demand – Low Penetration and Broader Sourcing: The cruise industry is significantly underpenetrated. Here are some statistics – in the US and Canada there are 330mm residents and 11mm annual cruisers i.e. a 3.3% penetration; In Europe – there are 500mm residents and 5mm annual cruisers i.e. a 1.1% penetration. For Latin America and APAC, the penetration rate is even lower, at 0.2% and 0.1%, respectively.  Although these statistics may be somewhat exaggerated as they include all residents rather than potential target audience and also focus on annual cruise passengers versus all-time cruise passengers, the point remains that this is an under-served market.  Cruise companies are focusing on tapping that under-penetrated demand by increasing significantly cruises in areas such as South America, Australia and Asia.  Furthermore, sourcing is going more global – in 2012 the two major players are expecting to originate c. 50% of their guests from outside the US. Five years ago, non-US guests accounted for less than 25%.  Lastly, people in the ages of 55-65 represent one of the largest cruising demographics. Fortunately for the industry, with the aging of the population this customer pool is growing.

• Supply – Lowest Consecutive 3-Year Growth in Two Decades: One of the key points made by the cruise industry’s “bears” is that the industry grew significantly in the past decade through a rapid debt-fueled capacity expansion with minimum respect for ROIC. However, it appears that this behavior is changing.  According to Enskilda Research, the cruise industry’s gross capacity growth is estimated to be 4.3% for 2012, 3.0% for 2013 and 3.8% for 2014. The Costa Concordia ship is very likely to be out of service for at least the entire 2012, which will reduce the capacity growth for 2012 to 3.5%.  Over the last two decades, industry capacity growth has been less than 4% only twice – once in 1994 (3.7%) and once in 2005 (3.0%), however these years were preceded by nearly double-digit increases.  During the balance of the last twenty years, capacity growth has varied between 6% and 12%. Partly due to the financial crisis restricting credit and partly driven by a renewed focus on balance sheet strength and free cash flow generation, the industry leaders have curtailed new orders to an unprecedented low three-consecutive-years growth rate.

• Energy Efficient Ships: Over the last 5-7 years fuel consumption as measured my tonnage/passenger-capacity-day has improved between 10-20% among the major cruise operators.  During that period, however oil prices have increased substantially eroding some of these benefits.

Royal Caribbean – An Inflection Point?

Historically, RCL has been the second industry player not only in terms of size but also in terms of operational performance as compared to CCL.  In terms of ROIC, RCL has averaged c. 5% over the last decade while CCL has been closer to 8%.  RCL has experienced, lower net pricing and relatively higher costs, partly due to mix and scale and partly to capital mis-allocation decisions, which has manifested itself in the lower returns.  It appears now that RCL’s relative performance is improving. In order to highlight this progress, we will outline some of the main drivers and sensitivities behind the RCL business model.  Here are some key definitions:

Selected Cruise Industry Definitions

• Available Passenger Capacity Days (APCD) -> the number of available lower berths multiplied by the number of days a ship is in revenue generation service.
• Occupancy -> the actual number of passenger cruise days divided by APCD and is based on the assumption of 2 berths per cabin. Some cabins may have drop down bunks and actually hold 3-4 people per cabin, which is why quite often occupancy figures are above 100%.
• Net Yield -> cruise revenues less airline revenue, travel agent commissions and expenses related to airline and onboard revenue, all divided by APCD. The yr./yr. change in net yields is the sum of the yr./yr. change in occupancy plus the yr./yr. change in net per diems
• Net Cruise Costs (NCC) -> cruise operating and selling and administrative expenses less travel agent commissions, expenses related to airline and onboard revenue, all divided by APCD.

The main revenue drivers for a cruise operator are ticket prices, on-board revenues, available capacity and occupancy - the higher each of these items is, the higher the revenues.  Of these four metrics, available capacity and occupancy have been the most consistent over the last decade. As indicated earlier, the industry, and RCL in particular, have consistently been adding capacity, albeit at a somewhat varying rate (3-12%, in the case of RCL).  Occupancy at RCL has also been steady, ranging tightly between 103-106%, i.e. ships always sail full.  Net on-board revenues have ranked third in terms of consistency, rising from $39/APCD in 2003 to $52/APCD in 2007 before declining due to the ’08- ’09 recession and the increased proportion of European guests who tend to spend less. 

The most volatile component amongst the revenue drivers has been net ticket revenues, as the cruise operators use ticket pricing as a lever to fill up available capacity. They have varied between $107/APCD and $132/APCD over the last decade.  Therefore the primary focus of the investment community, as it analyses RCL, is Net Yields, i.e. net revenues per passenger per day.  The sensitivities to the business model to a change in net yields are high. As per the latest company presentation, 1% change in net yield leads to $0.27 EPS change, which is about 13%-15% of EPS based on most current company guidance.

Historically, CCL has always had higher net yields than RCL (see table 1). Over the last nine years, that difference averaged c. $9 / APCD.  In 2012, RCL will exceed CCL’s net yields for the first time by over $3 /APCD.  This is driven partly by CCL’s Costa Concordia disaster as well as by the fact that Europe comprises a bigger portion of the revenues for Carnival. It is also due to RCL’s launch of some of the most modern and “buzz-generating” Oasis and Solstice Class ships.  Other factors contributing to higher net yields are broader global sourcing, greater diversification, exposure to higher-yielding regions and the recent upgrade of the company’s international distribution system.  Clearly, the favorable supply/demand dynamics discussed earlier will provide further support to the pricing in the industry, benefiting all players.  It is quite likely that net yields will rise over the next three years above recent peaks achieved in 2008 (RCL’s peak net yields were c. $184 vs. the current c. $170).

In the past, RCL lagged behind CCL not only in terms of revenue yields but also in terms of costs (see table 1). In the cruise industry, the main cost drivers are SG&A, food and fuel. Comparing the two major cruise operators, one can easily notice that net cruise costs were generally higher at RCL over the better part of the last decade.  Between 2003 and 2010, CCL average net cruise costs were c. $5/APCD lower than those of RCL. However, over the last five quarters the trend has started to reverse – in 2011, RCL spent approximately $4/APCD less. The main driver behind the improvement in net cruise costs are reduced SG&A per APCD and utilization of more fuel-efficient, larger ships (on average, RCL’s ships are 18% more fuel efficient as measured by tonnage per APCD).  Furthermore, RCL hedges 50% of its fuel consumption, while CCL does not and that has helped in a rising oil price environment. In terms of sensitivities, 1% change in net cruise expenses (ex fuel) is $0.15 change in EPS and 1% change in fuel prices equals $0.015 change in EPS.

Table 1. Comparison of RCL vs. CCL on operational metrics

                                                                        RCL                           CCL                           Difference (RCL-CCL)

Avg. Net Yields ’03-’11               $168.73                 $177.46                 -$8.73   (yields for ‘13 are estimated closer in line)

Est. Net Yields 2012                     $176.49                 $173.34                 +$3.15  -> First Time!

Avg. Net Costs ’03-'10                 $117.70                 $112.70                 +$5.00  (costs for ’12 are estimated closer in line)

Actual Net Costs 2011                 $122.40                 $126.11                 -$3.71   -> First Time!

EBITDA Margin ’03-’11                22.6%                     28.3%                   -5.7%    (margins for ’13 estimated closer in line)

Est. EBITDA Margin ‘12                19.7%                     20.2%                   -0.5%    -> First Time!

Source: Wells Fargo research.

The table above also shows that in 2012 EBITDA margins are starting to converge between the two players, after being apart c. 6% for most of the decade. Overall it appears that RCL is beginning to close the operational gap between itself and the leader in the industry.  The Costa Concordia disaster, which affected CCL more drastically, is certainly contributing to this relative performance.  However, there are a number of signs pointing that this trend should continue, which will contribute significantly to improved returns and profitability at RCL and hence a higher valuation.  Management of the company has recently stated publicly that it targets double-digit ROIC which is a change in strategy compared to a few years ago.

From a balance sheet and a cash flow perspective the company is also strengthening.  RCL was overleveraged during the financial crisis with Net Debt / EBITDA reaching c. 7.7x in 2009. The company expects that metric to decline to 4.50-5.00x by year-end and to 3.75x by late 2013/early 2014, which will place it well into the realm of investment grade.  Given the importance of debt financing for an asset-heavy operator, a stronger balance sheet provides greater flexibility and should boost valuation.  In the five-year period between 2006-2011, the company spent heavily on capital expenditures, averaging CapEx/Sales of 33% during that time, or an average of $1.9bn per year. For the next three years (2013-2015) the expectations are for that ratio to be in the range of 10-12% or lower, for an average of $0.9bn per year. Clearly, spending a $1bn less in CapEx/year will result in strong, positive free cash flow and a solid balance sheet.  This is again a turnaround in management behavior from the recent past as RCL generated negative free cash flow for majority of the last five years.

Recent Quarter Commentary

In the most recent quarter, the company reported that prior to the Costa Concordia accident booking orders were up +5% on +2% capacity growth and pricing was strong (i.e. net yields were anticipated to be up +4-6%). However, post the accident booking volumes declined with the largest impact anticipated in Q2 and Q3 of 2012.  The trends have started to improve but are not fully stable yet. The company expects net yields to be +1% to +4% for the year, while costs would rise 10-11% for Q2-2012 due to higher marketing (related to the accident as well as global expansion), longer than expected dry docking maintenance and higher fuel costs.  The company sees Q4 and 2013 continuing the strong pre-accident trajectory.  Guidance for 2012 is $1.80 to $2.10 of EPS.

Valuation

RCL had a weak 2011 stock performance driven by geo-political disasters - Japanese Tsunami, Arab Spring, rising oil prices, European crisis.  The stock was down nearly 50% during the year. It is still lagging significantly the S&P 500 index over the last twelve months. In addition to depressed technicals, we believe that valuation is also at similarly low levels.

Our valuation analysis focuses on historical multiples and asset valuations. In general, it appears that in periods of rising net yields, cruise companies receive higher multiples than in declining ones. The current year, 2012, is the third one in a rising yield environment and 2013-2014 should continue the trend, barring some large unforeseen geo-political risks.  RCL became public in 1993, so the following table 2, summarizes the multiples for the two peers since then.

Table 2: Historical Valuation

                                                                     RCL                           CCL                          

Avg. LTM P/E ’93-’11                                 14.9x                        16.8x     

Avg. LTM EV/EBITDA ’93-‘11                    10.8x                        13.6x

Avg. LTM EV/Berth ’93-‘11                      $207K                     $341K

Source: Wells Fargo.                      

Since coming public, RCL has traded at an average EV/Berth range of $170K-$243K. According to Enskilda Research, current replacement costs for RCL ships contracted for delivery in 2012-2015 range between $230K- $280K/berth.  Based on the current EV of $14.1bn and 95K berths, current valuation is $143K/berth, significantly below historical pricing.  Furthermore, the company will generate significant free cash flow over the next couple of years further reducing net debt and hence asset valuation. Looking at asset valuation differently, since going public in 1993, RCL has traded at a P/BV of 1.46x and currently it is trading at 0.64x – again a substantial discount.

Current consensus for 2013 assumes yield growth in the 3-4% range (i.e. roughly in-line with 2012 growth) and costs rising about c.2.5-3% (i.e. a little bit lower than 2012).  Given our positive view of the industry, and the company’s experience prior the accident (net yield growth of +4-6%), we think that such estimates are likely on the conservative side.  Nevertheless, we will use in our analysis current consensus estimates of $2.68 EPS and $1.7bn EBITDA for 2013.  At these estimates, RCL trades, at the current prices of $26.50, at 9.8x 2013 P/E and 8.2x EBITDA, again below historical valuations despite being in a rising net yield environment.  In prior positive yield environments, RCL has reached valuations as high as 23x LTM P/E. Its closest peer, CCL, is trading at 20-30% higher multiples than RCL for 2013. Overall, it appears that RCL is trading at a heavily discounted valuation both on an asset and on multiple basis.  Further deleveraging at constant multiples should provide a boost to equity valuations.  Lastly, assuming an average historical multiple for RCL implies values of $40-45 achieved within a 12-18-months timeframe.

Catalysts

• Recovery from Costa Concordia-induced discounted pricing – should be visible in Q4, 2012
• Easier comparables in Q2-Q3 in 2013, given the Costa Concordia lower booking in 2012
• Significant deleveraging as a result of positive free cash flow – assuming constant multiples equity values will rise
• Achievement of investment grade ratings in late 2013/early 2014
• Pricing recovery due to favorable supply / demand dynamics 2013-2014
• New modern ships delivery in 2013 and 2014 (capacity growth of c. 1%-1.5% in both years) providing “buzz” and higher yields/lower costs.

Investment Risks

• A greater than expected slowing in the U.S./European economies given RCL’s 2012 itinerary capacity exposure of 42% Caribbean, 4% Alaska, and 29% Europe.
• Inability to obtain financing at favorable rates and/or a sharp unexpected rise in interest rates, negatively affecting RCL’s variable rate debt or ability to refinance.
• Sharp upward spikes in fuel prices negatively impacting operating costs. Heightened risk of war / terrorist actions which could directly (attacks against as hip) or indirectly (attacks elsewhere) discourage travel.
• The addition of significant new industry capacity thereby disrupting pricing.

Hedges

A long investment in RCL could be hedged either by buying puts on CCL, which is more exposed to potential liabilities from the two recent accidents and has greater exposure to Europe, the weakest region globally at present.  Given the relatively depressed valuation of CCL and our positive view on the industry, put options are recommended rather than outright shorts.  Furthermore, given that personal travel in general is impacted by spiking oil price and economic weakness, a long/short investor could offset some of the cyclical risks associated with an investment in RCL by shorting a basket of hotel/gaming companies which have enjoyed a much stronger stock price recovery and higher valuations.

Catalysts

• Recovery from Costa Concordia-induced discounted pricing – should be visible in Q4, 2012
• Easier comparables in Q2-Q3 in 2013, given the Costa Concordia lower booking in 2012
• Significant deleveraging as a result of positive free cash flow – assuming constant multiples equity values will rise
• Achievement of investment grade ratings in late 2013/early 2014
• Pricing recovery due to favorable supply / demand dynamics 2013-2014
• New modern ships delivery in 2013 and 2014 (capacity growth of c. 1%-1.5% in both years) providing “buzz” and higher yields/lower costs.