Description

Summary

Global cruise operator Royal Caribbean (RCL) is +250% from March lows despite cont’d full stop in operations and re-start expectations being pushed out from initial 3Q20 to current 1H21. Investors appear to be assuming a rapid recovery to prior 2019 peak that appears unrealistic. Specifically, recovery expectations shouldn’t be anchored on 2019 which was the culmination of an atypical period of steady, predictable demand and the list of post-CV demand/op model headwinds/uncertainties is lengthy. Current quick return-to-normal expectations also don’t seem to account for material ongoing cap-structure damage and unprecedented net leverage magnifies downside potential.   

Thesis 

RCL is asymmetric to the downside as rapid return to prior-peak financials embedded in current expectations appears completely unrealistic even after acknowledging unprecedented uncertainty/lack of visibility that supports unusually wide range of potential outcomes. RCL’s EV is <15% below prior peak despite cash burn likely to persist for at least another year assuming phased re-start goes off according to plan. Alternatively, prior-peak $9.50 EPS is equivalent to <$6.00 on incremental interest expense and equity income degradation alone. Given well-documented relatively weak historical FCF/ROIC dynamics, RCL has typically been a sentiment-driven trading vehicle and that’s likely even more so the case throughout what will likely prove a lengthy and volatile recovery period. Base case is that rising risks associated with re-start and flattening recovery expectations take air out of current bullish sentiment and push stock ~30% lower. Ultimate downside risk in play is stock becomes an equity stub as realization of “tail” risk incl GFC, Costa Concordia and CV-19 hasn’t been that uncommon and fallout from CV-19 has both increased potential tail risks (i.e. regulatory) and magnified potential equity downside through outsized net leverage (>10x F22E). 

Catalysts

Catalysts incl 1/ re-start continues to be pushed/cash burn extended on inconsistent relevant jurisdictional response; 2/ shipboard CV-19 outbreaks re-occur as re-start commences and generate gov’t and media scrutiny; 3/ expected slope of recovery flattens as cont’d earnings disappointments enhance awareness that 2017-19 prior-peak comp is increasingly unrealistic; and/or 4/ realization of “tail” risk that has been increasing in frequency (i.e. GFC, Costa Concordia, CV-19) incl heightened regulatory risk (i.e. US tax status), fallout from rising geopolitical tensions, equity bubble bursting, etc.

Risks 

Primary risk is eventual full recovery narrative continues to be all that matters and combo of wide range of potential outcomes/zero interest rates/FOMO/retail interest/factor trading/passive and ETF inclusion sustain inflated equity value. Investors’ willingness to extend duration despite fund’l disappointment owing to interest rates being pinned to the floor also a consideration.

There was an attractive opp’y to get long cruise stocks on the unrealistic “nobody’s going to cruise again” narrative during the early stage of the CV-19 pandemic but it was surprisingly short-lived especially since CV-19 is by far the most extreme fund’l challenge the industry has ever faced. There’s no doubt there will be pent-up demand from experienced cruisers when sailings (hopefully) re-start sometime next year and precedent suggests the consumer does have a short memory. Nonetheless the pendulum has rapidly swung too far in the other direction and the “cruise is going to be back to 2019 peak in three years” narrative likewise appears completely unrealistic. With nearly the entire global cruise fleet laid up since mid-March and unlikely to fully re-deploy prior to 2H 2021 it appears V-shaped economic recovery scenarios and bullish price action have filled the fund’l void. The return to cruising that is viewed as a bullish catalyst increases risk as fund’l datapoints should start to matter again and risk of re-infection and subsequent fallout rises. Both the space and the name are name are well covered so here’s what bullish narrative may be missing:

1/ Recovery expectations shouldn’t be anchored to 2019 peak. Three years prior to 2019 peak represent an unprecedented favorable run for global cruise. From 2017-19 cruise benefitted from ideal conditions incl 1/ steady, highly predictable demand/lack of publicized incidents; 2/ absence of need for material close-in discounting; 3/ outsized onboard spend driven by above-avg load factor and PC spend; 4/ plentiful low-cost airlift; and 5/ opening of new markets incl China and Cuba. This period was thus characterized by an unprecedented lengthening of the booking curve which is unlikely to be replicated within any reasonable forecast period. This alone makes comparisons to the prior 2019 peak highly suspect especially given pandemic-driven fund’l shifts that preclude return to stringent deposits policies much less a return to widespread proliferation of non-refundable fares that benefited yield mgmt prior to CV-19.

2/ There’s very little demand for cruising prior to 3Q 2021. Bulls have latched on to commentary about “2021 bookings in line with historical levels” but that’s only because in a normal year so little out-year demand is on the books prior to Labor Day anyway. Extensive travel agent feedback suggests some pent-up demand among experienced cruisers but little sense of urgency and virtually no interest from inexperienced cruisers. Customer deposits per berth are back to 2011 levels incl FCCs and -75% y/y excl FCCs. And stickiness isn’t close to comparable to pre-CV period given ultra-lax refund policies req’d to avoid even further WC outflows in the form of cash refunds. These highly accommodative refund policies will also have to remain in place for the foreseeable future. Thus cabins will have to be booked and re-booked at far greater frequency than in post-2009 period much less the 2017-19 period.

3/ Some portion of recent CV-19 spending shifts likely sustainable. Nature and magnitude of recent consumer spending shifts suggests potential for some sustained share shift in leisure time/dollars. Increased penetration of alt accommodations particularly for vacation home rentals among the highly sought-after family demo is a notable change (RCI brand was notable beneficiary of inter-generational travel). And spending directed toward the “outdoor renaissance” and the high % of new buyers among related rec hardgoods categories suggests stickiness among some portion of that demand. This suggests potential for diminished trial and/or reduced cruise frequency especially among older demographic that has greatest pandemic scars.     

4/ New-to-cruise demand will be challenged for a long time. New-to-cruise demand was enjoying a revival prior to the pandemic and represented >30% of demand across many brands. Cruise has always been a product that needs to be sold and great strides had been made overcoming prior widespread negative perceptions. Now the industry must contend with the perception it’s in part responsible for the spread of CV-19 and that as a passenger there’s the potential you can not only get sick but also get stuck on the ship (biggest incremental consumer concern after catching CV-19 shipboard according to distribs). Add to that the agency distribution channel is increasingly becoming impaired just as experienced cruisers need hand-holding and new cruisers need convincing to overcome safety concerns.

5/ Fallout from highly publicized CV-19 missteps incl heightened regulatory risk. Without assigning any blame it’s clear there were issues with the cruise industry’s initial response to CV-19 and the subsequent months’ long crew repatriation process. These well-documented issues across most major source and destination markets suggest 1/ gov’t response is likely to be more oversight and quicker, harsher response to any future issues (i.e. travel restrictions, CDC No-Sail, etc) and cont’d inconsistency across jurisdictions that creates itinerary uncertainty appears likely. Combo of heightened awareness of industry’s use of resources and national/state/local budget shortfalls increases risk of incremental taxes, fees, port charges, etc. Likewise expect CV fallout to result in even greater media scrutiny on any cruise-related issues. 

6/ Cruise wasn’t great business pre-CV and unprecedented leverage amplifies downside.  RCL’s massive cumulative negative FCF over the past 20 years, its inability to generate consistent economic profit given its history of sub-WACC ROIC and subsequently the extent to which the equity has traded below book value for extended periods of time have all been well documented. RCL has been the most aggressive among the Big 3 in utilizing deferrals to shore up 2020 liquidity and avoiding straight equity issuance. The company is already >5x net levered vs prior peak EBITDA and is expected to show >10x net leverage into 2023. 

Catalysts 

Shipboard CV-19 episodes attract consumer and gov’t attention as broad re-start commences 

Expected slope of recovery flattens on cont’d earnings disappointments 

Realization of a broader set of tail risks incl stricter gov’t intervention and taxation  

Risks 

Non-fund’l dynamics sustain elevated valuation metrics

Duration gets extended on zero-rates argument    

Record elongated pre-CV booking curve re-established more rapidly than expected 

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.

Catalyst

Shipboard CV-19 episodes attract consumer and gov’t attention as broad re-start commences 

Expected slope of recovery flattens on cont’d earnings disappointments 

Realization of a broader set of tail risks incl stricter gov’t intervention and taxation