Carnival (CCL) and Royal Caribbean (RCL) have weathered one of the cruise industry's most difficult periods in recent memory. After scrambling to redeploy Southern Mediterranean capacity in 2010 because of political instability in countries like Libya and Egypt, the companies sailed into a year that saw more turmoil in its promising European base, with key sourcing countries (Spain, Italy, Greece) facing austerity measures, high unemployment, and overall economic duress. In addition, the Costa Concordia disaster off the coast of Italy, which portrayed the safety protocols of cruise ships in a less than favorable light, plagued the lines.
We believe that the external noise that has limited Carnival's and Royal Caribbean's stock price growth over the last eight months is largely in the past, and that more normalized patterns of demand and pricing will resume over the next few quarters and, more important, into 2013's wave season. While Europe could continue to drag on overall profitability in the near term, stabilization in the U.S. market with forays and expansions in newer geographic markets could provide longer-term opportunities for expansion. We don't see a change to our narrow economic moat rating for either company over the foreseeable future thanks, to their scale and barriers to entry.
We Expect Better News as the Next Wave Season Should Improve
Negative headlines have plagued the cruise industry in recent months. In January, the Costa Concordia listed in the Mediterranean (where it remains) and 32 lives were lost. In February, those who traveled to Puerto Vallarta on the Carnival Splendor and participated in a land-based excursion were robbed at gunpoint. Also in February, the Costa Allegra experienced an engine room fire that left the ship powerless in the Indian Ocean, an area susceptible to pirate attacks.
It would be difficult to duplicate another negative news year like 2012, but bad news isn't the only headwind for Carnival and Royal Caribbean. Both companies face a still-weak European consumer and are ramping up capacity in Asian markets as they continue to slow. However, the fact that Asian capacity is extremely limited and the population is underpenetrated should ensure that the current slowdown will be muted in both companies' results. Furthermore, as the year has progressed, the language that Carnival and Royal Caribbean have used in their press releases and earnings calls has become increasingly more positive versus the dire commentary earlier in the year.
We are convinced that 2013 will reflect more normalized demand for cruises, which should restore earnings power across the industry. We think Carnival and Royal Caribbean should be able to deliver mid-single-digit top-line growth over 2011--ignoring the anomaly that was 2012--with improved operating metrics and earnings per share growth that is materially higher (40% on average) than the current year.
Both Operators Stand to Benefit From Positive Secular Trends
Carnival and Royal Caribbean still collectively control 75% of global cruise capacity. Although the lack of meaningful competition might tempt these firms to rest on their laurels, both have adapted to evolving economic and demographic conditions to maintain their respective market positions.
With limited global shipbuilding capacity and a lead time of at least three years before new ship orders enter deployed capacity, we expect supply to become more favorable for the cruise lines relative to demand. Historically, capacity has been deployed countercyclically, with ship orders placed during strong economic periods and capacity coming on during weak economic periods. In the inverse, cruise lines tend to be hesitant to order ships during weak economic cycles that would be likely to come on line during better economic periods. As a result of the prolonged recent macro slowdown, Carnival and Royal pared their new shipbuilding plans relative to prior cycles, which should account for more muted capacity growth through at least the end of 2016 (and we expect this should be a less temporary shift). The 2010-20 period is shaping up to be the slowest-growth period for the industry of the past four decades, with expected average capacity growth through 2016 of only 3%, versus a 7% compound annual growth rate in the 1980s, 6% in the 1990s, and 7% in the 2000s.
The decline in total capacity growth coincides with an increase in demand as the baby boomers enter retirement and their time allocated to leisure increases. The most recent U.S. census projects the percentage of people older than 65 will climb to 20% over the next 20 years and stay there for at least another 15 years, before beginning to decline around 2050. In addition, between today and 2030, this slice of the population segment will be one of the fastest-growing demographics in the United States, projected to grow twice as fast as the total U.S. population through 2035. If the adage that cruises cater to "the newlyweds, the overfeds, and the nearly deads" holds true, Carnival and Royal Caribbean should see consistent demand for their products.
The trend we remain most concerned about is the increasing cost of new ship builds. We estimate that the average cost per berth has increased roughly 50% over the past 16 years, or 2.5% annually. This translates into a longer payback period per ship, all else equal, as additional itineraries need to be booked in order to reach break-even for each ship. Our concern is somewhat offset by the fact that a higher proportion of rooms on new ships is allocated to higher revenue-generating formats (like veranda rooms). Additionally, we believe the higher costs can be covered by increasing prices as both companies move into new markets like Asia, Australia, and Latin America. This limits capacity in existing markets (with fewer ships deployed) and new markets (entry capacity is small and the consumer is willing to pay up thanks to the newness factor.)
Importantly, while the target market for domestic core cruisers has decent penetration (about 25% of those older than 25, earning more than $40,000 annually), international reach still has plenty of room for growth, even in European locations where the cruise lines have operated for some time now. We still think one of the most compelling characteristics of the cruise industry is its ability to redeploy its assets to where demand is the strongest and the best yields can be obtained.
We do not believe that another player will enter the market and quickly take share in any meaningful way. Norwegian Cruise Lines, the third-largest player, currently has about 26,000 berths, versus Royal Caribbean's 100,000 and Carnival's 200,000-plus. For any player to acquire significant capacity, it would take the combination of time and investment dollars before either of the biggest players begins to feel threatened.
Cruise Industry Should Exhibit Some Cyclical Support
With Carnival and Royal Caribbean still generating more than half of their respective sales in North America, the stability of the domestic market remains crucial to the earnings and cash flow profile of each firm. Although both companies saw revenue declines of nearly 10% during the economic downturn in 2009, we speculate this decrease would have been significantly worse with less geographical diversification. During 2009, the euro remained strong and we suspect that European consumers alleviated part of a greater shortfall. At this point, we believe the domestic consumer has limited downside over the near term: Unemployment (and underemployment) remains relatively high, home values sit at somewhat depressed levels, and the wealth effect is unlikely to pack a greater psychological punch than it has over the past few years, all while the European consumer will likely stay in its current weakened position. This scenario should allow net revenue yields to resume growth at a pace that is moderately faster than the cost increases. In practice, year-over-year net yield growth is lumpy and can swing wildly on occasion, but we have forecast an average growth rate of nearly 3% over the next decade, which should encompass both very strong and very weak years.
Although the value proposition that the cruise industry offers has arguably narrowed over the past five years, the pricing over a land-based vacation remains compelling, based on our findings. For example, in 2011 a couple on a Royal Caribbean ship would have spent $343 per night (double occupancy) versus either $277 in New York City or $253 at Walt Disney World (single or double occupancy is the same in hotel pricing). We note that the cruise ticket includes meals and nightly entertainment, while the land-based vacations do not. This suggests that a couple visiting either New York City or Disney would have to obtain three meals daily (plus entertainment) for less than $66 or $90, respectively. Both land- and sea-based vacationers must add discretionary expenditures such as alcohol, gambling, and spa treatments, so we do not include any of these items in our analysis. We think as the economic environment stabilizes, land-based vacations will once again become more expensive relative to sea-based vacations, strengthening the value proposition over the next few years.
Our Valuation Suggests Upside
Carnival stock currently trades at a 10% discount to our $41 fair value estimate. While we remain concerned about some of the economic headwinds for Carnival, particularly in Europe, we think there are still incredible growth opportunities in new markets like Asia and Latin America.
Royal Caribbean currently trades at an 11% discount to our $35 fair value estimate. The management team's dedication to returning the company to investment-grade status could put a vise grip on cash returned to shareholders over the next few years as the company pays down debt, but would provide an earnings kicker while improving cash flow metrics longer term, making the current valuation more compelling.
Over the past five years, Carnival and Royal Caribbean have traded at an average trailing-12-month price/earnings ratio of 14. Carnival's 2012 fair value P/E of 21 indicates that it is slightly more expensive than Royal Caribbean's 2012 fair value P/E of 18, and we think Royal Caribbean's stock could have better upside potential in the near term, particularly if it begins to actively pay down debt to return to investment-grade status over the next 12-18 months. Overall, we still believe that Carnival is the better operator and praise the company for more cash flow stability. We have arrived at our fair value estimates for the cruise companies by assuming mid-single-digit revenue growth driven by slow increases in capacity and pricing for both Carnival and Royal Caribbean.
(By Jamie Katz)