Norwegian Cruise Lines (NCLH) is a mass market cruise company with 12 ships cruising in Europe and North America. It competes with cruise lines owned by Carnival Cruise Lines (CCL) and Royal Caribbean Cruises (RCL), both of which have much larger market share than Norwegian. The company is overvalued and overextended compared to its peers. I have cruised on the Norwegian Jade in the past, and enjoyed it, but I do not believe it's stock will provide an enjoyable experience going forward. Norwegian's fleet appears below.
Source: IPO Prospectus, NCL.com
Buyers of NCLH stock have focused on the company's impressive growth plans. Regular readers will know I love a company that is growing revenues, if I can buy it at a great price (like America's Car-Mart). Investors have been focusing on NCLH's earnings growth, which stems from taking delivery of a new (and large) ship every year. These new deliveries are significant for a company where the 12th ship just launched. Some analysis has called for Norwegian to grow revenue 13% compared to compared to its competitors growing at 4-5%.
The bull case neglects four important reasons why NCLH stock should decline.
1) Older ships moving to lower profit locales
On their conference calls Norwegian will be glad to tell you about how well their new ships are booking, but that's not the whole story. Norwegian Breakaway is cruising this summer from New York City to Bermuda, a profitable itinerary that was formerly sailed by the Norwegian Star. NCLH has moved the Star to their Baltic itinerary for this summer. That should be profitable, but they were cruising that itinerary last year with the Norwegian Sun. They moved the Sun to a one-way itinerary in Alaska, and upcoming cruises are as low as $249 per person per week. That price was current on NCL.com as of May 25th, 2013. This displaced ship is likely making much less money this year compared to prior years.
Aside from the evidence that the new itineraries are less profitable, it makes sense that Norwegian would put its ships on the most profitable itineraries available to it first, and then backfill to less profitable routes as it buys more ships.
2) Lack of loyalists to fill the new ships
Cruise lines offer perks to repeat guests. Norwegian does so using its Latitudes program, and RCL and CCL have competing programs. Many avid cruisers stick to one line to get higher status in the program, and thus get the associated benefits, which can include early boarding, discounts on onboard purchases, complimentary or discounted laundry and internet minutes, and the ever popular members' only party with free alcohol. These loyal customers tend to book early and spend more, but by expanding the fleet so quickly NCLH is diluting their impact. It will be very difficult to steal loyal customers from other lines, and organic growth of this segment will be slower than their expansion of available berths.
3) Too much debt
Norwegian has a current ratio of just 0.2, leaving them little margin to deal with a cash crunch should one appear. They also have $2.638 billion dollars in long term debt. With just $555 million of adjusted EBITDA in 2012, this business is levered with a 4.75X Debt to EBITDA. This actually overstates their debt carrying ability, as Norwegian is forecasting $74 million in sustaining capex this year. (Excludes newbuild program). Their debt ratio is much worse than Carnival, and this level of debt reduces their financial flexibility and makes their stock riskier.
Source: SEC Filings
4) Stretched valuation
The table below presents data pertinent to the valuation of NCLH at its current share price of $32.15 at the close on May 24th, 2013. Its 12 active ships have just over 30,000 berths (cruise industry term for passenger spaces at double occupancy). At its current price the company is selling for over $300k per berth. Its new ships were acquired at $212k per berth.
Source: SEC Filings
Paying $300k per berth for the Norwegian Breakaway when Norwegian just bought it for $212k per berth is unwise. There's no shortage of capacity to build cruise ships, they aren't worth more than they cost to build. However, you are also paying $300k per berth for Norwegian's other ships, like the Norwegian Spirit. At $301,871 per berth, the implied valuation on the Spirit is $609 million, for a ship that is 15 years old and was only valued at $350 million when it was new! The current valuation on the company is not anywhere near supported by the assets of the company.
This valuation is also not anywhere close to being supported by the cash flow of the company. With EBITDA of $555 million and $74 million in sustaining capex, the company has free cash flow of $481 million. It's enterprise value is over 19 times greater than its cash flow, a stretched valuation that isn't supported by the company's growth plans.
Although the valuation here is excessive, this is not solely a valuation short. Potential catalysts include reduced operating results as discussed above, a potential incident (CCL has been hurt by this of late), or future tax changes to currently favourable tax rules for foreign flagged ships. Their significant debt also makes them vulnerable to increases in interest rates.
The biggest catalyst here is the expiry of the lockup on the majority owners selling additional shares after the IPO. This lockup will expire on approximately July 17th, giving the major shareholders Apollo, TPG and Genting a chance to sell their shares. Apollo and TPG are private equity funds who would not be expected to hold their shares permanently, and this huge supply of additional stock will suppress the share price of NCHL. These private equity funds own many times more shares than are currently in the public 'ahem' float, and their sale has significant potential to reduce the price. Their IPO prospectus has more detail on page 33.
For all these reasons, NCHL is a sell/short, and may be attractive as the short side of a pair trade with CCL.