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If you caught a glance at a friend's paycheck and worked out that he had a $100,000 salary, you might be impressed. But if you also saw he was making mortgage payments on a $2,000,000 house, you wouldn't be so concerned with how great his salary is, most of his money would be used to cover his interest payments and he wouldn't get to keep very much of it at all.

That's the problem with Norwegian Cruise Lines (NASDAQ:NCLH). Since its IPO in February, the company has managed to maintain relatively stable growth in adjusted earnings and continues to expand its fleet of cruise ships serving exotic destinations around the world. Yet this growth in fleet size comes with a massive $3.2 B of debt on the books, which based on the current state of cash generation, the company has slim hopes of being able to pay back any time soon.

Adjusted Earnings

Norwegian reported adjusted earnings of $60.2 M, making it the 20th consecutive quarter of growth in adjusted earnings. Yet factoring in debt restructuring charges, Norwegian continues to operate a loss in the current year, amounting to $100M for the full year.

So where exactly does this difference come from? What are restructuring costs, and why does the company keep reporting front and center profits when its back page bottom line continues to be negative?

Norwegian restructured a good deal of its debt in the second quarter. It opened a $1.3B credit facility, used a portion of the proceeds to redeem $350M of 9.5% bonds and refinanced certain credit facilities relating to several ships. These refinancing transactions were done to "strengthen the Company's Balance Sheet and reduce interest expenses going forward" and incurred a fee of $70.1 M relating to these transactions.

Norwegian reconciles the difference between its reported adjusted earnings as follows:


(Click to enlarge)

At first glance, it seems that fees relating to debt pre-payments seem like a reasonable item to adjust out as by nature they seem to be one time charges. Yet in their discussion, Norwegian mentions that the amount of outstanding debt has not resulted in material changes in debt levels.

In fact, Norwegian's outlook for the next two years calls for more debt in exchange for new additions to their expanding fleet. Considering their current questionable profitability, this really brings to question whether the company is overloading itself with debt, and whether it will be able to generate enough cash to meet its massive debt obligations, or if charges related to managing and repaying its massive debt will continue to chew away at the common shareholder's bottom line.

Cash Flows

Over the course of the first half of 2013, the net cash position increased $37 M to a total of $82 M for the year. Let's have a look at the breakdown of the major transactions:

Norwegian Cruise Lines - Cash Flow Statement (extract)

Starting Cash Balance

45500

Operating Activities

Net Income (1)

-106415

Depreciation (1)

115946

Advance Ticket Sales Increase (2)

187868

Other

55381

Investing Activities

Additions of Property Plant and Equipment (3)

-759020

Financing Activities

Repayment of Debt (4)

-2081520

Proceeds of Debt (4)

2289253

Initial Public Offering

473017

Other

-137170

Net Cash at year end

82840

  1. Net Income and Depreciation - The Net income factors in the financing charges as interest expense, and we remove depreciation as it is a non-cash expense.
  2. Advance Ticket Sales - This account represents cash collected for future trips, essentially future revenues. This is an important cash flow item and the current balance of $542 M heading into Norwegian's busiest quarter of the year is over $80 M higher than the previous year which is a great sign for advance bookings of Norwegian Cruises.
  3. Additions of Property Plant and Equipment - The bulk of this transaction was related to the newest ship - Norwegian Breakaway which was delivered and launched in the second quarter of 2013. Norwegian has no other significant ship construction costs projected for the remainder of 2013 but expects to disburse another $747 M and $799 M in 2014 and 2015 respectively.
    For the remainder of 2013, Norwegian expects to spend another $40.5 M on business enhancement expenditures and $42.8 on ship building costs.
  4. Debt Transactions - Norwegian made a series of significant refinancing transactions, but overall only increased its debt by just over $200 M.
    Based on its guidance for the next years, in conjunction with the shipbuilding purchases Norwegian plans on financing another $668 M in 2014 and $630 M in 2015

Overall, the cash flow picture seems to be incredibly tight. The newest ship's cost of $759 M seems to have been paid for primarily by the IPO of $470 M, and the remainder of which was paid out of increased debt and the increase in advance ticket sales. Yet advance ticket sales are not yet revenues and represent an obligation to provide a service in the near future relating to the cost of the cruises that have already been paid for.

Advance Ticket Sales - A Cash Squeeze Coming Up?

Based on the margins in the second quarter, Norwegian pays the following direct costs on the sale of each cruise in proportion to revenues:

Norwegian Cruise - Direct Expenses in Proportion to Revenues

Commissions, Transportation and Other

18%

Onboard and Other

8%

Payroll and Related

13%

Fuel

12%

Food

5%

Other

10%

Total Direct Costs

65%

Cruise operating costs represent 65% of revenues, yielding Norwegian a 35% gross margin. If we were to assume most of these costs would be incurred in the same period as the cruise is taken, the $542 M of total advance ticket sales on the books represents an obligation for another $352 M of direct costs that have likely not yet been incurred. Yet, this $542 M has by the looks of things already been mostly spent!

Cash then, to meet this obligation, will have to come from opening cash and cash sales during the quarter. Norwegian's current cash position at the end of the second quarter is just over $80 M. Last year's Q3 sales were reported in the range of $670 M, and by all indications based on the performance so far this year sales will exceed this target. However, the minimum $670 M in potential sales is reduced by the amount of sales collected in advance, therefore at most the balance of $542 M sitting in the advance sales account. This really limits how much additional cash they can expect to generate in the quarter from sales that have not yet been booked, and could lead to a cash squeeze during the period as the company runs out of money.

Projected Cash flows

With this in mind, the rest of 2013 should look somewhat as follows:

Norwegian Cruise - Projected Operations Cash Flow 2013 ($Millions)

Second Half 2013 Adjusted Earnings (1)

192

Adjustments to convert to cash

Add back: Depreciation (based on guidance)

120

Less: Advance ticket sales already received

(542)

Add: Estimated advance ticket sales for 2014 (2)

375

Net Cash Generated from Operations

145

  1. Norwegian's estimate for Adjusted EPS 2013 of $1.30 to $1.40 seems very far away from the current adjusted EPS of $0.35 for the first half of the year (not including the financing charges). Nevertheless, this amount may be reasonable as the third quarter is the largest in terms of sales and the estimate is in line with analyst estimates at $1.35.
  2. I have left my assumptions more conservative to leave a bit more of a margin of safety for the actual EPS in my analysis. The assumptions for estimated advance ticket sales represent a $25M increase on December 2012 to mirror the increase from 2011 to 2012. This increase could be a bit higher as there is a new ship with capacity of 4,000 berths available and sales so far this year have been trending upwards.

Based on Norwegian's guidance of $1.30-1.40 EPS for the full year of 2013, an estimate of net cash generated from Operations the second half of the year would be around $145 M on $192 M of earnings in the same period.

Yet Norwegian is still planning some Capital Expenditures for the second half of 2013. As seen above, we should expect the capital expenditures of $84 M for Business Enhancement and Ship Building. This leaves us with $61 M in cash after investing activities.

But what about Financing and Debt Repayments? Norwegian's second quarter 2013 balance sheet shows $272 M of short-term classified debt. If only half of the short term portion comes due in the first half of 2013, the cash flows after financing would be of $-75 M.

It's quite clear then that Norwegian is not going to be able to sustain its cash needs in the second part of 2013. The options left then are either more debt to exacerbate the problem, or a new issuance of shares to dilute the current share value. Neither of these options is great, but Norwegian will be stuck with one of them if it wants to make it through the rest of the year.

The Competition

Norwegian's two much larger major competitors in the industry, Royal Caribbean (NYSE:RCL) and Carnival (NYSE:CCL) both seem to have their debt more under control.

Royal Caribbean carries a total of $8.25 B in debt on its balance sheet at the end of the second quarter, yielding a debt to equity ratio of 1.02. Using 2012 figures, this debt represents about 107% of sales and 8 times 2012 operating cash generated. Royal Caribbean had its own Carnival-esque incident during the year with a fire on board its Grandeur of the Seas ship, resulting in a $-.05 EPS impact. I continue to recommend a good look into Royal Caribbean. Despite the price being up over 13% from when I last recommended it in February, the company does not suffer from the same image damage as carnival, and continues to be fairly priced, much more so than Norwegian.

In terms of debt, Carnival Corporation fares even better with its $9.8 B of debt spread out over a much larger revenue base. The company's debt to equity ratio stands at .37 and this debt represents 63.7% of 2012 revenues. The total debt is only 3.3 X cash generated from operations in the full year 2012. Carnival however has had its own series of problems starting with the Costa Concordia incident and the Carnival Triumph. Revenues in the first half of 2012 have taken a slight loss compared to increases in both of its competitors. The share price since the beginning of the year has also lagged its peer group and is currently 5% lower than at the start of the year.


(Click to enlarge)

In comparison, Norwegian's debt to equity ratio stands at 1.47 and the debt represents over 140% of 2012 sales. The total debt represents 8 X cash generated from operations in the full year 2012.

Conclusion

So after this "adjusted profitable" year, Norwegian is again in a position of generating less funds than it needs. This is not necessarily a bad thing, as the company is trying hard to grow and increase the size of its fleet without compromising cruise quality, but in our case things seem to be getting out of hand.

Norwegian will likely not be able to make payments on its balance sheet debt in the second half of 2013 without issuing more shares or debt. Furthermore its plans for continued operations in 2014 and 15 call for the financing of another $ 1.3B over those two years. Without significantly increasing its ability to generate cash, how would it make payments on that new debt, let alone its current portfolio of $3.2 B at the end of the second quarter without negatively impacting the value to common shareholders?

With all this in mind, I would recommend to steer clear of Norwegian shares. The company has a great operation and is generating strong results, but there is so much debt to go with them that the lowly common shareholders will have little to nothing left by the time it's their turn.

Source: Norwegian Cruise Ships Are Drowning In Debt, Save Yourself