Carnival: 16% Decline Insufficient After Disaster

| About: Carnival Corporation (CCL)

On Friday, January 13th, the Costa Corcordia, which is owned by Carnival (NYSE:CCL) capsized off the Italian cost.

Little Apple has written a good summary of the event and implications here on Seeking Alpha, I agree the stock is unlikely to go bankrupt, but even with today's pre-market 16.5% stock decline, there is no upside in the stock.

This quantifies the financial impact of this sad event. On the company's own early estimates, earnings will decline over 6%. However, there are also risks to both the Costa brand and cruise travel more broadly, as well as legal risk, that could cause a broader sell off of CCL. Quantifying these risks suggests that Carnival has no upside, given the risk inherant in these situations and the probable continuing negative newsflow, Carnival is a sell. That is not to say it's going to go bankrupt, but there's no reason to own the stock at this point.

How Costa Fits In To Carnival - A House of Brands

Carnival takes a multi-branded approach to its cruise operations, in Europe, Australia and Asia it has five core brands: AIDA, Costa, Curnard, P&O (both UK and Australia) and Ibero Cruises. That segment generates revenue of $5.7B (40% of CCL total) and operating income of $1.1B (48% of total), so Costa is likely contributing in the region of $1B revenue and $200M operating profit. As of January 2011, the Costa brand had 14 ships or 14% of the company's total ships and 15% of the company's passenger capacity, though it's profit contribution is slightly lower. Costa has been in operation for 63 years and focuses on Italian, French and German customers.

Carnival's house of brands operating structure is relatively beneficial, because the impact of the disaster may be contained to Costa rather than Carnival more broadly.

Company's Estimate of Financial Impact

Carnival has released its own statement regarding the disaster here.

Area Estimated Impact
Deductible for damage to vessel $30M
Deductible for 3rd party injury $10M
Loss of use of vessel $85-95M
Total $125-135M

These costs would represent a 6.5% decline in net income relative to 2010. Bear in mind these are the company's early estimates, not independent estimates.

Impact to the Costa brand

Given the terrible nature of the disaster, it may have an impact both on the Costa brand and cruise travel more broadly. It will be hard for Costa to recover given the negative association. If CCL were to lose the Costa brand entirely and not recoup the revenues through other European brands, that would be $200M of lost operating profit, or approximately $140M of post-tax earnings, representing $2B of market cap or 7.5% of the total market cap at the pre-disaster 14.8x earnings multiple.

Impact to cruise travel

If the vivid nature of the disaster were to cause a general 10% reduction in cruise travel, that would cut CCL's profit by approximately $350M or $5.1B of market cap, or about 20% of the total market cap, again using the pre-disaster p/e multiple of 14.8x. These numbers are based on the lost revenue after subtracting the associated variable costs.

Legal and insurance risk

Carnival believes it is covered by insurance and it is too early for any legal cases to be bought, but if the depreciated value of the ship is in the region of $400M, I estimate a 25% chance the value is not covered by insurance. To be clear Carnival's expectation is that it will be and they will only pay the deductible, but the terms of the insurance agreement have not been disclosed.

Recommendation

Carnival should be severely discounted because of the disaster and the uncertainty surrounding it. A 6% reduction in earnings is high likely, as is reduction to the Costa Brand and cruise travel more broadly. Carnival was trading at $34.28 before the disaster and given a 6% earnings decline and a 50% probability of both a 10% drop-off in cruise travel and the end of the Costa brand, as well as a 25% chance of legal risk that translates into the stock at $27.17.

Pre-disaster CCL stock price $34.28
Immediate costs of deductibles and lost earnings at current multiple -$2.22
50% chance of Costa business being worthless -$1.28
50% change of 10% reduction in cruise volumes across CCL -$3.48
25% of failed insurance coverage or legal risk -$0.13
Resulting CCL price based on analysis $27.17
Current CCL price (based on London listing) $28.62

Given the need for a 20% margin of safety given the risks surrounding the stock, I would consider buying CCL at $21.70, a higher valuation is of course possible, as more news is disclosed about both the reasons for the disaster and the reactions to it, but this disaster will likely hang over the stock for many months to come, especially because the impact on customer's attitudes to cruise travel will take time to emerge.

The stock is trading slightly above my valuation even before a margin of safety, therefore I would sell it

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.