Royal Caribbean Cruises: Compelling Valuation, Attractive Entry Point

May. 8.07 | About: Royal Caribbean (RCL)

Royal Caribbean Cruises (NYSE:RCL) is the second largest passenger cruise operator in the world. The company operates a total fleet of 34 ships including its leading Royal Caribbean Cruises and Celebrity Cruises brands, and the recently acquired Pullmantur brand.

The company's ships will carry over 4 million passengers this year to destinations worldwide. While the company's Royal Caribbean International [RCI] division caters to the mass-market contemporary cruise segment, Celebrity Cruises has greater appeal to upscale leisure travelers given its position in the premium cruise segment. Royal Caribbean's ships offer a broad array of services and amenities, including swimming pools, beauty salons, exercise and spa facilities, ice skating rinks, rock climbing walls, gaming facilities, lounges, bars, retail shopping, and cinemas.

We expect Royal Caribbean to continue to benefit from favorable supply and steady pricing trends, which should lead to solid growth in revenue yields. Following a 9% increase in fiscal year 2004, the company's net revenue yield1 increased by an additional 7% in fiscal year 2005 and another 3.4% in 2006. In addition to modestly favorable pricing, we expect the company's net revenue yield to benefit from full occupancy and increased onboard spending per passenger.

At 106.5%, the company's annualized occupancy rate in fiscal year 2006 exceeded 105% for a third consecutive year. In addition, passengers continue to spend more aboard the company's ships, given an increase in the level of amenities and excursions offered to cruise passengers. Solid occupancy trends, a favorable pricing environment, and higher spending per passenger should allow the company to continue to leverage fixed costs and offset the inflationary pressures from higher fuel, employee-related, and food costs.

The company is also implementing a number of energy conservation initiatives and is enhancing the types and sourcing of fuels. This includes a plan to begin to install diesel generators aboard the company's gas turbine ships in April 2007. The company is also restructuring itineraries and has a number of other projects under way to increase fuel efficiency. While industry-wide demand trends remain favorable, we are also encouraged by the positive impact decelerating capacity growth should have on pricing and occupancy going forward.

According to statistics compiled by the Cruise Lines International Association [CLIA], the worldwide cruise industry added 60-plus ships in the four years ending 2004. However, CLIA expects the industry to add just 20 new ships through 2008. Given the time and shipyard capacity constraints imposed on newbuilds, we expect to see a substantially lower growth rate in industry-wide capacity over the next few years. Royal Caribbean is set to increase its capacity by 12.2% in 2007 and 8.4% in 2008.

We maintain our Buy rating for Royal Caribbean. Solid occupancy trends, a stable pricing environment, and higher spending per passenger should allow the company to continue to leverage fixed costs and offset the inflationary pressures from higher fuel, employee-related, and food costs. We also find the current valuation compelling. The shares of Royal Caribbean are currently trading at 13.5x our 2007 earnings estimate and a 15% discount to its largest rival. Royal Caribbean is also trading at approximately 1.5x book value per share. As such, we believe the current share price of Royal Caribbean offers an attractive entry point for investors into the passenger cruise industry. Our six-month target price of $48 for Royal Caribbean is based on a P/E multiple of 15.5x our 2007 earnings estimate.

INDUSTRY OUTLOOK

Our outlook for the consumer discretionary sector is neutral. The sector is comprised of a diverse group of companies providing gaming and lodging, travel-related services, toys and sporting equipment, educational and advertising services, and various other consumer cyclical products dependent upon consumer discretionary spending. Excluding education services, companies within the sector are positively leveraged to an improving economy, as higher disposable income is typically associated with high rates of employment, increasing household wealth and salaries, and strong consumer confidence. While the economy continues to grow at a steady rate, we remain concerned about increased inflationary pressures and the negative impact that inflation and low wage growth may have on consumer discretionary spending. We believe that the operating environment has become more favorable, particularly for those companies with relative pricing power in a more favorable demand environment.

INDUSTRY POSITION

Royal Caribbean Cruises is the second largest passenger cruise operator in the world. The company caters to the mass-market contemporary cruise segment through its Royal Caribbean International brand and the premium cruise segment through its Celebrity brand. With 34 ships servicing more than 4 million passengers annually, we believe the company's competitive advantage relative to smaller industry peers is its size. Given the strength and diversity of its brands and itineraries, the company has been successful at capturing a broader audience of potential and repeat cruise vacationers.

The company's financial position also allows it to continue to add new, larger ships to its portfolio. With price tags of upwards of $600 million, we believe these larger ships with improved amenities and favorable cost advantages, are beyond the reach of all but the largest cruise operators. The company's size also allows it to shift capacity to regions of greatest demand, something that land-based resorts are unable to do. In addition, we believe the company is well-positioned to continue to leverage shore-side and on-board expenses and continue to drive growth through yield management and its substantial marketing capabilities.

RECENT NEWS

On May 1, Royal Caribbean reported financial results for the first quarter of fiscal year 2007. Total revenue increased 6.72% from the prior year to $1.223 billion and was slightly above our expectation. Passenger ticket revenue increased 3.3% from the prior year to $0.870 billion. Net revenue yield and available passenger cruise days [APCD] decreased 3.4% and increased 9.7% from the prior year, respectively, while occupancy was down 140 basis points from the prior year at 103.7%.

Onboard and other revenue also increased 16% from the prior year to $353 million. Net cruise costs increased 5.4% from the prior year. Total cruise operating expenses increased 15.2% from the prior year, while SG&A expenses increased 7.5% from the prior year. The company reported net income of $0.04 per share compared to $0.55 per share in the prior year.

We note that the prior year results included a gain of $0.16 per share related to a lawsuit settlement, and did not include results from Pullmantur. The results were $0.02 below our expectation.

For fiscal year 2007, management expects net revenue yield to increase approximately 2%. Net cruise costs are expected to increase 3% from the prior year. As a result, management expects diluted earnings to be in the range $3.05 to $3.20 per share for fiscal year 2007. We note that although the company is currently 50% hedged with regards to its fuel costs for 2007, a 10% change in the market price of fuel for the year would result in an $18 million change in fuel expense, or more than $0.08 per share.

On August 31 2006, Royal Caribbean announced that it had agreed to purchase Pullmantur S.A., a Madrid based cruise and tour operator. Pullmantur is the largest cruise line in Spain, and operates in two primary business segments. The company's Cruise Line division owns and operates five cruise ships that operate in Europe (Mediterranean, Adriatic, and Baltic) and Latin America. The company's Tour Operations segment sells travel packages to Spanish guests including hotel and flights to the Caribbean, and sells trips to Europe for Latin American clients. The company also owns three planes which are used to support the cruise and tour businesses. Pullmantur will remain an independent brand owned by Royal Caribbean, and will become RCL's first wholly-owned European brand. RCL is acquiring Pullmantur for approximately $900 million ($552 million equity plus the assumption of $347 million in debt).

The transaction is being financed in the short term with bridge financing, and is expected to close by the fourth quarter of 2006. We note that the acquisition does appear to compliment the company's current portfolio, and increases the company's presence in the growing European market.

VALUATION

We maintain our Buy rating for Royal Caribbean. Solid occupancy trends, a more stable pricing environment, and higher spending per passenger should allow the company to continue to leverage fixed costs and offset the inflationary pressures from higher fuel, employee-related, and food costs. While the current top-line environment remains challenging, we consider RCL to be poised to strongly benefit given an increase in demand. We also find the current valuation compelling. The shares of Royal Caribbean are currently trading at 13.5x our 2007 earnings estimate and at a 15% discount to its largest rival. Royal Caribbean is also trading at approximately 1.5x book value per share. As such, we believe the current share price of Royal Caribbean offers an attractive entry point for investors into the passenger cruise industry. Our six-month target price of $48 for Royal Caribbean is based on a P/E multiple of 15.5x our 2007 earnings estimate.

RISKS

Revenue and earnings growth is largely dependent on the company's ability to generate favorable pricing, increase occupancy, and improve operational efficiencies. The company is susceptible to impact from changes in the cost of crude oil. As such, during periods of rising crude prices, higher net cruise costs are likely to offset some of the favorable yield impact to the bottom line. A cyclical downturn in the U.S. economy or another terrorist-related event similar to 9/11 could adversely affect demand for cruises. We note that Royal Caribbean utilizes a proprietary revenue management system, which relies on tactical pricing techniques, to maintain occupancy rates. Natural disasters, notably hurricanes, could have a negative impact on financial results, given that nearly two-thirds of the company's capacity is located in the Caribbean.


INSIDER TRADING AND OWNERSHIP

Insiders own 51% of the company's common stock. Institutional investors own 57% of common shares outstanding. Institutional holders with over 5% beneficial ownership of common shares outstanding include Capital Research and Management (8% of common shares outstanding), Barclays Global Investors (13%), and Allianz Global (5%).

KEY POINTS

  • We maintain our Buy rating for Royal Caribbean, based primarily on valuation.
  • Given favorable supply and steady pricing trends, we expect the company to continue to benefit from higher revenue yields, which should lead to solid growth in net income as the company brings on additional capacity.
  • The current valuation also remains compelling. The shares of Royal Caribbean are currently trading at 13.5x our 2007 earnings estimate and at a 15% discount to its largest rival. Royal Caribbean is also trading at approximately 1.5x book value per share.
  • 1 Total revenue per available passenger cruise day less commissions, transportation, onboard, and other direct expenses.

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