The Golden Age For Cruise Lines

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Includes: CCL, NCLH, RCL
by: Spring Mill Research
Summary

Here I discuss the tremendous ongoing organic growth of cruise lines.

Talk about all key growth metrics, including net yields, ship capacity and profits, as well as certain balance sheet (debt) and cash flow measures.

I conclude by valuing each of the three biggest cruise operators, and briefly discussing my rationale in buying Carnival Corp.

Throughout the article, current trends are provided in context with performance in past cycles.

The global cruise industry is set for another very impressive year of profit growth in 2017. A strong current (third) quarter - which accounts for up to 60% of full-year profits - should help ensure operating income again increases well into double-digits for the cruise industry's three biggest players: Carnival Corp. (CCL), Royal Caribbean (RCL) and Norwegian Cruise Lines (NCLH).

Source for all charts is company SEC filings.

Profiting From Ownership

Despite the advantages of asset-light espoused by many in the lodging industry (and myself), there is a lot to be said for the tremendous profitability derived from cruising's ownership-based model. That's especially so when those (offshore) cruise profits are tax free.

NCLH IPO'd in Jan. 2013. Results prior to then are as a private company.

Carnival Corp. should earn roughly $3 billion in 2017 net income, which exceeds the combined forecast profits for the world's three most profitable hotel companies (i.e., Hilton, Marriott, Wyndham). (I previously mentioned this in fall 2014 and investors still under-estimate CCL's profitability.)

Royal Caribbean and Norwegian Cruise Lines have a slight edge on Carnival on a profit-per-passenger basis. Each should earn more than $280 per cruise-guest in 2017, with more than two-thirds of their income through ticket sales, and the remainder via 'Onboard' spending. With a 2017 net margin in the teens for each, aggregate net margin for the 'Big 3' will likely have increased by about two-thirds since just 2014.

Advance cruise bookings on published itineraries provide some visibility into 2018 profits. My estimates suggest compound annual growth rate (CAGR) in operating profits (EBIT) from 2014 through next year of 22%, 21% and 19%, for RCL, NCLH, and CCL, respectively.

Steady Cash Flows In More Challenging Periods Also

From the past cycle's high (2007) to its low (2009), Carnival Corp's operating cash flows (i.e., EBITDA) fell by less than 10%, versus a 35% decline at Marriott, the world's largest hotel operator (by revenues).

It would be an understatement to say Royal Caribbean had a challenging year in 2009, with the bulk of its financing for the world's first 5,000-plus berth ship (Oasis of the Seas) coming due just as the economy hit rock bottom. Yet in just two years from that 2009 precipitous profit drop, RCL's EBIT had recovered to all-time highs (rewarding investors with a four-bagger in that span).

Build It And They Will Come...Paying Higher Ticket Prices

Much of the cruise oligopoly's resilience is simply down to lack of vacancies. Compared to typical occupancy levels of 55% - 80% for their hotel competitors, these cruise lines typically run 102-107% full. (Levels above 100% indicate more than 2 passengers occupied some cabins.)

The cruisers' massive yield management teams are adept at leveraging their fixed cost bases in times of tight demand. Robust advance bookings facilitate ticket price increases "closer-in": as a boat fills up, an operator's yield management team aims to ensure that the final booked berth pays the maximum ticket price.

Net (Revenue) Yields - changes in revenue after key variable costs (mainly travel agent commissions) - is the cruise industry's standard for organic growth/performance. In this high-fixed cost industry, net yield growth implies significant operating leverage

A few words about each company's current net yield trends:

RCL, the net yield leader (+6.3% FY17E) is currently benefiting (by up to 2 percentage points) from the mid-2016 de-consolidation of low-yielding Pullmantur. Moreover, strong industry-wide pricing power layered on the marketing benefits from steady launches of new ships are the template for Royal's staggering performance.

NCLH: Its strong very strong net yield performance trends have no qualifiers. My +6.1% forecast for full-year 2017, more aggressive than is implied by management's recent guidance -- tempered by the launch of a new ship in the current quarter.

CCL's net yields, though impressive across its massive fleet at +3.2% in FY17E, are / were (in H117's prior year comparisons) temporarily constrained in part by currencies (esp. sterling) due mostly to the large contribution from Princess Cruises and other UK-based boats.

Cautionary Notes About Industry Debt

When analyzing the relatively immature, capital intensive cruise line industry, there are important consequences (debt) and trade-offs (levered growth) to consider. At this stage in the broader economic cycle I am particularly sensitive to a cycle turn, and pay close attention to balance sheets and cash flows.

Construction of a cruise ship, which costs upwards of $200K per berth, requires a multi-year lead time (and build-options are costly and mostly inefficient). In the past, at least, cruise line operators made disproportionately ambitious orders on boats during the good times (i.e., robust discretionary spending, receptive lending), only to find that the cycle had turned a few years later, with ship-construction complete - and the bulk of payment falling due (about 2/3's of a ship's cost is paid in the final year of construction).

Earlier I mentioned difficulties faced by RCL upon taking delivery of the world's largest cruise ship during winter 2009 - a year in which its net debt vs. EBITDA exceeded 6.5 times. And in the prior cycle's downturn, from 2000-02 Carnival Corp., increased its own capacity each year from 10-21%, though it was far less leveraged than its closest peer, then and throughout their histories.

The balance sheets for Carnival Corp. and Royal Caribbean show net debt firmly below $10 billion from 2007 through Q217. But, because CCL generates more than twice RCL's EBITDA, Carnival has much better coverage levels. Finally, net debt at Norwegian Cruise Lines is half an EBITDA turn above even RCL's, thanks largely to the $3.0 billion acquisition of Prestige Cruises in late 2014.

Once Burnt…

Industry capacity growth, largely reflecting expansion by Carnival and Royal (given their >70% global share), has been moderated during the current cycle. Mid- to high single digit (%) annual growth in future global demand is now being met by only low to mid-single digit capacity increases. This unmet demand should support yield increases averaging at least 2% over the next several years.

Each of the three biggest cruise lines should net one- to two additional ships in service from 2017 - 2020. Both CCL and RCL are increasingly focused on maximizing their most profitable mix of boats while modernizing their fleets: sales of ships are increasingly common these past few years. NCLH, with its relatively modern fleet, continues to scale-up, and should remain the group leader in percentage unit / capacity increases for the foreseeable future.

Valuation & Conclusion

I value Carnival at $92 a share, 35% above recent quotes, based on EBITDA and PE multiples of 13.5 times and 18 times my 2018 EBITDA and EPS forecasts, respectively. At current levels, I am a buyer of Carnival for three main advantages (vs. RCL): 1) CCL's more conservative balance sheet; 2) my belief that Carnival's earnings growth is more predictable (if less robust); and 3) its cash flows are proven to be less vulnerable to short-term weakness than its peer's.

I ascribe a value of $150 to RCL and use 13.7 times and 17.6 times EBITDA and PE multiples on my 2018 forecasts. The 25% upside to my target is attractive. However, in the trade-off between long-term cash flows (at CCL) and visible profit momentum (RCL), I favor the former. That's particularly so when dividends (~2.5% at CCL and ~1.5% at RCL), and debt (discussed earlier) are factored.

From today's $58, NCLH is only about 10% undervalued. Due to its short track record, high debt and lingering LBO ownership, I use a 13 times EV multiple to arrive at my $65 target, about a half-point discount to the 2018E EBITDA multiples ascribed (above) to larger peers CCL and RCL.

Disclosure: I am/we are long CCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for entertainment purposes, a look at holdings in my personal portfolio - rather than investment recommendations.