Stormy Seas Ahead: DCF Valuation Of Royal Caribbean

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About: Royal Caribbean Cruises Ltd. (RCL), Includes: CCL, NCLH
by: KERresearch
Summary

RCL is priced for perfection and any secular headwinds could hurt RCL.

RCL cannot mantain the same rate of EPS improvement they achieved during the "Double-Double Program"

High debt load gives RCL little margin for error.

At Royal Caribbean's (RCL) historically high valuations, potential investors should avoid investing in RCL and early investors should consider trimming their positions. The past few years have been smooth sailing for Royal Caribbean as RCL has doubled its EPS and ROIC over the past five years. The cruise industry is experiencing a lot of tailwinds: 1) the economy is growing, helping luxury items, like cruising, 2) low oil prices significantly reduces costs, 3) There is relative geopolitical stability, a necessity for international travel, and 4) secular demand for cruising is rapidly increasing globally and largely remains untapped.

Since 2012, RCL's stock price has climbed 400% and trades at all-time highs at $124/share. We believe RCL is a healthy company, and their institutional changes have created great value for the shareholders, but the Street has failed to discount for a myriad of secular headwinds that could occur. RCL is trading at historically high valuations, and it would not be prudent to invest in them at this price. By using a Discounted Cash Flow model and a reversion to the mean analysis, we assigned a buy price of $80 and a sell price of $110.

The Negatives

Put RCL's Recent success in Perspective

The cruising industry is generally a very difficult industry to do business in, similar to the airline industry. The cruise ship industry is incredibly capital intensive. New ships cost between a $1-2 billion and require huge renovations 3 times before being scrapped at age 30.

RCL successfully doubled EPS and ROIC mainly due to cost cutting. The fleet became 25% more fuel efficient and RCL has benefited from ~$45/barrel oil (as you will see below fuel is the largest variable cost). It begs the question, how much more can RCL cost cut? No investor should expect the same Net Yield growth that RCL has delivered over the past five years. There isn't much more left to cut.

Beware Industry Cyclicality

Because of the discretionary nature of cruising, economic downturns hit the company hard in both the top and bottom lines. In the most recent recession, industry sales fell by roughly 10% but net income declined from 20%-50%.

The main three companies [RCL, Carnival (CCL), and Norwegian Cruise Lines (NCLH)] have increased the amount of Available Passenger Cruise Days ((APCDs)), or supply, by 2-3% a year, which is keeping up with the increasing demand for cruising. Since new ships take years to construct, supply and demand can be off for years. If demand doesn't keep increasing at 2-3% per year, the entire industry will suffer both on top line and net yield.

Tax Reform is not good for RCL

Royal Caribbean pays zero corporate taxes because they are incorporated in Liberia and not subject to tax under US tax code section 883. All income from US is "incidental". Therefore, if congress stops this loophole, RCL could be negatively affected.

Large Debt Load

At the end of FY16, RCL has $9,255 million in net debt. Their net debt/EBITDA is 3.47x, which is below its 5 year average of 4.54x. They also have $18 billion in contractual obligations with 77% being within 5 years and includes 70% of its LT debt. These obligations include $6.5 billion in ship purchase obligations, and the remaining $11.5 billion is in lease obligations and interest on the long term debt.

All this means that RCL has very little room for error because of the debt the company has.

Enterprise Value/Berth over Time

This is a monthly plot for the Enterprise Value/Berth, plotted monthly, for the big three Cruise Lines. It essentially says how much someone is paying per cabin, a different, industry specific take on P/Book Value The Blue line is the replacement cost of a berth, looking at how much new cruise ships cost. Each time, RCL has dipped below this line, it has offered outsized returns in the past. Carnival and RCL trade closely in line, while the more premium and younger cruise line, Norwegian, trades at a premium to the industry.

Created by Author using Data from FactSet and Annual Reports of RCL, CCL, NCLH

Relationship between EV/Berth and Price

This uses 1996 as the base year, making both EV/Berth and Price=100 and adjusting monthly. It breaks scale after 2012 because of the double-double program, but there is still a moderately strong correlation between the two variables.

Created by Author using Data from FactSet and Annual Reports of RCL, CCL, NCLH

Created by author

Valuation:

Method

We used a discounted cash flow model and a reversion to the mean analysis to value RCL. A DCF is a good way to value RCL because revenue and costs can be driven by pertinent, industry-specific items, and Capex and depreciation are predictably guided out. Reversion of the mean puts in perspective how much of RCL's price increase is due to improving fundamentals or valuation expansion. We chose not to do public comparable analysis or precedent transactions because of the lack of sample size in both.

Reversion to the Mean Analysis

We looked at RCL on a P/E, EV/Sales, EV/EBITDA, and EV/Berth ratios dating back to 2000. All these were selected as good measures for the company. EV/Berth is the enterprise value divided by the number of cabins operated by RCL. It is essentially saying how much money one is paying to own a cabin, and it fluctuates cyclically over time.

On the next page is the 1st Quartile, Average, and 3rd Quartile of all the data since 2000. The Quartiles are shown mainly to show the sensitivity of these valuation metrics. For reference, RCL is currently trading at a P/E of 18.42x, EV/Sales of 3.77x, EV/EBITDA of 12.02x, and an EV/Berth of $224,713/Berth.

Using this analysis, we arrive at a fair value price target of $110.45. Created by Author

Discounted Cash Flow

Using a DCF, we arrived at a price target of $97.98. We looked at the company granularly, analyzing the marginal rates of the company's line items and applied those rates to expected supply, which is easy to guide out.

Drivers

Capacity

Below is the supply aspect of the model. Passenger Cruise Days (PCDs) is the amount of people on a ship when every cabin is full, multiplied by how many days their ships are at sea. Available Passenger Cruise Days (APCDs) is PCDs multiplied by occupancy rate, which is routinely above 100%. PCDs is easy to guide out because management knows which ships they are expecting to retire, upgrade, and build, within the next 5-10 years, which is the main element of the metric.

Created by Author using data from RCL annual reports

Yield/Efficiency

Gross Yield is gross revenue for a segment divided by APCDs. Ticket gross yield is projected to be flat because the increasing demand for cruising will be counteracted by increasing supply. Onboard gross yield should slightly increase because RCL is continuing to push more and more add-ons. Net Yield is how much money is made per APCD after accounting for direct costs. For ticket sales, it subtracts for commissions and transportation. For onboard sales, it accounts for direct costs related to add-ons (think alcohol, soda, food for premium restaurants). We used sell-side projections for my estimates. Net yields are expected to rise because both are scalable.

Created by Author using data from RCL 10-Ks and FactSet estimates

Costs

We projected out costs into each specific category (Payroll, Food, Fuel, Other, Marking, Selling & Administrative) divided by APCD. This successfully considers supply differences per year so is a great way to look at the efficiency of the company. Fuel costs fluctuate largely per year, so we projected it out granularly. Fuel consumption per APCD is expected to go down, but it is tough to project fuel price. RCL does hedge, but large fluctuation on oil prices could either help or hurt the company.

Created by Author

Created by Author

DCF

Using those inputs we projected out revenue, operating profit, EBITDA, and cashflow. Capex projections are guided by management and is predictable because capex is for their new ships which are currently being built. We assigned an exit multiple of 10x because that is between the 7-12x range, that RCL has historically traded.

Created by Author

Target Stock Price

We arrived at a target stock price for RCL of $100. This value combines the ranges from both the DCF and Reversion to the Mean. The Bear Case for DCF includes fuel prices shooting up, gross yields falling because of soft demand for cruising, recession-like conditions in year 3, and an exit multiple of 7x. The Bull Case is oil prices fall more before stabilizing, gross yields increase as continued demand for cruising outpaces supply, and a 12x exit multiple. P/E and EV/EBITDA are higher because of the somewhat cyclical nature of cruising so we believe EV/Sales, EV/Berth, and the DCF to carry more weight for the target price. The left end of the blue bar represents the bear case. The overlap between blue and yellow is the base case, and the right end of yellow is the bull case.

Strengths

  • The cruise line industry has large barriers to entry, which protect the 3 big incumbent players.
  • Demand for cruising continues to increase. Market penetration has large upside potential to grow.
  • Management has shown with the Double-Double program that they can deliver on promises and make company more efficient.
  • Great value proposition of cruising. Cruises for a couple/family cost less than trips to Disney Land or expensive urban locations.

Weaknesses

  • Cruising is a luxury item, an economic downturn would severely hurt RCL's top and bottom lines.
  • The cruise industry is a capital intensive business. RCL has $9.2 billion in long term debt and $18 billion in contractual obligations.
  • The cruise industry struggles in environments of international strife and high oil prices, both of which are out of the industry's control.
  • RCL has a below average dividend yield of 1.70% versus the S&P 500.
  • The delay of years between ordering ships and ships being delivered creates imbalances between supply and demand.
  • An accident or ship malfunction would result in a public relations nightmare that could significantly hurt RCL's image.

Important Metrics to Keep an Eye on

In RCL's 10-Qs and 10-Ks, make sure to keep a close eye on net yields, change in cruise costs excluding expenses, and EV/Berth. The last one you would divide the enterprise value by total berths (the latest is 123,270. Don't forget to account for units with EV) and compare it to the chart earlier in the article. These tell more of a story than revenue or EPS growth.

Conclusion

RCL has been executing on all cylinders, improving top and bottom lines, and expanding margins and yields, and its stock price has appreciated accordingly. Although the cruise industry has not been the best industry to invest in historically because of the capital intensiveness of the industry, demand for cruising has significantly increased, and RCL and the cruise industry will continue to become a more favorable over the long term. RCL is priced for perfection so any headwinds could mean a large pull-back for the stock. This is a healthy and vibrant company, but shares need to significantly decline before it becomes a value stock. Great stock to put on the shopping list during a recession.

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