- The cruise line sector is far from dead, despite growing debt problems medium term.
- Carnival has asymmetric risk skewed to the upside.
- Carnival's booking trend shows that demand is going to return instantly once no-sail orders are lifted by the CDC.
- Cruise liners, including Carnival, are massively undervalued relative to their true earnings capability.
Cruise liners with suspended operations including Carnival Corporation & plc (NYSE:CCL) have the potential to double their valuations once no-sail orders are lifted and the sector returns to service. A successful vaccine roll-out reduces long-term risks for cruise liners which helps create asymmetric upside.
Risks to be considered and latest sector news
It is appropriate to discuss cruise liners through the lens of risk because of the COVID-19 outbreak last year and the resulting suspension of voyages. Cruise liners like Carnival now operate in an industry that is defined by extreme uncertainty. Although uncertainty about the sector has probably peaked last year, risks associated with cruise liners are real and could be existential if voyages don’t resume in 2021.
The Center for Disease Control suspended voyages last year to prevent the spread of COVID-19. The CDC issued its Framework for Conditional Sailing Order that extended the no-sail order for cruise ships until November 1, 2021. The order, however, can be rescinded or modified by the CDC Director, for example, due to public health considerations. Cruise ship companies have lobbied for a lifting of such restrictions, the CDC confirmed in March that it will, at this point, not allow an earlier start of voyages.
Quantifiable impact of COVID-19 on Carnival’s business
With that being out of the way, we should take a look at Carnival’s FY 2020 financial report to see what impact COVID-19 really had on the business since the cruise line industry was one of the first to come to a complete standstill.
Carnival’s revenues melted faster than an ice cream in the sun due to COVID-19. Carnival’s passenger ticket sales, its main source of income, dropped 74% to $3.7b in FY 2020 which could be expected since the business wasn’t allowed to operate for three-quarters of a year. Carnival’s net income was negative $10.2b and earnings-per-share were negative $13.20 compared to $3.0b in net income and $4.32 in earnings-per-share in FY 2019.
(Source: Carnival FY 2020 Annual Report)
With COVID-19 wreaking havoc in the industry, cruise liners turned to debt and equity to navigate the crisis. Carnival raised $3b in equity in FY 2020 and converted convertible debt early. It raised a large amount of debt, largely through secured term loans, second lien notes, and senior unsecured notes.
Carnival’s total debt is a risk factor and a big concern medium term should you choose to invest in this business. A look at Carnival’s balance sheet clarifies how the debt situation has worsened from FY 2019 and FY 2020.
Carnival’s long-term debt has more than doubled within a year from $9.7b to $22.1b.
(Source: Carnival FY 2020 Annual Report)
The increase in debt is in its entirety attributable to the suspension of voyages related to COVID-19 as management tried to keep the business afloat. The ability to place debt with investors, however, shows that the market generally trusts the survival prospects of the cruise line industry.
Debt in the entire sector has gone up for cruise liners and Carnival is not the only company having a “debt problem”.
If you look at the individual debt-to-equity ratios, Carnival actually looks to have less than a problem with debt than its rivals.
Booking trends for the cruise line industry are a bright spot and show that it won’t take long for cruise liners to fill up cruise ships once the CDC lifts its no-sail order. Carnival’s January release of its financials contained important information about the cruise liner’s booking situation. The booking update is the clearest indication of how fast customers are going to return to cruise ships when given the chance.
(Source: Carnival News)
The crucial sentence is the last one sentence in the bookings update … that 60% of bookings taken in the quarter ending November, were new bookings, not just customers rescheduling trips. Carnival’s booking update is very similar to Norwegian Cruise Line Holdings’ (NCLH) booking situation that painted a rosy picture about the return of demand.
Carnival EPS estimates and comparison to rivals
The problems in the cruise line sector are existential and manifold, there should be no doubt about: Cruise liners don’t yet know when exactly they are allowed to sail again, they have a lot of debt to service and are everything but popular right now. But exactly herein lies the chance to create asymmetric and strong returns.
The mean estimate for CCL is to earn a negative $4.30-share in FY 2021 and then earnings are slightly increasing until FY 2023. But estimates are more than likely to be very low as few analysts want to release optimistic earnings estimates at a time of severe uncertainty.
(Source: Carnival IR)
Even the FY 2023 per-share estimate of $1.73 hugely undervalues CCL earnings potential given that a more normalized earnings-per-share number is closer to $4 based on FY 2018 and FY 2019 actual earnings. But Carnival issued some shares in the meantime, so these earnings figures should be adjusted to allow for a better comparison.
The annual report shows the weighted-average number of shares has increased by 12% since FY 2019.
(Source: Carnival FY 2020 Annual Report)
So if you take the FY 2020 outstanding number of shares and adjust FY 2019 and FY 2018 earnings for the higher number, you’ll get $3.85 and $4.06 in adjusted earnings-per-share. Even when we consider Carnival’s dilution, CCL could earn, say, $3.80 per-share per year, which is more than double the FY 2023 depressed earnings-per-share estimate presented in the analyst forecast table.
If you were to take $3.80 per-share in estimated annual earnings, you’ll find that CCL sells for 7.0x expected earnings, which potentially could be achieved in FY 2023, assuming full operational capability.
Carnival's historical P-E ratio, that is before COVID-19, has been way higher and been above 12.0 for the majority of the last five years.
Risks to calculation
Uncertainty in the sector about the lifting of the no-sail order and the huge amount of debt in the sector are problems, but they are mostly refinancing problems and they can be dealt with in due time.
First, cruise liners need to be able to leave US ports and start sailing again, this is the first hurdle that needs to be taken.
There is also great risk in cruise liners giving in to the temptation to raise more equity if valuations continue to recover. A higher share price makes it tempting to raise equity to lower leverage. The price, of course, is more dilution and a probably even higher number of shares issued and decreasing earnings-per-share.
Besides the considerable sector risk discussed here, once no-sail orders are lifted and voyages resume, which could still be in 2021, Carnival and other cruise liners are primed for a fundamental revaluation amid an instantly improving industry outlook. Carnival’s booking situation proves that demand can be expected to return fast which supports a positive revision of earnings forecasts. Carnival has asymmetric risk skewed to the upside and the cruise liner could double its valuation without being exceptionally expensive compared to its historical P-E ratio.
This article was written by
Analyst’s Disclosure: I am/we are long NCLH. 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.
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