While COVID hit most industries with substantial headwinds and challenges, few were hit harder than cruise lines. As an extremely capital-intensive business, the cruise business is uniquely situated to fare poorly in a mass-lockdown environment amid a pandemic with a highly contagious, airborne pathogen.
After an industry rebound in the back half of 2021 into 2022 on the shoulders of the reopening trade, cruise lines are down again. Well, one cruise line specifically. In this article we will consider the fortunes of Norwegian Cruise (NYSE:NCLH). We believe that the company is at a major inflection point, and that investors would do well to get out now and wait for conditions to improve before taking a ride on this stock.
Over the last three months, Norwegian Cruise has lagged severely behind rivals Carnival Corp (CCL) and Royal Caribbean Cruises (RCL).
While Norwegian has been treading water, Royal Caribbean has returned 37%, while Carnival has returned 35%. Investors are likely wondering what gives, especially since the company delivered a strong Q3, where revenue per passenger cruise day was up 14% when compared against 2019 (we should note that this rise was primarily driven by price increases, and not by passenger volume returning to pre-pandemic levels). All this is not to mention that demand for cruises is off to a hot start this year.
Of course, management recently soured the narrative of this strong Q3 with a preview of Q4's and Q1 of 2023's earnings, stating in blunt terms that "we will report a net loss for the quarter and full year ended December 31, 2022 and the first quarter of 2023."
This is a disappointment given that analyst consensus had been that Norwegian would turn a profit in Q1 2023, but it isn't out of line with competitors--Carnival is expected to lose $0.60 per share in Q1 23, and Royal Caribbean is expected to lose $0.40 in the same.
So, investors ask again, what gives?
Norwegian Cruise wants you to know that it targets the upper crust of cruise line passengers. CEO Frank Del Rio noted this in the Q3 call, saying of the company's core customer and their resilient spending habits that "you may have heard commentary from credit card issuers this earnings season about continued strong spend on travel and experiences, especially by those in higher-income categories, reinforcing the continued strength and resilience of demand for cruising, particularly among Americans."
Del Rio also noted that COVID related health requirements are fading. Testing and proof of vaccination in most markets are no longer required, with Asia--the final holdout--loosening restrictions.
This reinforces a popular narrative among cruise industry bulls: that consumers are coming back with a vengeance that will benefit travel companies, and that COVID restriction rollbacks will aid in the boom.
We think this narrative is not so straightforward.
Let's start with the first premise. Some analysts and contributors to this site have argued that because airlines have experienced a resurgence, other travel and leisure industries like cruises will follow. We think this is a flawed argument.
The first example is that sailing on a cruise ship is nothing like getting on a plane. Unlike the few hours it takes to complete a flight, it is still entirely possible that COVID and other illnesses could sweep through a ship, affecting the experience of every passenger either through sickness, quarantine, or activity restriction. No airplane has had to sit on the tarmac for days on end due to illness onboard.
Further, we believe that the memory of cruise ships floating off coasts like isolated plague wards for weeks on end as passengers recover will linger longer in the minds of consumers than most assume. While die-hard cruise lovers will continue to go, adoption of new customers will be more difficult for some time going forward. This is evidenced by the fact that load rates at cruise lines have not reached pre-pandemic levels, while airlines are largely on track to surpass them.
The second premise is the dual threat that inflation and COVID pose to Norwegian's customer base. As Del Rio stated in the call, Norwegian's prime customer is more affluent than the average cruise passenger. This cuts in a few different ways.
Oh, and, you know, there could still be a painful recession around the corner. Let's not forget that pesky reality.
In addition to the potential for Norwegian's core customer to be squeezed, the company is in a tough spot when it comes to debt. At the filing of its last 10Q, this was the company's debt repayment schedule:
The road ahead indeed looks difficult, with a payment of $1 billion due in 2023 and $3.7 billion in 2024. In the short time since the Q3 results were published, however, the company has taken action. On February 2nd, the company issued $600 million of new debt at 8.375% per year to retire obligations due in 2024. It's often pointed out that only 25% of Norwegian's debt is variable--but that's kind of a cold comfort when you're forced to refinance debt at 8.375%.
Operating leverage is also top of mind for senior management. On the Q3 call, CFO Mark Kempa outlined that a top priority for the company is to try and reduce leverage on the balance sheet by systematically paying down and retiring debt.
We think this is a good goal, but now we are getting to the part where we think management has bitten off more than it can chew. Not only is the company placing itself into a situation where it is having to pay off (or make payments on) debt with much higher interest rates, but there is a dual threat looming--one that management created.
Before we get to that, though, we'd like to cover Norwegian's aggressive (and necessary) capitalization of expenses. Over the last several years, Norwegian has averaged a little more than $1 billion in capital expenditure [CAPEX] per year. Norwegian's CAPEX expenditures are typically for new ships, but the company also capitalizes ship improvements as well. When a company brings on new ships, it depreciates them on a 30-year useful life schedule.
Capitalizing these costs is fine--after all, we mentioned at the start of this article that cruise lines are very capital intensive businesses. However, capitalization plays a game with the financials that retail investors sometimes forget about.
When Norwegian takes delivery of a new ship, it accounts for that purchase in the CAPEX line item under the Cash From Investments section of the cash flow statement--not the Cash From Operations section. This means that unless you are calculating free cash flow, the cost of taking receipt of a new ship does not reflect or create an expense for the company at the time of delivery (at least from an accounting perspective). The expense comes into play when the ship is then depreciated over its 30-year useful life in the Depreciation and Amortization line item of the income statement in equal increments.
Yes--this is basic stuff. However, we think it's worth going over since many investors often mentally exclude non-cash charges like depreciation and stock-based comp from their glances at company results. It's just a non-cash expense, they think, it doesn't really affect the bottom line.
While you might be able to get away with this mindset when analyzing, say, a software company, in an industry as capital intensive as cruise lines or airlines, you do so at your own peril. After all, the company has paid for these assets in one accounting bucket, and the chickens have to come home to roost at some point.
With all this in mind, let's approach CAPEX from an angle that few investors take. Pretty much all investors worth their salt try to estimate revenue and pay attention to future revenue growth estimates--but very few look down the road and try to anticipate future costs in any meaningful way.
So, let's tie everything together.
One benefit for investors in analyzing companies with high CAPEX needs is that you can typically look down the road and assess what costs are coming in its future. Very few investors, however, actually do, and instead assume that CAPEX will continue more or less in a straight line.
Since shipbuilding takes years with orders being made long in advance--and since it is incredibly costly to cancel a shipbuilding contract or sometimes even to delay receipt--we have a unique benefit as investors to assess if the company's past decisions to expand future capacity were wise.
Norwegian currently operates 32 ships across its three banners: Norwegian, Oceania Cruises, and Regent banners. Only 11 of these ships have less than 10 years of useful life left (the three oldest ships were commissioned in 1998, giving them six more years of depreciation on the books).
In the last half of 2022, Norwegian took delivery of the first of six Prima Class vessels for its Norwegian banner. It has plans to take delivery of three additional vessels in 2023. This represents a 10% increase in fleet size.
In fact, through 2027 Norwegian expects to take delivery of eight total ships at an outlay of $6.6 billion. This will result in about 22,000 new berths.
For reference, Royal Caribbean, whose pre-pandemic revenue was almost twice that of Norwegian and which operates 61 vessels, is scheduled to take delivery of nine new ships through 2026 for $9.1 billion, which represents about 38,000 total new berths for passengers.
So, on a per-berth estimate, Royal Caribbean will pay roughly $240,000 per berth, the cost of which will be spread over 30 years. Norwegian will pay about $300,000.
We should point out that this is a more than 40% expansion on Norwegian's current berth estimate of almost 60,000 over the next five years--over which time Norwegian will have retired none of its vessels currently in operation.
Given that load (the percentage of a ship being filled to capacity) is still lagging pre-pandemic levels, this seems like something of a... problem.
Norwegian seems to be headed for something like the perfect storm. It currently cannot fill its ships to pre-pandemic levels, and yet its overall passenger capacity is set to grow rapidly in the next few years (close to 10% in the next year alone). All of this is self-inflicted, as Norwegian is set to expand at a faster clip over the next five years than its lower cost competitors.
At the exact same time Norwegian is going to have a growing number of berths to fill, it will also have to contend with newly onboarded depreciation charges which will relentless hammer EPS as new ships are brought into the fleet and old ones continue to serve without being aged out.
And, at some point, we are likely to hit a recession. While Norwegian management sounds supremely confident that their core affluent customer will ride out any recession unaffected, we think that customers on the margin are the ones to look out for. Sure, there is a group of people out there who will take their expensive Regent or Oceania cruise each year without fail. But an awful lot of people are more likely to decide, hey, let's spend a little less on our cruise this year and go with another line.
For all this, we haven't even touched on the direct impact that the war in Ukraine has had on Norwegian. Check out what CEO Frank Del Rio had to say on the last conference call.
[I]f you had asked me what is the single city in the world, port in the world that you cannot live without, I'd tell you it's St. Petersburg, and we lost it. Very, very high yields, incredible shore excursion sales. So onboard revenue was just higher than any other itineraries that I can think of, relatively long season. You can get to St. Pete in the Baltic in mid-May and you can leave in mid-September. So it's a real blow. It's a real blow... the impact on EBITDA has to be in the tens of millions of dollars.
Norwegian Cruise lines is a premium purveyor of cruises for affluent customers. Without doubt, they possess a world-class product--but a financial storm may be in the making.
Bookings currently lag pre-pandemic levels, and the company cannot raise prices forever to make up for the shortfall. The company also has to either retire or--more likely--refinance debt all while contending with the onboarding of new capacity which will create new expenses that further pressure operating margins.
While we don't think it's likely, we want to caution investors to be on the lookout for extensions in ship life (which would drive down depreciation costs), or impairment charges if the company takes a ship out of service early. The latter is an accounting game Wall Street may applaud because impairment is recorded below the operating expense line on the income statement. Impairment charges can often be explained away as one-time issues which, wouldn't you know it, also help in future quarters to reduce depreciation expense and improve operating margins since the remainder of the depreciation has now been zeroed out.
In short, there is a financial iceberg in Norwegian's path. We believe investors should stay on the sidelines until it is clear whether or not it can be avoided.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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