Description

Overview

Carnival Corporation is the world’s largest operator of cruise ships, operating across the AIDA Cruises, Carnival Cruises, Costa Cruises and P&O cruises lines in North America, Europe, the UK, and Australia/NZ.

Carnival is the largest participant in the cruise industry with 92 ships, ~260K person capacity, and 12.4mm travelers annually – equating to a ~30% market share. The industry’s other larger participants include Royal Caribbean (~18% market share), Norwegian (10%), and MSC (7%). Industry demand has continuously grown at 5.9% CAGR for a number of years (excluding COVID-19

The COVID pandemic had a severe impact to CCL, forcing it to halt service for 15 months, and raise $30Bn in debt in order to sustain operations. Since resuming cruises in July 2021, headline numbers have bounced back - with CCL reporting record revenues in 2023 following a strong period of post-COVID ‘revenge travel’. CCL has begun to try and deleverage, undertaking $2Bn of equity raises since 2021. However, cashflow remains strained and CCL has an unsustainable debt load with major upcoming debt repayments and capex commitments. Combined with a range of operational and earnings headwinds, we see a heightened risk of an additional dilutive equity raising being required to recapitalise the business in the next 12 months. CCL is a classic example of a unrecognized decliner given its compressing margins, debt load and operational risk exposures.

Core Thesis - Unsustainable Debt Load + Committed Growth CAPEX 

CCL is currently highly levered at 6.5x LTM EBITDA, and 0.9x EBIT/Interest expense. More significantly, CCL has >$13Bn of debt repayments and CAPEX commitments due through 2024/2025, vs. available liquidity of $8.5Bn - comprised of $2.4Bn in cash, a $.1Bn CAPEX facility, and a $3.0Bn in an undrawn revolver.

Concerningly, in recent quarters, debt repayments have been largely funded by a decrease in net working capital, rising from -$3.1Bn in Nov 2022, to -$6.2Bn in Nov 2023. In effect, the company has become reliant on utilizing customer deposits for debt servicing and committed capex expenditure. Since 2021, CCL has benefited from a $4.2Bn increase in customer deposits (source of cash), enabling a ~$3Bn reduction in net debt. 

However, despite record revenue in 2023, Cash from Operations (ex. Customer deposits) of $3.1Bn was insufficient to cover CAPEX + interest expenses of $5.4Bn, let alone required debt repayments of $7.9Bn. Even at peak earnings in 2019, CCL only generated $3.0Bn in net income, with negative cash flow of $0.5Bn due to CAPEX.

In the near-term, CCL is also bordering on breaching a key covenant, with current EBITDA / Net Interest Expense of 2.3x in FY2023, vs. a covenant limit of 2.0x from August 2024 to May 2025. Looking forward, we project CCL as having negative free cash flow of ~$750m in 2024 after accounting for interest servicing costs. This will lead to further deterioration of CCL’s balance sheet, and require an equity capital infusion in order to remedy.

Operational Headwinds

COVID-19 prompted a wave of new-ship building and fleet revitalisation across the cruising industry - including CCL where 26 older ships were retired and traded out, However industry growth has materially outstripped CCL, with CAGR of capacity for the industry from 2019-2026 of 4.3% vs. CCL at just 1.1%. As a result, Carnival is forced to compete on price with industry competitors that are running newer, more efficient ships that are more attractive to customers.  Industry capacity additions have thus been met by a strong surge in customer demand as the Post-COVID ‘revenge travel’ theme continues to play out. However, any reduction in consumer travel spend caused by macroeconomic weakness would have a disastrous impact on the industry, as it approaches oversupply.   

Cost Inflation 

Post COVID, CCL has experienced a major uplift in expenses as a % of revenue across major line items including fuel, food, onboard costs, payroll and commissions. This has led to a material drop in CCL’s operating margins, which have fallen from ~17% pre-Covid to 9% in 2023, despite record revenues and strong customer demand. We posit that CCL is being forced to price at below market price points in order to compete with newer competitor ships, and ensure strong customer advance deposits which can be used to repay CCLs unsustainable debt load. 

Oil Price Risk 

Consensus analyst numbers are pricing in no increase in CCL fuel costs for 2024 and 2025, despite rising consumption (as new ships are brought online), and rising prices for IFO380. CCL undertakes no hedging of fuel costs, and so is fully on risk for any increases in fuel prices which have risen materially in 2024 on the back of ongoing OPEC production cuts and rising tensions in the Middle East.

A return to 2022 fuel prices would result in a ~$500m hit to earnings, which represents ~25% of CCL’s 2023 EBIT. This ignores the increasing costs associated with CCL’s ongoing commitment to transfer to biofuels, which will involve a significant premium to heavy fuel oil, today it is totally uneconomic. 

Operating Issues 

CCL has experienced operating issues of late as it continues its ramp-up from COVID-19. Most notably, its brand-new, largest ship - the Sun Princess - has twice had to delay its inaugural voyage, requiring CCL to reschedule customers, offering refunds and travel credits in the process. Additionally, Carnival had to reroute 12 of its cruises in January this year as Red Sea tensions escalated. 

Net Zero Transition

CCL has also committed to a highly ambitious green energy target of net zero by 2050. Initial progress towards this goal has been focused on ‘easy wins’ of improving fuel efficiency that have actually improved margins. However, this lever has been exhausted and converting the fleet to green-fuel alternatives will, at minimum, be a permanent and significant structural increase in fuel costs for CCL, and likely require $Bns in upgrades to the existing fleet, which are 30 year life assets. 

In order to offset CCL’s annual GHG emissions at today’s carbon credit prices, CCL would be required to expend ~$570m annually at current prices of ~$55 per tonne. However, if carbon prices were to return to their peak 2023 prices, this would translate to a ~$900m annual cost.

Risks to Short Thesis

1. Resilient Customer Demand

• CCL saw record demand in 2023, and have a strong order book in place for 2024, with ~2/3s of available berths pre-filled

• Continued resiliency from consumers in 2025 may enable CCL to claw back historical margins and assist in paying down their debt load

2. Trading Volatility

• CCL has traded in a wide range in the last 12 months, with a low 40% below current prices, and a high 20% above current prices.

• Given this volatility, a CCL short position should be sized appropriately

3. Deleveraging

• CCL successfully managed to reduce its net debt load by ~$2Bn in 2023 in addition to extending the maturity of several of its issues

• This was partially enabled by the rise in customer deposits on its balance sheet (effectively an exchange of debt), but is evidence of CCLs commitment to right-sizing its capital structure

4. Industry Consolidation

• The entire cruise industry was negatively impacted by COVID, as a result, a number of minor competitors went bankrupt, and major competitors have similar debt constraints

• It is possible this enables CCL to capture a more dominant market position in the medium term, as its size gives it a relative advantage in being able to weather challenging trading periods, and then capture a greater proportion of the recovery

Near Term Catalysts

1. Equity Raising

• Given CCL’s required $7.5Bn of committed CAPEX and debt servicing costs in 2024, we anticipate that an equity raising will be required, given projected free cash flow is insufficient to cover interest expenses.

2. War Risk

• Continued escalation in naval warfare with Western powers and the Houthis (particularly, the possible entry of Iran) will continue to disrupt CCL operations, negatively impact margins through insurance costs, and decrease cruise popularity amongst customers

• CCL has already been forced to re-route 12 of its ships that were scheduled for Red Sea cruises in early 2024.

3. Oil Prices

• OPEC+ is now expected to maintain production cuts into 2Q2024, this will continue to support higher oil prices of which CCL has unhedged exposure

• Further escalation in middle eastern conflict could also result in a significant step up in oil prices 

Valuation / Recommendation 

Pre-COVID, with net debt EBITDA of just 2.0, CCL traded at 7-8x NTM EV/EBITDA, and a ~30% discount to key competitor Royal Caribbean. Today, with Net Debt/EBITDA at 6.5x, and insufficient free cash flow to cover interest expenses, CCL trades at 8.6x NTM EV/EBITDA, a ~10% discount to Royal Caribbean which has a structurally superior balance sheet, and has already returned to profitability. Given CCL’s stretched balance sheet and upcoming CAPEX commitments, we argue a return to its historical 30%+ discount to Royal Caribbean is justified. 

As a result of CCL’s unsustainable liquidity position, operational issues, oil risk exposure, and potential ‘cum-equity’ position, we see CCL as 30% overvalued today. To contextualize, this drawdown would see CCL return to its pre-COVID EV/EBITDA trading multiple, when it had balance sheet leverage of just 2.0x EV/EBITDA.  

To de-risk this trade and hedge out exposure to a potential acceleration in the cruise recovery, we will further research a pair trade of Long Royal Caribbean and Short Carnival Cruises.

Catalyst

Equity Raise/Debt Maturities