Description

I am recommending a short position in Carnival Cruises (CCL) equity (currently at ~$25 - 26 / share), which I believe presents a compelling near-term risk / reward proposition, with total return potential of >35% over the next 3 – 6 months.  CCL is the largest global cruise operators w/ over 89 ships (over 40% of its capacity is geared toward Western Europe and Latin America) w/ another 17 ships contracted for delivery (contracts have no outs) between now and 2012.  While I believe CCL is a franchise asset w/ attractive long-term (5 – 10 yrs out) growth dynamics, I believe CCL short equity is one of the more attractive risk / reward opportunities on expressing a muted view vis-à-vis the US consumer incrementally pulling back / shifting their near-term consumption trends (and focusing more on servicing debt / focusing on employment retention / saving).  Moreover, perceptions around the cruise industry seem very analogous to the gaming industry from 12 months back (i.e. given the high-growth nature of the industry for the past 15 years, analysts took a largely complacent view in assuming these entertainment business models were “recession resistant”).  While these “entertainment” assets may prove out to be attractive long-term franchises, the US consumer is currently / incrementally changing their near-term consumption trends.  In particular, given the recent “shocks” to the US consumer (net worth impact vis-à-vis housing / negative portfolio impact and heightened job insecurity), longer-term / exotic entertainment packages are being put on hold for the near-term which has a meaningful impact on cruise operators that are seasonal and heavily reliant on the December – February Wave Season pre-booking period (>50% of bookings are generated during this period). 

 

Up until this past Friday (October 31^st), CCL management has provided a sanguine outlook on the cruise industry (akin to gaming companies 12-months back – recall MGM and Wynn management comments that suggested consumer appetite for gaming and capacity were aligned w/ the stars for l-term growth) - CCL management has highlighted the resiliency of the US consumer.  This past Friday, however, CCL management incrementally shifted their tone (similar to RCL management who announced Q3 last week as well) and announced the suspension of the common dividend ($1.60 / share per annum – approx $1.3Bln per annum) for 2009E given liquidity concerns around new ship-builds in 09E + debt maturities in 09E – 10E.  In addition to the dividend announcement, management provided a preliminary outlook for 2009E ($2.50 - $3.00 of EPS compared to $2.82 - $2.85 in 08E – an amazing feat if they can keep earnings flat / up YoY in this environment esp w/ CCL’s >40% exposure to Western Europe).  Key mgmt assumptions for this 09E outlook included: (i) constant FX net yields of -1% to -5%, (ii) bunker fuel at $380 ($65 WTI-equiv) and (iii) FX on Euro of 1.30 and 1.67 on Sterling.  Following the call, Street analysts largely parroted CCL management’s comments and highlighted the prudent capital allocation decision to cut off the dividend given the frozen credit markets.  While this is hopeful thinking (and may ultimately prove out to be right), the reality of the situation is that 09E is (i) shaping up to be a very challenging year (as recent / proprietary calls out to the industry affirm) both on pricing and bookings, (ii) CCL management’s assumptions for 09E leave them w/ little wiggle room (note that a. every $75 move in bunker fuel / approx $12 move in WTI-equiv equates to ~10% drag on earnings power, b. every 2.5% move in net yield equates to a 10 – 12% drag on earnings power and c. every 5% move in FX equates to ~2.5% drag on earnings power).  The biggest concern I have w/ CCL management’s assumptions is around net yield (notable commentary on Friday’s call can be found in the transcript) in which they seemingly glossed over recent pricing / bookings (which would a base case of net yield could be south of -7.5%) and in particular, did not address the significant / recent weakness (highlighted through aggressive price promotions to fill out capacity) that is taking place in Western Europe (>40% of their capacity).  Based on my base case assumption of -7.5% net yield (if pricing continues to track early / recent indicators, this could be closer to -10% to -12.5%), ~1.25 rate on the Euro (not unreasonable and arguably should be less than 1.2 given relative strength of USD to Euro) and 70 – 75 WTI-equiv (largely in-line w/ current spot – i.e. taking no view on oil), equates to 09E EPS of approx $1.75 / share (versus Street of ~$2.75).  Assuming an 7.5x EBITDA multiple (which seems generous given the changed growth profile / industry over-capacity and reliance on the consumer), this translates into FV of approximately $15 - $16 per share (versus current $25 - $26 / share or approx >35% downside)

 

While the CCL bull case largely relies on the industry’s attractive long-term demographic trends / under-penetrated nature / inexpensive entertainment package (and ability to weather a downturn – highlighting 01 – 02 performance), there are five primary reasons why I think shorting CCL equity in the near-term is timely / actionable including: (i) European weakness is the next big shoe to drop given industry over-capacity in the region (>40% of CCL’s capacity – FX rates could have a material impact in addition to fundamental weakness), (ii) operating leverage to the business model is significant (akin to Las Vegas gaming business model, over 40 - 45% of the costs are fixed w/ remaining costs semi-variable – upshot being any near-term weakness has significant flow-through to the bottom line) and ROIC is low (historically, RCL and CCL have operated at high single-digit / low double-digit ROIC – not very impressive in the grander scheme of things and arguably deserving of a sub-market multiple during a consumer recession), (iii) recent price promotions out of cruise operators is surprisingly negative and highlights the near-term uncertainties ahead (given the critical “Wave Season” period kicks off in December through February - dictates a significant percentage of their forward sales, recent price promotions of 15 – 30% is concerning as it highlights the fact that cruise operators have still NOT been able to catch a supporting bid from the consumer), (iv) liquidity pressure given contracted 09 – 10E new ship-builds (noted on call but ultimately analysts have to factor in these contracted funding requirements as it materially impacts the cash flow of the business), (v) mis-perception that cruising is a “defensive” vacation alternative (given the fact that the US consumer is currently pencils down on making long-term spending decisions, this is especially punitive on the cruise business model given its reliance on affordable plane tickets which is largely dictated by scheduling well in advance of any trip) and (vi) technical forced selling will be prominent over the next couple weeks given the dividend suspension (according to the desks I’ve spoken to, suggests approx 10 – 15% of the shareholder base requires the dividend so will be forced to sell – akin to a 10 – 15 day short squeeze / but opposing direction)

 

SHORT THESIS

 

1. MIX CHANGE:

• RCL and CCL have been aggressively moving ships out of the competitive Caribbean market and into the less-penetrated European markets
• Given the value of the US dollar, people may be less inclined to travel to Europe as offshore excursions/port stops will be more expensive
• In 2009, the European source market brands are entering a negative pricing cycle that will be exacerbated by major supply growth

 

2. DEMAND/PRICING IS VULNERABLE AS THE US CONSUMER CONTINUES TO SUSPEND L-TERM SPENDING DECISIONS

• Due to the fact that many travelers book their trips well in advance (3-6 months), the current weakness that consumers have begun to feel has resulted in significant pull-back on these longer-term spending decisions
• Heavier use of incentives and outright discounting in the North American market has picked up (recent checks highlight 15 – 30% price promotions akin to ski / resorts discounting that we all read about vis-à-vis Vail Resorts, etc)
• Travel agents citing slowing trends, particularly in Alaska and Europe (>40% of CCL capacity in Western Europe)
• North American market will need heavier discounting to stimulate fill on stiffening comps, given weakening US consumer discretionary dynamics
• Potential for accelerating cancellations if economic conditions continue to deteriorate (CCL management noted this concern on their call on Friday)

 

3. CRUISE VACATION INCLUDES NECESSITY TO PURCHASE PLANE TICKET:

• Highly elastic demand with respect to plane ticket purchasing
• Increasing cost of plane tickets and weak consumer market provides further incentive for people to either stay at home or do something more local for their vacation

 

4. ON-BOARD SPENDING DECREASING:

• Belt tightening has been evident in weaker onboard spending cited by CCL and RCL
• Previously, high-margin onboard and other revenues have benefited from broader add-on spending options (alternative dining, activities, broader retail, etc), strong shore excursion uptake, and higher pricing

 

5. SUPPLY/CAPACITY GROWTH:

• Over the past ten years, the number of North American berths has increased 120%, which is 3x the number of rooms in Las Vegas and 5 times the number in Orlando, yet those markets have seen price increases, while cruises have not

• European cruise capacity is slated to grow 42% from 2008-2011

 

6. NEW SHIP-BUILDS / DEBT MATURITIES:

• More than $11Bln is contracted over the 4-years in new ship builds.  While the cruise business model should theoretically generate FCF, the heavy capital expenditure nature of the business model (coupled w/ longer-term uncertainty around capacity once industry ship-building “normalizes” 5 – 10 years out) results in negative FCF for the next 3 – 5 years

 

7. TECHNICALS:

• Given dividend cut, 10 – 15% of the shareholder base will be forced to sell their shares in the next couple weeks

 

CAPITALIZATION

 

CAPITALIZATION	8/31/2008		VALUATION MULTIPLES
Cash	$1,473.2		EPS - Consensus	$2.75
			P/E	9.2x
Debt	$9,220.0
Contracted 09E Ship-Builds(1)	$3,000.0		EPS	$1.75
Net Debt	$10,746.8		P/E	14.5x
Price	$25.40		NORM VALUATION
# FD Shares	786		P/E (2)	9.0x
Market Cap	$19,964		Earnings / Share	$1.75
TEV	$30,711		Implied Price	$15.75
			Ups / Downs	(38.0%)
(1) Per mgmt guidance on Friday's call
(2) Implies 7.5 - 8x EBITDA multiple

 

 

RISKS

 

-          HISTORICAL MULTIPLE: Street analysts like to harp on historical trading multiples of 8x – 20x+ EBITDA for cruise operators (akin to gaming companies).  While this may be the case longer-term, the growth profiles of these businesses has materially changed in the near-term that arguably deserves a market-multiple given consumer reliance

-          DIVIDEND RE-INSTATED: mgmt / Board have retained the right to continue assessing the dividend (if credit markets improve, etc).  While this is a risk, can arguably be hedged out via buying CCL CDS (as dividend re-instatement would be credit dilutive) 

 

CATALYSTS

 

-          NEAR-TERM (10 days): large funds who will require the dividend will sell down their exposure

-          NEAR-TERM (2 mths): when CCL reports their YE 08 results in mid-December, they will lower their outlook / provide muted 09E guidance

-          LONGER-TERM ( 3 – 6 mths): when Wave Season does not materialize and Western European weakness is greater appreciated, management will reduce 09E guidance to approximately $2.00 per share

-          LONG-TERM (6+ mths): given the Western European biz is heavily reliant on the US consumer (FX rates are not a help given USD strengthening), CCL will likely reduce 09E guidance to $1.50 - $1.75 range noting the European weakness as the culprit

 

Catalyst

- NEAR-TERM (10 days): large funds who will require the dividend will sell down their exposure
- NEAR-TERM (2 mths): when CCL reports their YE 08 results in mid-December, they will lower their outlook / provide muted 09E guidance
- LONGER-TERM ( 3 – 6 mths): when Wave Season does not materialize and Western European weakness is greater appreciated, management will reduce 09E guidance to approximately $2.00 per share
- LONG-TERM (6+ mths): given the Western European biz is heavily reliant on the US consumer (FX rates are not a help given USD strengthening), CCL will likely reduce 09E guidance to $1.50 - $1.75 range noting the European weakness as the culprit