Description

Certain statements contained herein reflect the opinion of the author as of the date written. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Pitch:

I remain bullish on the cruise industry over the long run because of the good value I believe cruising provides to its customers. I believe cruising is a secularly growing industry evident by the continued increase in global demand coupled with rising net yields. Global penetration rates are still low and even in the most developed regions like North America, penetration is still low-double digits.[1] The key question is whether growth in supply over the long-term will exceed demand growth and hurt pricing. Over the short-term, this is a risk and I think that is one of the main concerns.

However, over the long-term, mitigating factors are that there is only so much supply that can come on in a given year due to the natural constraints from available shipyards; the industry operates largely as an oligopoly with CCL, RCL and NCLH controlling ~80% of capacity;[2] and the ability for the “big 3” to reallocate capacity geographically to better meet demand (see NCLH’s move of the Norwegian Joy from China to Alaska last year). That point is key because the cruise industry is suffering from the short-term impact to earnings from the Trump administration banning cruise ships to Cuba on 6/4/19. Since then, through 8/30/19, NCLH is down 6.5% while RCL and CCL are down 14%-15%. This compares to the S&P 500 and consumer discretionary sector increasing by 4%-5% over that period.

As of 8/30/19, RCL trades at an undemanding valuation of less than 10x 2020E EPS and barring a recession, should be able to grow revenue and EPS at a mid-high single and low-mid double-digit rate, respectively, over the next several years.

Business Description:

Royal Caribbean Cruises Ltd. (NYSE: RCL) is the second largest cruise company in the world. In 2018, RCL carried ~22% of all global cruise guests.[3] RCL operates cruise ships across several brands and has global operations in North America, Europe, Australia, and Asia.[4] RCL caters predominately to the contemporary cruise market. RCL’s closest competitors, Carnival Corp (NYSE: CCL) and Norwegian Cruise Lines (NASDAQ: NCLH), serve the contemporary and premium/luxury market segments respectively.

Investment Thesis:

The cruise industry is out-of-favor. As of 8/30/19, CCL, RCL, and NCLH collectively trade at ~9x 2020E EPS, which approximately represents a 4x P/E discount to their ten-year average and a 5x P/E discount to their fifteen-year average. Relative to the S&P 500, the group trades at a ~50% discount on 2020E consensus earnings estimates.

Concerns over capacity growth, tepid Chinese demand, recession fears and unfavorable FX have weighed on their multiples. Yet despite these concerns, I believe RCL remains an attractive investment opportunity given its ability to earn incremental ROIC well in excess of its cost of capital, its disciplined approach to fleet expansion and its attractive valuation.

Fundamentals at RCL are strong. RCL’s booked position for 2019 is at record volumes/pricing across its core regions. Next year the market expects RCL to generate constant currency net yield growth of ~2%-3%, which reflects management’s positive booking commentary, RCL’s investment in Silversea Cruises (who competes in premium market), and the benefits from CocoCay.[5]

The cruise industry is relatively straightforward to model because of the visibility into future capacity. It takes between 3-4 years for a new ship to be constructed and there are only three major shipyards (Meyer Werft, STX France, and Fincantieri), which places a cap on future capacity growth. Together these shipyards have a maximum capacity of 12 ships per annum. With future volume growth given (while exact timing can vary), to model RCL one primarily needs to make assumptions regarding pricing and expenses. RCL expects to grow its fleet at a ~6% CAGR from 2017-2021, which is in line with the industry average of ~6.1% from 2017-2021 and in line with historical norms (e.g. ~5.7% from 2000-2017).[6]

I believe the combination of capacity growth and net yield growth of 2%-3% should enable RCL to grow revenue by high single-digits over the next 2-3 years. If the overall macro environment remains healthy over the next couple of years and fuel prices remain relatively stable, I think RCL should be able to grow its EPS by a low-double digit CAGR.[7] If this scenario unfolds, RCL’s shares may be attractive on an absolute and relative basis. I believe shares could trade at ~$150 over the next 12-18 months, which represents nearly 50% upside from today's share price.

Major assumptions include: 1) capacity comes online as the company has forecasted; 2) RCL realizes net yield growth of ~2%-3% in each of the next two years; 3) fuel prices remain stable at current levels; 4) RCL uses the majority of its excess free cash flow to repurchase ~$1.4B worth of its stock cumulatively from 2020-2021 at an average price of ~$120; and 5) the stock trades at 12x 2021E EPS exiting 2020.

Industry Analysis:

Relative to other industries, I believe the attractiveness of the cruise industry is above average. From a financial perspective, cruise operators pay almost no taxes, have sustainably low cost of capital and collect cash upfront from bookings, which helps with general liquidity and free cash flow.

Low Taxes: RCL pays very low corporate taxes due to favorable international tax laws for shipping income. The Company’s historical tax rate has ranged between 0%-1%.[8]

Low Cost of Debt Financing: cruise operators typically use export credit agencies (ECA) to line up financing for new builds at relatively low interest rates. Before a new ship is ordered, operators usually get an 80% financing commitment from an ECA.[9] In terms of payment timing, approximately 80% of the total purchase price is due at delivery.

Negative Working Capital: Operators typically try to (and do) book cruises at least six months in advance of the actual departure date. This helps not only from a pricing perspective, but also from a cash flow perspective. More recently, cruise operators have extended their upfront booking windows beyond six months to take advantage of strong demand.  

Complementing the cruise industry’s durable financial advantages are strong secular trends. Cruising has been the fastest growing category in the leisure travel market for many years. Growth in passengers carried has compounded at 5% per annum over the last decade.[10] Looking forward, I believe operators should continue to benefit from demographic tailwinds (particularly the baby-boomers), growth in Chinese demand from nascent levels, constrained capacity and the value proposition of cruising over land-based vacations.

Demographics: ~50% of North American (NAm) cruisers are 50+ years of age.[11] We expect the utilization from this age group to accelerate moving forward and RCL should be a beneficiary. In addition, I believe millennials’ desire to spend discretionary income on travel/experiences should work in RCL’s favor.

Growth in Chinese Demand: The Chinese market is expected to grow at a ~20%+ CAGR over the next decade.[12] Chinese customers spend significantly more than Americans on international cruises, which improves net yields. Over the last year, Chinese passenger growth has slowed because China imposed a travel ban to South Korea.[13] If China can return to its 20%+ growth, then the market could absorb nearly 33% of industry supply growth through 2022.[14]  

Constrained Capacity Growth: Historically, capacity has grown in line with passenger growth at 5%. If every shipyard produces at maximum capacity (without going bankrupt or experiencing any significant delays during construction), capacity could theoretically grow at ~7%. While this is unlikely to happen, even if capacity does grow too rapidly in one region, operators will act rationally and move their ships to a region where returns are more attractive.

Value Proposition of Cruising over Land-based Vacations: Cruising allows passengers to “sample” a number of different destinations within a short time span at a comparatively low cost. U.S. resorts are ~20% more expensive than cruises on a relative basis.[15] According to industry publications, it’s not unusual for cruisers to subsequently plan a land-based vacation at one of the sites they visited on their cruise. The main factors influencing an individual’s decision to cruise are as follows: 1) cost; 2) destination; 3) overall experience; 4) quality of the ship (including rooms and common areas).

Why RCL?

Strong Fundamentals Lead to Multiple Expansion: RCL’s strong booked position for 2019 should assuage investors’ concerns about capacity growth in the near-term. If global economic growth remains strong over the next year, RCL’s shares may re-rate higher to a multiple that is more consistent with its ten-year average of nearly 14x forward EPS.[16] 

Measured Capacity Growth: Because cruising remains underpenetrated, RCL can add capacity at a MSD rate to grow revenue. RCL is expected to add capacity at a ~6% CAGR through 2021, which is roughly in line with historical averages.[17]

Silversea’s Investment: RCL acquired a two-thirds equity stake in Silversea Cruises for $1B on June 14th, 2018. The acquisition price paid was 11x normalized EBITDA including synergies. Silversea Cruises operates five premium ships and four expedition vessels. I believe the deal should enable RCL to bolster its luxury offering and reduce the cyclicality of its financial results. For instance, NCLH noted that net yields for its luxury Prestige ships (Oceania and Regent) did not decline YoY a decade ago during the Great Financial Crisis whereas CCL’s net yields dropped 14%.[18] Silversea’s current EBITDA margins are dilutive to RCL’s mix; however, RCL expects to realize at least $50MM of run-rate synergies over time.[19]

Capital Allocation and Improving Balance Sheet: RCL is expcted to repurchase $1B+ worth of its stock cumulatively in 2020-2021, while also utilizing a portion of its free cash flow to reduce its leverage to ~2.4x by year-end 2021.

Inputs & Assumptions for Valuation:

I believe RCL should be able to grow revenue by 10%+/7% in 2019/2020 through increased capacity and modest pricing growth. If this happens, net cruise costs excluding fuel should scale modestly as they have in the past. Assuming fuel prices remain relatively stable and RCL uses its free cash flow to repurchase shares, then the company should be able to earn EPS of ~$12.00-12.50 in 2021. Applying a 12x-13x multiple to 2021 earnings, RCL’s shares could trade at ~$150 in the next 12-18 months. I believe this nearly 50% upside represents an attractive risk/reward tradeoff relative to other opportunities in the market.

Risks:

Industry capacity growth results in negative net yield growth, causing multiples to contract

A shipwreck such as the one (Costa Concordia) that occurred in 2012, which hurt Carnival’s reputation and net revenue yield growth in the year immediately following the accident

Reduced desire to travel due to terrorism

A deep and prolonged global recession

Fuel prices continue to rise, which impacts demand due to cost based price increases and therefore impacts earnings growth

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.

[1] Credit Suisse

[2] BAML

[3] RCL carried 6.1MM guests of the industry’s 28MM guests, per 10-K

[4] Brands include Royal Caribbean International, Celebrity Cruises, and Azamara Club Cruises. Ship data as of year-end 2018.

[5] CocoCay is a resort/water park located in Bahamas that opened in May 2019

[6] RCL capacity growth unadjusted for acquisition of Silversea Cruises, per company disclosures

[7] Includes share repurchases

[8] RCL 10-Ks

[9] Investor relations call with NCLH on 9/28/16

[10] Company filings (CCL, RCL, NCLH)

[11] BAML

[12] Bernstein

[13] As of Q2’18, the Chinese are still not traveling to Korea

[14] Credit Suisse

[15] Credit Suisse

[16] Capital IQ

[17] Per company issued guidance

[18] RCL Investor Relations call 9/28/2016

[19] Per company issued guidance

Catalyst

No global recession over the next 12-18 months occurs. This would allow the cruise industry to perform well, which could result in normal revenue and earings growth and pave the way for multiple expansion.