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Carnival Corporation (CCL) is a well-run cruise operator whose stock is trading at 11x forward earnings. The company is investing in expanding its business, while paying out a healthy dividend and buying back its shares. The stock has more than 20% upside to a $65 fair value, representing a reasonable 14x EPS. Enjoy a 4% dividend yield in the process.
Carnival is a global cruise operator that operates under the Carnival, Holland America, Princess, Seabourn, Costa, AIDA, P&O and Cunard brands. Each brand is differentiated to some extent by the size of its ships, staff to guest ratio, destinations, target audience and onboard amenities. The company is headquartered in Miami, Florida. It was founded in 1972 by Ted Arison, whose son Micky is currently the company’s Chairman.
The business is a straightforward one. The company buys ships, hires crew, and provides passengers an all-inclusive vacation to a destination, along with selling additional services to a captive audience. The financial reporting is uncomplicated. The company has a $36 billion market cap and $46 billion enterprise value. More than half of the company’s revenue comes from North American travelers.
The CEO for the last five years, Arnold Donald, has done a creditable job of operationally managing the company, investing in the business and returning cash to shareholders. Most crew members are from Asia and Eastern Europe and are non-unionized. As a result, wage increases for cruise lines are more muted, as compared to US airlines where labor is constantly angling for a bigger piece of the pie. The industry is also able to enjoy decreases in fuel prices when they occur, albeit to the extent they are not passed on to customers through competitive forces.
The company generated $19 billion of revenue for the year ended November 30, 2018. This represented healthy 8% growth over the prior year. Passenger ticket revenue amounted to 74% of the total, with most of the rest coming from onboard sales. Operating income was $3.3 billion, a 17.6% margin. Major costs include commissions, payroll, fuel, food and ship depreciation. Interest expense of $200 million is understated due to some interest being capitalized, while a 2% tax rate is low due to the way cruise companies structure their business by domiciling ships in low tax regions. Excluding a small amount of unrealized gains on fuel derivatives and a gain on a ship sale, the company had $3 billion of net income or $4.26 per share.
Along the way, CCL has improved its gross margins by about 10 points from the l0w-30s to the low-40s. It’s decreased its operating expenses, as well, resulting in improved EBIT and EBITDA margins. It has increased its CapEx to reinvest in the business and build capacity, but despite this, it has improved its Owner Earnings and Free Cash Flow along the way.
On the balance sheet side, the company has $10.3 billion of debt, well-supported by $35.3 billion of property and equipment. As cruise sales are made well in advance of actual sailings, the company held $4.3 billion of customer deposits that will be converted into revenue in the future.
A look at the cash flow statement reveals the weak spot of the cruise industry. The company generated $5.5 billion of cash from operations, but spent a whopping $3.7 billion on capital expenditures (compared to $2 billion of depreciation). Thus, it generated only $1.8 billion of free cash flow, compared to $3 billion of net income. Effectively, it is re-investing 40% of its net income to grow the business. The company paid out $1.4 billion in dividends and bought back more than $1 billion of its shares, adding a modest amount of debt to its balance sheet.
Despite the significant CapEx investments, CCL’s FCF to Sales is about as good as it’s been:
The company announced that bookings for 2019 are considerably ahead of the prior year. It expects cruise revenue to be up 5.5%, with capacity growth of 4.6%. The company expects to benefit from benign fuel prices. All in, the company guided to $4.50 to $4.80 in EPS for the coming year, which at the mid-point would represent 9% growth over the prior year. The analyst consensus estimate currently stands at $4.80, which implies that analysts view the guidance as conservative. However, given that, a weak economy could more easily make for a downside surprise.
Fears of an economic downturn and general stock market malaise have led to the stock dropping 20% in the last year and becoming mispriced, leading to a good buying opportunity. The value proposition offered by a cruise is arguably better than an air + hotel vacation, so the company could attract a new base of travelers in a mild downturn, according to the company’s CEO. Currently, less than 5% of the population in the US and Europe goes on a cruise in a given year. However, a severe downturn and the resulting loss of consumer confidence would crimp demand as leisure travel is a discretionary expense.
On a base case, with the company growing revenues in the low single digits and EPS in the high single digits, valuing the company at a P/E ratio of 14 seems reasonable, equating to a 7% earnings yield. Applied to the mid-point of guidance next year ($4.65), this would imply a fair value for the stock of $65. That is more than 20% upside from the current $52 level. Although there is no specific catalyst on the horizon, I would expect the stock to move higher as the 2019 results are achieved and the company buys back stock. The company pays out a dividend of $0.50 every quarter, so you get paid well while you wait.
Although I don’t like putting too much weight on historical P/Es, since the business and its growth may have changed, a 14x P/E would be historically on the low side for CCL (though it is trading at just under 12 right now).
As a bull case, if the company reaches the high-end of its EPS guidance and trades at 15x EPS, you are looking at a $72 stock, or 40% upside in the next year including dividends. (Or, in an even more bullish case and CCL’s P/E even reaches its 10 year median of 22, we’re talking about $102.)
In a bear case, the company would come in at the low-end of its guidance and trade at 10x EPS, taking the stock to $45 or 15% down from its current level. At its worst, CCL’s P/E hit 7.25 during the Great Recession, but didn’t stay there long.
The company’s main US listed competitor, Royal Caribbean (RCL) is trading at a similar valuation of 11x forward EPS, while a smaller competitor Norwegian (NCLH) is at 9x forward EPS. I would add that Norwegian’s earnings quality is poor, with the company regularly excluding recurring costs from its pro-forma figures, so the discount is illusory.
If we try a DCF valuation of the firm using a fairly conservative Owner Earnings growth rate of 6% (it’s been more like 20% since 2015), and a discount rate of 7%, we end up with this:
Its current price gives you a 25% margin of safety, even with these non-aggressive assumptions.
Having a couple of thousand people in an enclosed vessel for days or weeks at a time isn’t an ideal sanitary situation. Every once in a while, there is an outbreak of illness (usually Norovirus) on a voyage, leading to refunds and bad publicity.
A deteriorating global economy could lead to a fall-off in demand. Or the company could mis-execute and miss profit expectations.
Operating a cruise line is a capital-intensive business. In good times, such industries tend to over-invest, leading to excess capacity in a downturn. Loss of capital discipline represents a risk outside an individual shareholder’s control.
The CEO of the Holland America line is named Stein Kruse!
The Partnership advised by the author owns shares in Carnival (CCL) and Royal Caribbean (RCL).
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