Royal Caribbean: A Buy in Carnival's Wake

Minyanville

With all of Carnival's (CCL) deserved bad publicity, I am surprised that both Royal Caribbean (RCL) and Carnival, based on consensus EPS estimates for 2014, discount only 3% five-year EPS growth rates -- albeit I have a 7% risk discount for Royal and a lower 6% risk discount for the "higher quality" Carnival, which at this point can be considered higher quality solely on its stronger balance sheet.

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With the present federal administration, I would not expect to see an economic recovery through the end of Obama's term. Hence, a 2% GDP growth and 2% inflation for 4% nominal GDP seems likely. Cruising expenditures in the US should only do a 1.25 to 1.5 multiple of that growth, down from 2 to 1 in the industry's growth years. That implies a top line of 5-6% revenue growth for the industry. If I assume that fuel will grow at approximately the same rate, and that third world labor costs grow at the same 5-6% (for people on these ships who earn substantially above what they would in their home countries), margins will not change because of these factors. Ship capacity should grow 2-3%, implying some very slow margin strengthening over the next three to five years. That could result in the compound average growth rate of EPS being in the 6-7% range.

A 6-7% growth rate would -- in my three-stage EPS growth model, with a 4.1% risk free rate (long T- bond plus 1%) -- result in deserved prices of $37 - $39 for Royal Caribbean, 13-17% appreciation for what I would call a base outcome. Because Royal has no sizable capacity additions coming, debt is being rapidly paid down and the 7% risk discount required by investors should be approaching Carnival's 6% over the next three to four years. A 6.5% risk discount implies $40; a 6% risk discount implies $43.

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That was my thinking post Costa Concordia's running aground, but before the Carnival Triumph, Elation, Legend, and Dream incidents. Yes, Carnival has more ships than other cruise lines, but the number and quick succession of recent negative incidents say to me as an outsider that Carnival's operations have to be considered relatively poor.

Management has said that it will be spending between $200-300 million more per year on maintenance, as I read their comments. They also said that their fleet was aging, but that does not wash when the ships are depreciated on a 30-year life and most are still much younger.

Most sell-side analysts say that it will take a year or two for Carnival to regain its trendline normal earnings level, and that's before factoring in the cost of the additional maintenance. I disagree. I believe that there has just been too much publicity to overcome in the medium term at least. There are enough other options for cruisers.

I have no historical precedents to handicap a market share shift away from Carnival, but I believe that the company will lose market share because of all the recent bad press. I made some calculations of a 1% market share shift from Carnival's lines going to proportionally to Royal's lines and Norwegian Cruise Line (NCLH). (The numbers I had to work with are pretty inexact, and my assumptions are pretty gross, though indicative.) A one-percentage point change in market share over three years adds $.55 per share to 2015 EPS, which would then be $3.75. Because production of product cannot be increased to take dollar market share in this case, I am predicting an increase in relative pricing between Carnival and both Royal and Norwegian Cruise Line. By my extremely rough calculations, that increased pricing differential would be 2%. That seems to be intuitively possible and a reasonable sort of "insurance policy" to be bought for the average relatively sedentary and unadventurous middle aged and older adult buyers who are the core cruising market.

If this scenario did play out, it is reasonable that Royal would also achieve the 6% risk discount and be considered the quality investment in the cruise industry. In that "home run" result, the stock could be worth $49 for 50% appreciation.

These are excellent outcomes. There are two caveats, however. First, a recession or economic slowing in the US would hurt the company's financials. The other caveat is a worry for all consumer discretionary activities geared toward older adults such as gaming and cruising. Nobody seems to be talking yet about the increased spending for health care that seniors will have to face because of Obamacare-related cutbacks. I have not come to grips with that yet and it will not unfold for maybe two to three years, well after this stock will have "worked," if it is going to. (I do know that Boyd Gaming (BYD) will have completed its own look at the issue for the gaming industry in a few months. Kudos to the strategic planning function at Boyd.)

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