Shares of Carnival Corp. (NYSE:CCL) rose approximately 6.7% by noon on Dec. 20 after the cruise line released its earnings for the fourth quarter of fiscal 2019, which ended on Nov. 30.
The quarter saw diluted earnings per share of 62 cents, beating analyst estimates by 10 cents and bringing the earnings per share for full fiscal 2019 to $4.33, which is higher than Carnival's own lowered earnings guidance of $4.23 to $4.27 per share (guidance was originally higher, but management lowered its expectations after the third-quarter earnings report due to rising fuel costs). Revenue for the quarter came in at $4.78 billion compared to forecasts of $4.6 billion.
Carnival has been growing its earnings per share at an average rate of 29% and its revenue at an average rate of 3.9% per five-year period.
Fuel prices and tightening regulations
Carnival's stock dropped more than 9% following the release of its third-quarter earnings for 2019. The decline was not because of earnings or revenue, which topped analyst expectations and came at the peak of the company's earnings cycle, but because of certain forward-looking statements that served to lower investors' expectations.
The one that struck the most fear into investor sentiment was the one on fuel prices: "Based on a 10% change in fuel prices versus the current spot price that was used to calculate fuel expense in our September 26, 2019 guidance, we estimate that our adjusted diluted earnings per share guidance would change to the following: $0.05 per share for the fourth quarter of 2019," meaning the company expected to lose 5 cents off its upcoming earnings per share due to fuel price increases.
While fuel costs did not see a 10% increase during the fourth quarter, there was some upward price pressure due to increasing demand. Demand for bunker fuel increased by 3.5 million barrels per day in 2018 alone, while Carnival consumed 822 metric tons in its 2019 third quarter compared to 818 tons in its 2018 third quarter.
The real pressure will come in the first quarter of 2020, when IMO 2020 goes into effect and limits the sulfur emissions of ocean-going vessels to 0.5%. The sulfur-rich bunker fuel typically used in marine vessels contains 3.5% sulfur, and slashing the allowed emissions all in one go is not likely to make for an easy transition.
"The industry is not ready," Kurt Barrow, an IHS Markit consultancy vice president, said. "You're not going to build enough new refining equipment nor add enough scrubbers."
Carnival is going the scrubbers route for its vessels, which is the more cost-saving route as the spike in demand for more refined gas products will make the price extremely unpredictable, a dangerous situation for a business that burns approximately 2,500 metric tons of fuel per year in its operations. To appease environmentally conscious investors and customers, Carnival has dubbed its scrubbers "advanced air quality systems" and is touting them as a better way to remove sulfur and other pollutants from fuel combustion emissions.
Despite prevalent investor fears that IMO 2020 will wipe out significant portions of business with heavy marine fuel consumption, the effect on Carnival may not be as bad as what it's hyped up to be. The cruise line began adding scrubbers to its ships in 2013, and by the end of fiscal 2018, 74% of its fleet had scrubbers installed (which cost approximately $500 million).
On its website, Carnival says :"Through extensive independent testing, the systems have proven capable of outperforming low-sulfur fuel alternatives such as marine gas oil (MGO) in terms of overall cleaner air emissions and no negative environmental impact to oceans and seas, all as originally intended by the International Maritime Organization (IMO)."
Carnival's optimism for its fiscal 2020 earnings shone through in its earnings guidance of $4.30 to $4.60 per share, which falls in line with analyst expectations.
Good sales usually win
As of Dec. 20, Carnival has a market cap of $35.66 billion, a price-earnings ratio of 11.33, an Altman Z-score of 2.46 and an operating margin of 16.31%. GuruFocus has assigned the company a financial strength score of 6 out of 10 and a profitability score of 8 out of 10.
According to the Peter Lynch chart below, Carnival is currently undervalued based on its earnings, reflecting a similar situation as what the company's stock faced in the 2008 financial crisis. Despite the fact that demand for its products sank very little, sentiment predicted that in times of financial crisis, there would be hardly anyone who would be willing to spend their hard-earned money on a cruise.
It is possible that fears of a recession in light of the longest bull market in U.S. history have helped to depress Carnival's share prices as well. Based on what happened to Carnival's stock in 2008, it is possible that the beginning of the next bear market will see share prices plummet. Until then, it seems possible that strong earnings potential and optimism from both the company and analysts could cause Carnival's market valuation to strengthen, though the effects of this may be reversed by the fear of oil price increases when IMO 2020 arrives.
Disclosure: Author owns no shares in any of the stocks mentioned.
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This article first appeared on GuruFocus.