All Aboard? Royal Caribbean Cruise Lines Attractive at $30

By Ronald Thomas, CFA  MAR 16, 2012 2:20 PM

Royal Caribbean management has finally come to the conclusion that cruising is not a growth industry, and that it will now manage the business that way.


It may be time to take a ride on Royal Caribbean (RCL).

The stock, at $30 per share and using consensus ’12 and ’13 EPS estimates of $2.24 and $2.91, discounts a 2% five-year compound growth rate. Importantly, the risk premium applied is 6.5%, a .5% add on to Carnival’s (CCL) 6% because of a poorer balance sheet.  If it deserved Carnival’s 6% discount, which I believe it increasingly will, the implied growth rate would be 1%. Either way, the stock is a buy.

The worldwide cruise industry has grown at around twice the rate of US GDP growth historically. That is with 60% of passengers coming from North America. With 10% from countries in the developing world, that leaves 30% from Europe. That 2-to-1 ratio cannot hold given that the US has retrenched and has an inflation-adjusted income which is not presently growing overall.  Additionally, the market is now more mature. Capacity being gradually deployed to emerging market countries can only partially counter the incremental future demand weakness from the Europe, mainly the PIIGS (Portugal, Ireland, Italy, Greece and Spain) nations. But the slow growth of the entire region and its lack of financing for its heavy coming retirement burdens will tend to dampen demand as well.  I would expect that cruise industry expenditures would grow at something closer to 1.25-1.5 times US GDP.

As a worst case growth scenario, if I assume no real recovery from 2008 recession but only a return to a normal 2-3% real GDP trend line with 1-2% inflation, US GDP grows 3 to 5%. Using Street low EPS estimates of $1.81 and $2.35 for 2012 and 2013 respectively ($2.35 is 30% over the $1.81 that is somewhat depressed by publicity from Carnivals accident and other incidents and is 19% lower than consensus of  $2.91), and 4% nominal GDP growth multiplied by a conservative 1.25, results in 5% industry revenue growth.  I will assume that oil, which has been the biggest factor in taking down operating margins from 16% in the early 2000s to 12% in 2011, is not much of a factor in a slower growth economy implied by slow growth in the developed world. Therefore, I will say that oil price increases counter the operating leverage here and that earnings only grow 5%. Thus, the implied price is the present $30.

I believe that Royal Caribbean management has finally come to the conclusion that cruising is not a growth industry, and that it will now manage the business that way. Capacity growth will be in the 2-3% range for Carnival and less for Royal, indicative that they will be managing for a slower growth environment. Royal’s fleet is newer, with more of the huge ships that customers prefer.  Hence, cash goes up and financial leverage declines for Royal.  Bond ratings go up and the risk discount, or PE discount, if you are still into PEs, to Carnival goes away. 

Another thing that might go away is the customer perception that Carnival and Royal are equivalent operators. I have seen too many accidents on Carnival’s lines vs. Royal’s lines, and I can also remember seeing, about a decade ago, crew members on a Carnival ship trying to hose down a flame in an exterior cabin by shooting water out the window of a further forward cabin and letting the wind take the water into the burning cabin’s porthole. The explanation I heard in the news is that the temperatures were too high inside to get near the cabin.  (Yes, my memory is right on this. It's something you take note of.)  I cannot make any real claims about safety form the outside, but I can see where the perceptions, which can become reality, are definitely on Royal’s side on safety.   

Six percent revenue growth (1.5 times 4% nominal GDP) and a 6% risk discount imply a $33 price (again using the Street low 2013 EPS estimate).  How about a 1% point revenue growth gain for Royal from a market share shift?  That is a $34 stock. Again, I am assuming no operating margin growth as banker fuel takes the operating leverage.  Without that assumption you can add  3 to 4  dollars to the implied stock price.

I do not mean to imply such relatively low appreciation potential. What would be the effect of some faster trend line growth in GDP or an actual two to three years of growth at above trend line, i.e., a bounce back from the recession?  That would, in my opinion, mean a new federal government administration.
Then the scenarios get more favorable and open-ended. To cite one, if I used a consensus Street estimate of  $2.91 for 2013, which has some recovery already built in, and assumed a mild recovery of three years of 8% earnings growth thereafter (and retreat toward a 2% terminal growth rate from there), and the better bond rating, 30% appreciation to a $39 stock price is warranted.  The stock price leverage is there.
No positions in stocks mentioned.

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