Royal Caribbean's Valuation Is Now Fair, but Industry May Be Facing High Waters
By Ronald Thomas, CFA Oct 28, 2013 3:50 pm
Although the company has gained market share, overall capacity is still getting worse, and other economic headwinds may soon create new obstacles.
Royal Caribbean (NYSE:RCL), at $43, achieved the fair value level I expected when I recommended purchase in March of this year at $30. (See Royal Caribbean: A Buy in Carnival's Wake). However, some of my worries are coming to the fore, and I believe that it would be a good time to take profits.
My original recommendation was based on a slow-growth economy, specifically 2-3% economic growth at most, and not a full economic recovery from the recession. I also expected cruise industry expenditures to grow at 3-5% at most. And there has been no evidence since then to believe otherwise. After Carnival's (NYSE:CCL) problems, I expected that there would be a market share gain by RCL. Now, based on only one or two quarters of data seen, I believe that has been happening.
But the possible events and changes I named in my caveats are also now a reality. There has been some some weakness in the consumer sector, for example, especially in clothing and auto parts, among other industries.
I also said, "Nobody seems to be talking yet about the increased spending for health care that seniors will do 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 believe all of the hubbub over the Affordable Care Act site debacle will concentrate the thoughts of American consumers on the eventual financial fallout from Obamacare. That shift could hurt the stock market overall, but I think that it will have the most impact on cruise customers, who are a fairly conservative, unadventurous group. Retirees will not have problems with Medicare initially, but I believe that they will reduce their spending when they see what's coming. The core crowd (age 45-65) will, I believe, cut back as they see or become the victim of dropped policies. Premiums will increase, of course, and in the shorter term, must come out of discretionary spending.
At 3.6%, the expected compound average growth rate in capacity for the next five years is still higher than I would like to see. While that figure is a big decline from the growth rate of past years, it is still higher than a reasonable expectation for weighted average GDP growth of the North American plus European Economic Community. In other words, overcapacity is still getting worse.
My present valuation, with Royal's attainment of a deserved 6.5% risk discount, is fair. I use consensus EPS estimates of $2.31 and $3.06 for 2013 and 2014 respectively. But I do not use the $3.84 for 2015, because these estimates have an acceleration in revenue growth from 5%-ish in 2014 to 9-10%, which includes high margined onboard revenue, which I think is unwarranted. Using a $3.54 for 2015, I put together two next-12-months earnings-per-share estimates of $2.66 and then $3.24. Using a 4.2% risk-free rate (3.6% long Treasury plus 60bps to counter quantitative easing), my model says that the stock at $43 is discounting an 8% five-year growth rate, which is maybe 1-2% higher than what I might expect.
One more consideration, albeit one for the future: I am beginning to wonder if the industry is on a bit of a treadmill as newer, bigger ships are added to the fleets. I realize that they are more profitable from a margin standpoint, but I wonder whether part of their margin increase comes from customer demand, as they are willing to pay a premium for the biggest and latest. What would happen to margins if capacity growth grew at zero? Profitability would obviously go up, but I wonder if enough passengers currently going out on the biggest ships would choose to go elsewhere, so that the leverage would not be up to expectations.
I have also had other non-economic concerns about the largest ships. As I was writing this I noticed a New York Times article from October 27, 2013 entitled "Too Big to Sail? Cruise Ships Face Scrutiny" by Jad Mouawad. It is interesting reading, though it will not affect an investment in a cruise line -- until it does.
No positions in stocks mentioned.
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