Carnival's fourth-quarter results showed a marked improvement in cruise demand. Even though revenue fell 3% from the prior year because of declines in ticket pricing and onboard spending, customer deposits--a forward-looking indicator of future revenue--increased for the first time since the third quarter of 2008.
Despite the small decline in revenue, Carnival's operating expenses rose 2%, partly because of increased depreciation costs for its newest vessels. This reduced operating margins by more than 400 basis points to 9%. Carnival's aggressive pricing allowed it to maintain a high level of occupancy during the economic downturn, but now that consumers are gaining confidence, we believe Carnival will be able to raise prices again, which should boost growth and improve profitability.
As we have said all along, Carnival was well positioned to make it through the economic downturn, and we expect the company to return to economic profitability as cruise demand continues to improve. We are leaving our fair value estimate unchanged.
Fair value estimate (US-traded ADRs): $38 ¦ Fair value uncertainty: High ¦ Economic moat: Narrow
Thesis (Last updated 22-09-2009)
Carnival is the largest competitor in an industry that benefits from scale advantages. There are significant barriers to starting a cruise line, preventing additional competition and leaving Carnival with a narrow moat. The long-term prospects for this company look promising.
We think the cruise industry has a bright future. Cruises are a relative bargain compared with the rest of the vacation market--the opportunity to visit more than one destination with several included amenities at a competitive price has earned cruises high levels of customer satisfaction compared with other vacation categories. As a result, the total number of worldwide cruise passengers has increased by about 8% per year since 1990, but only 17% of the US population has ever taken a cruise. This low level of penetration leaves ample room for Carnival to grow domestically, and international markets should provide attractive growth opportunities, as well. In fact, the company increased its international capacity by more than 9% in 2008. Similarly, a growing elderly population, larger and more advanced ships, and increased cruise awareness should all drive profitable growth for years to come.
Consolidation in the cruise industry has created a virtual duopoly. Carnival and Royal Caribbean carried approximately 49% and 24% of all global cruise passengers in 2008, respectively. Greater scale allows cruise lines to leverage fixed costs across bigger fleets and larger ships. Advertising, administrative, and port costs are relatively fixed regardless of the number of ships in operation, and similarly, fuel costs do not increase proportionately with the size of ships. At the moment, Carnival has the largest fleet but has smaller ships than Royal Caribbean. As a result, Carnival generates superior operating margins but pays greater fuel costs. At this point, it would be prohibitively expensive and time consuming for another operator to achieve the scale needed to successfully compete with Carnival and Royal Caribbean.
Of course, it's not all rosy for the cruise lines. Carnival does not hedge its fuel obligations, so rising fuel prices represent a formidable threat to free cash flow. At the same time, the industry is always threatened by bad weather or acts of terrorism that could significantly curb demand. Similarly, an economic downturn could hinder consumer spending and depress Carnival's revenue growth. We think these risks contribute to a high level of uncertainty in our fair value estimate.
Still, despite the short-term risks for Carnival, we think the company has a solid foundation upon which to grow profitably. We expect the company will continue earning returns in excess of its cost of capital in the near future.
Valuation
We've increased our fair value estimate for Carnival's US-listed ADRs to $38 from $22 (as yet we do not have a fair value estimate for the UK-listed stock but we're working on it). Although we only slightly augmented our operating assumptions, Carnival's large amount of financial leverage creates a rather large increase in our fair value estimate. We now believe Carnival will increase revenue at an annual rate of 6.1% during the next several years as a result of ticket price increases, onboard spending increases, and capacity increases as the company recovers with the overall economy. In addition, increasing scale in the cruise industry leads to efficiencies that augment profitability. We expect Carnival's operating margins to normalise between 20% and 25% within the next few years. At normalised levels of demand, we believe Carnival can earn an economic profit.
Risk
Carnival faces some uncontrollable risks. If fuel prices increase significantly, free cash flow will suffer. The company also pays an insignificant amount in taxes, but this could change if the exemptions it receives are eliminated. Additionally, Carnival is vulnerable to inclement weather or acts of terrorism, which could drastically curb demand. Finally, if expansion outpaces demand, excess capacity would hurt operating profits.
Management & Stewardship
Micky Arison leads Carnival as its CEO and chairman. His father, Ted Arison, founded the company in 1972, and Micky started at the bottom and quickly rose through the ranks, becoming CEO in 1979 and chairman in 1990. We believe the management team is exceedingly experienced and capable of running a successful cruise line that creates value for shareholders. In fact, the executive management team has an average tenure of 19 years with the company. Although we believe Arison is a capable leader, separation of the chairman and CEO roles would promote independence of the board of directors and greater stewardship for minority shareholders. Still, the Arison family has a greater-than-50% stake in the company, creating an enormous incentive to run the business as well as possible. Management compensation is reasonable as well, equaling only 0.25% of revenue.
Overview
Growth: Carnival increased revenue by 12% in 2008. We expect a lower growth rate of 6.1% during the next five years, driven mostly by fleet expansion, increased service offerings, price increases, and demographic trends.
Profitability: We expect Carnival to earn an average return on invested capital of 7.6% during the next five years. This is lower than the company's 10.9% weighted average cost of capital. We expect operating margins to remain stable through 2012 as greater scale advantages are offset by fuel price increases.
Financial Health: Carnival is in solid financial shape. The company's debt is a mere 2.3 times EBITDA. Operating cash flow easily covers interest expense, and the board has approved a $1 billion stock-repurchase programme.
Profile: Carnival is the largest cruise operator in the world and generated more than $14 billion in revenue in 2008. The company's 91 ships take passengers to destinations around the world with approximately 70% of ticket revenue coming from US departures. Carnival's ships are operated under the company's 11 brands, the largest of which are Carnival Cruise Lines, Princess Cruises, and Costa Cruises. Carnival is incorporated in The Republic of Panama.
Strategy: Despite already being the largest cruise operator, Carnival plans to add 22 new and bigger ships to its fleet during the next five years, representing a 36% increase in capacity. These ships will be used to broaden the variety of destinations Carnival can offer to customers, and they will diversify its customer base and lower its relative costs per ship. Increasing cruise and brand awareness will also be a top priority as the company aims to entice more first-time cruisers.
Bulls Say
1. Carnival owns some of the most well-known and respected cruise brands, making it an obvious choice for both novice and experienced cruisers.
2. Cruise industry dynamics are improving as the elderly population and cruise awareness continue to grow.
3. Compared with other types of vacations, cruises have the highest customer satisfaction and are a relative bargain for many vacationers. This solid product with low penetration should flourish under good management.
4. Carnival paid out 39% of operating cash flow in dividends in 2008, resulting in a 6.7% dividend yield at our fair value estimate.
Bears Say
1. A lack of fuel hedging will cause Carnival's free cash flow to suffer quickly if fuel prices rise substantially.
2. Weather or acts of terrorism could prove to be a significant deterrent of potential cruise vacationers.
3. Scale benefits give cruise companies the incentive to constantly increase capacity. If the industry expands too quickly, excess capacity could hurt profitability.
Warren Miller is a Morningstar stock analyst.
