In the last post, I made the case for stability in the cruise industry.
Now I’ll talk a bit about tailwinds and valuation.
Sell side analysts talk about occupancy, available passenger days, net yields and several other industry metrics that are likely useful while trying to pinpoint short term earnings potential. However, I am not interested in the cruise lines because of the short term earnings potential. I am interested in them because I think they are stable businesses with little risk of change over the next ten years or so. In the shorter term I really have no idea what will happen with prices. I think the equity is cheap now, but it is certainly at risk of decline due to a global consumer spending slow down, a terrorist attack, an out break of bird flu, an accident at sea, a spike in oil prices, and any other number of factors.
However, the above mentioned risks have always been present, and they will always be present in the future. I really don’t think there is any way to invest around them.
It is worth noting however, that in the past, despite all of the previously mentioned risks which have manifested themselves at various points, the two companies still managed to post 10 year average ROEs of 8.2% (RCL) and 10.9% (CCL). These averages have also been significantly impacted by the last few years of the great recession, suggesting that a true normalized ROE number would be higher, rather than lower.
Of course, historical ROE numbers are useless if you think the future of the industry is at risk, but I don’t. In fact, I think the future of the industry is brighter than its past as there are a number of tailwinds developing. First, and perhaps most obvious, is the aging population in the US. The average age of cruise passengers is over 50 years old, and there is a significant senior segment. Second, historically cruising has been a mostly North American phenomenon, but that is changing. According to RCL’s recent investor presentation, 3.3% of the American & Canadian population are cruise customers, while only 1.1% of Europeans, .2% of Latin Americans, and .1% of the population of the Asia/Pacific region are. That provides a long runway of growth potential as the situation in Europe stabilizes and other regions become more prosperous. Additionally, new destinations are coming online as is evidenced by the fact that in 2007 50% of RCL’s cruises were Caribbean, and in 2012 only 42% were. Furthermore, vessels are becoming more fuel efficient, and capacity growth is slowing as management teams have indicated they will be more focused on strengthening their balance sheets and focusing on ROIC rather than blind expansion as they had been in the past.
All of those tailwinds are great… but I don’t want to pay for them. And at today’s prices, I am not. Today I am paying for the assumption that consumers will never go on cruises the way they used to, ships will crash, and terrorists will attack cruise ships. I am happy to buy that assumption.
RCL is trading for .61x book, and CCL is trading for 1.04 book. With average ROEs of 8.2 and 10.9 respectively, at these prices with a cost of capital or hurdle rate of 10%, intrinsic value of the shares can be estimated at 82% of book for RCL (8.2% / 10% )and 109% of book for CCL (10.9% / 10%). For RCL that implies an intrinsic value of over $32 and for CCL a price around $33. This is obviously a very simple valuation, but in a business whose long term prospects are as stable as i believe the cruise business to be, simple is all you need.
I believe these estimates are conservative for a few reasons. First, book values for cruise lines are understated due to the effects of inflation. The ships are typically deprecated over a 30 year period, but a new build costs significantly more than the carrying value of the old ships. Second, as mentioned, the 10 year average ROE number that I used is likely understated. Third, the previously listed tailwinds should all benefit revenue in the future, meaning even higher ROE. Additionally, it is worth noting that historically P/B for RCL was mostly above 1.5x and for CCL mostly above 2x with the exception of the post 9/11 years and great recession years.
In summary, I don’t know what will happen in the short term, but for an individual investor that does not have to pander to the whims of impatient customers that expect quarterly results the way most institutional managers do, I think that the cruise lines will perform very nicely. At these prices RCL has an almost 25% margin of safety vs a low estimate of intrinsic value, meaning the margin of safety is probably closer to 40%.
Disclosure – establishing a long in RCL and hoping to add more lower.