Category Archives: RCL

More on Cruise Lines: Tailwinds and Valuation

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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.

Cruise Industry at a Glance (RCL / CCL)

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Buffett has often said that when valuing a company he tries to picture what the value line sheet will look like in ten years. The implication is that Buffett is only interested in companies that are resistant to change. Now, I am not suggesting that the cruise lines have the growth prospects of a Buffett company, but I do think that the industry will prove to be resistant to change, which makes it easier to value. In fact, short of Richard Branson or Sirgei Brin succeeding in the commercialization of space travel on a grand scale, I really can’t see how the cruise business will change at all in the future.

The cruise business is a good business with high barriers to entry. Competition within the industry is centered on price and service, and as usual where price is a factor, economies of scale matter. RCL and CCL respectively control 24% and 49% of the worldwide cruise industry through a variety of branded subsidiaries that are meant to appeal to different price points, geographies, and cultures. RCL and CLL are able to leverage one operational framework as well as spread their risks across many boats and clearly benefit from these economies of scale. What this means is that the existing power players could easily move to undercut the prices of new entrants or existing upstarts if a threat developed.

Additionally, cruising is an industry where reputation is important. Feeding, housing, entertaining and otherwise caring for hundreds of people while at sea is an impressive logistical feat. Consumers are likely to go with a name they know and trust – perhaps a friend had a great vacation on XYZ cruise lines – rather than try their luck with an unproven upstart that may be thought of as more likely to have problems at sea a consumer is likely to also go with XYZ cruise line. Because of the above any new entrant would likely need to be branded (example: “W Cruises” brought to you by the W Hotel or something along those lines that implies quality) or really access only a small niche within the broader market.

Further protecting the established norms is the fact that global port capacity is limited, and port operators may be reluctant to deal with new entrants for fear of angering their larger clients. If there is limited dock space, and you are the port operator, would you be more likely to work the port schedule around the new company that operates one or 2 ships that come to port once or twice a month, or with the company that operates a half dozen ships that come to port 10 times a month? The same can be said about the outside vendors that cruise ships partner with to provide “excursions” for their guests. If you are in the business of taking cruise ship passengers on jet ski or horseback rides, you would be more inclined to deal with the companies whose ships come to port most often, making it more difficult for an upstart to provide add on experiences for their guests.

Also a thought, although I’m not sure how relevant it is due to the declining importance of travel agents as a whole, but I would think that people going on cruises would be more likely to use a travel agent than the average traveler due to the fact that cruise customers tend to be older (assuming less likely to book online) and that cruises have multiple moving parts between flights, transport to the dock, the cruise itself, and then add on activities. Travel agents would likely be incented to push cruises from the major operators in some sort of rewards plan.

As for why the cruise lines never priced each other to death airline style, I think there are two main reasons. The first is that the industry is differentiated vertically, meaning that there are high end cruises, low end cruises, and everything in between. On the high end as with many things considered “luxury” pricing cruises higher helps attract a certain clientele. For this well heeled clientele discounting prices is a bad thing. When one has an elitist attitude, a lower price makes the experience more accessible for those in a lower social strata which the elitist does not wish to be associated with, and these customers will gladly pay up to ensure they are only surrounded by people who they view as social equals. On the low end, value conscious consumers book far in advance trying to lock in the best price, allowing the cruise operator to adjust pricing upward based on remaining supply for the next round of buyers. Of course as time until departure gets low prices adjust downward to ensure a full boat.

The second reason is that cruise offerings are differentiated horizontally, meaning that there are many different cruise niches. The obvious here is geography, but other niches such as black tie dinners versus adventure excursions are also plentiful. Additionally, different ships are pitched as different experiences with the net effect being that cruise experiences are not as commoditized as one may first assume.

All of the above is enough to get me interested in taking a look at what the future of the industry may hold, and what valuation currently looks like.

More on that in the coming days.