Back To The Future: Cruise Line Industry Skirted Fundamental Analysis For A 100% Gain, But Can A Miracle Happen Twice?
In May Of 2010, I published a series of reader contributions on the cruise line industry as well some proprietary research on a particular company in said industry - Royal Caribbean Cruise Lines. The consistent, globally synchronized flood of money totally distorted market pricing and risk in public equities - thus often distorted practically applicability of hard core fundamental and forensic research. Long story short, 2+2 equalled 4 arithmetically, but as a speculator in the globally liquidity slush bowl that was the playground of the coordinated international central banking cartel, the sum was more like 8. Of course, this meta-math is quite unsustainable. Quite frankly, it was a wonder that it has lasted this long, but sooner or later, math tends to subvert magic, which at the end of the day, is really nothing short of psychological prestidigitation, smoke and mirrors. We have revisited this industry after finding a tad bit more optimism for one of the leading companies than we feel is warranted. That report will be posted for subscribers tomorrow, but for now let's look at how we came to this conclusion through 2 and a half years of observation.
The following is a summary compilation of contributions from readers and some rough spreadsheet work from our analytical team regarding RCL. It has not been put in formal report form, but we feel the contents are worth perusing. The entire document is available to subscribers here: RCL_050910_Reader Contribution. The proprietary research on this company is available to subscribers here: RCL 050510 Release Candidate 05/06/2010. And now, on to a brief of the analytical view of recent history...
Existing qualities for an optimal short candidate:
- ROIC < WACC and decreasing, for many years
- Huge leverage and debt maturities currently with low coupons
- Altman Z score <1
- Industry requires enormous capital to grow the business
- Industry has excess capacity and is adding more anyway
- Huge exposure to the Euro and US consumer and vulnerable to weak macro
- High cost producer
- Weak competitive position with competitors who are lower cost with better balance sheets
- Bullish investor sentiment and valuation above long term averages
- Insiders dumping their stock
- And a catalyst to help investors revaluate their bullish stance
Only thing I’m missing on this short is identifiable fraud and accounting shenanigans
RCL Summary: “Slow Motion Train wreck”
Market cap: $7B
Target holding period> 1.5 years
One must remain cognizant that the holding period suggested was not that of a momentum, nor a day trader.
Current Valuation: EV/EBITDA of 11.6 street estimates, 18 P/E on 2010 EPS.
Shares already sold short: 27M shares
Total float: 130M shares
Stock Downside: real possibility the equity goes to $0 over next 2 years based on Altman Z score and potential that CCL decreases prices to push on RCL’s stressed balance sheet. Consider the impact sovereign defaults would have on RCL if credit markets froze up in response while RCL attempts to fund $2.6B in debt maturities and $4.4B in ship building commitments over the next 3 years with a vulnerable balance sheet and minimal/zero fcf.
While this has proven to be historically pessimistic, and frankly even a tad bit pessimistic at the outset, the logic behind the funding issues was (and still is sound). The sovereign debt issue is a credit/currency crisis that has been postponed by central bank prestidigitation, with a literal cornucopia of stop gap measures that have prevented currency collapse and postponed several serial defaults but at the price of compounding the over-indebted problem by piling indebted countries with even more debt while crippling revenue production through austerity measures - thus at the same time not only failing to provide a lasting solution but further exacerbating the problem while simultaneously extending it. Reference
Stock Upside .: A 20% premium on 10 year average EV/EBITDA multiple gets 11.4x. Then using 10% higher than the already optimistic 2011 street estimates of EBITDA of $1.5B, so RCL generates $1.65 in EBITDA in 2011. This would imply an ev of ~$18.8B, subtract ~$9B of net debt at that time and get market cap of $9.8B vs. current $7B market cap. Or potential upside of 40% if they blow away optimistic estimates, issue no equity and earn a 20% premium to historical valuation multiples. Limited takeout risk given industry fundamentals.
Risk/Reward: 2.5x (100%gain/40%loss)
“90 second Summary” on short RCL equity
A short of RCL equity as a way to express an opinion of a long term shift in US and EU discretionary spending patterns and increasing savings rates. RCL equity has further downside from being over leveraged coming into a competitive pricing environment in a business with tremendous fixed costs.
Due to long lead times on ship orders, I believe the cruise operators are portraying an unrealistic future in order to secure future capital. Nearly every other leisure industry from gaming, theme parks and airlines are all postponing capex and pushing out orders are much as possible yet the cruise line industry (primarily CCL and RCL) are both increasing capacity steadily in 2010 and 2011 after dramatic capacity increases in the past. Street estimates call for increases in prices and net yields while capacity is added to an industry with decreasing demand.
I prefer shorting RCL to CCL due to a very stressed balance sheet, weak market position, poor relative profitability and increasing likelihood of price competition with largest and dominant competitor.
Insider sales have been accelerating with a recent flood of open market sales by a wide range of company insiders including the CEO
Fundamentals and Catalyst
Recently CCL and RCL equity has moved sharply up on talks of price increases. Given huge inherent leverage in an industry with large fixed costs this is tremendously bullish for the stocks. Recent talk of price increases but could be marketing just to incent people to book ahead of time since lead times decreased dramatically in 2008-2009. Not expecting prices to get back to 2008 levels.
One could go long CCL to hedge out risk of industry wide rebound and use CCL div to pay RCL short cost. Could also use put options on WTI to hedge out risk of oil declining. Short oil not a bad trade in its own right. One can sell otm puts to help pay for short and help buffer risk.
5 key points why shorting RCL and the cruise liner industry is attractive
Excess Capacity and aggressively adding more
Very low asset turnover.
Simply not generating enough sales on their assets.
1% change in net yield is .24 for RCL
Over last 10 years capacity has roughly doubled by growing at 8.5% CAGR. Ended 2008 with over 370k berths on ~300 ships. Between 2009 and 2012 capacity will increase by another 25% to over 460k berths. Expecting US gross capacity to grow 3-4% 2009-2012 with Europe gross adds in the 8-9% vs. historical CAGR of 10% over past 10 years.
Cruise lines international association says that global cruise passenger traffic only grew 7.3% CAGR between 1990-2007 and by 5.1% to 13.2M passengers in 2008. This huge increase in capacity over the last 10 years has been the cause of falling ROIC and decreasing profit margins as supply > demand. Instead of pulling back on capacity they are adding more!
Increase in global capacity? 8.6% in 2010, 5% in 2011 and 3.6% in 2012, but installed base has increased 50%+ higher than that which existed before the last fleet expansion in 2003.
Between 2009-2012 CCL expected to spend $9B on 17 new ships, 11 for EU and 6 for NA. RCL though has 6 ships at a cost of $5B and adding 28% to their capacity. The 5400 berth Oasis of the Seas and Allure of the Seas will both be the largest cruise ships in the world. Average cost for both is $225k per berth.
In 2010 CCL is growing capacity in 2010 by 8% and 6% in 2011. RCL by 12.7% in 2010 and 9% in 2011.
The bullish news is that RCL only is going to add 2/3 of a ship per year after 2013?! This industry should be adding NO new ships starting NOW.
Bull case is that new boats will have higher margins and drive more revenue, but it seems logical to me that given the large influx of new boats coming online that the older boats will become less preferable for customers and likely need further discounting (since discount to get occupancy up to 100%).
More efficient vessels increasing margins while capacity increasing revenue?? Not unless consumer spending rebounds dramatically.
Weaker US and European consumer
- Don’t need to tell you that the US and European consumer is facing serious leverage and income issues. Worth noting that shorter notice of trip planning require more working capital also.
- This change in spending patterns though would be the last draw as more capacity chases decreasing demand now, pricing will certainly come under pressure. In this situation the competitor with lower costs and a stronger balance sheet will emerge the victor.
Huge fixed costs creates enormous operating leverage, if pricing decreases, this devastates cash flow and earnings.
- Cruise liners have tremendous leverage as over 40% of costs are fixed with the rest semi fixed (ie personnel). 20% of revenue from onboard spending, with nearly 100% fixed costs.
- RCL and CCl are 75% of the market. And cruises are priced so they always sail at least 100% occupancy so regardless of pricing they will ensure they fill the boats.
So, after reviewing this I'm sure many are wondering what went wrong with such a well through out thesis. I will revisit what went wrong and more importantly whether or not the entire thesis is wrong in the next two to three articles.