Carnival's Return to Profitability Supports a Visible Path Back to an Improving Credit Quality Asset

Senior Equity Analyst

Jaime M. Katz

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Carnival remains the largest company in the cruise industry, with nine global brands and more than 90 ships at the end of fiscal 2022. The global cruise market has historically been underpenetrated, offering cruise companies a long-term demand opportunity. Additionally, prior to the pandemic, the repositioning and deployment of ships to faster-growing and underrepresented regions like Asia-Pacific had helped balance the supply in high-capacity regions like the Caribbean and Mediterranean, aiding pricing. However, international demand has lagged domestic demand since cruising has resumed, a trend that could take some time to normalize, which could challenge the economic performance of Carnival over the medium term. 

Consumers resumed cruising in summer 2021 (after a year-plus no-sail halt), and cruise operators have been able to reassure passengers of both the safety and value propositions of cruising (offering a holiday product at 25%-50% less than land-based alternatives). At year-end, 90 ships were deployed with eight of the company's nine brands sailing their entire fleets. On the yield side, we expect Carnival pricing pressure to ease as future cruise credits move into the rearview mirror after 2023, while the firm should be able to capture a lift from rising occupancy. And on the cost side, higher spend to maintain tighter health protocols have alleviated, helping manage expenses. Higher than normal dry dock days along with inflation and foreign exchange headwinds could crimp profitability intermittently. 

These above factors should lead to average returns on invested capital including goodwill, that are set to languish below our 10.7% weighted average cost of capital estimate until 2027, which supports our no-moat rating. While we believe Carnival has carved out a broad offering across demographics, the product still has to compete with other land-based vacations and discretionary spending for share of wallet. We contend it could be harder to capture the same percentage of spending over the near term given the current political instability in Eastern Europe, heightened by recent media attention.

Business Strategy & Outlook

We lowered our economic moat rating to none from narrow for Carnival in 2020. While Carnival has historically benefited from its brand intangible asset, cost advantage, and efficient scale moat sources, we believed these factors had largely been degraded, aggravated by the global spread of COVID-19 and its corresponding travel restrictions and travel hesitancy. While travelers are moving beyond their apprehensions, financial returns remain bound by a robust invested capital base that will continue to prevent the company from generating excess economic rents in the near-term.

Historically, Carnival touted a solid brand intangible asset, allowing the firm to capture rising capacity-adjusted yields, which rose a modest 1% on average in the five years ending 2019. But despite the widespread offerings Carnival provides thanks to its diverse fleet, the firm generated 2019 per diem prices that were subpar relative to its peer set at $179 (versus $257 for Norwegian and $209 for Royal). We utilized 2019 as a reference point, as Carnival only operated sailings through March 2020, and sailed with extremely limited capacity in 2021-22, rendering the annual metrics not meaningful. In our opinion, the significant shared capacity between the three largest players can force Carnival to be a price-taker in periods of economic or geopolitical distress, despite offering widespread choices. And although concerns around reduced demand and supply are largely in the rearview mirror (as consumers were more cautious about group gatherings and after cruise operators divested underperforming hardware), we still expect near-term pricing gains to come only incrementally. Over the next decade, we forecast around 2% yield growth, not far above the 1% average pricing increases over five years ending 2019. Fiscal 2023 is the last year that should be plagued by the redemption of future cruise credits as Carnival returns to full occupancy, allowing Carnival to approach 2019 pricing this year. While Carnival should be aided by its shared revenue management system to tactically price itineraries, we surmise any benefit will be more than offset by incentives customers could expect in order to sail over the medium term, particularly if the macroeconomic environment weakens. Furthermore, pricing gains could be bound by the hesitancy of new cruisers over the next few years, as those potential customers could opt for more safely perceived land-based vacations given the negative media spin in the past (norovirus outbreaks are the latest media highlight).

Additionally, although there has historically been evidence that a cost advantage has persisted for the sizable operators (for example, over the five years ending 2019, Carnival, Royal, and Norwegian all paid a high-20% level of net cruise costs on SG&A, while Lindblad, with eight owned expedition ships and five seasonal charter vessels spent more than 50%), we believe this argument will no longer hold true as cruising resumes. Some scale will be lost from ships that have been sold and scrapped. Moreover, as occupancy returns to normal, we expect there could be dislocation between revenue and items like payroll, food, and fuel, until Carnival has a more complete picture of how demand could ultimately trend longer term.

Our efficient scale moat source has also been disrupted as a result of COVID-19--a key tenet of which was barriers to entry. We had historically been concerned that large ships cost between $500 million and $1 billion, requiring access to liquidity. However, if some of the large operators continue to trim older hardware from their fleet to prune underperforming assets, sold ships could be repurposed for another operator at a significantly less expensive price. Carnival reduced its capacity by a total of 19 ships (13% of prepause capacity) during the pandemic, as it rationalized its underperforming assets. It announced the removal of another four smaller ships in 2022 and three ships in 2023, bringing the total to 26 ships, which should place more than 25% of Carnival's capacity with new more efficient ships, helping profitability. Furthermore, despite the high costs of entering the industry, some new players are still attempting to tap into the cruiser base as extensions of their existing operating businesses, like Virgin or Ritz-Carlton (with neither brand exposed to negative media surrounding COVID-19 on the seas), potentially increasing the competitive landscape.

Adjusted returns on invested capital, including goodwill, have neared our estimated 10.7% weighted average cost of capital in the past. However, we believe Carnival could generate average ROICs including goodwill around 9% over the next five years, hindered by cost inefficiencies in the return to cruising. While the customer penetration rates remain low, with a single-digit level of the global population ever having cruised, we believe low switching costs could hinder the growth rate of cruisers, decreasing our confidence that Carnival is poised to generate ROICs above WACC over the next five years.

None

Economic Moat

Carnival

Carnival Corp. engages in the operation of cruise ships. It operates through the following business segments: North America and Australia (NAA) Cruise, Europe and Asia (EA) Cruise Operations, Cruise Support, and Tour and Others. The North America and Australia (NAA) Cruise segment includes the Carnival Cruise Line, Holland America Line, Princess Cruises, and Seabourn. The Europe and Asia (EA) Cruise Operations segment consists of AIDA, Costa, Cunard, and P&O Cruises (UK). The Cruise Support segment represents port destinations and private islands for the benefit of its cruise brands. The Tour and Other segment operates hotel and transportation operations of Holland America Princess Alaska Tours. The company was founded in 1972 and is headquartered in Miami, FL.

Earnings data Q3 2023

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