Higher Demand and Stringent Balance-Sheet Management Lead Royal Toward Record Earnings in 2024

Senior Analyst

Jaime M Katz

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Consumer interest in travel has maintained momentum for Royal Caribbean into 2024, continuing the robust demand and pricing trends in the business. The redeployment of the fleet was completed in mid-2022 and occupancy has returned to historical levels aiding a normalization of profits and cash flow. Royal Caribbean reported record pricing in 2023 (13% above 2019's level), with further growth anticipated in 2024, given robust advance booking patterns and price levels thanks to a healthy consumer appetite for travel. On the cost side, expenses should be better managed ahead as a result of optimized occupancy and ongoing productivity initiatives, aiding profitability.

These factors should lead to returns on invested capital, including goodwill, of 14% in 2024, handily surpassing our weighted average cost of capital estimate (10%). Royal Caribbean has carved out a compelling position in cruising thanks to its contemporary brand, a key factor that has supported price improvement and our narrow moat rating. We surmise the relative value proposition the firm offers will entice new travelers to embark in cruising, benefiting scale over time, which should help leverage costs.

After tapping into significant liquidity during the pandemic, the firm has improved its balance sheet, recently announcing the repayment of $1.25 billion in expensive corporate debt and refinancing at a materially lower rate (saving about $80 million in interest expense annually). With $5 billion in customer deposits as of Dec. 31, and around $2 billion in debt coming due through the end of 2024, we expect Royal will continue to pay down corporate debt with excess cash to work its way back to investment-grade status (net debt/EBITDA should fall below 4 this year, by our estimate).

In November 2022, Royal unveiled its Trifecta initiative to capture capacity adjusted EBITDA of more than $100, double-digit adjusted EPS, and midteens ROICs by 2025. Despite global economic uncertainty, our forecast calls for $10.23 in adjusted EPS, EBITDA of $107 per available passenger cruise day, and midteen ROICs (14%) in 2024, a year ahead of plan, as Royal's value proposition continues to resonate with consumers.

Business Strategy & Outlook

We rate Royal Caribbean as having a narrow moat, which we believe arises from three sources, including efficient scale, brand intangible asset, and cost advantage. Prior to January 2024, we had a no moat rating on Royal, due to the uncertainty around the length of lockdowns and the impact to ROICs. We forecast ROICs that are even better than the pre-COVID-19 period over our outlook, reaching 21% at the end of our forecast versus 8% in 2019 (when the firm formerly held a narrow moat rating), well above our 10% weighted average cost of capital estimate.

To begin, we see efficient scale as a key moat source, which has often been reflected in highly capital-intensive industries such as the cruise industry. This is ascribed to the cost of ships (which can run as much as $1 billion for new construction), increasing the capital requirements of operators, and the high fixed costs associated with the cruise model (we believe more than two thirds of costs are fixed in the short run).

Also, we see meaningful barriers to entry, which bolster the efficient scale moat source. For example, new peers will likely be unable to access cheap financing through export credit facilities, making the cost of ship builds less affordable. Export credit agencies offer loans, guarantees, and insurance to help local companies (shipbuilders) limit the risk of selling goods and services abroad. With lower counterparty risk comes lower interest costs. For reference, Royal pays 4% or less on most of its ship financing, well under current market rates. But often, smaller operators don’t have access to such inexpensive debt—before Silversea paired up with Royal Caribbean, the company pursued a private placement for its $550 million notes, which were priced at 7.25% to refinance existing debt and new ship builds. Importantly, these financing partners were accommodative during the pandemic, halting amortizing payments while the industry was shuttered. Furthermore, along with special financing around shipbuilding, there is limited global capacity for new hardware, making a fast ramp of any new peer difficult. Royal currently has eight ships on order for delivery through 2026, while brands like Virgin and Disney have only one and two queued for delivery over the same time horizon, respectively. 

Additional evidence of efficient scale stems from sunk costs and historical precedent. As proof of the deep pockets essential to support passenger and capacity growth while remaining prominent in the industry, Royal had already devoted $30 billion in net property, plant, and equipment (PP&E) as represented on its balance sheet on Dec 31. Also, with respect to new entrants, Morningstar’s methodology indicates that if a market has seen little entry or exit over a long period, efficient scale is more likely to be present. There has been insignificant entry or exit into the category in recent years, with modest changes including Virgin adding four ships and Genting’s cruise lines (Dream and Star) liquidating with eight ships. Given that Royal’s share hasn’t shifted in recent years (at around 25% over the last decade), we believe the efficient scale moat source will remain in place over the next decade-plus, particularly given the fixed capacity of ship builders and the corresponding constraints).

We also think Royal has a brand intangible asset edge, as evidenced by pricing power, industry concentration, and risk aversion that dictates purchasing decisions. Pricing power has been displayed more reliably among the cruise majors in the years leading up to, and post, the pandemic. In 2023, Royal already surpassed its 2019 net yields per diem. This four-year turnaround in pricing is much faster than the last industry downturn—after the 2008 downturn, Royal was able to surpass prior pricing in 2017, climbing back over nine years. Moreover, we think Royal should be able to grow pricing by around 2.5% annually over the long term, a touch behind the 4% the firm captured in the five years prior to the pandemic (which were skewed by two years of 7% annual pricing growth and including Silversea in 2019), but ahead of the less than 2% inflation Morningstar expects between 2024-27. 

We attribute pricing growth to better revenue management systems, more dynamic pricing, and a stepped-up marketing demographic strategy depending on the brand, itinerary, and price point. But we also think Royal’s brands offer its passengers extremely unique opportunities through products like Perfect Day at Coco Cay. We believe there is currently no close substitute for Coco Cay, the private island owned by Royal Caribbean that offers a water park, zip line, hot air balloon, and freshwater lagoon. While there are several private islands affiliated with different brands, the purchase and development of something similar would take both time and capital (Coco Cay’s initial development efforts cost more than $200 million, and subsequent development has followed) that a new entrant might not find as a practical source for capital allocation. But Royal hasn’t stopped at this unique economic prospect. Outside of further development at Coco Cay, it’s also creating the Royal Beach Club at Paradise Island, accessible at the Nassau stop. This will be a 17-acre destination experience near the pier, which is expected to combine the island’s beaches with private cabanas, pools, island-style barbecues, live music, local artisans, and more, where most of the economics will accrue to Royal (Bahamians could be offered up to 49% equity). Also, prior to the pandemic, efforts to expand another wholly owned facility in Vanuatu was to be undertaken but has been stalled as the firm has prioritized getting back to business as usual. We surmise over time Royal will continue to pursue destination development to continue to capitalize on additional itinerary excursion revenues.

Having such unique and coveted destinations on itineraries also protects pricing at Royal, as it allows the firm to pursue a marketing strategy to fill berths, rather than a discounting mechanism, resulting in more tactical pricing. Norwegian’s prior CEO Frank Del Rio was a pioneer of the market to fill strategy, highlighting the firm’s differentiated offerings rather than lowering prices to optimize occupancy. The appropriate marketing strategy helps clearly convey to consumers that to get the best price and room of choice, early booking is the optimal strategy and that as the sail date approaches, price hikes are likely and cabin selection is increasingly limited. Moreover, to prevent discounting during times of waning demand, the company adjusts its strategy to add additional benefits to the total cruise package (spa credits, beverage discounts) to tempt consumers to sail, optically holding its total yield firm. Using a bundling mechanism helps set consumer perception on pricing—without broad industry discounting, it is unlikely for per diem pricing to be as volatile as in the past. This helps bound pricing pressure during cyclically weak periods, which we believe is a widespread goal across the industry. 

Also, considering the mix of repeat travelers in cruising and the aversion of travelers to trying a different brand with a dissimilar experience, we believe loyalty exists for passengers that have already traveled successfully on an existing cruise brand. For comparison, hotel operator chains get around 50% of room nights booked by loyalty members on average, around the roughly 50% last disclosed as repeat at Royal. This is seen in Royal’s robust market share (by berths). Plus, the increasing benefits that loyalty members obtain as they consistently travel with their preferred brands aids in driving repeat business. For Royal Caribbean, after sailing three nights with the brand, Crown & Anchor Society members get priority check in, exclusive rates, reduced rate upgrades, and a private departure lounge with continental breakfast, among other amenities. After 30 nights (basically four week-long cruises), cruisers begin to also accrue discounts on balconies and suites and invites to exclusive events, offering preferential treatment to those that stick with the brand. We think this has surfaced in resilient market share over time, given finite building capacity (we don’t expect new entrants in the shipbuilding industry focused primarily on cruise hardware) and the high fixed costs for any new startup. 

We expect Royal will continue to drive higher pricing through its capital spending programs set to elevate the brands by uplifting the product while in dry dock, increasing consumer willingness to pay for sailing on that updated hardware, and bolstering spend around new onboard activities. In 2018, Royal planned to invest $900 million in fleet modernization efforts over four years and across 10 ships (across the Oasis, Voyager, and Freedom classes) to improve consistency in the experience across the line. While some of these efforts were sidelined by COVID-19, they were not dissolved, and as such, such efforts will return in 2024. Generally, refurbished ships that have been put back into existing markets have performed well, garnering improved yields (pricing, often a mid-single-digit or more above existing hardware) versus pre-dry dock performance.

Finally, we believe Royal has captured a cost advantage moat source stemming from proximity, buying power, and low-cost financing. As Royal ports well-demanded ships in more locations outside of the traditional Florida market, its brand is more accessible to potential consumers, which should support interest from potential new cruisers. Royal has 14 North American port choices (U.S. plus Vancouver) to embark from, helping reach a broader proportion of the population. For example, the populations of the greater Los Angeles area (around 13 million), New York (24 million), and Seattle (4 million) together represent 41 million potential travelers, more than 12% of the U.S. population, as Royal looks to expand the home ports of its fleet. 

Incremental passengers provide improved scale benefits for Royal, allowing for the delivery of the product at a cost lower than its smaller peer group. Prior to the pandemic, Royal paid just under 30% of net cruise costs on SG&A, while Lindblad, a much smaller publicly listed competitor with 17 expedition vessels spent more than 50%, indicating that size provides scale efficiency gains. In our opinion, limited global shipbuilding capacity should keep Royal relatively larger than numerous other operators over the long term, spreading costs over a wider base. Furthermore, below the line, debt financing costs will provide another cost edge to Royal, as cheaper ship funding through the earlier discussed ECAs will facilitate lower relative interest rates to the peer set. We don’t expect this option to disappear as its purpose is to incentivize foreign companies to keep employment in certain industries (shipbuilding) supported. The incumbent cruise operators have articulated such a factor is imperative to continue to encourage business.

Narrow

Economic Moat

Royal Caribbean Cruises

Celebrity Cruises is a premium cruise line which was founded in 1988 by the Greece-based Chandris Group. In 1997, Celebrity Cruises Ltd. merged with Royal Caribbean International to become Royal Caribbean Cruises Ltd., which operates Celebrity, Royal Caribbean International, Azamara Club Cruises, Pullmantur Cruises and CDF Croisières de France.

Celebrity Cruises

Royal Caribbean Group is a cruise company, which engages in the ownership and operation of the following global cruise brands: Royal Caribbean International, Celebrity Cruises, and Silversea Cruises. The firm also holds interest in TUI Cruises GmbH, which operates the German brands TUI Cruises and Hapag-Lloyd Cruises. The company was founded by Arne Wilhelmsen in 1968 and is headquartered in Miami, FL.

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