Undervalued global cruise companies set sail for growth

Are you considering a vacation cruise this summer? Even if you can’t afford such a luxury you may consider an investment in the industry itself because the big names—Carnival (NYSE: CCL), Norwegian Cruise Line (NAS: NCLH), and Royal Caribbean NYSE: RCL—are trading at compelling discounts and boast a competitive edge that should last a decade, says Morningstar.

Carnival, Norwegian, and Royal Caribbean each carry narrow moats and are trading at discounts of up to 25 per cent, according to Morningstar senior equity analyst Jaime M Katz.

Norwegian is the standout, trading at a 19 per cent discount to a fair value estimate of US$54 set by Katz. It faces fewer competitive risks than its peers and the spending of its consumers is more protected in the near term, Katz says.

But before we examine these stocks in more detail, let’s first consider the outlook for the industry and the competitive advantages of the major cruise operators. 

According to the Cruise Lines International Association, the horizon for cruise companies looks clear. The industry continues to grow at 5–7 per cent a year and is worth $134 billion. In Australia, it makes a $5 billion impact.

The association says 24 new ships were rolled out in 2019, with a total of 122 ships set for construction between now and 2027.  

And more people are taking cruises. The industry has a target of 38 million passengers on 434 ships by 2027, which equates to 5.4 million passengers a year. Katz’s estimate, which relies on this data and company estimates, is slightly more optimistic. She says global passengers will rise to nearly 35 million by 2025, which equates to 7 million passengers a year. 

And if you thought it was only silver-haired retiree couples stepping aboard, think again. Future travel groups include the solo traveller, all female groups, working nomads, off-peak adventurers and generation Z.  

Exhibit 1: Steady passenger growth has persisted across the global cruise industry over the last decade

Source: Cruise Line Industry Association, Morningstar estimates

Big names displace the competition

Carnival, Norwegian and Royal derive their economic moat from three sources: efficient scale; reputation (or brand intangible asset); and cost advantage. To have one of the five moat sources is good but to have three—the other two being switching costs and the network effect—is a rare feat, says Katz. Only about 5 per cent of Morningstar’s global stock coverage have it. 

“Unique circumstances surrounding the industry, including limited shipbuilding capacity and strategic financing, should continue to offer protection to industry incumbents and their leading market share positions, preventing new entrants from scaling up and quickly taking share,” says Katz. 

“Our long-term growth thesis still hinges on low global penetration of the cruise market, which should offer opportunity to most cruise carriers and lead to some control in pricing.” 

Exhibit 2: CCL, RCL, NCLH have around 50% of ships and about 75% of berths in global cruising (2018)

Source: Company filings, Cruise Industry News

And as newer, more cost-efficient ships hit the water returns on invested capital could continue to rise, while higher free cash flow and return of capital to shareholders increases.

“We continue to favour shares of Norwegian, trading at a 19 per cent discount to our US$67 fair value estimate, just 9.5 times our 2020 earnings per share forecast, offering investors the opportunity to set sail.”

High costs sink potential rivals

Several factors support competitive advantages in the cruise industry. Chief among them is efficient scale, which is derived from high “sunk” costs—or the amount of capital invested; and the steep barriers to entry. 

In 2018, Carnival, Royal Caribbean and Norwegian accounted for about 50 per cent of ships in the water and about 75 per cent of berths in global cruising. As well as this vast market share, the big names have deep pockets, which makes it hard for rivals to compete. Consider for instance, Norwegian’s newest addition, the Norwegian Encore.

The 3998-passenger, 169,116-ton vessel is a hotel and amusement park in one. It is the fourth and final ship in the fleet’s Breakaway-Plus Class and cost nearly US$1 billion to build. Among its amenities is a go-cart racing track, which at 1100ft (335m) is the world’s longest, the largest outdoor virtual reality laser tag arena, and a multi-storey water slide.

The cruise ship "Norwegian Encore" leaving the Meyer Werft building dock earlier this year

“Large ships cost between US$500 million and US$1 billion to build on average,” says Katz. “And, new operators are unlikely to have access to the cheap financing through export credit facilities.”

Over the past two decades no new competitor has been able to forge a meaningful percentage of market capacity—that is, more than 10 per cent, says Katz. In this same time, the only player to manage to grow to about 10 per cent market share has been Norwegian. 

“In fact, consolidation implies the reverse has largely occurred across the cruise industry, with most of the market incumbents gobbling up the smaller competitive threats over the past 30 years.”

And even if a cashed-up rival sought to make its mark, it would have another hurdle: gaining entry to a build slot at one of the major shipyards, which are booked out as far as 2027 for some companies, including Norwegian. 

Customer loyalty

Another key competitive advantage is customer loyalty, Katz says. Passengers who have had a pleasant cruise are inclined to stick to the line they know and like.

Citing data from the 2017 Cruise Lines International Association cruise line report, Katz says 92 per cent of cruisers say they will probably or definitely book a cruise as a next vacation. This helps explain the consistent market share the leading operators have held, despite smaller niche players attempting to enter the market in recent years.

According to the same report, 78 per cent of those who took an ocean cruise said they were very satisfied with their cruise when the family (children included) helped plan. This figure rises to 90 per cent when travel agents are involved. Agents, Katz says, play a key role as they are better placed to tailor a cruise to their customers.

What’s more, the big players like Carnival, which own several brands including P&O Cruises in Australia, can continue to serve customers as they move through the income demographic. 

“As consumers move through their life cycle, they could theoretically move from Carnival (average age around 45) to Princess (more than 50) to Holland America (around 57) to Seabourn (60 plus).”

Norwegian Cruise Line NCLH

4 stars | Price: US$53.97 | Fair value: US$67 | Narrow moat | Stewardship: Standard 

Norwegian Cruise Line is the world's third-largest cruise company by berths, operating 27 ships across three brands (Norwegian, Oceania, and Regent Seven Seas), offering both freestyle and luxury cruising.

With 10 passenger vessels on order among its brands through 2027, Norwegian is increasing capacity faster than its peers, expanding its brand globally. Norwegian sails to more than 450 global destinations. 

“Norwegian trades at a 19 per cent discount to our current US$67 intrinsic value. With a higher percentage of the fleet marketed to high-income consumers (through the Oceania and Regent Seven Seas brands), and a wider tilt to sourcing from North America, we think the spending base of Norwegian's consumers are relatively more protected in the near term, given still low unemployment, modestly rising wages, and low interest rates domestically.” (Jaime M Katz)

Carnival CCL

4 stars | Price: US$44.50 | Fair value: US$58 | Narrow moat | Stewardship: Standard

Carnival is the largest global cruise company, with more than 100 ships on the seas. Its portfolio of brands includes Carnival Cruise Lines, Holland America, Princess Cruises, and Seabourn in North America; P&O Cruises and Cunard Line in the United Kingdom; Aida in Germany; Costa Cruises in Southern Europe; and P&O Cruises in Australia. Carnival also owns Holland America Princess Alaska Tours in Alaska and the Canadian Yukon. Carnival's brands attract about 12.5 million guests annually.

“While Carnival trades at a more than 20 per cent discount to our $58 fair value estimate, we believe it has the most near-term risk of the three cruise companies we cover. With higher exposure to a European consumer stemming from brands like Costa and Aida, Carnival has struggled to take pricing in the region recently. However, Carnival's financials remain tidy, with an average debt/capital ratio of 28 per cent and a free cash flow yield of 5 per cent over the past five years, allowing for a consistent return of capital to shareholders.”

Royal Caribbean RCL

3 stars | Price: US$119.42 | Fair value: US$131 | Narrow moat | Stewardship: Exemplary 

Royal Caribbean is the world's second-largest cruise company, operating more than 60 ships across six global and partner brands in the cruise vacation industry. Brands the company operates include Royal Caribbean International, Celebrity Cruises, Azamara Club Cruises, and Silversea.

The company also has a 50 per cent investment in a joint venture that operates TUI Cruises and a 49 per cent stake in Pullmantur, allowing it to continue competing on the basis of innovation, quality of ships and service, variety of itineraries, choice of destinations, and price.

“Royal Caribbean offers the best medium-term EPS growth, bolstered by more than 6 per cent average capacity growth and diligent cost controls. However, leverage remains elevated following the Silversea tie-up (Royal took a 66.7 per cent equity stake in Silversea Cruises in 2018 to help expand its reach into the luxury segment of the market), with debt to EBITDA rising to more than 3.5 times, increasing near-term financial risk (we expect Royal's debt/EBITDA to fall back below 3 times by 2023.) Royal's shares trade at a 10 per cent discount to our US$131 fair value estimate.”