Carnival Cruise Lines

Clay Smolinski, portfolio manager of the Platinum European Fund, sets out the investment case for Carnival, the world’s largest cruise line that was founded in 1972 with just one ship.

Carnival was founded and is still operated today by the Arison family, who starting with one ship in 1972, built Carnival into the world’s largest cruise line, today carrying 9.5 million passengers per year across a fleet of 100 ships.

A new investment established over the quarter is our holding in the UK listing of Carnival Cruise Lines.  Carnival is interesting in the sense that it is the only cruise operator that has true brand and product segmentation, controlling nine brands that differentiate themselves not only based on aspects such as product luxury and age groups, but also through being tailored to cultural and regional tastes.  For example, on Carnival’s German brand AIDA, the language, food, entertainment and custom (no tipping) are all German.

This has given Carnival the advantage in pioneering new markets and has allowed them to expand outside of the US to the extent that 50% of profits now come from Europe, Latin America and Australia.

From a broad industry perspective, the cruise lines hold a number of unique advantages when compared to other leisure/transport alternatives, namely:

-        Due to registering their vessels in tax free locales (the so called ‘flag of convenience’ states such as Panama or Liberia) or under ‘tonnage tax’[1] agreements, cruise lines pay almost no tax.

-        Their mobility and operation in international waters allow them to source a great deal of their staff from low labour cost countries (i.e. serving Western customers with emerging world costs).

-        The cruise industry is unusually concentrated. 75% of capacity is controlled by two firms, Carnival and Royal Caribbean who control 50% and 25% respectively.

These cost advantages aided by technological advances in ship building (vastly increasing the scale and range of activities that can be offered on the ships) have allowed the cruise lines to offer very attractively priced holidays.  For instance, for $150 per person/per day, over a seven day cruise you will get transported to four different ports, with accommodation, all meals and entertainment included.  In regions with a wealth of interesting coastal destinations (i.e. the Mediterranean) that is a fairly compelling offer.

The desire to exploit this privileged position has seen both Carnival and Royal Caribbean go through a massive expansion in capacity over the last decade.  The two combined on average brought 7 to 8 new ships (equivalent to >23,000 passenger capacity) into service each year, which based on an average seven day cruise length meant in order to have these ships sail full all year round[2], they needed to find between 800k–1 million new cruisers per annum.  While this strategy has been great for revenue growth and broadening the profile of cruising worldwide, it has come at the cost of profitability - Carnival’s revenue and passengers carried are up fourfold since 2000, while Earnings Before Interest and Tax (EBIT) has only doubled.  Simply, the need to attract passengers to fill so many new ships hampered Carnival’s ability to raise ticket prices, while the cost of oil has quadrupled since 2002 – the end result being that Carnival’s profit per passenger/per day has fallen from $54 in 2005 to an all-time low of $32 today.

So why are we interested in Carnival now?  The key is that both Carnival and Royal Caribbean have stepped back from their growth-at-all-costs strategy, and are now concentrating on recapturing the profitability that was lost during the building boom.  From 2013 onward, capacity growth for the global cruise industry will be 2-3% versus the 10% seen over the last decade and the number of new passengers that need to be sourced globally will be closer to 350,000 rather than the 800k-1 million previously.  Given the pricing convention of the industry (i.e. you discount to ensure every ship sails full), and the fact that those new to cruising are naturally the most price sensitive given their unfamiliarity with the product, this change in the supply dynamic should have a significant effect on the ability to raise prices.

In 2011, Carnival earned revenue of $179 (made up of a $139 ticket price and $40 of on-board spending) per passenger/per day, still well below the $195 made in 2008 prior to the price cuts during the GFC.  If Carnival can return prices close to the $195 level, they should be on track to make upwards of $3 billion of net profit, putting the company on an eight times earnings multiple.  The added benefit is that with the far lower rate of ship building, in this scenario almost all of that $3 billion can be returned to shareholders in the form of higher dividends, share buybacks or debt reduction.  Predicting the exact timing of how long it will take management to reposition for higher pricing is difficult.  However, with Carnival’s valuation sitting at historic lows post the Concordia tragedy and the recent oil price spike, we feel it is an investment that has minimal downside should the pricing story not play-out as hoped, but considerable upside if it does.

[1] A system where a ship owner pays tax based on the size of the vessel (gross tonnage) rather than the actual profit made by the vessel, with the end result usually being an extremely low level of tax is paid.  Tonnage tax regimes are common in developed markets like the UK and Italy.

[2] The cruise industry tends to book to 100% occupancy, the example being that it is better to aggressively discount any unsold tickets close to sail date as you will still capture the customer's lucrative onboard spending.

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