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Royal Caribbean (RCL) - Long - Writeup


The Depth Report

Royal Caribbean Cruises Ltd. (RCL)


Overview:

Royal Caribbean owns and operates cruise ships under several brands including Royal Caribbean, Celebrity, and Silver Seas. We first started looking at the cruise lines around 2 years ago because we saw the industry was undergoing a transition. Over the last 2 decades, cruise ship capacity has grown 7% annually, but what we noticed was that due to design changes, the new ships had a much higher return on invested capital. RCL’s return on invested capital improved from 4.9% in 2012 to 11.5% in 2018. The same calculation adding back fuel produced an increase from 10.4% in 2012 to 15.2% in 2018. The reason to evaluate returns excluding fuel is that it’s an expense that’s partially out of the control of the company. We wanted a measure that focused on tracking the change in company operations which is why we look at the latter metric as well. This level of improvement in return on invested capital made the industry worth researching.


While this writeup is focused on RCL, we also think Norwegian Cruise Line Holdings Ltd. (NCLH) also represents an excellent investment opportunity, and that will be the subject of a future writeup.


New Ships:

We believe the majority of the increase in return on invested capital came from changes in the design of the new ships. First, the size of these ships has changed radically. In 1998, Royal Caribbean launched Vision of the Seas with a capacity of 2,076 passengers. In 1999, the first Voyager class ship, Voyager of the Seas, launched with capacity for 3,114 passengers. Spectrum of the Seas, the first Quantum Ultra Class ship, launched this year with a capacity of 5,622 passengers, and some of the Oasis-class ships can host over 6,000 passengers. Every ship is a floating, hotel, casino, entertainment complex, gymnasium, and amusement park. In addition, every ship has dozens of restaurants. Spreading out the fixed cost of operations over more passengers alone will improve returns on capital.


The newer ships are also more fuel-efficient. The new engines have reduced fuel usage by around 30%. Fuel as a percentage of revenue was 11.8% in 2012. That’s declined to 7.5% for 2018, and is trending in the mid-6s so far this year. RCL already buys 30% of its fuel with the sulfur removed, and started installing scrubbers on ships in 2014. At this point, almost all of the expense of installing scrubbers is behind the company, and we don’t anticipate that new environmental regulations that will begin in 2020 will have much of an effect on profitability. RCL hedges forward fuel purchases. The company typically hedges fuel cost by around 50% - 60% for the current year, 45% - 55% for the next year, and 20% - 30% for the following 2 years.


Onboard spend is another area where the newer ships excel. While both pricing and capacity have increased revenue substantially for the cruise lines, onboard spend is increasing even faster. The reason this matters is the margins on onboard spending have reached 80% (up from 73% five years ago). People used to view a cruise as an all-inclusive vacation with a little cash added in for tips and drinks. The new ships have a completely different model. In addition to the standard overpriced shore excursions, ships now have activities like onboard go-karts, bumper cars, ice skating rinks, sky cranes lifting passengers out over the ocean, and full spa services. Some ships are even starting to charge for nightly entertainment and shows which used to be complimentary for all passengers.


Food options have changed as well. Dining on a cruise ship used to be relatively elegant. People would dress for dinner, show up at the assigned time, and the food was usually good to excellent depending on the night. Because passengers had an assigned table, they’d get to know other passengers during the voyage which provided an incentive to eat in the main dining room. There was often a camaraderie formed among table-mates meeting on vacation. Now, many ships have abandoned assigned dinner times in favor of allowing guests to reserve a table at a time convenient for them. As we understand it, the quality of food in the dining room has declined as well. This has coincided with a large increase in the number of specialty restaurants on the ships. The lower quality of food in the main dining room has driven passengers to these specialty restaurants which either charge a special dining supplement, or have a la carte pricing. Essentially, passengers in these restaurants are paying for two meals; the one they’re not eating in the main dining room, and the one they’re paying extra for in the specialty dining rooms.


All of the cruise lines are selling drinks packages as well. The companies have severely restricted the ability to bring alcohol and bottled water onto a ship meaning passengers are now paying resort prices for water, soda, and cocktails for the entirety of their trip. An all you can drink soda package runs $13 - $15/day and a beverage package including alcohol runs $63 - $89/day. A family of 4 could end up spending over 1,400 dollars on drinks alone if they buy some combination of drinks packages.


Internet access is another area where ships are using new technology to improve onboard spending. Royal Caribbean charges $18 a day for a “surf and stream” package which would amount to $126 for a 7-day cruise. The family rate is around $12 per device per day so for a family of four to remain connected will add another $336 in onboard spend. Depending on the cabin, ship, and pricing, these packages could add almost 10% to the cost of a cruise with no additional overhead for Royal Caribbean. While many people use the expensive onboard Wi-Fi to keep in touch with the office, we’ve heard that a huge amount of on-ship internet use is for social media. People are posting real-time photos of their trip, the ship, and port destinations to Facebook and Instagram. Essentially, many passengers are paying Royal Caribbean for the privilege of posting what amount to RCL advertisements to their social media accounts.


Finally, the design of the ships themselves have radically changed pricing. A couple of decades ago, one frequent reason people cited for not wanting to get on a cruise ship was the fear of feeling claustrophobic. They worried they’d feel trapped on the ship. On way Royal Caribbean addressed that fear was with the Voyager class ships introduced 20 years ago. Royal Caribbean carved out the interior of the ship for 5-6 stories creating a “Grand Promenade” with shops, restaurants, and bars. Formerly, balconies were considered a high-end luxury with only 20% - 30% of cabins featuring them. The Grand Promenade allowed RCL to change the low-priced interior cabins with no windows into balcony cabins that overlooked the festive inner part of the ship. With that innovation, RCL turned about 70% of cabins into balcony cabins, and started getting better pricing for the whole ship.


Capacity and the Initial Opportunity:

During early 2018, RCL stock fell from $135 in January to below $110 in April. The primary reason for this decline was concern about new capacity additions planned for the Caribbean in the fall of 2018. The Caribbean market accounts for over 1/3 of all cruising capacity, and during the colder months, can be over 50% of industry capacity. There was concern that all the new larger ships would overwhelm the market, and lead to a decline in pricing. Given the importance of the Caribbean market, we looked into this concern. First, the cruise companies were reporting no slowdown of bookings, or pricing in forward months. Then, we called the Florida-Caribbean Cruise Association. They projected cruise arrivals to the Caribbean and Latin America to increase by around 4.5% in 2018. That wasn’t out of line with either historical trends, or industry growth. Still, with the market focused on capacity additions, we looked for a way to prove or disprove the market perception.


Fortunately, cruise ships take a long time to build which means it’s possible to get a schedule of all new launches. We researched a list of every cruise ship that was due to be delivered in the next 18 months. From that list, we sorted out every ship with over 100 berths that was going to be sent to the Caribbean. From there, we went to an online booking site, and checked to see if we could book a cabin on each of these ships. It turns out that we were able to book berths on every single one of these ships.


In other words, the industry-shaking event that had the market concerned had already happened, and all of the capacity that people worried would enter the market was already competing in the market. The key point was that when a ship is finished, the cruise line doesn’t drop the ship in the water, and start to sell cabins. The companies start selling berths 12-18 months in advance. Once we got to the 3rd quarter earnings announcements, Royal Caribbean reported record bookings at record prices including strong pricing in the Caribbean. The bear thesis was incorrect.


The Problem Now:

With the bear thesis disproved, and continuing replacement of older inefficient ships with newer ships featuring a higher return on capital, we would have expected the stock to be up. As of this writing, RCL stock is at $112, only slightly above its price about a year and a half ago. We believe there are multiple reasons for that most of which are one-time in nature.


Fuel and Fx:

As noted earlier, Royal Caribbean hedges much of its fuel prices, but the company still has to buy fuel both in the spot market, and to hedge future needs. The trend in fuel prices over the last two years has been upwards, and the strong US dollar has also impacted profitability. In 2018, fuel and Fx negatively impacted EPS by $.58. Those factors have been an additional headwind in 2019 as well. We view these items as reversion-to-the-mean variables which means that while an individual quarter or year will be affected, over time, fuel and Fx will be neither a headwind nor a tailwind. We further note that the entire industry is trending towards much more fuel-efficient ships meaning that changes in fuel prices will matter less over time.


The Cuba Ban:

During his second term, President Obama overturned a decades-long rule that prohibited visitation to Cuba. That meant that the cruise lines could start sailing to Havana. Royal Caribbean had one ship with a Cuban itinerary in 2017, and two ships sailing there in 2018. In 2019, President Trump overturned the rule and prohibited future sailings to Cuba. This created two problems for the cruise lines. First, while Cuban sailings represented only 3% of capacity, Royal Caribbean got premium pricing on those itineraries. Second, the company had to offer passengers currently booked on sailings to Cuba the option to cancel, or an incentive to keep their vacation plans without the prospect of seeing Havana. RCL has talked about a 70bp hit to revenue which would amount to around $.35 of EPS this year. That headwind will diminish in 2020 and disappear by 2021. There is also the possibility that a future administration could change the rule again, or that President Trump could change his mind about the existing travel ban.


The Cuba Lawsuit:

In 2019, Javier Garcia-Bengochea filed a lawsuit against Carnival Cruise Lines under the 1996 Helms-Burton act. The suit alleges that Carnival made use of the Port in Havana that was owned by Mr. Garcia-Bengochea’ grandfather and later, was nationalized by the Castro government. The law provides for US citizens to sue for compensation of nationalized Cuban assets. Royal Caribbean and Norwegian Cruise Lines have both been sued as well. The cruise lines are arguing that they paid to make use of the ports and were customers of the ports not operators. They believe that the lawsuits should be directed at Global Ports Holding, a Turkish company which has operated the port terminal since 2018. They further argue that when they sailed to Havana, they were operating legally under US law.

We believe that President Obama had the power to make sailing to Cuba legal, and that the cruise companies were operating legally when sailing to Havana. We further believe that President Trump had the power to make sailing to Cuba illegal, and that the cruise companies stopped sailing there immediately. To us, the arguments made by the cruise lines that they were acting as a customer, not as an owner/operator are compelling. With that said, we are not international attorneys, and in August, a Federal judge in Miami declined to dismiss the case, and ruled that Mr. Garcia-Bengochea could proceed with the lawsuit.

Accident in the Bahamas:

In April, while docked in the Grand Bahamas, a crane fell on the Oasis of the Seas, one of RCL’s largest ships. The damage has been repaired, but the ship was out of service for a few weeks which hit EPS by $.25. While accidents do occasionally happen, this fits the definition of one-time extraordinary event.


Drydock:

Every 5-6 years, each ship is put in drydock for renovations. These renovations could be as simple as redecorating and replacing worn carpets, or as complex as cutting a ship apart, and rebuilding it as a larger vessel. These occasional drydock events are what allow these ships to have 30-year lives. While it’s difficult to get exact data on the number of drydock days, or more importantly, the number of berths lost to drydock days, we have gotten the sense from RCL that 2019 had more drydock days than usual. This is another reversion-to-the-mean item where any given year will have a greater or fewer number of drydock days, but over time, these will be a more consistent cost.


Hurricane Dorian:

All cruise lines operating in the Caribbean are subject to disruptions from hurricanes that typically occur in the fall. This year’s Hurricane Dorian was more disruptive than usual. While we don’t yet know the exact cost of the hurricane, Royal Caribbean was particularly affected due to its Perfect Day at CocoCay resort. This location is so popular that passengers pay a premium for itineraries that dock there. Royal Caribbean offered passengers who missed their “Perfect Day” future credit. We’ve seen estimates that the hurricane will cost around $.13 in EPS and expect more information from the company soon.


Growth Cap-x at the Port of Miami and CocoCay:

RCL’s expense structure was high this year as the company was in the process of building out a new facility in the Port of Miami, and its resort facility in CocoCay. Boarding a cruise ship used to be a miserable hours-long experience. Royal Caribbean is improving its port facility in Miami and using technology to improve the process for its guests. We see a value in not making new guests have the first experience of their vacation be waiting in line for 3 hours. We’ll add more detail on CocoCay later in this report. For the sharp-pencil accounting crowd, it is true that most of the expenses for this construction were capitalized. However, items like electricity, water, stevedoring, and some of the labor costs were expensed prior to opening these revenue-enhancing assets. That will change in 2020 as construction is largely complete, and RCL is already benefiting from these assets.


The Opportunity Now:

We note that the cruise industry experienced an enormous amount of bad news in 2019, but almost all of these items are either one-time in nature, or unusual outliers from more customary cost trends. With investors focused on these negative items, we believe that as we get past the one-time items, the fundamental trends for RCL are positive. We’d highlight the following:


Cruising has been a long-term growth business. Over the last two decades, passenger growth has been about 7% annualized. Despite that increase, most of the US population has never been on a cruise. The important Caribbean market is seeing continued strong pricing, and there is increasing interest in Alaska, European river cruising, and Asia as destinations.


Demographics are strongly favoring cruising. More families are taking multi-generational vacations, and a cruise is a good option allowing young kids to be active all day while providing older generations the chance to engage in other activities or relax by the pool. The entire family can meet up for breakfast and dinner, and share shore excursions ensuring the family gets time together every day without having to focus exclusively on activities geared towards one age group.


In addition, millennials are embracing cruising. We’ve seen multiple research reports detailing how millennials are more experience-oriented than possession-oriented. Many members of this generation may have no desire to own a car, but getting on a cruise ship and seeing 3-4 different exotic locations in a week appeals to them.


The Perfect Day resort in CocoCay was completed earlier in 2019, and results have been better than expected. Perfect Day is a private beach resort featuring a water park, and additional adventure activities. The original idea was that instead of docking at a public port and having guests spend their money in town, Royal Caribbean would dock at this new private resort, and guests would pay for admission to the water park and for other adventure activities. This ensured that RCL would get 100% of the off-ship spend for the day. Even more incredible to us is that while passengers could eat for free on the ship, they would be buying food from RCL vendors while at Perfect Day.


It turns out that Perfect Day has been more popular than expected, and RCL is seeing higher pricing on itineraries which include a stop there. Passengers are actually paying RCL a premium price to be taken to the company’s private amusement park when the passengers will then pay an admission fee to enter the park. We’re continually amazed and impressed at how the cruise lines get passengers to pay for the same thing twice.


One final area where the cruise lines are taking advantage of technology is the disintermediation of travel agents. At this point, it’s easy for passengers to research ships, ship features, itineraries, and pricing. It’s even possible to bring up deck plans for each ship to ensure that you’re not booking a cabin right under the gym or next to a staircase. More guests are booking directly with the cruise lines eliminating the need to pay travel agent commissions. Every ship also runs an on-board sale encouraging guests to book a future cruise while still on their current vacation.

Valuation:

Analyst estimates for RCL haven’t changed much in the last quarter, and the estimate of $9.64 in EPS for 2019 is slightly below guidance issued at the beginning of the year. While declines in earnings estimates haven’t been good for the stock price, we see the situation differently. Each quarter, booking and yield (industry term for pricing) have been at record levels and better than expected. The core business is outperforming estimates and expectations. What has brought the estimates down are the one-time extraordinary items detailed above. While we acknowledge there will be future hurricanes and accidents, 2019 had more than its share of one-time surprises. The fundamentals of the underlying business are stronger than ever.


With the stock at $112 and an estimate of $10.75 in EPS for 2020, RCL is trading at 10.4x next year’s earnings with a 2.8% dividend yield. Thinking about a long-term growth rate for the company, capacity grows by around 7% a year, and a margin improvement of 1% would add another 5%. We think that getting past the construction expenses at the Port of Miami and Perfect Day plus continued reduction of fuel usage as newer more efficient ships replace older ones means that operating margins could improve by a few percentage points over the next few years. Add a few percentage points of pricing increases gets us to annual growth in earnings in the mid-teens. With the S&P 500 trading at 19x next year’s earnings, with RCL’s long-term growth in earnings power in the mid-teens, and with a 2.8% dividend, we could see the stock trading at 15x or around $160.


What’s it Look Like if We’re Wrong:

The one concern we’re unable to fully address is a recession. We have to acknowledge that RCL is a leisure company, and in a challenging recession, people do cut back on vacation spending. In 2008 and 2009, returns fell and the stock price declined. This is not a recession-proof company. We’d note the following points:


Many economists and market strategists have been warning about a recession for years. There’s an old joke about someone admiring a great economist because he had correctly predicted 25 out of the last 7 recessions. Of course, it will happen at some point, but we’d have missed a lot of gains if we had gone to cash every time someone said the market was expensive, or that the economy was about to turn.


These cruise ships are incredible assets. Even in 2008 and 2009, the ships sailed full, and returns on capital started improving by 2010. A recession won’t be pleasant, but it won’t be the end of these companies either.


Finally, one key point that many people seem to miss about the cruise lines is that their assets are mobile. These companies operate world-wide, and it’s a given that there will always be markets experiencing relative weakness. Cruise ships can be re-deployed and sent from weak markets to stronger ones. Every year, a few ships are re-positioned, and the cruise lines even get passengers to pay for passage while the companies re-allocate their assets to the best markets. This represents unique flexibility not seen in operators of traditional hotels, resorts, or amusement parks.

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