Life Is A Carnival - Take Another Look

By Will Ashworth | March 06, 2012 AAA
The first two months of 2012 arguably is the worst start to any cruising year in Carnival Cruise Lines' (NYSE:CCL) 40-year history. In January, the Costa Concordia hit a reef, killing 25, with a least seven others missing. Then, on February 27, the Costa Allegra caught fire and all 1,000 passengers had to be evacuated off the ship. Given the bad publicity at one of its brands, you would think its stock would be down more than 7.3% for the year as of February 28. However, relative to the S&P 500, it is underperforming by 16.8% and that surely has investors concerned. Where it goes from here is anyone's guess. Long-term, any further weakness presents a real buying opportunity.
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Stock Price
Let's go all the way back to Sept. 11, 2001. After the tragedy in New York City and elsewhere, its stock price fell 41% upon the Sept. 17, 2001 reopening of the markets. Adjusted for dividends, it closed that fateful day at $16.04. As we now know in hindsight, the markets recovered and Carnival's stock ended the year exactly where it was before September 11. In the 10-plus years since, it's achieved a total return of 3% versus 4% for the S&P 500. In those 10 years, Carnival's stock has finished the year in positive territory on just four occasions with an average year-end closing price of $35.50. On just two occasions did its stock close the year below $30. While past results don't predict future returns, it's safe to say that your downside risk at current prices is reasonably low. If you choose to own its stock, use any drop into the 20s as a welcome opportunity to buy more.

Issues to Overcome
The first and most obvious is the total cost of the Costa Concordia disaster. Initial company estimates peg the cost at $95 million or 12 cents a share for loss of use and another $80 million or 10 cents a share for deductibles, etc. Credit Suisse analyst Tim Ramskill believes the cost will be much higher as concerned consumers take a pass on cruising. Others aren't so sure. Bob Levinstein of CruiseCompete.com, suggests that most of the slowdown in demand immediately following the accident was for shorter cruises with people new to cruising. More experienced travelers know these types of accidents are rare. If anything, this type of thing only makes cruising safer in the future. Long-term, the customers will come back. They did after 9/11 and that was a much bigger situation. It might cost the company 25 cents a share or more but in the end, this will make its business stronger.

More of a concern than the occasional mishap, which I'm not trying to downplay, is its margin erosion. Back in 2002, its gross and operating margins were 47.1 and 23.9% respectively. In 2011, they were lower by 1230 basis points and 960 basis points. Much of this decline is due to increased competition from Royal Caribbean Cruises (NYSE:RCL), Disney (NYSE:DIS) and others.

In fact, David Dingle, CEO of Carnival plc (NYSE:CUK), its European business, suggested last May at the annual U.K. Cruise Convention that profit margins had to improve in the cruise industry or there would be dire consequences. I'm not sure things are that bad, but certainly there's room for improvement. In the past five years, Carnival has made capital expenditures of $16.4 billion to generate $10.4 billion in after-tax profits. In other words, it spent $1 to make 63 cents. While it's better than Royal Caribbean, which spent $1 to make 24 cents, it's definitely unsustainable. At some point, Carnival needs to start making more from less.


Upside
Cruising provides an experience second to none. My wife and I were married on a cruise ship and in seven short days we were able to visit several different countries with little hassle or effort. For most people, it's the best way to combine a reasonably priced vacation with a real travel experience. You can't get the same experience flying to some all-inclusive hotel in Mexico. Therefore, although prices and costs need to change industry-wide, cruise companies still offer something that others can't.

Furthermore, when you consider that Cunard's Queen Elizabeth 2 operated as a cruise ship for 39 years, there's more than enough time to recoup the investment on each ship. Any increase in the price of a cruise, combined with a drop in operating expenses (oil prices, food and labor) will lead to increased profits and a better return on capital. In 2011, its free cash flow as a percentage of sales was 6.8%, its highest level since 2006; more importantly, its free cash flow was 56% of net income, the second highest in a decade. There might be some issues at hand, but overall, its business is solid.


The Bottom Line
Carnival has underperformed the markets since the end of 2001. Reversion to the mean works on both sides of the coin. If you buy some now and then every time it drops below $25 in the future, I'm confident you'll make money no matter what happens to it or the cruise industry as a whole. When compared to Marriott (NYSE:MAR), Hyatt (NYSE:H) and every other high-end hotel and resort company, Carnival and its peers offer a better experience at a better price.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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