Carnival: Cruising to a Nice Return

How will you spend your holidays, this summer? We all need them and we are prepared to pay good money for them. But the holiday sector has offered mixed rewards for investors of late.

A few weeks ago I took a look at look at Thomas Cook Group PLC (TCG). It is a great business, but in the package holiday business competition is intense and margins are under pressure.

Now there is one sector of the holiday business that is growing fast and where the business model permits more favourable margins. This type of holiday has something for every age and demographic and generates a high level of repeat customers. Furthermore, it is rapidly becoming the preferred choice for Asia’s growing middle class.

It is time to get on board the boom in cruise holidays.

Scanning the horizon from the bridge, one cruise operator stands out. It is the biggest and has the most global clientele. But, before we go to the captain’s table, let’s just consider what is so unique about today’s cruise lines’ business model.

When you go on a cruise, unlike other types of holiday, the means of travel and the accommodation offered are one and the same. Modern cruise liners are not just floating hotels; they are floating resorts with restaurants, swimming pools, spas, shopping malls, casinos, night clubs, golf ranges, rock-climbing walls and theatres available for the benefit of up to five thousand captive (literally, but in the best sense of that word) guests.

People go on cruises because they get to travel to exciting locations and to enjoy the open sea, yet only have to unpack their suitcase once. Very often, they don’t have to endure the tortures of modern airports at all. While aboard, they stay in comparative luxury and normally eat better than in hotels of equivalent standing. Cruise lines include all meals (and even soft drinks) in the cruise package.

Cruise passengers can also go to shows, listen to live music, attend lectures, go to the cinema or gym, dance and drink. Parents can park their offspring in the Kid’s Club and chill.

So cruise operators have become adept at filling their increasingly massive vessels by offering attractive packages. I have recently received offers for Mediterranean cruises that work out at around £70-£90 per person per day out of the UK. (That’s with an inside berth, mind you). Given that this includes all meals and use of facilities, most people would consider that reasonable. High-end packages, of course, can cost considerably more.

Once the guests are aboard, cruise lines naturally exploit the massive potential for up-selling. Notably, drinks are normally pricy and the casinos costly. Shore excursions, arranged with local operators, tend to be expensive but are nonetheless popular. On-board souvenir shops do a brisk trade. Spas normally offer a wide range of therapies at more than land-lubber prices. On average, each passenger spends at least half of their package price again on board ship.

Some people still think of cruises as holidays for well-healed retired folk and there are some operators who specialise in this sector with, for example, round-the-world luxury itineraries. But most operators have striven to diversify their appeal. In fact, it is the democratisation of the cruise business from decidedly up-market some years ago to mass-market today that makes it the fastest-growing sector of the leisure travel market.

(Yes, I do admit that democratisation can go too far. Remember that here, as elsewhere, you get what you pay for).

According to Cruise Market Watch, this year there will be over 22 million cruise passengers[i]. This number will be made up of just over 13 million North Americans, 5.7 million Europeans and about three and a half million passengers from Asia and elsewhere. The growth in passenger numbers has been compounding at a rate of over 6.5% per annum since 1990. Average revenue per cruise passenger has been rising by a similar amount.

Savvy tourist destinations are competing to be ports of call on cruise itineraries. In the Caribbean, a typical cruise ship carrying 2,500 passengers and 500 crew members generates US$285,000 in revenue for each port of call it visits (roughly US$100 per passenger). Not surprising then, that up-market cruise terminals have been under constructed from St. Petersburg to Singapore to Shanghai.

More high-end cruise terminals are under construction. Step forward, Vladivostok. I’m serious: it’s going to be a top casino destination for a predominantly Chinese and Korean market.

While there are many small niche players, this growth industry is dominated by two huge concerns, both (ultimately) American. Carnival Cruise Lines (NYSE:CCL and LSE:CCL) controls about half of global cruise revenue while Royal Caribbean (NYSE:RCL) controls about a quarter. As one might expect, the market leader is also the more profitable business in the sector.

Carnival Corporation is the leading global cruise company and one of the largest holiday companies in the world. Its portfolio of leading cruise brands includes Carnival Cruise Lines, Holland America Line, Princess Cruises and Seabourn in North America; P&O Cruises and Cunard Line in the U.K.; AIDA in Germany; Costa Crociere in Italy; Ibero Cruises in Spain; and P&O Cruises in Australia.

These brands, immediately recognisable to cruise enthusiasts, offer a wide range of holiday products across a culturally varied customer base. One of Carnival’s competitive advantages, in addition to its market dominance, is that it combines local branding with global reach.

For example, most of Costa Crociere’s loyal clientele regard it as a quintessentially Italian brand, though in fact it is marketed and sustained across a global network. By the same token, when the Costa Concordia disaster occurred off the coast of Tuscany on Friday, 13 January 2012, although this was a massive blow to Costa Crociere, it didn’t negatively affect Carnival’s other brands.

Carnival also owns Holland America Princess Alaska Tours operating in Alaska and the Canadian Yukon. In addition to the cruise brands, Carnival has a Cruise Support unit that includes cruise port facilities in Mexico, Turks and Caicos Islands, California, and Honduras. Cruise Support owns and operates about 15 hotels and lodges across the Caribbean.

Carnival Corporation added its 100th cruise ship to its fleet in April 2011, with the delivery of the Carnival Magic. At 130,000 gross tons, the Carnival Magic is almost five times the size of its first ship the Mardi Gras (27,250 tons), launched in 1972. Carnival Magic has a capacity of 3,690 guests compared to the Mardi Gras’ passenger capacity of just 906.

Bigger vessels offer more varied facilities for a wide range of customers, further range and better economies of scale. In 2014 Carnival took delivery of two new spectacular ships, Regal Princess and Costa Diadema. More vessels are under construction.

In the last full financial year to 30 November 2014 Carnival Cruise Lines reported net income of US$1,236 million on revenues of US$15.884 billion[ii]. Earnings per share came in at US$1.59 and the dividend payout was US$1 per share. The latest half year figures to 31 May this year were upbeat.

For a capital intensive business like this one, bottom-line profits can be heavily skewed by capital expenditure and depreciation. Since the overwhelming majority of the company’s asset base is tied up in its cruise liners, Return on Invested Capital (ROIC) is regarded as the most important metric in this business. Carnival improved ROIC by 1% in 2014 and the long-term goal is to keep this metric in double digits.

What is exciting about this business is the huge potential for long-term growth. Industry insiders identify two target markets. One is that of the hard core resistors – the 80% or so of US holiday-makers who have never been on a cruise either because they have not bought into the concept, or because they perceive it as beyond their price point. The other is the travel market in developing overseas markets.

Currently, the Asia-Pacific region lags behind the Caribbean, Europe and Alaska as a cruise destination and as a market. But there is long-term growth potential for a region with improving ports and alluring destinations. China’s middle class, and India’s, is several hundred million strong and is developing a reputation for discernment. Carnival’s Costa Crociere has been offering Asia-Pacific vacations on the Costa Allegra for years now. Carnival is targeting Asia as a source market.

The main risk factor is that customer numbers will not grow in tandem with additional capacity coming on-stream in a highly capital intensive industry. But some studies suggest that capacity is growing slower than demand, suggesting that margins may improve further.

Carnival is the only company to be included in both the S&P 500 index in the US and the FTSE 100 index in the UK. Carnival Corporation and Carnival PLC (formerly P&O Princess Cruises PLC) operate as a Dual Listed Company (DLC) structure whereby both function as a single business through contractual agreements between the US and the UK legal entities.

These two entities technically have separate boards of directors but the composition of those boards is identical. Shareholders of both Carnival Corporation and Carnival PLC have the same economic and voting interest but their shares are listed on different stock exchanges and are not fungible. Figures in the Annual Report and Accounts represent those of the consolidated business. Dividends per share are declared in US Dollars.

Carnival PLC is worth a punt in the expectation that they are already benefiting from a large population of retired folk with cash in the bank and a younger moneyed demographic which is increasingly favouring this style of vacation. And don’t forget the growing popularity of cruises with middle class Chinese.

On 16 July, Carnival announced that it would increase its quarterly dividend for Q3 2015 by 20% to $0.30 per share reflecting strong cash flow from operations approaching $4 billion this year. Carnival is benefiting from lower fuel prices. The shares have done well of late, but even given a forward price earnings ratio of around 30, they’ve probably got further to go.

[i] See: http://www.cruisemarketwatch.com/growth/

[ii] Annual Report 2014.