Brand Equity Improvement Could Set Carnival's Profits Sailing

Additionally, now that brand equity improvement appears to be well underway at the Carnival and Costa brands, the ability to raise prices in response to consumers' rising willingness to spend seems feasible, and we think this is the catalyst that can boost revenue quickly. Locally, we believe this will be a function of a middle-income consumer who feels increasingly positive about discretionary spending, which should benefit the Carnival brand over the near term--we have already seen stabilizing yields in the Caribbean, a key deployment market at the brand. Higher potential pricing and conservative cost growth should lead Carnival to the double-digit returns on invested capital it seeks, which we forecast the company to achieve in 2018. A moderate drop in the share price would offer investors the opportunity to participate in the potential payoff from initiatives the company has underway.

Brand Intangible Asset Improving as Concern About Quality Abates Carnival's narrow economic moat is predicated on brand intangible asset, cost advantage, and efficient scale. In the near term, we believe the company can best affect the brand intangible asset and cost advantage to improve the strength of the underlying moat and profitability, which should lead to improved ROIC performance. Carnival's ROICs fell below double digits (and its 10% weighted average cost of capital) in 2009, at the onset of the last recession, and have yet to recover as certain portfolio companies sustained brand equity damage in 2012 and 2013, after the U.S. consumer had begun to recover. However, now that the Carnival and Costa brands have shown sustained improvement in perception, we see Carnival capturing double-digit ROICs within the next three years.

Much of the price improvement that will help achieve these results is contingent on flawless execution of deployment decisions and revenue management strategies, as well as a generally healthy global consumer whose willingness to spend on a cruise experience rises incrementally every year, along with no major political or economic shocks. The ability to alter the supply/demand equilibrium will largely rely on successfully penetrating the Asian consumer base, which could absorb part of the capacity set to come on line over the next decade. Carnival has nine new ships set for delivery through 2018 (one P&O, two Carnival, two Holland America, one Princess, one AIDA, and two Seabourn), with another nine ships expected to be deployed between 2019 and 2022.

Continuous improvement in Carnival's cost advantage has also become a more visible and well-articulated part of management's strategy. With its largest fleet on the seas, we see operational excellence and continuous improvement as imperative to expand the company's operating margin longer term.

We see the upside in the operating environment to be more promising than in the past because of the increasing focus on revenue and expense management techniques. This leaves more potential benefit to Carnival shares than we had previously thought, if management can execute on its initiatives. The likely improvement in other cruise operators still stands, including the tremendous capacity growth that Norwegian NCLH is set to benefit from. However, we deem Norwegian and Royal Caribbean RCL as overvalued at current levels versus our view that Carnival is fairly valued. Over the near term, we see a catalyst in Carnival's ability to raise prices if consumer confidence improves. Domestically, this would be a function of a middle-income consumer who feels increasingly positive about discretionary spending (and recent data indicates positive employment and wage growth), which could benefit the Carnival brand over the near term. Stabilizing yields in the Caribbean, a key deployment market, support this thesis. In our opinion, shares that fall modestly from current levels would be trading at a wide enough margin of safety to adjust for any unforeseen near-term risks to the business.

Capacity-Adjusted Pricing Well Below Peak, Leaving Room for Improvement In our opinion, Carnival has a solid opportunity to improve net revenue yields over the next three to five years as it rebuilds its brand equity. Even with the steady uptick in U.S. consumer confidence over the past five years, along with a stabilizing European consumer, Carnival has not yet been able to recapture the lucrative per diem yields it achieved before the last recession. In fiscal 2008, Carnival delivered net revenue yields per diem of $195. We forecast it will generate roughly $165 in net revenue yields per diem during 2015, still 15% below peak levels. After the recession, Carnival was disproportionately affected by self-inflicted mishaps, including the Costa Concordia accident and the Carnival Triumph incident, which weighed on the pricing power of two of the biggest brands in the portfolio due to negative publicity, leading to yields that declined 4.6% and 2.1% in 2012 and 2013, respectively.

We view two factors as instrumental in Carnival's ability to raise pricing in the years ahead. First is the continuous improvement in brand equity, which has begun to build over the past two years, leading to better perception of the portfolio of brands and their quality and giving Carnival some pricing power. Second are the pricing actions that have been taken across major operators in the industry, particularly the abatement of widespread discounting as a tactic to fill ships.

Improved brand equity, which should support our narrow economic moat rating, could evolve from steps Carnival has taken to ensure minimal risk from future brand destruction. This should stem primarily from protecting the customer's vacation experience by assessing how to best control specific operating procedures and processes that are under the company's management. We think the nearly $700 million spending plan (nearly 6% of 2013 revenue and about one fourth of average capital expenditures over the past five years) that Carnival initiated immediately after the Carnival Triumph lost propulsion in 2013 is a good example of management's willingness to protect the brand equity and invest to improve the guest experience, even at significant cost--the implication is that such an investment pays off in positive brand perception. The company upgraded emergency safety and hospitality systems across its fleet, with just under half of the total expense to upgrade the Carnival brand ships, including better emergency generator power to keep necessities like fresh water and working toilets available and improved engine and fire systems to prevent the loss of propulsion. Improvements of this type assure consumers that if any specific operation were to fail while at sea, they would remain comfortable and taken care of until the problem could be resolved or they could be returned to port safely.

Additionally, promotions like Carnival's Great Vacation Guarantee, which offers a 110% refund for dissatisfied consumers, conveys the company's confidence regarding its product offerings, which helps boost brand equity. (Royal and Norwegian have price guarantees if a consumer finds lower fares, but no experience guarantee.) Product updates and guarantees offer cruisers comfort and confidence that time on their holiday will be well spent and that the experience will be topnotch, independent of mechanical issues or other distractions the crew may have to resolve, or the customer will be repaid. Carnival's ability to deliver positive experiences for all cruisers on the fleet all of the time will be imperative to rebuilding trust. Given heavy repeat-guest nature of the business (according to the Cruise Lines International Association, 62% of cruisers are repeat customers, taking an average of 3.8 trips), emphasis on current positive experiences should pay longer-term dividends for the company in the form of more booked itineraries as brand perception improves.

Initiatives like these appear to be paying off, as the company's brands are coming back into favor with consumers. Last fall, Carnival Cruise Lines was recognized in the YouGov 2014 Mid-Year Buzz Rankings Report as the most improved in consumer perception among all brands in the United States, confirming the effectiveness of the company's marketing, product initiatives, and public relations campaigns over the past few years. If this brand momentum can continue, we think Carnival will be able to raise prices at the enterprise level at 2%-3% annually beyond 2015, a year that has been plagued by foreign exchange headwinds, leading the company to capture peak yields again around 2022. This forecast is in line with our longer-term pricing outlook for Royal Caribbean and slightly slower than faster-growing, younger-fleet peer Norwegian.

Management also continues to pursue directives across the fleet in order to support yield growth, which includes evaluating revenue management practices, an initiative that began in 2014. This was the first time management was ready to address, at the enterprise level, where there were gaps, improved practices to implement, and best tools that could be shared across all of Carnival's brands to optimize yield growth potential. Carnival brought in pricing experts to provide a comprehensive assessment of its revenue management systems. This resulted in the implementation of strategic leadership to focus on enhancing yield growth. Carnival placed a coach at the brand level of its portfolio companies to ensure that communication across offerings becomes seamless; it also hired a vice president of group revenue performance to ensure that collaboration persists and improved practices are adopted efficiently across the enterprise. Ultimately, this streamlining of data and information should allow Carnival to use aggregated data to make strategic incremental price changes at frequent intervals to maximize its revenue stream by capitalizing on the best opportunities to raise prices.

Additionally, the company facilitated a brand segmentation study across cruisers and noncruisers to better understand its end users. Assessing guest records to better understand what drives consumer spending and how to increase loyalty across the fleet could lead to higher ticket and onboard spending of future guests. Raising spending just moderately could be meaningful to Carnival's intrinsic value--management has noted that with 80 million passenger cruise days a year, one additional dollar across the fleet is $80 million, which could be meaningful over time for a firm with $16 billion in annual sales (though in a singular year it would be worth only a few pennies).

Pricing Strategies Align for Higher Overall Industry Yield Growth Carnival should also benefit from Royal Caribbean's and Norwegian's pricing strategies and explicit financial goals. Peer positioning should both directly and indirectly affect Carnival in a positive way, helping the biggest industry player capture higher yields and improved profit performance.

Royal Caribbean's pricing integrity program offers deployment options to consumers earlier in the calendar than in the past, permitting for the marketing of these itineraries further in advance, in order to prevent aggressive discounting as the departure date moves closer in. Royal Caribbean's lack of close-in discounts should prevent Carnival from having to respond to lower last-minute prices set by its most sizable competitor. At Norwegian, the namesake brand has adopted a pricing strategy from its Prestige segment that markets to fill ships rather than discounts to fill. Historically, Prestige's brands (Regent Seven Seas and Oceania) have announced to the travel agent community and cruisers when prices might be scheduled to change, and when it might be important for passengers to book early to obtain the rate and cabin they desire. This tends to prevent last-minute discounting, which in turn upholds brand perception, which makes it easier for the company to raise prices in the future. This strategy has helped Prestige's and Norwegian's yields to surpass prerecession levels versus their peers, which have yet to recapture such levels. If the stable economic environment prevails, Norwegian's pricing strategy should also benefit Carnival, as the lack of discounted prices could prevent aggressive competitive pricing behavior.

Carnival has similarly articulated its distaste for discounting. Last year, the company said it had begun to hold pricing firm at the expense of occupancy over the prior few quarters, a technique that benefited yield growth, which ticked up 1% in 2014 despite inconsistent performance in the Caribbean and foreign exchange headwinds that picked up toward the end of the fiscal year. While management's commitment to holding price has been more vague than its competitors', we believe the executive team will find it in the company's best interest to hold pricing firm as long as possible, barring a major economic downturn or external shock that would warrant a dramatic response. Overall, we think consistency across major industry operators regarding pricing is likely to benefit all constituents, barring improper incentives for any single operator to discount. With further upside to return to peak yield per diem levels, Carnival has a good runway for price growth from current levels on a per diem basis, in our view.

Management Continues to Pull Cost Levers to Improve Expense Structure Being the largest participant in any industry can lead to scale advantages if the company can operate efficiently and wield negotiating power with its vendors. However, over time expenses can stray from their optimal levels, becoming out of sync with the maximization of operating profit as the enterprise evolves. Carnival has integrated numerous acquisitions and received delivery of varying ship classes, leading to operating profit performance across the fleet that could be inconsistent. We think management has taken important steps to improve profitability across all of the brands and the enterprise over the past 18 months that could structurally change the company's cost profile over the next few years.

First, the company has made key management changes to ensure that costs are being closely watched, including filling a chief operations officer role and hiring a chief procurement officer, in order to control expenses across multiple functions of the organization. Second, persistent diligence in fuel usage through technology and processes across the fleet keeps per diem cost growth depressed. And finally, the repositioning of ships and disposition of lower-yielding and less-efficient capacity changes the composition of the operating margin profile at the enterprise level as lower-margin-producing ships exit the fleet.

At the end of the second quarter, Carnival was already on course to capture $70 million-$80 million in cost savings during 2015. These savings stem from the company's air travel initiative as well as procurement savings in categories like food, beverage, and shore excursions (last year the company also experienced $20 million of managed costs to avoid inflation, aggregating in a total $100 million in savings). While $100 million in cost savings may not seem meaningful relative to the $8.6 billion we forecast Carnival to spend on net cruise costs or the $3 billion in revenue costs including commissions and transportation in 2015, it is the outcome of primary steps in the firm's saving initiative, and we believe the firm will focus its energy across numerous operating expense opportunities ahead, driving long-term operating margin expansion.

The chief procurement officer, who was hired to oversee strategic sourcing and supplier relationship management, should also improve the company's expense structure over time. Strategic vendor knowledge that overlaps with some of Carnival's key vendor relationships could help Carnival maximize the potential of its scale while improving guest satisfaction, as better products may be able to be offered at similar prices.

Controlling all costs has been an ongoing effort over the past decade, with better fuel utilization as a tenet of Carnival's total cost-control strategy. The company continues to implement newer technologies such as hull coating systems, energy-efficient lighting, usage of waste heat, and voyage optimization to improve its energy consumption. Between 2007 and 2014, the company lowered its fuel usage 25%, saving more than 1 billion gallons of fuel and $2.5 billion of fuel cost. We expect innovation in technologies and materials to facilitate further savings, helping costs grow slower than inflation, in line with management's previously stated goal, which calls for expenses that are flat or rise at half the pace of inflation.

While we don't think fuel costs per diem will remain at the depressed levels we foresee over the remainder of 2015, since energy prices have already risen above their lowest prices, we do not expect them to rise back to 2011-14 levels, which were markedly higher. Morningstar's energy team forecasts the price of midcycle Brent at $75 per barrel, which is still higher than the current market price but meaningfully lower than the $100-plus between 2011 and mid-2014. We think this will lead to a rising incremental fuel expense for Carnival, which should be partially offset by operating efficiencies and the zero-cost collars the company implements to hedge energy costs.

Finally, we expect Carnival to improve its cost profile by disposing of or repositioning older, lower-profitability ships, which capture lower yields and use fuel less optimally, in order to maximize operating income. The company disposed of 16 ships during 2006-14, but its fleet still contains many ships that were built 20 years ago or more. Despite refurbishments, we see these older ships as the most likely to be up for sale over the next decade, outside of dispositions already previously disclosed.

Overall, we believe these factors have positioned Carnival to be able to better control its expense growth than in the past. The appointment of leaders who are responsible solely for ensuring that costs remain reasonably controlled indicates to us that it is less likely for any manageable costs (excluding fuel) to get out of line with the growth of the overall business.

Better Revenue Potential, Focused Expense Control Lead to Potential Opportunity Carnival's shares are currently trading just below our $53 fair value estimate. We believe the price/fair value discount to Royal Caribbean and Norwegian is due to three factors. First, foreign exchange still weighs on the onboard spending power of travelers (only 55% of Carnival's cruise guests are sourced from North America), and that keeps investors hesitant on the shares. Second, brand equity at the Costa and Carnival brands, while improved, has not yet returned to peak levels, and it could take some time to fully restore. Finally, relative to its peers, Carnival remains the most exposed to the middle-income consumer, who has proved to have less-consistent and harder-to-predict spending habits. In our opinion, this is one of the near-term catalysts for the business, and recent commentary about the stabilization of pricing in the Caribbean, where the Carnival brand is heavily deployed, indicates as such.

Longer term, we have net revenue yields rising at a low-single-digit pace of 2%-3%, as premiums from new ships are offset by lower increases in prices on the older fleet, while net cruise costs grow at 1%-2%, or just around 1% excluding fuel, leading to earnings per share growth of nearly 20% per year over the next five years (mostly from the company's earnings rebound in 2015-16). This assumes that Carnival resumes share repurchases in 2016 as bigger capital-expenditure programs are completed, ships continue to be financed with credit export facilities (Carnival still has the lowest leverage in the industry), and rising pricing power with higher cost savings generates improving operating cash flow.