Carnival's Attractive Even With Lower Outlook

The company now expects 2019 constant-currency yield growth of just 1%, a significant slowdown from the 4% it was able to capture in 2018, but also a tick down from the implied first-half 2019 guidance offered last quarter. We think most investors expected that the first half would post near the bottom of the range but the second half would be stronger, inferring a full-year lift from 2018, which has failed to surface. More disconcerting is whether the failure to capture meaningful yield growth is predictive of consumers being less willing to spend on cruises, something we don’t believe we will have a clear picture of until mid-2019. For now, all measures point to spending remaining healthy for U.S. consumers, which represent around half of Carnival’s sourced customers.

Mitigating yield downside is improvement in costs (excluding fuel) in 2019, which Carnival forecasts to rise just 0.5% on a constant-currency basis and fall 1% on an as-reported basis, well ahead of our forecast for an as-reported 0.5% increase. With lower yield and lower costs incorporated, our 2019 earnings per share estimate of $4.57 should remain largely unchanged and falls squarely into the company’s outlook for EPS of $4.50-$4.80. We do plan to lower our $69 fair value estimate by a few dollars to adjust for the company’s higher capital expenditure guidance, which reflects the true spending outlook. That said, we view the shares as undervalued, trading at less than 11 times the midpoint of updated EPS guidance and more than 20% below to our expected fair value estimate.

Carnival’s updated 2019 outlook doesn’t alter our longer-term forecast for as-reported yield below 2% and cost growth of more than 1%. This is modestly better than the 1% average as-reported yield growth and modestly worse than the 1% cost growth the company has captured post-recession (2009 and beyond). The silver lining for Carnival is that despite slower yield growth, operating cash flow should still rise, supporting debt service, dividends, and increasing share repurchases (particularly since the shares have tumbled from their 52-week high of $73). With the least leveraged balance sheet of the three sizable publicly traded cruise operators, Carnival is likely to trade more narrowly than its peers (narrow-moat Norwegian NCLH and Royal Caribbean RCL) in the event of an economic downturn, in our view, attracting more conservative investors seeking share ownership in the category.

Best Able to Capitalize on International Markets Carnival is the largest company in the cruise industry, operating 10 global brands with more than 100 ships in service and passenger capacity of more than 200,000, allowing it to reach a diverse group of consumers in a lightly penetrated vacation segment. Efficient scale, the lowest unit costs in the industry, and intangible brand assets provide the company with a narrow economic moat.

Carnival’s market is underpenetrated, with less than 4% of the U.S. market ever having cruised. With low domestic penetration rates and even lower international recognition (less than 3% in Europe), upside potential remains significant. The repositioning and deployment of ships to faster-growing and underrepresented regions like Asia-Pacific should help balance supply in high-capacity regions like the Caribbean, which should provide for more strategic pricing tactics globally. In our opinion, Carnival has the best ability to capitalize on these underserved international markets, thanks to its global reach and tailored fleet.

Domestically, the aging population remains key regarding the supply/demand imbalance in the cruise industry, in our view. This segment should drive demand and create a disconnect between the demand in the market and the supply of berths for at least the next 10 years as the 65-and-older demographic grows faster than overall cruise industry capacity. The stable employment situation should also boost lower-income consumers’ willingness to spend, helping the namesake Carnival brand continue to deliver double-digit returns on invested capital.

The company is set to receive 18 ships between 2018 and 2022, boosting supply growth over the next five years. In our opinion, it can still lower costs through improved procurement expenses and better fuel efficiency; ships using liquefied natural gas came into service in 2018. It can also improve revenue via the revenue management optimizer it implemented across six brands, which should help improve EBITDA margins to 32% from below 30% over the next decade.