Carnival's Brand Equity Intact

Despite facing multiple headwinds in 2019, including Cuba travel restrictions, Hurricane Dorian, and shipyard delays, Carnival CCL/CUK was able to eke out 3% earnings per share growth for the full year. The fourth quarter performed ahead of our expectations on price and cost metrics, with an as-reported yield decline of 3.6% and cost (excluding fuel) increase of 1%, better than the 4.8% decline and 2.5% increase we had modeled, respectively. These factors led to adjusted EPS of $4.40, $0.14 ahead of our forecast. However, the company’s 2020 outlook was more tepid than we anticipated and includes yields that decline 1.5%. This is below the 0.5% increase we were looking for but still represents an improvement over the 2.6% yield downtick Carnival experienced for 2019. Costs excluding fuel that fall 0.5% in 2020 were also less favorable than the nearly 2% decline we predicted, but higher spending on marketing to elevate brand awareness should ultimately support more interest in cruising, helping to stabilize pricing.

Booking commentary indicated that demand uncertainty was not escalating, as booking volume was running higher with prices that were in line for full-year 2020 over the last eight weeks. Even with ongoing weakness in key markets like the United Kingdom (Brexit), Alaska (capacity growth), and Europe (weak economics), our long-term outlook is unchanged and our $58 fair value estimate is intact. We view the shares as undervalued, trading at 11 times the midpoint of management’s 2020 EPS guidance. However, Carnival’s valuation (and multiple) could remain depressed until better earnings growth comes into view, which investors could have more clarity on over the course of 2020.

The year ahead is likely to have numerous puts and takes that should nearly net out for Carnival. Fuel prices, fuel mix, and foreign exchange are expected to provide around a $0.20 per share tailwind to earnings, while prior-year events (Cuba, for example) and voyage disruptions are set to generate around a $0.15 headwind. We expect ongoing strength in the spending of North American guests will provide the most support for Carnival over the year ahead, while continental Europe remains problematic in taking pricing gains. We don’t expect a resolution to Brexit or a wide improvement in mainland European GDP growth rates over the year ahead, tempering our enthusiasm for onboard spending from that customer base. That said, we don’t believe cyclical pressures will hinder Carnival’s brand intangible asset, and we expect the company’s economic moat will remain intact over the next decade.

Efficient Scale Biggest Contributor to Moat We assign a narrow economic moat to Carnival. Efficient scale provides the most robust evidence that an economic moat exists, driven by high sunk costs, significant barriers to entry, mature demand, excess capacity, and historical precedent. This is supported by a brand intangible asset and cost advantage that afford the cruise operators a competitive edge and ultimately the ability to generate excess economic rents over the next 10 years.

First, we believe the most quantifiable evidence that indicates an efficient scale moat source exists for Carnival are high sunk costs and barriers to entry. These two factors prevent new entrants from ramping up quickly in market share and converting customers from Carnival’s existing brands to new brands or offerings. As evidence of high sunk costs across the industry, the capital already committed from Carnival has been robust, and assets on the balance sheet indicate deep pockets or massive liquidity are required to facilitate growth in the cruise market. Carnival, which has about a $36 billion market capitalization and $20 billion in gross sales, had gross property, plant, and equipment representing more than $50 billion and ship factors accounting for the majority of the amount on its balance sheet at year-end (stemming from more than 100 ships).

Also supporting Carnival’s efficient scale moat source are barriers to entry stemming from three factors, two of which are liquidity driven. First, large ships currently cost $500 million-$1 billion to build on average. Second, new operators are unlikely to have access to the cheap financing through export credit facilities. Third, there is limited worldwide shipbuilding capacity. The cost of ships has been rising over time, with the contemporary brands ordering hardware with significantly more berths and additional amenities versus ships built a decade ago. For example, in 2007, the cruise order book had an average cost per berth around $199,000. When we assess the order book for 2020, the average price per berth rises to about $470,000. As higher costs per room are set to prevail with elevated input costs for the expedition and luxury lines, the payback period is likely to extend for each operator, making the economics less favorable for new entrants if they attempt to outdo the existing players operating in the market. Furthermore, accessing the right type of capital is critical for financing ships, with access to low-cost export credit facilities utilized liberally across the major, sizable cruise players. But not all companies have access to export credit facilities, leaving some of the smaller players, which generally can’t absorb the higher costs affiliated with more expensive debt service as easily, paying a higher rate. With many of the shipyards booked at capacity over the next five years, even if a smaller player could access financing, it might not be able to find a builder that could spare capacity for the newbuild.

Less obvious quantitatively but still supporting an efficient scale moat source are factors like historical precedent and excess capacity. Our methodology indicates that if a market has seen little entry or exit over an extended period, efficient scale is more likely to be present. While there have been some new players attempting to tap into the cruiser base, there hasn’t been a new competitor over the past two decades that has been able to establish itself and rise to represent a significant percentage of market capacity (more than 10%) over the past 10 years.

We consider excess capacity as relevant when incumbent companies can meet incremental demand for the foreseeable future at no or very low marginal cost, making the opportunity less profitable for potential entrants. With existing operators paying very low rates, we think new entrants would be hard-pressed to capture a better marginal cost than the industry incumbents are already finding. For Norwegian’s NCLH four ships coming on line in 2022-25, the company has locked in rates well below 3%, a level we think riskier, new operators in the space will find difficult to source from the private debt markets.

Given that the incumbent players haven’t materially shifted share or position in recent decades and we don’t anticipate the implementation of regulatory or legislative hurdles to jeopardize the existing operator’s positions, we believe the efficient scale moat source will remain intact over the next decade-plus.

High Market Share Is Brand Intangible Asset Carnival's brand intangible asset also supports our narrow economic moat rating, supported by the high market share of the business, which has persisted over time as consumers continue to choose the company's offerings. In 2018, Carnival held 42% of global market share, while Royal Caribbean RCL clocked in at 23% and Norwegian 9%. This hasn't changed materially over the last decade.

Additionally, despite fleet growth over the last 10 years (which has largely covered a healthy global economic period domestically with a fair level of instability in Europe over the earlier part of the decade), the cruise industry has taken a firm tack on pricing, indicating it would be willing to sacrifice some occupancy (which runs north of 100%) to protect yields. The group has attempted to sustainably take price increases annually, supported by board directives to improve returns on invested capital at Carnival. The ability to consistently move prices upward has allowed Carnival to generate more than 1% as-reported average yield growth over the last five years, despite foreign exchange headwinds. This is versus about 1.5% growth for the domestic consumer price index.

Additionally, we contend that significant capital expenditure programs continue to elevate the brands run by Carnival, supporting the brand-driven moat source. Bringing innovation to older ships while in dry dock stimulates revenue opportunities, as an updated product will improve customer willingness to pay for better onboard offerings; recently refurbished ships put back into existing markets have performed well in recent years, garnering improved yields versus pre-dry-dock performance. With Carnival understanding that elevating brand relevance is imperative, it has executed on improvement programs like its Fun Ship 2.0 initiative, investing $500 million across the fleet for improved dining, entertainment, and public venues to enhance customer satisfaction.

Cost Advantage Adds to Moat We believe Carnival's cost advantage stems from the ability to produce a good or service at a lower cost than its peers. We think the most important factors supporting Carnival's cost advantage moat source are proximity, buying power, scale, and access to low-cost financing. We contend that the proximity cost advantage has been improving for cruise operators in recent decades. This factor can arise from proximity to customers, which manifests as a transport cost advantage. The cruise operators have been increasingly able to attract new customers as they have moved beyond traditional Florida-based ports and have home-ported in new locations, offering more cruising opportunities for customers within driving range. We think the industry can now reach a significantly higher proportion of the population, with the population of the greater Los Angeles area (where the Carnival Panorama is set to home-port) around 13 million, New York around 20 million, and Seattle around 4 million. These three cities as home ports together represent 37 million potential travelers, more than 11% of the U.S. population.

Also, Carnival’s more than 100 ships offer the company the ability to procure marketing, food, and other items across a large-scale format, providing negotiating leverage with vendors. The sheer size of the major operator’s fleets could imply some scale function exists across the cruise industry. We believe this scale allows Carnival to procure marketing, food, and other items across a large-scale format, providing negotiating leverage with vendors. When we assessed the percentage of selling, general, and administrative expenses as a percentage of net cruise costs over the last five years, Carnival paid a significantly lower proportion of net cruise costs than a smaller operator.

Overall, these three moat sources--efficient scale, brand intangible asset, and cost advantage--offer enough evidence to support a narrow economic moat rating for Carnival.