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Cruise Lines Ready to Set Sail

Jaime M. Katz, CFA

Jaime Katz: After facing a difficult period that included the global economic recession and numerous ship incidents, which led to negative publicity, we believe the cruise industry is set to generate increased earnings, cash flow, and ROICs, thanks to their narrow economic moats and competitive positions.

Carnival (CCL), Royal Caribbean (RCL), and Norwegian (NCLH) have narrow economic moat ratings that are predicated on efficient scale, brand intangible asset, and a low cost structure, which allow the businesses to help the company raise prices, control costs, and keep competitors out of the market.

We believe the cruise companies on our coverage list can generate increased cash flow and ROICs for two reasons. First, deployment and sourcing is becoming increasingly global. In recent conference calls, both Royal Caribbean and Carnival have discussed the redeployment of ships into Asia--a previously untapped and underpenetrated region with an increasing population moving into the middle class with discretionary income to spend on travel. The redeployment of ships shifts the supply-and-demand equilibrium of capacity, which will better allow for cruise companies to raise prices in years ahead.

Second, better control of costs helps boost returns to the bottom line and invested capital. Cruise companies have the ability to better manage expenses like fuel, [selling, general, and administrative expenses], port fees, and vendor contracts, which should lead to higher EBITDA margins in both 2015 and beyond. Additionally, all management teams are focused on recapturing double-digit ROICs in years ahead, which should lead management to make proper capital-allocation and strategic decisions in coming years.

While all of the cruise names on our coverage list are currently overvalued, we think there could be a catalyst ahead in lower fuel prices and better penetration in untapped markets like Asia and South America in years ahead.