Royal Caribbean Cruises (NYSE:RCL) stock roughly doubled since its mid-March lows, a sign that the panic surrounding the consumer discretionary sector is starting to stem a bit. Still, I don’t believe the stock is cheap enough for your attention at the moment.
Negative headwinds will continue to affect the sector for several more years. Free cash flows flatlined, and there is little hope for recovery before 2021. On a separate note, Royal Caribbean is also heavily leveraged and will continue to take out more debt to finance its operations. You can’t blame it, considering there are no cruises at sea.
The situation is particularly painful since revenues were on the rise before the novel coronavirus struck, and the company was also offering excellent returns for loyal investors. However, the situation has turned bearish, and it doesn’t look like things will change anytime soon.
That’s why cruise lines and airline stock remain a risky proposition.
Mounting Debt Will Erode RCL Stock Value
Royal Caribbean was already highly leveraged before Covid-19 struck. Long-term debt was on the rise for several quarters, and that is unlikely to change this year.
Working capital needs and capital expenditures will be taken care of through dry powder. RCL recently launched an offering of $3.3 billion in senior secured notes – a two-tranche offering, one set of notes will expire in 2023, and the other in 2025. In a statement detailing the notes, the company said it was looking to repay $2.35 billion of debt through the issues, while the remainder will go towards business expenses.
That is hefty debt to go on top of a highly levered balance sheet. At a time when there is no money coming in, increased interest expenses will stifle growth and slow the company’s recovery.
Revenues Will Take Some Time to Recover
Before the pandemic, revenues were increasing at a steady pace for RCL and others in the sector. Bookings were at all-time highs, and margins were also improving. However, due to the novel coronavirus, revenues are expected to take massive hits this year and the next.
Analysts estimate RCL will finish with revenues of $3.83 billion in 2020, a 65% drop over the year-ago period. However, things will begin to normalize in 2021, with an expected figure of $8.73 billion. Although the numbers are not as good as the approximately $11 billion the company managed in 2019, they show analysts expect some sort of recovery by 2021.
As I mentioned earlier, RCL was progressing at a good pace when the virus struck. Year-over-year revenues grew at 6.44%, whereas the sector saw revenues grow at 2.74%. To put that into perspective, RCL outpaced the industry by a whopping 135.07%. Return on equity finished 16.15% in 2019.
That’s very impressive, considering that it doubled from December 2014.
Now that we have established certain excellent aspects of performance, it’s also prudent to identify areas that RCL could have improved upon as well. Cash flow generation, for example, was unimpressive for the past five years, even though revenues were on the rise.
Where did the cash go? Well, it went towards capital expenses, stock repurchases, and repayment of debt. You can’t blame the company for this since it wanted to return since the pandemic is an unforeseen crisis. However, the strategy has left Royal Caribbean incredibly vulnerable during Covid-19.
Is RCL Stock Fairly Priced?
Over the last month, the RCL stock rose by over 30%. On a trailing 12-month basis, shares are trading at a price-earnings ratio of 61.80, versus a sector median of 18.51 times. That’s quite a steep difference, and it’s difficult to justify investors paying almost 62 times over the company’s earnings to get a hold of RCL stock.
EPS estimates for 2022 and 2023 are $5.40 and $6.46. At that point, analysts are expecting P/E ratios of 10.06 and 8.41. Those seem a better bargain than snapping up shares at the moment.
It’s a Brave New World
Journalists, academics, and thought leaders are already speaking about the post-Covid-19 world at length. Cruise lines are also a significant part of this discussion since thousands of people living together will leave them at greater exposure to viruses.
Health and safety checks are therefore going to form the fulcrum of operations for cruise lines even if the U.S. Centers for Disease Control and Prevention gives these companies the green light to resume activities, fears regarding the industry will persist.
It’s also important to note here that the cost structure of RCL and other cruise line companies such as Carnival (NYSE:CCL), and Norwegian (NYSE:NCLH) will undergo a massive change as a result of this pandemic. Aside from more significant health and safety precautions for the staff, these companies will also have to install quarantine areas.
That will help in isolating patients that show any symptoms and will ensure safety for the other passengers. Mechanisms for transporting these passengers to nearby hospitals will also be needed on board.
At the same time, cruises will also need to have comprehensive testing gear in place to make sure the remaining passengers are screened for the virus.
All of these initiatives will incur additional costs for RCL and erode its bottom line. What’s worse is that these costs will be a permanent fixture until we have a widely available vaccine.
Bottom Line on RCL Stock
RCL stock is a high-risk stock at this point. Cruise lines are in disarray and they will need time to get back on their feet. Compounding RCL’s woes is its free cash flow and debt position. With revenues eliminated from the equation, the company will take out expensive debt to finance its operations. That will put a strain on its bottom line and will slow its recovery.
RCL will survive the crisis, but there is little evidence to suggest earnings will return to pre-pandemic levels in the coming two years. That’s why it’s better to sell the stock right now.
Faizan Farooque is a contributing author for InvestorPlace.com and numerous other financial sites. He has several years of experience in analyzing the stock market and was a former data journalist at S&P Global Market Intelligence. His passion is to help the average investor make more informed decisions regarding their portfolio. Faizan does not directly own the securities mentioned above.