On Thursday, Carnival Corp (NYSE:CCL) gave a sobering business update. While bookings for 2021 have somewhat recovered, the update also revealed that Carnival had used every financial maneuver to raise liquidity. Carnival stock sank 3%, adding to its year to date (YTD) -67% loss.
Today, investors have priced Carnival stock as if the world’s largest cruise line will never recover. Its two smaller rivals, Norwegian (NYSE:NCLH) and Royal Caribbean (NYSE:RCL), on the other hand, are valued as if nothing’s wrong in the world. It’s a massive disconnect from reality.
And that opens an opportunity. Carnival remains stronger than its two rivals, so investors looking to profit from a recovering economy should consider a paired long-short strategy. In other words, buy CCL and cover with an NCLH/RCL short.
Carnival Stock Is a 200% Return Opportunity
As a tech-focused growth investor, I tend to pass on capital-intensive companies like cruise lines. Despite decent profits, these companies are endless cash pits; the billions of dollars needed to build their ships drag down return on capital invested (ROIC). And that reduces long-term investor returns. Over the past decade, no publicly listed cruise line has outperformed the S&P 500.
These, however, are extraordinary times. With Carnival Cruise lines trading at just 0.6 times book value (compared to its long-term average of 1.9 times), even growth investors would be foolish to ignore this opportunity.
The Cruise Industry: Beaten Down and Cheap
After years of consolidation, Carnival and its two rivals, Royal Caribbean and Norwegian, now make up almost three-quarters of the world’s cruise industry. That means before the coronavirus pandemic, industry profits were relatively high and stable; since 2000, only Norwegian had lost money in any given year.
But that was before Covid-19.
Since March, revenues at all three cruise lines have tumbled to almost zero. Though some cruise lines are slowly resuming limited European routes, U.S. “no-sail” orders still prohibit all cruises from the world’s largest market until at least Oct. 31. Analysts expect the recovery could take years.
Carnival, however, stands to weather the storm.
The Best Capitalized of the Big-3
Of the three major cruise lines, Carnival holds the least debt. Even now, its 1.1 times debt-to-equity (D/E) ratio is far lower than RCL’s 2.2 and Norwegian’s 2.4. (It’s also true when you include second lien debt)
Carnival is also the most consistently profitable. It earned the highest return on assets (ROA) in 2019.
- CCL: 6.8%
- RCL: 6.5%
- NCLH: 5.8%
Though it’s low leverage depressed ROE (a profitability measure that includes debt) in good times, the company’s financial prudence pays off in bad.
CCL Stock: The Poster Child of the Coronavirus
Yet, Carnival is the cheapest of the three cruise lines. Why?
Early in the coronavirus pandemic, Carnival had the great misfortune of picking up not just one, but two high-profile outbreaks of the time.
- Diamond Princess. The first super-spreader event outside China. By late February, the Carnival-owned vessel, docked in Yokohama Bay, accounted for over half of known non-China infections.
- Grand Princess. Among the first wave of coronavirus cases to reach the U.S. After docking in Oakland, the ship accounted for the first known person in California to die of the virus at the time.
Princess Cruises also happens to be Carnival’s largest brand, making up almost a quarter of the cruise line’s revenues.
Today, Carnival trades for the cheapest on tangible book…
- CCL: 0.6x
- RCL: 1.9x
- NCLH: 1.2x
…and on the price to cyclically adjusted PE (CAPE) ratios
- CCL: 7.5x
- RCL: 20.6x
- NCLH: 16.5x
More advanced DCF modeling and ratios also show the same story.
But investors shouldn’t lose sight of the long term. The cruise industry has recovered from multiple rounds of both the Norovirus and Legionnaires’ disease before. And with a vaccine on the horizon, the industry should recover from the coronavirus pandemic as well.
Going Long/Short with Carnival
What should investors do with Carnival Stock? First, let’s calculate its value. Using consensus estimates of a 2023 return to normalcy and factoring the company’s B1 bond rating (implying a 24.8% chance of bankruptcy), a two-stage DCF model shows a fair value of $46, almost a 200% upside. That would mean a 16.5 times CAPE ratio.
But before investors open their checkbooks, know this: there are still some long-term risks to the cruise industry. Firstly, rival Norwegian could go bankrupt. That would roil the market for second-hand cruise ships, making it harder for Carnival to mortgage or sell their vessels. Secondly, Carnival could still run out of money if “no-sail” orders get extended another 24 months. Even its financial resources aren’t infinite. Finally, a sudden increase in interest rates could make the company’s debts unserviceable.
To close out these three risks, investors should turn to a long-short strategy. Using the same valuation methods for Carnival’s competitors show:
- NCLH: Fair value = $20.5 | 14% upside
- RCL: Fair value = $63.5 | -7% downside
Norwegian, with a far higher debt load, is the far most vulnerable to bankruptcy. Royal Caribbean is overpriced. Either should make a good pair with CCL for a long/short trade.
It’s going to be a slow recovery for Carnival: generating $2 billion of free cash flow still means taking 4-5 years to fix its balance sheet. But for those foreseeing a quick coronavirus recovery, it’s essential to pull the trigger now.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.