The world's three largest listed cruise operators, Carnival Corporation (CCL, Financial), Norwegian Cruise Line Holdings Ltd. (NCLH, Financial) and Royal Caribbean Cruises Ltd (RCL, Financial), have all received much attention this year, especially from value investors.
It's clear why these businesses have started to attract value seekers. After they were forced to suspend the majority of their operations at the beginning of the coronavirus crisis, shares in each respective business have dropped below book value. On top of this, booking trends show demand remains high for 2021. These positive factors have drawn in investors who think they're getting a bargain.
The question we have to ask, however, is whether these stocks are real bargains or if they're value traps.
Bargain or value trap
There is no set formula we can use to determine whether or not a stock is undervalued or if it is a value trap. However, there are some indicators we can use to determine if this is the case. The most obvious is whether or not the business is facing structural or cyclical issues.
On this point, we can determine that these cruise companies are facing mostly cyclical issues. Even though it has expanded dramatically in recent years, the cruise industry still accounts for a minuscule share of the global tourism industry. This suggests that the industry should continue to grow in the years ahead, even though demand might suffer in the near-term due to the coronavirus crisis.
The other indicator that is quite reliable in determining whether or not a business is a value trap is debt. Companies with high levels of debt find it hard to invest in their operations and devote lots of cash flow to reducing borrowings. This can hit growth and shareholder returns. These businesses cannot pay out dividends or repurchase shares until they produced debt to a sustainable level. At the same time, highly indebted companies struggle to invest in new machinery, technology, or cruise ships.
All three of the cruise companies listed above fail on this point. Since the crisis began, cruise companies have been scrambling to raise cash. Carnival, for example, has raised around $10 billion in cash and debt. This additional funding will prevent the company's collapse this year, but it has had to borrow at rates over 10%. The impact this will have on the business over the long run is far from clear.
Royal Caribbean has followed the same path. In May, the company raised more than $3 billion at rates of over 10%. Then in June, it borrowed another $2 billion. At the time of writing, the company's market capitalization is only $11.3 billion.
Norwegian raised just over $2.2 billion in a mix of stock and debt in May.
These fundraisings will help the companies stay afloat for the year. After that, it's impossible to tell at this stage what impact the additional borrowing will have on long-term growth.
Using a back-of-the-envelope calculation, I estimate that on Royal Caribbean's new $5 billion, 10% interest debt, the company will have to spend $500 million a year on interest. Last year, the group's pre-tax income was $1.9 billion. Interest on just the new debt alone (not accounting for the debt existing before the Covid-19 crisis) will consume 25% of this income.
What's worse is that in most cases, this debt is senior secured against the companies' vessels. This may have an impact on their ability to raise funds in the future.
All in all, this borrowing makes it very difficult to place a value on cruise companies. We know they look cheap based on historical figures, but at this stage, it is impossible to tell what the balance sheets of the respective companies will look like in 24 months. As such, owning these stocks right now looks like speculation.
Disclosure: The author owns no share mentioned.
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