Since the beginning of the pandemic, cruise companies have been virtually uninvestable. The stop-start nature of Covid restrictions around the world, coupled with self-imposed unwillingness to travel for many, have impacted the ability for these companies to grow and improve their financial situations after the abrupt halt to their income hit their already debt-ridden balance sheets hard.
There are some signs that things could finally be looking up for cruise companies. Wall Street analysts are expecting the three largest operators, Carnival (CCL, Financial), Norwegian (NCLH, Financial) and Royal Caribbean (RCL, Financial), to return to growth in 2023. All three are projected to earn a profit next year, for the first time since 2019.
Of the three, Carnival is currently the cheapest by traditional metrics. The stock is trading at a price-book ratio of 1.3. The company also has the lowest level of net gearing among the three, although we cannot take these debt figures at face value due to financial engineering.
With interest rates set to increase in the months ahead, however, a company's debt sustainability is far more important today than the overall level of debt. If a company has lots of fixed debt on long-term maturities, it is going to perform far better than a business with a low level of debt on floating rate deals.
There's another issue to consider here. All three of these companies secure their debt against cruise assets, mainly cruise ships.
Weakened balance sheets
The value of cruise assets has plunged over the past couple of years. The world's largest cruise ship, Global Dream II, which had the capacity to carry 9,000 passengers, is going to be scrapped before its first ever voyage after its owner collapsed and no buyers materialized for the $1.6 billion vessel.
Put simply, I do not think it is unreasonable to say that investors cannot take debt metrics for these businesses at face value in the current environment. And if we cannot take debt metrics at face value, it becomes very difficult to analyze these companies based on book value alone.
That means we have to turn to earnings projections to value cruise operators. Assuming Wall Street analysts are relatively on the money when it comes to growth next year, all three of these companies are trading at forward price-earnings ratios of around 12. That does not seem too demanding, but it does not look particularly cheap either.
Neither does this valuation seem to take into account any potential risks to growth, such as an economic recession or a downturn in consumer spending.
To justify their current valuations, these companies would have to continue to grow over the next couple of years and pull themselves out of the pandemic slump they have found themselves in.
There is no guarantee this growth will happen. The biggest challenge they all face is interest costs. After the pandemic, they have ended up with huge amounts of additional borrowing, adding significant fixed cost to the balance sheet. No matter whether or not interest rates are fixed, they will need to be paid, severely cutting into earnings.
With the highest net gearing rate in the group at over 100%, Norwegian spent over $400 million on interest in the first six months of 2022, more than food and fuel for its ships. That illustrates the scale of the challenge here. These companies not only need to grow but grow significantly in order to start reducing debt and maintain their borrowings at the same time.
With the outlook for the economy deteriorating, there is no guarantee they can do both, although there is no guarantee they will continue to struggle either. The outlook for the sector is just as uncertain as it was two years ago.