Carnival Corp. Q2 Preview: Assessing Debt Impacts On Growth Outlook (NYSE:CCL)

Investment Thesis

The cruise industry is still in the midst of a strong consumer spending cycle, as manifested in Carnival Corp.’s (NYSE:CCL) Q1 earnings report in March this year. The company’s management had described their Q1 performance as “fantastic across the board” with “yet another set of records,” as the company registered “record revenues, record bookings, and record customer deposits.”

The popularity of Carnival’s cruise packages in the Caribbean, Alaska, and Europe zones helped improve the net yield for the company. However, geopolitical tensions in the Red Sea region impacted Carnival more than other cruise operators. I believe, this impact appeared to be more meaningful to Carnival than other operators, per management commentary.

Since the Q1 earnings, there are two forces that are now at play for Carnival as it heads into earnings next week: sustained demand for cruise packages versus the uncertainty from the Red Sea region and other headwinds. At the same time, Carnival’s stock appears adrift, as seen in the chart below.

With uncertainties persisting in Carnival’s case, along with its debt loads on its books, my models suggest the stock is a Hold at the moment.

Cruise market continues to demonstrate consumer spending

Per industry research published by the cruise industry’s leading research body, CLIA (Cruise Lines International Association), last month, the cruise market is expected to see a ~10% increase in the number of ocean going passengers, as noted in the chart I borrowed from CLIA’s research document and added below in Exhibit A.

Most cruise passengers are expected to travel to regions around the Caribbean and Bahamas, with research pointing to ~45% of ocean going passengers traveling to the Caribbean region, while passengers from the United States continue to dominate the wallet share of passengers in terms of spend, as ocean-going passengers from the USA region have now grown over 19% to 16.9 million passengers since 2019. The research also revealed that expedition- and exploration based cruise itineraries are the fastest growing among cruise deals, with such itineraries experiencing a 71% growth in cruise passenger volume as compared to 2019.

This plays into one of the strengths of Carnival, which has Princess and Holland America cruise lines traveling to popular destinations such as Alaska and Antarctica. In fact, the company’s management noted in the previous call that the Caribbean, Alaska, and Europe cruise itineraries had all delivered an incremental 1% yield improvement last quarter. In the last earnings call, management revealed that they expect net yields to improve by ~9.5% y/y in 2024.

However, management also mentioned that the geopolitical tension in the Red Sea region would impact their bottom line due to itinerary disruptions and cancellations. In total, I estimated the total impact on management’s full-year adjusted EBITDA of about 3-4%, if I include all the headwinds that management now expects: ~$130 million due to Red Sea disruptions, $45 million from higher fuel prices, and ~$10 million from the Francis Scott Key Bridge in Baltimore earlier this year. Taking into account all these headwinds, management should either be re-affirming their full-year adjusted EBITDA guidance of $5.63 or raising the mark. At the same time, as I mentioned earlier, management sees net yields of ~9.5%, which should lead to strong revenue growth this year despite the Red Sea tensions that are offset by the popularity of cruises from the Caribbean, Alaska, and Europe regions.

Plus, I will be curious to hear management’s updates about any further headwinds from the Red Sea geo-tensions. One of its peers, Norwegian Cruise Line (NYSE:NCLH), sees less of an impact from the disruptions in the Red Sea, of ~1.5% headwind to net yields. Also, on their own Q1 FY24 call, Norwegian’s management revealed that while most of the impact will be absorbed in Q2, Norwegian’s management expects Q3 to be one of their highest net yield quarters. If Carnival’s management sees similar trends, then it should provide a lift in their outlook.

Carnival’s debt load still looks moderately worrisome

As I mentioned in my post on Norwegian Cruise Line, Carnival and Norwegian were two cruise operators that rapidly issued large volumes of debt through the pandemic to survive the lockdown periods. This resulted in overcapitalized balance sheets and sudden surges in share dilution through the pandemic lockdown periods, eroding shareholder capital during those periods. Carnival’s management has reiterated their goals to reduce debt load, and it is imperative that the company grow its top and bottom lines at rates that allow its management to service its debt and reduce its leverage ratios back to historical levels.

So far, per its latest 10-Q, this is what Carnival’s debt looks like, as shown in Exhibit B below.

Per its last report, the company carries about $2.2 billion in cash, while net debt stands at ~$30 billion. With high interest rates and service fees, the company will have to grow fast to cut down on its debt and service its remaining debt at the same time. Higher EBITDA margins and customer deposits are two main ways the company prepays debt to reduce its debt burden. Refinancing debt is also another strategy I observed management resorting to.

Managing debt is critical for the company, as they have stated previously; it impacts their ability to order ships and optimize Capex. Therefore, I looked at two metrics, leverage ratios and interest coverage ratios, to observe the company’s ability to manage and service debt, as noted in Exhibit C below.

As noted above, at the current rates of net debt, adj. EBITDA growth, and interest expenses, leverage ratios look to be getting well back to historical averages, but interest coverage ratios are still quite low. I would have preferred if interest coverage ratios were at least 2-3x. I believe this is due to the unfavorable interest rates, which imply higher interest expenses for the company. Per the last report, this figure stands at $2 billion in Q1 FY24.

Uncertainties cause headwinds in Carnival’s upside

I expect Carnival to grow its revenue in the mid-single digits on a compounded basis through FY26. With just ~3 ships being added, the company will be focused on increasing capacity, as it has demonstrated over the past year. This means it should be growing marginally faster than the 7% growth that CLIA expects over the same time period, as I pointed out earlier in Exhibit A.

I estimate the company to be growing at a relatively faster pace of 15–16% through FY26. This is based on the efficiency of fuel consumption, pricing, and lower sales and marketing cost goals relative to its peers, as demonstrated in their Investor Day presentation last year. These would actually be impressive growth rates demonstrated in their adjusted EBITDA, warranting a much higher forward valuation multiple, since the company was growing its adjusted earnings at roughly twice the pace of the S&P 500’s long-term average.

However, I will assume that there are about $2 billion of expenses every year that depress the value of the adjusted EBITDA that investors eventually receive. Per my estimates, this implies a forward PE of 5x that I use in the model below in Exhibit E. Also, for calculation purposes, I have assumed a discount rate of ~13.8%, while I expect share dilution to remain stable up to 1% per year on average.

Based on my model above, I note that Carnival is fairly priced by investors at the moment as it heads into earnings next week.

Other factors to consider

In addition to some of the notes I made earlier about what I will be watching from management, such as things like further Red Sea disruptions, additional fuel price impacts, etc. I will also be observing how management frames the demand environment surrounding cruises.

In addition, markets are expecting Carnival’s management to report Q2 EPS of -2 cents on revenues of ~$5.7 billion while guiding for Q3 revenues of $7.7 billion and full-year revenues of $24.5 billion.

Note: Carnival Corp. reports Q2 FY24 earnings next Tuesday, June 25th, before markets open.

Takeaway

Carnival Corp. appears fairly priced heading into earnings next week. While headwinds such as Red Sea disruptions are largely set to be contained as per Carnival’s peers, it will be interesting for me to note management’s comments and forward-looking guidance based on any signs of persistence of these headwinds and demand environment vectors. Management appears to be working towards better managing its debt loads but will have to pull more levers to stay relevant as compared to its peers.

At this point, I will rate Carnival as a Hold as it heads into its Q2 earnings next week.