10 Bad Years at Carnival (CCL): Oil and the Economy Changed – The Business Didn’t

by Geoff Gannon


Quan here.

Someone who reads the blog sent me this email:

Hi Quan,

I’ve read your posts on Carnival (CCL) with interest and just had a quick look at the numbers. 

If size brought economies of scale in the cruise industry, Carnival would be earning increasing returns. The numbers say it isn’t.  It has tripled its (net) operating assets over the last decade and its operating profit has grown by 54%. Or $790m more operating come in return for $19.8 billion in investment. That’s a RONIC of 4%. 

What does the capital cost? The debt costs 5% after tax, so let’s say that 8% is fair estimate for the cost of capital. That works out to $792m of value destroyed in the pursuit of economies of scale.  If the next decade is like the trailing ten years, CCL will destroy $2.4 billion.

Why? Because entry costs are low – all you need is money – and exit costs are high – once you’ve spent $1 billion on a ship you’re stuck with trying to pay for it. So what do you do? You slash prices. So do your competitors.  Your margins fall but your asset turns stay the same. Buying more ships can’t be a solution to that conundrum. It just multiplies the problem.  More industry capacity means more power to the travel agents who fill these ships with passengers.  

Buying bigger ships will get you some economies of scale but, again, anyone can buy bigger ships – all it takes is money. So the benefits of scale economies from ship size will pass directly to passengers in terms of lower prices. And the costs of bigger ships – having to fill an even larger number of berths per cruise, being desperate – is retained by the cruise operator.

Think of the cost structure facing a cruise operator. There’s a bunch of big-ticket items that it can’t do anything about: commissions, fuel, D&A, drydocking, maintenance & repairs, port facilities, insurance, food & other consumables, etc. It may be able to do something about corporate overhead. But not in a situation, such as Carnival’s, where it’s running 10 different brands each focused on particular customer segments. It’s hard to see, for example, what the commonalities are between the Costa brand and the Holland America brand. They serve different customers, using different everything, in a different place. So if Carnival has tripled its assets and shaved just 10% off its SG&A costs (for a saving of 1% of revenue), that’s probably why.

The closes analogue is, in my view, is the airline industry, not Walmart or newspapers or POSCO or anything like that. And if that’s the case, the only way to survive, let alone prosper, is to either go premium (Emirates, Cathay) or to disrupt the business model (Southwest, Ryannair). Size won’t save you; it will just make you the biggest loser.

Look again at Carnival’s numbers over the last ten years: gross margin relentlessly down, EBIT margin down, overhead ratio unchanged, asset turns unchanged, cost of capital up. Which adds up to an ROIC that’s been halved. That’s not a recipe for success. But it seems to me an accurate picture of what will – what must – happen over the next ten years. When a well-known $20 billion company consistently trades at a low EV multiple for 10 years there's going to be a reason for it and it's going to be a good one. 

These are great points. Let’s start with the analogy between cruise and airline industry. This was exactly my impression of Carnival when I started doing research on the company. But there are some key differences.

The competitive position in these industries is entirely different.

The top 4 domestic airlines have U.S. market share of...

Delta:16%

Southwest:15%

American: 13%

United: 11%.

Meanwhile, the top 4 cruise companies have worldwide market share of...

Carnival: 52%

Royal Caribbean: 26%

Norwegian: 8%

MSC: 5%

Differences in relative market share – for example Delta’s 16% divided by Southwest’s 15% – are very small in the airline business. They are huge in the cruise business.

There is a much bigger gap between the #1 and #2, and #2 and #3 in the cruise industry than in the airline industry.

Also, most cruise lines were founded in the 1960s and 1970s.

Norwegian was founded in 1966. Royal Caribbean was founded in 1968. Carnival was founded in 1972. They were all founded under very similar circumstances.

Meanwhile, new airlines get into business all the time. So the historical evidence points strongly to the idea that it is possible for new airlines to enter the business and achieve lower costs on certain routes, flying out of certain airports, etc. than established competitors. There is very little evidence of this in the cruise business.

So, there seems to be higher barriers to entry in the cruise business than most people think. Even though return on capital has been higher in cruises than airlines - more new airlines are started than new cruise companies. That's the historical record.

There was a period when a lot of cruise lines started. Then some cruise lines became so big that there’s no more room for new entrants. Why is the cruise industry different from the airline industry? 

I can think of 3 good reasons.

 

Cruise Lines Always Operate at Full Capacity – Airlines Do Not

First, cruise lines have the ability to run at full capacity. The occupancy rate in cruises was always over 100%. Carnival’s lowest occupancy rate relative to stated capacity – actual capacity is often 5% to 10% higher than stated capacity – for the last 15 years was still over 103%. Even if you take the most demanding view of possible occupancy in the cruise industry – that you can always cram 110% of stated capacity on to a ship – you are still left with the conclusion that Carnival hasn’t sailed with its ships less than 94% full in any of the last 15 years. Less than 6% empty was the worst year. And that probably overstates how many people you can consistently cram onto a ship.

So, it’s safe to say that even in their lowest utilization year Carnival was operating at around 95% of capacity. Meanwhile, airlines have recently operated at 83%. Median occupancy at Carnival since 1997 was 105.6%, Again, if you assume actual capacity is 110% of stated capacity – which is aggressive – you are left with the conclusion that in an average year Carnival’s ships are 96% full. Currently, Southwest (LUV) flies 81% full. And that’s better than they’ve done in quite a few years. To be fair, though, it is much easier to increase capital turns in the airline business – by turning your planes faster than the competition – than in the cruise industry. Southwest has had success in that area.

So the airline industry’s load factor has recently been around 83%. While the cruise industry has been operating close to full capacity. Load factor and occupancy are not identical. But it’s obvious that planes always fly less full than cruise ships sail.

The problem with airlines is that they provide a point to point transportation service. People consider location, time, and price when they buy flight tickets. Not just price. While there may be little differentiation between which airline you fly – there is always some differentiation in your mind in terms of where you fly out of (for example, the choice of flying out of Buffalo or Albany makes a big positive difference to the passenger, but only complicates life for an airline). So, airlines differentiate from each other by time and location. Unfortunately, that’s not a sustainable form of differentiation. You can’t repeat that differentiation across the entire network. So airlines are trapped in a kind of low level warfare where it is often possible to compete away good returns by offering flights from more airports and more times to the same location someone else is already making good profits on – when the economics of the airline business suggest airlines should actually try to offer fewer times and airport choices but always fly full.

They can’t. Cruises can.

Airlines don’t have the luxury of gathering people in one place on one day to fill the ship like cruise companies do. People buy cruises for vacation. Usually they buy far in advance. They’re more flexible with cruise schedule than flight schedule. And in capital-intensive industries like airlines and cruises, utilization is the key to success.


Scale in Cruise Lines Matters More Than in Airlines

Second, scale in cruise lines matters more than in airlines. The biggest cruise company is the most profitable. That’s not so true in airlines. The biggest airline is not necessarily the most profitable. What matters the most is being #1 or #2 on a specific route or in a specific airport. The reality of airline economics is probably a lot different than a view of the whole company shows. Some routes are profitable. Many are not. The airline’s poor competitive position across much of its network hides some really strong profit centers. And the biggest airlines are not the number one or two at all the airports they operate in. The ability to copy success from one niche to another in airlines is lower than at a cruise line. Airlines are much more diffuse than cruise companies. If you read about where airlines and cruise lines put their planes and ships at different times and what locations they operate out of – this will be very obvious. The concentration in time and space of cruises vs. airlines is something that immediately jumps out at anyone who compares the two industries.

To illustrate this point, consider that when we are talking about the entire cruise industry – we’re really talking about no more than 200 ships. On any given day, there are thousands of airplanes in the air in the U.S. alone. This may sound like a silly statistic. But it’s not. Airlines are defined by their diffusion. Cruise lines are defined by their focus.

So, a cruise line is much better able to bring its cost advantage to every market. After filling their ships, cruise lines compete on lowering cruise operating costs. Running bigger ships provide great efficiency in operating cost and entertainments. But so does running bigger brands. Getting big and having a lot of ships gives cruise companies great bargaining power in procurement or in dealing with travel agents. We can see that advantage in the comparison between Carnival and Royal Caribbean. I expect the cost gap between Royal Caribbean and smaller companies are even bigger than the gap between Carnival and Royal Caribbean.

In airlines, the most significant ratio is load factor. Airplane cost is fixed. Aircrew cost is fixed. Fuel cost is fixed. A higher load factor reduces average cost. Being the biggest in an airport or a route is important for achieving a high load factor. But that is less repeatable from one airport to another or from one route to another than a cruise’s operating cost advantage. Very often an airline gets big, expands into new routes and fails to maintain its profitability. An airline also faces competition from another who might not want to be the biggest in a route but just wants to feed more traffic to its most profitable routes.

This difference in how customers use airlines and cruise lines is critical. It requires airlines to spend more time flying planes on routes they do not dominate.

 

Higher Barrier to Entry

Third, from a competitive perspective, it’s easier to start an airline than a cruise line. The key is being big in a niche market. Many new airlines can start big in a location. It’s not that easy in cruise business. If I want to start a cruise line, I'd try to start big in Asia. That’s the best place to avoid competition and establish my dominant position. But in the winter, I’ll need to redeploy my ships to some warmer places like Australia. Unfortunately, Carnival already has Carnival cruise line, P&O Australia, and Princess targeting all market segments from contemporary to premium in Australia. Carnival seems to be in a better position to get the Asia market than me – even if I was able to start a line from scratch in Asia. That’s because cruise lines often use ships in not just one strong port – they develop two strong positions for the ship throughout the year. Airlines could follow the same strategy of focusing on only flying between two really strong airports for the company – if people were willing to all congregate in one place at one time. They aren’t. So feeding passengers into the juicy routes becomes a big part of an airline’s business.   

A little bit more on barrier to entry is the complication of operating a cruise. While an airline's network is very complex, a single flight is pretty simple. The reverse is true in cruises. A single cruise is extremely complicated. It's an incredible logistical feat. Every single cruise company must have the ability to offer a vacation experience with extremely low margin of error on each voyage. The logistics are complicated from the very first cruise. Even a new company with one ship would face this complexity. Understanding of a market is also important in many phases from designing the ships, to creating atmosphere and choosing food menus that fit a target market. That’s why even though it seemed extremely easy for Disney to bring their experience in theme park to cruises they still had to contract with another cruise line from 1980 to 1995. And Disney is a special line like your premium airline analogy. Disney has 2% market share.

 

Don’t Buy a Cyclical Stock When the Margin is High, Buy When the Margin is Low

Finally on your operating margin, I think this is where we can find value. I would say profit margin started to decline from 2007. That was an oversupply. I think part of the reason was that cruise lines had been over optimistic in building capacity. Part of the reason was the financial crisis. Demand for vacations dropped a lot. The only concern I have with cruise business is, as you point out, the high exit cost. The cyclicality of return on capital in the cruise business is very similar to insurance. Demand is very stable. But supply is not. And the pain from mistakes lags the actual poor decisions regarding supply. But given the high barrier to entry, there’s no reason to doubt cruise lines will slowdown capacity expansion to improve return on capital. Yet the market is paying at a fair multiple of current earnings. And I think current earnings are depressed. I think the stock price will be much higher when the margin returns to normal. That’s the reason for my short-cut suggestion of buying Carnival stock when its ROE is lower than average, and selling Carnival stock when its ROE is higher than average.

 

Carnival’s 10-Year Decline in Margins, ROE, etc. is Cyclical Rather Than Competitive

Carnival does not hedge fuel costs. And cruise companies cut prices to fill ships. So a rise in fuel prices and a fall in passenger demand for vacations has a big impact on a cruise company’s margins, ROE, etc.

Over the last 10 years, fuel costs rose and rose and rose. Then there was the biggest recession in 80 years. Does it really make sense for a company to trade at a normal P/E ratio relative to today’s earnings when the situation is so different from what normal is likely to look like?

This cyclicality is critical. For most of the years you are talking about, the cruise industry's passenger capacity was increasing by 5% to 7% a year. It is now set to grow at just 3% a year in the near-term because the major companies have ordered fewer ships. 

 

How Much of Carnival’s Reported Results are Due to Changes in Fuel?

Carnival doesn’t hedge fuel costs. So, the rise in oil prices during the 2000s can hide the underlying business performance of the company. For example, rising oil prices can make Carnival’s earnings look stagnant when they were really growing quite nicely.

In Billions

2003

2004

2005

2006

2007

2008

2009

2010

2011

EBITDA  Before Fuel Costs

2.31

3.48

4.25

4.54

4.92

5.75

4.62

5.39

5.97

EBITDA After Fuel Costs

1.97

2.99

3.54

3.60

3.83

3.98

3.46

3.76

3.77

 

You can see the combination of economic conditions and oil prices quite nicely in that chart. To the extent the economy is poor and fuel costs are high – Carnival’s margins, ROE, etc. should be considered abnormally depressed. To the extent the economy is strong and fuel costs are low – Carnival’s margins, ROE, etc. should be considered abnormally inflated.

Today, I believe Carnival’s reported earnings are abnormally depressed due to economic conditions – the hangover from the Great Recession – and oil prices.

This wouldn’t be worth mentioning if Carnival had a higher than normal price-to-earnings ratio. But it has a very “normal” P/E even though it seems more likely that current earnings are abnormally low rather than abnormally high.

These cycles of high fuel costs and/or poor passenger demand can last a very long time in both airlines and cruise lines. It’s important not to confuse macroeconomic headwinds for a deterioration in competitiveness.

Southwest was one of the best performing stocks before the 2000s. Then they ran into a lot of macroeconomic problems. But the difference between the Carnival and Southwest is still obvious in this comparison of return on capital – including intangibles – over the last 10 years:

 

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Southwest

4%

7%

4%

7%

6%

8%

2%

1%

5%

2%

Carnival

10%

8%

8%

9%

9%

8%

6%

6%

6%

5%

 

I think it’s likely both companies can increase their returns on capital from the levels they achieved since the financial crisis simply because that was an abnormal period.

And I think a lot of the trends you are seeing in Carnival’s performance are really just based on changes in oil prices and changes in economic conditions. Which are two things we probably shouldn’t count on continuing in the same direction forever.

Talk to Quan about Carnival (CCL)