Carnival (CCL): Survival of the Fattest

by Geoff Gannon


Quan here. 

Nate from Oddball Stocks read my post on Carnival (CCL) and Chuck E. Cheese (CEC) and suggested I do scuttlebutt. Which means looking further than just reading 10-Ks to learn about intangibles.

 

Scuttlebutt is More Important For Some Companies – Less Important for Others 

I think scuttlebutt is important. For CEC, I need to regularly do scuttlebutt to track the customer image of CEC. That’s because customer tastes might change. But in some businesses, we just need to focus on the key metrics that we can find in the SEC filings. In the cruise business, the 3 key filings are Carnival’s 10-Ks, Royal Caribbean’s 10-K, and Norwegian’s S-1. Between them these 3 companies account for 85% of the worldwide cruise industry. The key metric in the cruise industry is cost.

 

Survival of the Fattest 

It is survival of the fattest. Warren Buffett once wrote: 

When Charlie and I were young, the newspaper business was as easy a way to make huge returns as existed in America. As one not-too-bright publisher famously said, “I owe my fortune to two great American institutions: monopoly and nepotism.” No paper in a one-paper city, however bad the product or however inept the management, could avoid gushing profits. The industry’s staggering returns could be simply explained. For most of the 20th Century, newspapers were the primary source of information for the American public. Whether the subject was sports, finance, or politics, newspapers reigned supreme. Just as important, their ads were the easiest way to find job opportunities or to learn the price of groceries at your town’s supermarkets. The great majority of families therefore felt the need for a paper every day, but understandably most didn’t wish to pay for two. Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of the newspaper jungle: Survival of the Fattest.

Thus, when two or more papers existed in a major city (which was almost universally the case a century ago), the one that pulled ahead usually emerged as the stand-alone winner. After competition disappeared, the paper’s pricing power in both advertising and circulation was unleashed. Typically, rates for both advertisers and readers would be raised annually – and the profits rolled in. For owners this was economic heaven.

The product economics of the cruise business are very different from newspapers. But there are some similarities in the way competition works.

All the leading cruise companies are both big and old. Achieving scale early on has been key to taking market share in the cruise business.

 

Three Companies Control the Vast Majority of the Cruise Industry

Royal Caribbean and Norwegian won’t go out of business. But the fattest Carnival is in a much better position to maintain and gain market share.

Carnival already has 52% of the world cruise market. Royal Caribbean has 26%. Norwegian has 8%. All 3 were founded between 1966 and 1972.

 

Carnival is the Low Cost Operator

Carnival has better efficiency than Royal Caribbean on 3 levels. One is commission and onboard cost. Two is cruise operating cost. Three is SG&A.

Let’s start by comparing commission cost and onboard cost.

 Onboard cost is the cost of onboard sales like drinks, etc. The one advantage RCL has over CCL is a revenue advantage – not a cost advantage. RCL earns about $5 more in gross profits from onboard revenue per passenger per night than CCL. However, this comes with a cost. RCL ships have about 20% more public space on average than CCL ships. This may help explain their lower capital turns.

So, CCL has to pay on average less percentage of ticket sales and onboard sales than RCL. Specifically, as a percentage of total sales, CCL’s commission and onboard cost is 4.94% less than RCL:

After commission and onboard cost is cruise cost. RCL hedges its fuel costs. CCL does not. For this, I just compare cruise cost excluding fuel as a percent of total revenue:

Having more ships and cruise lines gives CCL bargaining power in dealing with travel agents and food and drink suppliers. Another reason is CCL’s better cost control.

Again, as a percent of total sales, CCL’s SG&A is 0.74% lower than RCL.

So, on average, CCL enjoys an EBITDA margin that is 7.41% higher than RCL.

CCL also has better capital turnover than RCL:

To keep things simple, let’s assume both companies have 0.5x capital turnover. That means CCL has about 3.7% higher EBITDA/capital than RCL. That translates into about a 2.22% return on capital gap – after depreciation – between CCL and RCL. And CCL actually depreciates its assets a little faster than RCL.

 

High Returns on Capital Help Support High Market Share Growth

A 2.2% return on capital advantage is a huge gap in the cruise business. The average return on capital of CCL over the last 10 year is about 11%. So RCL is the second biggest player but can earn less than 9% return on capital. I don’t know any new entrants that can get into this business and survive.

I’m not worried about anyone stealing market share from CCL. Assuming that the cruise market grows 7% a year, RCL’s earnings are just barely enough to let them maintain market share without borrowing. If RCL wants to gain market share, they have to build new ships. Even if people love RCL and RCL wants to grow faster, they have no choice other than borrowing more money.

Meanwhile, CCL’s retained earnings can afford them to gain market share. They can grow even more aggressively by borrowing more debt. Actually, CCL leverages much less than RCL.

Finally, CCL has many lines targeting different market segments. For example Carnival is for people looking for bargains while Princess is premium. If a market segment shows more potential than another, Carnival can always build more ships to support the growth of the appropriate line. They’re in a better position, in terms of financial strength and return on capital than anyone else to increase capacity.

And, in the cruise business – it’s survival of the fattest.

Talk to Quan about Survival of the Fattest