This post is to continue my discussion on 15 stocks I know. Today, I’ll talk about Carnival (CCL), and Chuck E. Cheese (CEC).
#4 Carnival (CCL)
Carnival is the biggest cruise operator with a 44% market share. Carnival, Royal Carribean (RCL), and Norwegian share 85% of the total cruise market between them.
Carnival’s Wide Moat Comes From Economies of Scale and Experience
Big ships provide great efficiency. Big ships can offer more amenities and therefore give a fuller experience to customers. Whether carrying one hundred or one thousand customers, a ship still requires one captain, a staff of highly paid engineering officers, one power plant, etc. Fuel expense per berth also decreases as the size of a ship increases. And having more hotel staff to cater to more customers does not cost much more because these workers’ wages are so low.
Big ships are expensive. A new one costs no less than $500 million. And one ship is not enough. One must have a fleet of big ships to reach economies of scales in marketing and to have negotiating power with food suppliers.
That means it costs a lot of investment for someone to get a chance to compete with Carnival.
But cost is not the only problem. Operations in this business are extremely complicated. Take food for example. A 7-day cruise requires about 5 tons of food. There’s no room for errors. Food cannot be sourced from the port of call but must be moved by flights to ensure quality and satisfy the varied tastes of customers. There are only several hours to load up food at each port. Again, Carnival has a fleet of ships with identical menus to maximize efficiency.
It’s just irrational for anyone to spend billions to compete with Carnival.
Carnival Has Acceptable Future Prospects
Future cruise demand is favorable. Market penetration is low. And cruises provides much more value than land-based vacations.
But the product economics of cruises are bad. Capital investment is too high. And growth requires new ships. Carnival is the best run company but was able to make only 11% pretax return on tangible capital over the last 10 year. With a reasonable level of leverage, they earned 14.5% pretax ROE. The good news is that Carnival doesen’t have to pay any taxes. So they can earn an acceptable return on equity.
Good Capital Allocation
Carnival has always kept a disciplined approach to growth. They made some acquisitions in the past but Micky Arison, the CEO, was famous for “never parting with an unnecessary dollar.” The only occasion where Carnival overpaid was when they acquired Princess at more than three times the price they had originally valued Princess. Micky Arison later confessed that he was unwise at the moment.
One ratio I like to use to test capital allocation is the average 10-year return on equity, without excluding intangibles from the calculation. Carnival’s average 10-year ROE is 11.17%, which I think is good considering the bad economics of cruise industry.
How I Would Like To Buy Carnival
I prefer DreamWorks (DWA), Nutrisystem (NTRI), and Ebix (EBIX) to Carnival because capital-intensive business is not my type. But considering Carnival’s competitive position and average return on tangible asset, Carnival may be a good buy.
One concern with Carnival is something out of their control. That is supply. It’s too difficult to predict animal spirit. Cruise business is still growing. There may be someday when people get excited and build a lot of cruise ships. A ship’s useful life is long. It has no other use. Any oversupply can last very long. And no one will be able to make much profit as long as there is an oversupply of ships.
That’s a risk that Carnival cannot control. Although I think Carnival, Royal Caribbean, and Norwegian are all conservative, that’s still a risk.
But that’s not a value investor’s problem. It takes a while to build ships. It takes seconds for a stock price to reflect people’s excitement. We can always sell stocks at high price before oversupply happens. We can find all information about the industry’s expected capacity in the 10-Ks filed by Carnival and Royal Caribbean. A short cut is to buy Carnival stock when its ROE is lower than average and sell Carnival stock when its ROE is higher than average.
Right now, Carnival’s return on equity is lower than average.
#5 Chuck E. Cheese (CEC)
Chuck E. Cheese’s stores offer food (mainly pizza) and entertainment including animatronic shows, arcade-style and skill-oriented games, amusement rides, video games and other activities. Chuck E. Cheese targets families with children between two and 12 years of age.
From 1989 to 2001, the stock price appreciated more than 30% per year while the earnings per share increased nearly 40% per year. From 2001 to 2010, the average pretax ROIC was 23.33%. Average ROE is 26.5%. And the company’s stock price grew 19% annually over the last 22 years.
The Number Shows That the Company Must Have Done Something Right
CEC has a strong competitive position in its niche. CEC has a lot of restaurants clustered in a lot of large metropolitan areas. CEC is also the only national player in this business. That gave them significant marketing efficiency. Chuck E. Cheese does not spend much on actual advertising as a percent of sales. However, in customers’ mind, Chuck E. Cheese means “kids’ pizza,” or “kid’s party.” The visit frequency is low, yet the brand recognition is high. In short, CEC is a place for parents to take their kids.
The long tenure of regional managers and executives at CEC suggests that this is a good organization. The average tenure of District and General Managers is 12 years. For Regional Presidents and Area Directors it is 20 years. And for executives it is over 25 years.
The management seems good too. They are conservative in expansion, and bought back a lot of shares in the last 10 years. That helped improve ROE even when the company became mature.
Why I Prefer DreamWorks, Nutrisystem, Ebix, and Carnival to Chuck E. Cheese
There are two reasons.
First, CEC is mature. I don’t expect many new stores to be opened. Future earnings growth may come from store expansion. Yet, the store expansion rate is not fast.
Second, it’s difficult to track whether the brand image is deteriorating. There are hundreds of stores, and something bad in each store can damage the brand image. That can be bad service. That can be a fight between emotional parents, etc. And parents are very sensitive to image when choosing products/services for their children.
Unlike Carnival, I don’t have any easy way to check CEC’s brand image. Unlike DreamWorks that can produce a flop and go on to produce another movie, or Nutrisystem that builds the brand mainly through advertising and product quality, CEC has to control 556 stores. In this sense, CEC is in a difficult business.
But CEC’s earnings have been more reliable than most companies.
To be continued…