Carnival Uncertainty Demands Wide Margin of Safety

Costa accident pressures Morningstar's fair value estimate, uncertainty over liability requires a wide margin of safety

Jaime M. Katz, CFA 17 January, 2012 | 9:22AM

Carnival's (CCL) Italian ship, the Costa Concordia, was abandoned on Jan. 13 after striking a rock off the coast of Italy which caused severe damage to the hull that caused the ship to list. In light of panicked reviews and the confirmation of deaths with no clear understanding of the total liability for the company, the stock traded off close to 17% on the London Stock Exchange on Jan. 16.

We are raising our uncertainty rating to very high from high until we better understand the full liability potential of the incident and can determine the impact of this news on the important booking (wave) season. Although we believe that the cruise industry is positioned well to benefit from overall supply and demand trends, we think earnings this year are at risk as this incident weighs in the forefront of travellers' minds. As most cruisers tend to reserve between five to six months ahead, January puts us in the critical booking period for third quarter cruising, which was responsible for 70% of total earnings per share in 2011. We find that this also comes at a challenging time considering the weakness in European economies and the still uncertain political environment in the southern Mediterranean. Although Carnival has made some strategic repositioning of ships over the last year, Europe remains a critical market for the company and an accident like this, in addition to an already weak environment, could prove problematic for the company over the near term.

Carnival did respond to both the travellers, with condolences, and to the investing community, with revised earnings guidance for 2012. The immediate impact of the Costa Concordia accident is expected to cost the company $85 million to $95 million (£55 million to £62 million) if the ship is out of service for the 2012 year. The company does have insurance for damage with a deductible of $30 million for the vessel; however, Carnival self insures for loss of use, which could be significant if the $650 million ship is beyond repair. Similarly, the company has a $10 million deductible on third party personal injury liabilities. We are not privy to the stipulations on either insurance contract, nor are we experts in Italian maritime law, so we will hold off on claiming to have grasp of total liabilities for now. We believe Carnival has a strong balance sheet that will help weather what has turned out to be nothing short of a public relations nightmare, and that after some time has passed consumers will remember that the cruise industry has been around for 40 years and has a fairly pristine safety record.

We will lower our earnings estimate for the 2012 year to just below the implied guidance (adjusted for the impact of the accident). These adjustments also reduce our fair value estimate for both the U.K.-traded and U.S.-traded shares. However, we acknowledge that there could be some downside risk to these numbers if the liability turns out to be greater than management currently anticipates or if media coverage of the incident adversely impacts wave-season booking and pricing activity. Our long-term thesis for Carnival remains intact, but we believe near-term complications require a wide margin of safety before taking a position in Carnival's stock.

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Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Carnival PLC4,923.00 GBX-0.47
About Author

Jaime M. Katz, CFA  is an equity analyst for Morningstar, covering leisure and travel and retail.