Narrow-moat Carnival (CCL) closed out another year with clear brand equity and operating efficiency improvement, despite foreign exchange headwinds. The company has come a long way in repairing its image across its portfolio, helping deliver constant currency yield growth of 4.2%, better than cost growth excluding-fuel of 3%.
Carnival expects that over time China should surpass North America in demand
Both net revenue yield and net cruise cost growth are projected to be lower than we had previously anticipated for 2016, we had increases of 2.4% and 2%, respectively, versus guidance of up slightly and 1%, in current currency, but the revisions on both lines still offer a similar operating margin profile, indicating our $56 fair value should not change meaningfully.
We view shares as modestly undervalued, but think Carnival could deliver some additional operating income upside if it finds more revenue synergies or cost reductions than currently anticipated; $75 million in savings are expected in 2016. Relative to its publicly traded peers, Carnival has the least detailed medium term plans. Both competitors have set expectations through 2017, but the implication of reaching double-digit returns on invested capital over the next two to three years infers earnings before tax margins are set to improve by at least another 100 basis points between now and 2018, when we forecast Carnival to reach 10% returns on invested capital.
The tone of the call was cautious, with North America described as strong and the global macroeconomic and political situation was noted as volatile, particularly in Europe. We perceived much of the commentary as positive, and see underlying improvement ahead.
With cumulative bookings for the first three quarters well ahead and at slightly higher prices than last year, we believe Carnival is in good strategic position for 2016 and should be able to avoid the need for aggressive close-in discounting. Commentary that close-in bookings were much better than expected in the fourth quarter as rational pricing across the industry has taken hold, supports this thesis – at least for 2016.
Number One…
We think there are three key drivers over the next few years that should support Carnival’s profit improvement. The first is the continuation of growing brand equity at Carnival brand. The Carnival branded fleet is already generating returns on invested capital in the double-digit range and was called out as a primary contributor to better than expected ticket yields at the North American brands in 2015. The brand still represents nearly 30% of the company’s berths, and good health at the subsidiary level is imperative to achieve total top-line performance at the enterprise.
Company net revenue yields per diem remain well below peak levels, at $166 in fiscal 2015 versus $195 in fiscal 2008, but we surmise the stabilization of the low-end consumer and the rising willingness of that demographic to spend on big-ticket items, as durable demand has been robust recently, should bolster the company’s ability to take pricing in years ahead.
Number Two…
Second is China, which is still comping above the company average and is poised for a long runway of growth; with a 60% rise in capacity during 2016 the company indicated it could see some pricing tempered. However, Carnival expects that over time China will be able to absorb both new and repositioned ships in the market and should surpass North America in demand. This would imply more than five million Chinese cruisers over time, from less than a million passengers in 2015, which means Carnival could increase passengers carried by 25% from current levels, if they control 50% of the local market as well as the global market.
Number Three…
And finally on the cost side, we believe the leadership changes and renewed focus on enterprise wide synergies has offered Carnival a more holistic perspective to controlling costs than in the past. The company has pressed to reduced air/travel expenses, food and beverage costs, and more during 2015, but the improving scale on a worldwide basis across brands has the ability to squeeze significantly more leverage out of the business than in the past.
We commend the company for undertaking the evaluation of costs as an ongoing project, and believe that as scale rises, particularly in Asia Pacific there will be ways to incrementally take costs further out of the structure, supporting earnings before tax margins that surpass 30% over the next decade.
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