Narrative Changes, Part 2: Why the Cruise Sector Deserves a Narrative Change

Part one of this mini-series outlined our thoughts on why narrative changes happen.  Part two will discuss why we believe the cruise sector should experience a positive narrative change.  Let’s dive right in.

To recap, these are some of the reasons why narrative changes occur:

1. A change in revenue growth

2. A change in margin outlook

3. A change in balance sheet health and/or capital allocation

4. A change in predictability of revenues (more or less cyclical)

5. A change in competitive intensity

6. Strategic M&A

7. Serendipitous “ah ha” by the market, i.e. fantasy land (this never happens)

At Recurve, we focus on companies that can generate strong growth in free cash flow per share (FCF/share) over the medium term.  There are a lot of other attributes we care about, as we outline in our Builder Company framework, but free cash flow per share is the primary metric that we use to forecast the future IRR of our portfolio companies.  We prefer to focus our efforts on identifying companies that participate in the top three categories listed above: acceleration in revenue growth, margin expansion, and improving capital allocation.  Our companies tend to have elements of all three which work together to grow revenue, grow EBITDA faster than revenue, and grow FCF/share faster than both revenue and EBITDA. 

We believe the cruise sector, somewhat of an orphan in the public markets, deserves greater consideration as a “quality compounder” type of business that could experience a narrative change.  Even if not, the outlook for normalized free cash flow per share over near-, medium-, and long-term horizons is compelling enough to produce attractive multi-year IRRs.  Below we will walk through why we think this sector deserves deeper consideration and appreciation by the investment community.

The Cruise Growth Algorithm

Many investors find a lot of comfort in growth algorithms consisting of healthy volume growth, healthy pricing growth, and moderate expense growth.  This can come in many different forms.  Chipotle grows its restaurant count and its same-store sales, all of which generates operating leverage at the holding company.  Hermes opens new stores, grows volume per store, and increases prices each year to generate steady high single-digit/low double-digit compound annual growth. 

Likewise, the cruise sector generates a similar growth algorithm:

1. Moderate capacity growth.

2. Moderate to strong pricing growth.

3. Extremely modest expense growth per passenger (well below pricing growth). 

This has been true for most of the last decade, save the Covid-affected period in which the sector was forced to shut down for 500 days.  As we enter the second year of “normal” global cruise operations, we believe the sector deserves a narrative change. 

Jason Liberty, RCL’s CEO, simplified the company’s growth algorithm on its recent Q4 2023 earnings call:

“Our proven formula for success remains unchanged. Moderate capacity growth, moderate yield growth and strong cost controls lead to enhanced margins, profitability and superior financial performance.”

— Jason Liberty, CEO of Royal Caribbean

It sounds simple and easy, but there are few companies and industries that do this well over long periods of time.  The cruise sector is one of those industries.  Let’s take a look at RCL’s guidance for 2024 as an example of its growth algorithm at work, using normal verbiage instead of cruise lingo:

• Capacity growth = 8.5%

• Pricing growth per passenger = 5.25-7.25%

• Cost growth per passenger = 3.75-4.25%, including 315 bps of extraordinary costs in 2024

As mentioned in the last point, 2024 has some exceptional elements to it.  Capacity growth is higher-than-normal due to some very large ships being delivered within a 12-month period, including Icon of the Seas, the largest ship ever built.  In most years, the growth formula would like something like this:

• Capacity growth = 3-5%

• Pricing growth per passenger = 4-6%

• Cost growth per passenger = 1-2%

If we compound this formula over time, it generates 7-11% revenue growth and 4-7% cost growth, which generates natural margin expansion over time.  It’s a nice growth formula with translates into >50% incremental EBITDA margins, well above the company’s current low-30% margins. 

The charts below show the resulting normalized EBITDA and EBITDA CAGRs at the low end and at the high end of these growth algorithm ranges.  At the low end, the result is a 12% 10-year CAGR with EBITDA rising 2.8x. 

At the high end, it’s a 20% 10-year CAGR with EBITDA raising roughly 4.75x. 

This growth algorithm and the industry’s low penetration are compelling reasons to be interested in the cruise sector.  We believe Royal Caribbean (NYSE: RCL) can execute somewhere between the two cases shown above to produce an EPS CAGR over 20% for the next 5+ years by driving healthy growth in EBITDA and reversing the dilution the company was forced to take on during the Covid shutdown.

From 2014 (when the three major players publicly committed to improving returns) to 2019, RCL increased its net prices at a 5.1% CAGR.  From 2014 to 2023, RCL increased its prices at a 4.2% CAGR.  The company has guided to a 5.25-7.25% increase this year, another year of robust pricing growth.  Importantly, the gap between cruise pricing and land-based alternatives has widened, offering the cruise sector a nice pricing umbrella even if there were to be pricing pressure elsewhere in the vacation sector.

Analyzing the Cruise Opportunity

Investors will attribute significantly different valuations to market leaders that are 75% penetrated vs. those that are proven but have only 25% penetration.  The former would trade at valuations commensurate with a mature quality company, while the latter would trade at growth multiples.  The market tends to reduce the discount rate on future cash flows if and when a low-penetration company has established its market leadership with high confidence.

With this in mind, we think the market should evolve its view on the cruise industry’s addressable market.  Compelling new and updated hardware and private destinations like CocoCay allow the cruise sector to compete against many more land-based alternatives. Royal Caribbean is competing successfully in this market.  Cruising is not just for turnkey destination-seekers – it’s also for those seeking a relaxing, fun, entertaining experience onboard.  It’s one of the best formats for family vacations and multi-generational vacations.

Cruise companies have movable assets that offer incredible gaming, entertainment, and dining options at sea while also offering global destination diversity and private theme park-like destinations that are competitive with land-based alternatives.  Penetration rates could and should be multiples higher than they are today, supporting many years and decades of secular growth: 

• Only 7-8% of Americans have cruised within the last three years and 85% of the population never has been on a cruise. 

• 2% of Europeans have been on a cruise. 

• Less than 1% of Chinese citizens have cruised. 

This industry has a high repeat customer rate and high customer satisfaction, but low penetration.  It cannot expand supply rapidly because only a handful of shipyards can build cruise ships, and they are constrained to adding roughly mid-single digit supply every year.  Cruise companies suggest the yards have not fully recovered to their pre-Covid productivity, reducing supply growth vs. pre-Covid times – both a blessing (for pricing) and a curse (for long-term volume growth).

This is a nice backdrop for steady penetration growth in a supply-constrained industry.  The natural output is that supply will be filled with demand at higher clearing prices, supporting the second important attribute of the growth algorithm.  Cruise companies also benefit from strong customer loyalty and repeat rates to sell cabins well in advance of sailings, thereby creating a dynamic of scarcity which is supportive of healthy pricing growth over time. 

Why a Narrative Change May Occur

This Insight is about why we believe a narrative change for the cruise sector could occur.  Let’s walk through the categories mentioned above to see where these changes are possible.

1. Acceleration in revenue growth.  Unlikely.  This is unlikely to cause a narrative change because the growth algorithm is rather steady.  Even though growth should remain healthy and we think there is longer-term upside compared to consensus estimates, shocking growth discontinuities from Covid are in the recent past.

2. Margin expansion.  Yes.  We believe margins will surprise to the upside.  Analysts expect margins to rise modestly from current levels, but incremental margins are well above current levels (~50%, well above low 30% current margins) and future growth should convert to additional EBITDA and net income very efficiently.

3. Balance sheet and capital allocation improvements.  Yes.  This is where we think the sector has the biggest opportunity to change narratives.  Balance sheets were significantly damaged during the Covid shutdowns, but the strength of the business since resuming operations has put the companies on a path to much healthier metrics which will soon allow for capital returns to resume.  RCL’s credit rating was just upgraded two notches by S&P and is one notch below investment grade.  Additionally, repaying expensive “crisis debt” will fuel accelerating growth in net income and EPS as the companies reduce their interest expense burdens and eliminate dilutive convertible debt.

4. Demand becomes less cyclical.  Maybe.  In the next cyclical slowdown, the industry has a chance to flex its superior value proposition and sail through relatively well because of its strong advanced booked position and its low penetration rates.  These companies can offer great experiences at lower costs – a great recipe to take share even in slower environments. 

5. Market becomes less competitive.  No.  We don’t foresee any changes to competitive dynamics in the vacation industry.  It is a large and fragmented market within which cruise companies can continue to disrupt and take market share. 

6. Value unlock through strategic actions.  No.  There are some private company M&A opportunities which could be interesting, but they are unlikely to change any opinions about the sector. 

7. Serendipitous “ah ha” by the market, i.e. fantasy land (never happens). No.  Perhaps this has happened for other investors, but it’s never happened to us!

In short, we expect cruise companies’ steady margin expansion and repaired balance sheets to drive a capital return story that should drive narrative change across the sector.

Now, let’s discuss what we think holds investors back from seeing this as a sector for long-term compounding.  We think it boils down to a few factors:

1. The companies carry high debt loads and high financial leverage, the result of not generating revenue for 500 days during the pandemic period.  All are rapidly deleveraging and paying down their most expensive and punitive debt as quickly as possible.  However, there is some cruise-specific nuance that must be understood as well.  The majority of the companies’ debt is secured financing for their ships at highly attractive rates (many in the 2-3% range) through export credit agencies (ECAs).  On an asset basis, these companies have incredibly high return on equity (we discuss this in our Insight on NCLH).  Cruise companies own and operate their assets, not just operate them, and they get extra economic yields from their ownership of those assets.

2. Growing capacity is capital intensive, which dampens reported free cash flow.  We’ve heard criticisms that the industry is in a perpetual capex cycle.  However, that capex is financed at extremely low rates and generates great returns, per the point above.  It is far more informative to use an AFFO-like metric or an ex-growth capex metric to evaluate these companies’ underlying free cash flow generation.  Having done this analysis, we conclude that EPS is a very good proxy for normalized free cash flow per share.  The overall pricing tailwind to the sector drives improving economic yields to cruise companies over time. 

   If a cruise company stopped or slowed capacity additions for some period of time just to show off its free cash flow generation (like Amazon does every few years), it would likely experience a gush of free cash flow from continued pricing growth and much lower capital intensity.  However, with demand outstripping supply, it would be sub-optimal to slow down on purpose. 

   New cruise ships deliver new capacity that is consumed immediately since nearly all ships sail full.  They enjoy premium pricing during their inaugural seasons, but settle into very productive pricing ranges thereafter with like-for-like pricing growth over time, driven by industry demand tailwinds.  A ship like Icon of the Seas is over a $2 billion asset that will pay back in four years, but is productive over 30 years. 

3. Some investors are concerned with cyclicality since cruising is a purely discretionary experience.  However, the industry’s low penetration has insulated it from dramatic peaks and troughs excluding the global financial crisis and, of course, Covid-19.  However, we expect this point will take some time to prove out with investors.

We think it’s important to emphasize that the sector has attributes that many investors tend to like, including:

1. High customer satisfaction and high repeat customer rates.  Depending on the brand, 40-60% of cruise demand originates from repeat customers.  Many cruises guests book their next cruise while onboard!  A high repeat rate reduces the cost of customer acquisition, but if it were too high it would be hard to grow penetration significantly over time.  The healthy mix of new guests expands the companies’ customer files which can be mined with targeted offers based on known purchase history.  The sector enjoys a healthy mix of new and repeat customers for a loved, underpenetrated growth sector that will grow into the future.  We estimate that Royal Caribbean generates its “repeat customer” demand from only about 10% of its total historical customer file each year, suggesting repeat guests need only cruise once every 10 years to fill 50-60% of its capacity with repeat cruisers.

2. Significant forward visibility from the booking curve.  Cruise companies tend to be 50-65% booked at the turn of each year, before the main selling season officially begins in January (called Wave season).  This gives them great cash flow dynamics (booking deposits hit the balance sheet well before the cruise occurs) and significant visibility which allows them to optimally manage pricing and yields over time. 

3. Large spreads between ROIC and cost of capital.  As discussed above, cruise companies have attractive long-term reinvestment opportunities with high-confidence spreads between ROIC and cost of capital.  A $1 billion ship financed with 80% of 3% ECA financing and 20% of holding company debt at 7% would amount to a 3.8% WACC, well below the high-teens (or better) ROICs generated on new assets. 

4. Portfolio-enhancing investments in private destinations which improve returns for fleets.  We outlined RCL’s massively accretive investment in Perfect Day at CocoCay in which we estimated payback of <6 months due to the yield premiums each visiting ship generates and the on-shore revenue the island generates.  All cruise companies are further investing in magnetic private destinations which should benefit the industry and the companies’ return profiles and economic yields.   

Conclusion

We believe cruise companies will generate >20% EPS growth for the next several years at a minimum.  This growth will be the result of a steady growth algorithm, margin expansion, and accretive capital allocation policies.  Net income should grow while shares outstanding shrink, all while balance sheets deleverage into healthy, investment-grade ranges, fully healing from the Covid shutdowns.  Though the sector’s investment IRRs are attractive without a narrative change, we believe cruise companies have a good opportunity to experience multiple expansion as investors reassess their confidence in the steady growth algorithm and the discount rate that should be applied to this underpenetrated area of the global economy. 

We hope that more investors will come to see the cruise sector more favorably, similar to other companies with similar growth algorithms and consistent performance.  Cruise stocks trade below 15x current year earnings despite this attractive long-term outlook.  Many other stocks with similar growth algorithms, low end market penetration, and higher investor confidence in the future (i.e. lower discount rates) trade above 25x earnings.  It’s a nice setup of >20% IRRs from annual EPS growth with upside optionality should a narrative change occur.