Norwegian Cruise Line Holdings - Supply and Demand for the Ocean Cruise Market

Vacation is a secular growth market.  As incomes rise and people grow their discretionary budgets, they want to travel.  They might replace their mattresses less frequently if budgets are tight, but they still want to go out into the world - to Disneyland, to Las Vegas, to the beach, to Europe, etc.  There are lots of options across the spectrum of price, experience, location, and other factors.  Cruising offers one of the most cost-effective ways to see the world in a turnkey, low-stress, enjoyable way.  I thought I'd shed some light on the industry and provide some context for supply/demand trends and the unique capital intensity of the industry.

Recurve owns Norwegian Cruise Line Holdings, so when I use practical examples, I will mention NCLH.  (Disclaimer: this post does not constitute investment advice and is for informational purposes only.) 

First, let's talk about supply and demand dynamics.

Supply

Industry supply is rather easy to show because the global fleet is well-known and new deliveries are highly visible.  There are four large holding companies that control 90% of global capacity: Carnival Corp (CCL), Royal Caribbean International (RCL), MSC Cruises (private), and Norwegian Cruise Line Holdings (NCLH).  There are smaller cruise lines like Disney, Virgin, Ritz Carlton Yacht Collection, Viking, and others, but the four large companies control >85% of the the ocean cruising market.  That said, individual cruise lines within these holding companies serve various sub-segments of the market.  For instance, AIDA is a brand within Carnival that serves the German-speaking market, while Regent Seven Seas is a luxury brand within the Norwegian Cruise Line Holdings portfolio.  In general, brands within RCL and NCLH primarily source from North American markets and exclusively speak English onboard. 

Due to long lead times for new ships, we also have high confidence in the industry's future capacity.  See below for CLIA's account of industry supply by year.

Source: CLIA

There are only a handful of shipyards in the world that build cruise ships for the major brands, and we know what's on the order books through 2028.  Lead times are many years and the earliest a cruise line could receive a new large ship, if ordered today, would be 2028.  In other words, the gross new supply additions are highly visible to all participants.  This is important because it allows for the industry to absorb known capacity increases rationally and methodically - especially because cruise lines can take bookings 2-3 years in advance of the sailing date, and sometimes even farther out.  There is significant planning and booking activity that begins well ahead of the delivery date.

The cruise industry has some unique attributes when it comes to its assets and supply dynamics.  Let's go through them:

1. Cruise lines own all their ships.  This is different from most big hotel operators (for instance, Marriott owns or leases <1% of its properties) and airlines (American Airlines owns about half, leases the other half).  The "why" is interesting, which I will discuss below in more detail.  The short answer is that cruise companies have unique access to the cheapest financing available and that the paybacks are attractive enough to justify owning and operating their ships. 

2. Large cruise ships are built by shipyards in Germany, Finland, France, and Italy.  Other large shipyards exist in Japan, Korea and China, but none have any significant market share in the cruise segment.  Cruise ships are hard to build.  Asian shipyards haven't been able to build them profitably. 

3. Combining points 1 and 2 above, what we have is a concentrated service industry (the cruise lines) that own and operate their assets while competing in a fragmented vacation market, buying from a concentrated manufacturing base (the shipyards).  The cruise industry is concentrated, but they compete much more with other vacation alternatives than with each other. Shipyards are generally running at full capacity in their cruise business, which is why the order books are only open for delivery starting in 2028.

4. Finally, cruise ships are highly customized by brand and by class.  They are not easily interchangeable from brand to brand, as a 737 or A320 might be for airlines, or even a downtown hotel for Marriott.  Transferring ships does happen on rare occasions, but doing so can involve significant changes to venues, formats, supply chain, and more. 

Capital Intensity

Before moving on to demand, I want to double-click on point #1 above - cruise lines buying and owning their assets.  To support their strategic shipyard operations, the shipyards' host countries offer cruise companies export credit agency (ECA) debt.  The mechanics work like this:

1. Let's say a cruise line orders a ship with 4,000 passenger capacity at $250k per berth, or $1b, for delivery in 2028.  At signing, $800m of ECA financing would be arranged based on sovereign rates, plus a small spread.  These loans amortize over 12 years and are fixed - there is no mechanism for interest rates to increase even if sovereign rates change later.  For NCLH, its average ECA interest rate for its deliveries through 2028 is 2.5%. 

2. The cruise line would make an initial down payment of $20-30m upfront.  Additional progress payments would be made along the way, typically starting 18-24 months before delivery. 

3. Upon delivery, the remainder would be paid by the cruise line to the shipyard.  The $800m ECA would be paid to the shipyard as well, and the liability would be transferred to the cruise line with asset-specific debt.

Typically, cruise ships generate an unlevered cash payback of 5-6 years which is quite strong for assets that have a 30-year useful life.  Of course, their highest-earning years are upfront when customers want to try the latest and greatest hardware.  Let's look at some of this math to determine the return on equity capital:

• Let's say NCLH buys a $1b ship with 80% loan-to-value, has a 2.5% export credit agency loan with 12-year amortization, and a 5-year unlevered payback. 

• This means a $200m equity check and an $800m loan.  A 5-year unlevered payback implies $200m of cash flow.  From this $200m, we subtract $67m of debt amortization ($800m/12) and $20m of interest expense (2.5% on $800m).  That results in levered cash flow of $200m - $67m - $20m = $113m.  The return on its "equity" payment in the ship, on excluding corporate overhead, would be $113m/200m, or 56.5%.  There are other nuances to this analysis, but the broader point is that the economic yields are attractive. 

One criticism of the cruise industry that I have heard is that it is capital intensive which hurts free cash flow.  However, with return dynamics like those described above, I don't mind the capital intensity.  Capacity growth is measured and predictable which reduces the risks around investing in new ships.  If it were possible for a third-party to buy the ships and lease them to the cruise lines at a lower total cost of ownership, I would be all for it.  But with the ECA financing and the unlevered return dynamics described above, I believe the cruise lines are the logical owners of their assets and generate returns far in excess of their incremental cost of capital.

Demand

Now, let's talk about demand.  The addressable market is huge because the sector can attract all types of vacationers.  Those that want to go to the beach can hop on a Caribbean cruise.  If you want to eat, drink, and socialize - there are options for that as well.  There are brands, ships, and itineraries that fit different tastes and preferences.  All have all-inclusive basic food and non-alcoholic beverage services with a plethora of options to upgrade the experience (at a cost).  Cruise ships are moving city-hotels, with hospitality amenities and venues serving all types of preferences at every tier of service. 

Less than 10% of major source market populations cruise, and less than 1% of the global population has ever cruised.  NCLH has less than 1/4 of the room capacity of just the Orlando market, but it delivers guest experiences globally.  Additionally, cruises offer compelling value - especially now - compared to land-based alternatives.  See below for NCLH's side-by-side comparison:

Source: Norwegian Cruise Line Holdings Investor Presentation

One important consideration on demand is that cruise ships sail full at all times (ex-Covid).  Load factors average 105% over the course of the year, where 100% assumes double occupancy (typically >100% is achieved with children).  Variable costs are rather low once a ship is sailing, so most times it makes economic sense for operators to fill them up.  The industry has undergone significant rationalization on this front - because of the high fixed-cost dynamic, it used to be characterized by steep discounting to fill ships at the last minute.  Customers knew this and would take advantage of last-minute deals.  However, the three major holding companies have invested significant resources and efforts into "flipping the booking curve" so that, for the best cabins and experience, it is beneficial to book early (similar to airlines).  On some sailings perhaps interior cabins would be discounted close in, but nice balcony suites are likely already been booked.  These days, NCLH is ~65% booked for the next 12-month period, with much higher booked rates closer in. 

If load factors are constant at 105%, demand must be measured in revenue terms rather than volume terms.  Total demand = passengers carried x average per diems.  This can be further broken down between ticket prices and onboard spend.  Before Covid, cruise companies would generally extract net pricing growth of +3-5% per year, meaning demand was growing in excess of supply growth, which averaged about 5% from 2016 to 2020.  In good years, net yields rose closer to 5%; in bad years it was closer to 3%.  This occurred with steady, healthy supply growth coming into the industry year-after-year.  I believe the same dynamic will resume going forward, but there is a chance of a "burp" of better pricing in the years following 2025, when new deliveries start to slow down while demand continues to increase, as shown below.

Fincantieri, one of the largest shipyards serving the cruise industry (~40% market share), believes the market will become undersupplied in 2025/2026.  How they define demand isn't clear, but I believe they are more right than wrong, with cruise lines taking delivery of their pre-Covid orders but not yet replenishing their backlogs. 

Source: Fincantieri Investor Presentation

Finally, there are some other notable industry characteristics that help generate and meet demand over time:

1. There is a high repeat cruising rate.  For NCLH, 45-60% of their brands' customers are repeat.  It's important to have a healthy ratio of repeat and new-to-cruise/new-to-brand customers to support future capacity growth.

2. Cruisers love to cruise.  Satisfaction rates tend to be well north of 90%, depending on the brand, and are similar to all-inclusive resorts. It's one of the highest-rated vacation options for consumers.

3. Because of the nuances involved in brand selection, itinerary selection, ship selection, and cabin selection, travel agents remain the primary channel for customers to book cruises.  Over time their direct business has grown larger, but cruise lines have been able to leverage a large, distributed trade group that has been loyal to the category for a long time.

4. Cruise lines are priced very favorably vs. land-based alternatives. Additionally, the industry priced aggressively in a short selling season as cruise lines got their ships back in the water after the Covid shutdown period. Meanwhile, land-based resort destinations have benefited from strong demand and very strong pricing growth.  As shown in the chart above, the gap between cruising and land-based equivalent vacations is now larger than ever at 40-50% (vs. 20-25% normal).

5. This goes without saying, but cruise ships can move around and change itineraries if there are weather disruptions, if demand isn't developing as desired, or for other optimizations. 

6. Cruise companies vary their advertising, bundling, and promotional strategies across different source markets (e.g. Americans for Europe, Europe for Alaska, etc.).  There are a lot of ways to maximize demand and optimize demand generation over time, source markets, and channels. 

The cruise industry has fascinated me ever since I first looked at it because it is benefits from long-term secular demand and capacity tailwinds and because its benefits from vertical integration still seem misunderstood by those who haven't studied it carefully.  There are long-term drivers to support very healthy normalized EPS growth for all players, over a medium- to long-term horizon. 

I believe all the English-speaking brands have attractive supply/demand characteristics, but I have a preference for NCLH above the others for a handful of reasons:

1. It has the most capacity growth in its pre-Covid order book, to be delivered through 2028, with extremely favorable economic yield potential (pre-inflation costs with post-inflation revenues).

2. It has size and scale, but its brands are still not fully penetrated in all the important cruising markets.

3. It has the highest proportion of US customers, which are the highest yielding in the world.

4. I have a preference for its go-to-market strategy with more luxury/upscale brand positioning, less discounting and promotional activity to fill cabins (it prefers to add value by bundling amenities instead of discounting price), and longer, more exotic itineraries which attract loyal and less price sensitive customers - and generate superior yields. 

This post gives a glimpse into some of the reasons why like the cruise industry and hopefully gives you a feel for how and why I believe the leading companies will create value over time.

Disclaimer:

The information in Recurve Capital’s Insights constitute Recurve’s own opinions and should not be regarded as a description of services provided by Recurve Capital LLC. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.

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