Royal Caribbean Is The King

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Business Description       

Royal Caribbean Cruises Ltd. (RCL) is the world’s second largest cruise company.  The company operates under three various brands: Royal Caribbean International, Celebrity Cruises, and Azamara Club Cruises. Royal Caribbean jointly owns and operates TUI Cruises, has a 49% stake in Pullmantur Cruises, and is a minority owner of SkySea Cruises. As of January 26, 2017, the company operates a total of 49 ships with thirteen more under construction. Through these various brands, Royal Caribbean offers trips between 3-20 nights to 535 destinations across all seven continents.  The company’s vision is to generate superior returns to their stockholders by empowering and enabling their employees to deliver the best vacation experience and enhancing the well-being of their communities.

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Investment Rationale

The Roland George Investments Program invested in Royal Caribbean (RCL) in November 11, 2014. The investment was based on Royal Caribbean’s opportunity to capture lost market share from the mishaps of Carnival Corporation, as well as increases in GDP and disposable income following the 2008 recession and the rapid rate of baby boomer retirement. The program also valued the company’s segment specialization strategy to expand their business to growing markets such as the Asia, Latin America and driver markets. Since the acquisition, Royal Caribbean’s stock has outperformed the S&P by 28%, and earnings are set to be double that of 2014. The reasons for the acquisition are as follows:

A buy in Carnival’s wake: Royal Caribbean was poised to capture lost market share from the mishaps of Carnival Cruise Lines. Since 2010, Carnival Corporation’s (Royal Caribbean’s main competitor) market share has decreased from 55% to 48.1% due to 5 major problems that left their company scrambling and Royal Caribbean seeing blood in the water.  With 5 new ships in the horizon potentially generating 1.2 billion in revenue, Royal Caribbean was on their path to major growth in the industry.

Increase in GDP and disposable income: With GDP expected to grow at 2.5% per year and disposable income by 2-3% respectively, the cruise industry was expected to see major gains in the coming years.
Since disposable income and cruise revenues are highly correlated, this positive trend mixed with GDP growth increased total passenger guest by 8% and was expected to grow by 10% moving forward. These were perfect conditions for Royal Caribbean for the following months.

Increased Passengers Entering Retirement: The target market for Royal Caribbean is guests over the age of 50. Aging baby boomers are entering retirement at rapid rates giving Royal Caribbean a stable passenger base to market and tailor its cruises for.

Segment Specialization: In 2012, Royal Caribbean’s profits got affected by the Economic slowdown in Europe. As a result, RCL switched their focus to other fast growing markets such as Asia and Rivers by planning the launch of the 4 most innovative and differentiated ships in the market. The total number of passengers from the Asian Market in 2012 was 1.2 million, and is expected to rise to around 3.8 million by 2020 (216% increase), giving RCL great opportunity to grow.

Recent Performance

Since our last review at the beginning of 2016, Royal Caribbean has lost 3.26% compared to the S&P 500’s 13.9% gain. As a result, The Company has underperformed the market by 17.16%. The following events affected the stock’s performance over this time period.

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A: Slowing Chinese Growth At the beginning of January, China’s manufacturing sector contracted and overall growth of the Chinese economy slowed. Because Royal Caribbean is heavily invested in the Chinese cruise market, Investors became worried that Chinese consumer discretionary spending would fall and Royal Caribbean was oversold.

B: Missed Revenue: RCL released its annual report and reported a revenue of $1.9bn which was a negative surprise of 2.4% compared to estimates ($1.95b). Additionally, Royal Caribbean stated that they expect Net Cruise Costs (NCC) excluding fuel would be 4.5% to 5% higher which caused the stock price to plummet. Royal Caribbean bought back $75m worth of shares between the 3rd and the 4th of February. This alleviated the downward trend in the stock price.

C: CDC Announces Effects of ZIKA Virus: The CDC announced that the ZIKA virus can cause brain damage to infants born of infected mothers. Because over 33% of cruise lines are deployed to serve the Caribbean and South America, Royal Caribbean experienced a significant drop in value.

D: Brexit Causes Uncertainty for European Union: Britain voted to leave the European Union on June 23, 2016. Over 28% of global cruise passengers are from Europe. The immediate effects of the Brexit vote led to uncertainty concerning the future of the EU and the friendly trade agreements that make commerce between European nations easy.

E: Dividend Increase: On September 19th, 2016, Royal Caribbean announced a 28% increase in quarterly dividends to $0.48 per share. Then, on October 27th, 3rd quarter earnings were released. Earnings per share were $3.2 which represented a surprise of 3.09%. Additionally, net income for the 3rd quarter was $693m which represented a positive surprise of 3.45%

F: Double Double Program and Earnings Growth: Royal Caribbean released their 4th quarter report for 2016. In this report, they announced earnings per share of $5.93 which represents a 25% increase in earnings for 2016 over 2015. The company also announced that they expect to reach double digit earnings growth for 2017 which will be the 5th consecutive year this has happened.

Financial Performance

2016 Fiscal year Results: Royal Caribbean reported Unadjusted Net Income of $1.28 billion, or $5.93 per share, compared to Unadjusted Net Income of $665.78 million, or $3.02 per share from 2016.  This represents a 92% year-over-year increase in Adjusted Earnings but this was primarily due to a $411 million impairment of Pullmantur’s assets in 2015 rather than a reduction of costs or increase in revenue. Additionally, Net Yields for the full year increased 3.9%. The strengthening of the dollar and rising fuel prices have worked together to reduce 2016 Earnings Per Share estimates by $0.08. Despite this negative impact, Royal Caribbean’s final Adjusted EPS was $6.08, representing a 25% increase from 2015.

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Fourth Quarter 2016 Financial Results: Total revenues during the fourth quarter of 2016 were $1.909 billion compared to $1.902 billion in 2015. Onboard revenues increased by 4.4% but ticket revenues decreased by 1.1% for the same period (Year Over Year). Net yields (revenues net of variable costs) increased 5.3% primarily due to increased operational efficiencies. In the fourth quarter of 2016, Adjusted Net Income was $264.7 million, or $1.23 per share versus $206.8 million, or $0.94 per share in the same quarter in 2015, representing a 28% increase.

2017 Expectations: Because of their strong position in key markets such as North America, Europe, China, and Australia, Royal Caribbean is expecting Net Yields to increase 4 to 6%. Key to this increased yield is strong demand for Ovation of the Seas in Australia and Harmony of the Seas in the Caribbean. Additionally The deconsolidation of Pullmantur is also aiding expected Net Yield growth. Despite rising fuel prices and a strengthening dollar negatively impacting projected Earnings Per Share for 2017 by $0.10, C.F.O. Jason Liberty claims that 2017 will be a great year for Royal Caribbean due to cost management. Even after taking into account rising fuel prices, interest rates, and a strengthening dollar, E.P.S. for 2017 are projected to be between $6.90 and $7.10. If estimates hold, Royal Caribbean will be well on their way to achieving their goal of doubling 2014 Adjusted Earnings Per Share of $3.39. Compared to 2016, costs are expected to be down in the first half of the year but up in the second half. This along with foreign exchange, rising fuel prices, and the sale of Legend of the Seas mean that E.P.S. for the first quarter of 2017 will be $0.90.

 Analyst Recommendations: Analysts still evaluate Royal Caribbean favorably, with 20 buy, 5 hold, and 1 sell according to Bloomberg. Looking at median price targets, Royal Caribbean exhibits a target of $109, showing a potential upside from its current price of $94.52. With a growth target of 15.7% over the next 5 years, Morningstar provides investors with 4 Buy Recommendations, and 2 Hold Recommendations. Thomson Reuters provides 11 strong buy, 8 buy, 4 hold, and 1 sell recommendation. The average price of the top analysts covering the stock is $105.41.

Growth Analysis

 Increased market share in Asia: With cruise tourism in Asia expected to grow 175% over the next 5 years, Royal Caribbean plans to set their footprint in that market. When compared to the growth rates of North America (17%) and Europe (33%), Asia is the key to future industry growth. Of all the nations in Asia, more than 94% of new customers will be from China. According to the Cruise Lines International Association, while Star, who is the biggest Cruise line in Asia, hosts the largest number of Asian cruises, the volume of scheduled cruises decreased from 420 in 2013 to 352 in 2015. Conversely, Royal Caribbean increased their number of

sailings from 106 to 166 in the same period. In addition, Star reduced their capacity by 11% annually from 668,000 passengers to 545,000 in 2015, while Royal Caribbean increased their passenger capacity from 328,674 passengers to 553,870, resulting in a 68% increase. This trend along with Carnival’s hurt reputation

over the years poses a great opportunity for Royal Caribbean to increase their market share within this market.

Increases in capacity:  Between November 2014 and April 2015, Royal Caribbean welcomed Quantum and Anthem of the Seas. These vessels are the most innovative ships in the market and each can hold up to 4,180 guests.  Additionally, Royal Caribbean plans to expand operations with an additional eight ships planned to enter service by 2020. Collectively, these vessels will add a total of 27,750 berths to Royal Caribbean’s capacity. For 2017, 2018, 2019, 2020, and 2021, Royal Caribbean is expected to change capacity by (1.7%), 3.1%, 7.5%, 3.7%, and 7.4% respectively.

Growing target market: The prime market for the cruise industry is growing as the population ages. Although cruises are marketed for all ages, the average age of cruisers is 50 years old. Everyday there are more Americans retiring as the baby boomers are retiring at fast rates. According to a study made by the Cruise Lines International Association (CLIA), 11,000 people retire every day. Many of these baby boomers entering retirement are looking to travel before they potentially can’t anymore. This key demographic of baby boomers between the ages of 65 and 90 is expected to grow to 25% of the population by 2030. According to CLIA, this aging segment will directly affect the industry at least for the next five years bringing higher revenues and profits to Royal Caribbean and related competitors. Additionally, by 2030, millennials will have much more consumption power and in the long term, Royal Caribbean would like to specifically target this demographic.

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Foreign Exchange Risk: In 2016, Royal Caribbean was forced to write off $24.6 million in cash due to a stronger dollar. In 2014 and 2015 respectively, Royal Caribbean had to write off $6.3 million and $17.6 million. This was primarily due to a strengthening dollar against both the Euro and the Chinese Yuan. Because Royal Caribbean received roughly 9% of their business in China and 38% in Europe. I used the Federal Reserve Bank of St. Louis to run linear regression comparing the end of month change in a broad trade weighted dollar index to the end of the month percent change in the stock price for RCL. Using this data I calculated that at a 95% confidence level, there is a negative correlation between the increase in the value of the dollar and the price of the stock. For every 1% increase in the value of the dollar, the stock price will fall 0.95%. However, this only explains 8.2% of the change in the stock price. Despite a strengthening dollar, because Royal Caribbean is poised to take advantage of the fastest growing cruise market in the world (China) the increased revenues and earnings will outweigh foreign exchange risk. Additionally, Royal Caribbean already takes part in significant hedging activities to minimize cost increases due to fuel and foreign exchange.

Economic and Industry Analysis

8Royal Caribbean is classified in the Hotel, Restaurant & Leisure industry, but in order to get a better forecast of Royal Caribbean’s potential, I classified the company in the Cruise ship Sub Industry. The Cruise ship Industry is divided into deep sea cruising and river cruising, including 450 companies with annual revenue of 39.6 billion dollars in 2015. In this sub industry 90% of revenues are generated from deep sea cruises. The major players in this segment are Carnival Cruise Lines, Royal Caribbean and Norwegian. When it comes to the cruising industry, these three companies make up 90% of the revenue which is why comparing Royal Caribbean to these companies serves as a better baseline for comparison.

The industry is made up of 3 types of cruise ships:  Contemporary, Luxury and Premium. Contemporary cruises are cheaper cruises targeting lower income families. They usually have a lesser quality of food and amenities on the boat. Premium cruises are the second best in terms of quality because they are equipped with slides, pools and Casinos. The downside is that they are not as nice and they are drastically smaller. Luxury cruises are the top of the line and usually cruise for 1-2 weeks. Luxury vessels are able to accommodate more than 5,000 people and are currently the largest and most sophisticated vessels in the world.

When looking at the Cruise industry as a whole, there are a few main growth factors to look at. The cruise industry is heavily dependent on disposable income of its passengers, GDP growth, guest growth and environmental and health concerns.

Disposable income trends: Disposable income in the industry is very important. If cruisers do not have extra income to spend on vacations, they will not. The financial meltdown in 2008 and 2009 stopped a 19 year streak of positive disposable income numbers which hurt the cruise industry with lowered EPS and revenues. The surprising thing about this is that the total passengers still increased even when disposable income decreased. According to the IBIS World, disposable income increased at a compound growth rate of 1.5% from 2010-2015. Real disposable income grew by 4.5% and 3% in 2014 and 2015 respectively primarily due to falling energy prices. This lead to a comparable increase in consumption growth. Now that energy prices are stabilized and expected to rise, we should see consumption taper off in 2017. A real threat to consumer

disposable income is expected inflation of 2.4% to 2.6% while unemployment is only expected to decrease 0.2% for the year.

9GDP growth: Being a cyclical stock, Royal Caribbean’s business is positively correlated to GDP. GDP Growth Rate in the United States has averaged 2.075% since 2013. The Bureau of Economic Analysis announced that the Real Gross Domestic Product in the United States expanded 2% in the fourth quarter of 2016 over the previous quarter. Expectations for Real Gross Domestic Product growth for 2017 hover around 2%. Because nearly 50% of Royal Caribbean’s earnings are sourced from the United States, we can expect to see earnings per share growth comparable to that of 2016 for the coming year. This means that the cruise industry as a whole can expect to see moderate gains resulting from strong North American Demand.

Guest growth:  Worldwide, the cruise industry has an annual passenger compound annual growth rate of 6.55% from 1990-2019. Growth strategies to date have been driven by larger capacity new builds, ship diversification, more local ports, more destinations and new-on board and on-shore activities that match the demand for consumers. These activities help increase penetration in markets by adding new innovative ships with more capacity and higher efficiencies. In 2015, 20 million passengers cruised from North America, Asia, and Europe alone, with 12 million sourced from North America, 6 million from Europe, and 2 million from Asia. The largest gains in customers are expected to be from China because they make up more than half of the Asian market currently. By 2021, Asian demand is expected to jump to 5.5 million customers. 4.3 million of these customers will be Chinese. Royal Caribbean is well situated to take advantage of these gains because of their continued investment into the Chinese market through a joint venture known as SkySea.

Environmental and Health Concerns: In the past, ships have been discharging their waste directly in the ocean. In 2010, there was a move by the Cruise Line International Associates (CLIA) about going green and keeping the waters safe. Companies in the industry were fined millions of dollars for dumping their waste in the ocean which made companies realize that they would save money by saving their waste and getting rid of it at the ports. The cruise industry has developed an initiative where they reuse the waste as energy on the vessel.10

The more predominant factor in the industry is passenger safety. Over the past years there have been tragic occasions where cruise ships had problems. Between 2010 and 2012 carnival’s cruises caught on fire and Costa Concordia crashed in the Mediterranean sinking the boat. Fortunately no one was hurt because it sank slowly and close to shore. The most recent accident was when a ship lost all power and the sewage went into all the rooms. All these occasions were produced by Carnival Cruise line and as a result their market share has decreased from 55% to 48% in recent years. This has allowed royal Caribbean to increase their market share by 5% between 2015 and 2016 in revenue for the industry.

Pro Forma Income Statement

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I constructed a Pro Forma Income Statement to estimate Royal Caribbean’s revenues and earnings per    share growth for the next two years. These estimates were found through analyst estimates, research of Royal Caribbean’s managerial expectations and historical growth rates: According to my analysis, I expect Royal Caribbean’s revenues to be $8.78 billion by the end of 2017 and $9.074 billion by the end of 2018 resulting in a 3.3% increase.

Revenue Growth: Royal Carribbean and the industry as a whole have very seasonal revenues with the highest revenues coming in the second and third quarters of each year. I calculated the average year over year growth rate for each quarter using historical data for the past 36 quarters. The average growth rates for the first, second, third, and fourth quarters were: 3.75%, 3.62%, 2.75%, and 3.45%. Then future revenue was calculated by multiplying current 2016 quarterly revenue by the average quarterly growth rate. Using the same method but with my estimates for 2017 and then 2018, I calculated the estimated revenue for both 2018 and 2019. The resulting estimates are in line with current analyst estimates.

Cost of Revenues: Since Royal Caribbean is a seasonal business, I estimated cost of revenues based on the historical averages of each quarter for the past 2 years to come up with estimates for 2017 and 2018. I used recent data because since 2014, the company has made it a point to reduce their costs by increasing efficiency. I arrived at a cost of revenue percent of 40%, 38.4%, 34.9%, and 36.9% for quarters 1 through 4.

Operating Expense: I estimated Operating expenses by calculating the percentage of revenue it made up quarterly since 2009. Then I found an average percent for each quarter typically. For the first, second, third, and fourth quarters, I calculated 52%, 50%, 40%, and 51% Using these numbers, I calculated forward operating expenses as a percent of my projected revenues.

Earnings per Share Growth: Based on Royal Caribbean’s estimated revenue growth, cost of revenue, operating expenses and Non-operating Income, I expect EPS of $6.49 for 2017 and $6.83 for 2018, representing a 5.2% increase. This estimate is in line with the low end of analyst estimates.

   Valuation

The Franchise Value Model: Incorporates the company’s ability to repeat its business model at a lower cost. Franchise Value is created when the company uses its competitive advantage to reinvest its retained earnings on future products to repeat its business. Royal Caribbean is currently reinvesting their earnings into the company for the production of new ships. The company is coming out with new ships and constantly on the cutting edge of the cruise industry. Additionally, Royal Caribbean is focusing on reducing costs to promote profitability. For this model I used a ROE of 14.94%, a book value per share of $40.97, a growth rate of 2.3%, a required rate of return of 11.27%, and a Future ROE of 15.43%. This resulted in a fair value for Royal Caribbean of $122.83, an undervaluation of 29.95% (Appendix 4).

Growth Duration Model: The Growth Duration Model finds the fair value of a stock by comparing it to its industry as well as a major competitor. I compared Royal Caribbean with the Hotel, Resort, Cruise industry and also with Carnival, their top competitor. The industry P/E used in the model is 15.53 and an estimated industry growth of 19%. Using my estimated EPS of $6.49, Royal Caribbean is undervalued by 6.42%. Carnival has a P/E of 15.01 and a growth rate of (4.0)%. When compared to Carnival, Royal Caribbean is undervalued by 26.63%. Altogether, my analysis results in a fair value for Royal Caribbean of $110.14, an undervaluation of 16.53 % (Appendix 5).

Average Fair Value: Based on the two models used to calculate the fair value for Royal Caribbean, the average fair value for Royal Caribbean is $116.49, representing an undervaluation of 23.23%.

 Reasons to Hold

Earnings Per Share Growth: Strong management has set goals of doubling earnings per share every 3 years by focusing on reducing variable costs and maintaining revenues. For example, in 2016 net yields increased 5.3% promoting increased margins. For 2016, Adjusted Earnings Per Share were $6.08 which shows a 25% increase over the previous year despite a strong dollar and rising fuel prices. Because of strong demand in Europe and China, Net Yields (revenues minus variable costs) are expected to increase 4% to 6% in 2017. Even though fuel prices are rising and the dollar is strengthening, Earnings Per Share for 2017 are expected to be $6.49 according to my estimates. This puts Royal Caribbean within sight of doubling Earnings Per Share of 2014 ($3.39). If successful, this will be the 5th consecutive year that RCL has doubled Earnings Per Share.

Demographic and Capacity Growth: Because the primary market of the cruise industry (individuals aged 65 to 90) is expected to grow to 25% of the population in the United States by 2030, Royal Caribbean and the whole industry can expect to see a large increase in North American demand in the next 5 years as more individuals retire every day. This combined with millennials increased spending power by 2030 and Royal Caribbean’s average annual capacity increase by 4% means that revenue will continue to increase.

Chinese and Asian Demand: Compared to the growth rates of North America (17%) and Europe (33%), Asia is the key to future industry growth In the next 5 years, Asian demand for cruises is expected to rise by 175% to 5.5 million customers annually. 94% of these new customers are expected to be Chinese. Royal Caribbean is poised to take advantage of this trend considering they are the second largest supplier of cruises in Asia (25.6%) and increased their passenger capacity by 68% (553,870) between 2014 and 2015

Recommendation: Royal Caribbean is the only cruise line that consistently outperforms the S&P 500 and heir competitors. The company has done a great job strengthening their brand and growing not only their target markets, but their market share as Asian markets are expected to grow by 174% by 2020. Adding Carnival’s hurt reputation, increase in capacity, favorable economic trends in China and top of the line vessels being built by Royal Caribbean, my estimates result in a fair price of $116.49, an undervaluation of 23.23%. As a result, I recommend at this time that the Roland George Investments Program HOLD all 850 shares of Royal

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