Carnival: Fed Rate Cuts Ease Debt Burden (NYSE:CCL)

Investment theory

Today, cruise stocks sit at one of the sweet spots of risk and reward.

Meanwhile, many cruise operators have raised their outlook for this year as demand for cruise vacations continues to grow. User generation. Then, on the other hand, a set of economic indicators, such as jobs data, inflation, etc., should give the Federal Reserve sufficient reason to cut interest rates.

As cruise demand continues to grow, lower interest rates will give cruise operators more room to expand margins even in a high-demand environment, especially since most cruise operators have significant debt on their balance sheets, putting pressure on their operating leverage.

Carnival Corporation (New York Stock Exchange:CCL) is one of the cruise operators with the largest debt profile when compared. Although it lags behind its peers, it has proven to be an effective force as demand for cruises grows.

The company is expected to report Q3 CY24 results before markets open on Monday, September 30.

Based on the momentum shown by its peers, I now believe Carnival has upside potential and am upgrading the company to Buy.

Cruise industry momentum should help Carnival expand margins.

In my previous article on Carnival, I expressed a neutral view on the name because the company did not show the growth rate it needed. In my estimation, the growth Carnival recorded, especially operating profit, had to grow much faster than its competitors due to its debt burden.

Based on the respective Q2 results of Royal Caribbean (RCL) and Norwegian (NCLH) and Carnival’s last Q-report, we observe that the latter’s revenue growth has outpaced its competitors. Unfortunately, Carnival has struggled to operate with a margin profile that allows it to manage its debt more effectively than its competitors.

Investors will find this line of reasoning particularly useful, as it allows them to compare the company’s operating growth rate with its ability to repay debt through interest payments, which will inform the valuation multiple to use, as discussed later in the valuation section.

Investors can see that Carnival’s TTM debt leverage ratio is currently 2.9x, much better than Norwegian or Royal Caribbean, both of which are over 4x, but Carnival has higher interest expenses. It is therefore very important that Carnival continues to grow its margins, which are currently around 12.1% on a GAAP operating basis and around 20% on an adjusted EBITDA basis.

When I asked Carnival management on its Q2 conference call about their strategic priorities between expanding margins and reinvesting in the business to capture more demand, they sounded more focused on increasing margins first.

I don’t have a metric that tells me how much we’re going to invest in a particular quarter or a particular year. I’m talking about operating margin. There’s still a lot of work to be done. EBITDA margin, when we reach our June guidance, will be about 5 points up year-over-year and a few points down from 2019. So there’s a lot more work to be done, and that’s what the team is very focused on.

Management guided for 2024 adjusted EBITDA growth of 40% to $5.83 billion, according to the last report. This adjusted EBITDA target was revised upward by approximately 3.6% as management sees increasing demand levels. The company said that the increased demand levels give it the confidence to guide a stronger net margin of ~10.3%, which is 75 basis points higher than it had anticipated at the beginning of the year.

Carnival’s peers all reported strong growth in their respective second-quarter reports and are forecasting even stronger growth going forward.

Norwegian raised its 2024 guidance for the third straight time, saying it “expects adjusted EPS to grow approximately 120% compared to 2023, driven primarily by our ability to capitalize on strong market demand.” Royal Caribbean also said it expects “onboard consumer spending and pre-cruise purchases to significantly exceed 2023 levels, driven by greater participation at higher prices.” Royal Caribbean management also added additional insights on the earnings call.

In fact, our research shows that consumers spend more on travel than on any other leisure activity and plan to increase their travel spending over the next 12 months.”

My expectations for Carnival are that management will announce improved margins and financing, and that we expect higher growth across the board, from net margins to adjusted EBITDA.

Carnival Corporation’s valuation suggests some upside.

In my previous report, I had forecasted Carnival to grow revenue by ~7.4% through CY26, with strong growth expected this year. However, given the strong progress the cruise industry has made and the robust outlook, I have also revised upwards my growth targets for Carnival, and now expect the company to report revenue CAGR of ~8% through CY26.

I also expect a moderate revision to Carnival’s margin profile and a larger upside to Carnival’s adjusted EBITDA. I now expect Carnival to post at least a 16% CAGR in adjusted EBITDA through CY26, as management has reiterated its priority to expand margins.

That would put Carnival’s earnings multiple at around 30x going forward, but with annual interest expense of $1.9-$2.0 billion, I would expect Carnival’s earnings multiple to be around 6x in my view.

Assuming a discount rate of 11.8%, $1.28 billion in outstanding shares, and a dilution of approximately 1%, the stock price is expected to rise by approximately 17-18% from current levels.

Risks and other things to know

Interest rates are a big factor influencing Carnival’s earnings potential. In my assessment above, I have not yet taken into account any changes in the current interest rate environment.

Morningstar’s rate cut estimates are in the range of one to two rate cuts, which is consistent with market expectations. It is difficult to estimate the exact impact on Carnival Corp., as the company, unlike other companies, does not accurately describe the duration of its debt and does not disclose the median/effective coupon rate of its debt profile.

In the last earnings call, management added:

From a rate cut perspective, we are in an improving credit environment. And hopefully, our rates, our future rates will be lower not only because of the rate cuts, but also because of the credit improvement and the narrowing of credit spreads. And on top of that, we expect to refinance. And that refinancing will lower our interest expense. So we have a very good opportunity looking ahead, which will be a positive net present value.

So, the fare cuts and strong demand environment for the cruise industry should give a boost to Carnival Corp. But if either demand or interest rates don’t turn in Carnival’s favor, there could be serious headwinds.

Takeaway

Carnival Corp. is expected to continue to benefit from the strong demand environment as its third-quarter report is due in late September. In addition, the company’s debt repayment targets may be relaxed by lower interest rates, which could boost margins. As a result, investors are likely to see earnings multiples expand.

I upgrade my rating on Carnival Corp. to Buy.