Geoff Gannon June 28, 2012

Carnival (CCL): No Pricing Power – But Plenty of Value Created Over Time

Geoff here.

Since Quan started writing about Carnival (CCL) here on the blog, we’ve gotten a lot of emails from people saying the cruise business is a bad business – even for the leader – and that these companies only destroy value.

It’s perfectly valid for people to have a different view of the future than Quan and I do. But when it comes to the past – it’s really not possible to argue Carnival has destroyed value.

This  may sound obvious to some. But I’m going to take a moment to explain it – because it’s a really important concept.


Carnival Has Zero Pricing Power

Carnival has no pricing power. The product economics of the business are not good. They can’t raise prices relative to competitors and still fill their ships. This is not Wrigley. This is not Coca-Cola (KO). This is not See’s.

But Wal-Mart (WMT) never had a dime of pricing power. Neither did Southwest (LUV). I don’t care if my PC has Intel inside or AMD inside. If Intel doesn’t maintain an advantage in terms of cost, performance or both – which requires constant improvement – it also has zero pricing power.


Return on Capital is Driven by Both Product Economics and Competitive Position

Most companies that earn economic profits do not earn them because they are in an inherently better business. Chris Zook’s series – he works for Bain consulting – estimated that two-thirds of economic profits are due to a superior competitive position. Only one-third is due to superior product economics.

I love superior product economics where I can find them. It is better to sell candy than cruises. But even in candy – it is better to be See’s than Russell Stover.

Most companies earn economic profits because they are – at the moment – in a better competitive position. Unfortunately, it is difficult to know whether the competitive position of most companies will get better, worse, or stay the same over the next 5 years, 10 years, 20 years, etc.

But some corporate records – and family fortunes – are built on maintaining a constant competitive lead in an otherwise unimpressive industry.

In no sense can it be said that Wal-Mart, Southwest, or Intel were ever in an industry with good product economics. But in those periods where they earned good returns on capital – they had a competitive lead on the completion.


If You Built a Fortune – You Created Value

This is kind of obvious. But it’s worth mentioning. Anyone you see on a list of billionaires either created or inherited a fortune. You can always trace those kinds of fortunes back to some sort of shareholder value creation. No one earns a billion dollars in wages. They earn it from owning something and having that something increase in value.

That obviously doesn’t mean Rupert Murdoch – simply because he’s a billionaire – necessarily created value in the last 10 or 15 years. It doesn’t mean his unleveraged returns were terrific. You’ll have to look into the past of News Corp (NWSA) to figure that out.

But it does mean he created shareholder value at some point.

Micky Arison, Carnival’s Chairman and CEO, is ranked #75 on Forbes list of American billionaires. He has a net worth over $4 billion. That comes from owning Carnival stock.


Slow and Steady Value Creation – With the Use of Debt

Carnival’s stock price has compounded at a rate of 9% a year over the last 25 years. They’ve also paid dividends in every year throughout that period except for when the dividend was suspended during the financial crisis.

For example, since 1991, Carnival has returned $8.7 billion through cash dividends and share repurchases – netted against share issuance. Today, the company has about $9.3 billion in debt.

Some people have emailed me and Quan about the fact that Carnival borrows money to build new ships that have a poor return on capital.

This is a legitimate concern. But it’s not supported by the past record. The issue of Carnival’s returns on incremental investment are complicated by a tripling of oil prices over the last decade or so.

If you look at returns separate from fuel costs, there has been no deterioration in Carnival’s return on investment. It has actually risen a small amount over the last decade.

If you look at Carnival’s returns on capital after fuel costs – which is obviously what the company reports – returns have been more than cut in half.

Which is the right way to look at the company’s returns?

Let me put it this way. If I’m analyzing an oil company, I do not assume that today’s oil prices should be the basis of long-term investment decisions. Likewise, I hope that Carnival decides whether or not to contract for new ships with more in mind than what oil prices have been in the last few years.

It’s worth mentioning that the period where there was deterioration in Carnival’s ROI was just in the last 5 years. During this time, real oil prices were as high as they have ever been.

Nonetheless, Carnival’s return on net tangible assets – basically the company’s unleveraged return on equity – has not been below 8%. What worries people – and justifiably so – is that this 8% number is the present number.

Before 2002, Carnival almost never earned less than 15% on its net tangible assets. From 2002 through 2007, Carnival earned about 13%. It is the returns from 2008 through today that concern people. They now average about 8%.


Carnival’s Capital Costs in Perspective

Carnival aims to have a credit rating of Baa or higher. Moody’s recently rated them higher than that. Today, the long-term Baa yield is about 5%. Again, I’d estimate Carnival’s return on net tangible assets has been about 8% since the crisis. And much, much higher in the past. I’d also estimate that excluding fuel costs – Carnival’s return on capital today would be very similar to what it had been in the past. This is not to say fuel costs aren’t real. They are totally real – Carnival does not hedge in any way. It’s only to say that the decline in Carnival’s return on capital is due to rising fuel costs rather than deteriorating competitiveness.

Carnival’s two big competitors – Royal Caribbean (RCL) and Norwegian – use a lot more debt relative to their size than Carnival does.  In fact, Carnival and RCL have very similar amounts of debt in total dollars. Yet, Carnival has twice the market share of RCL. And every point of market share at Carnival tends to convert into more EBITDA than over at RCL.

Carnival is not an especially reckless borrower by general standards. And they are actually a conservative borrower by cruise industry standards.


Carnival’s Return on Net Tangible Assets Are Good Relative to Other Asset Heavy Businesses

I like an asset light business as much as the next guy. Probably more. At the same price-to-normal earnings I am much more excited by an advertising agency than a cruise line, railroad, etc.

But let’s be honest here. There is a reason Carnival borrows. They borrow to contract for new ships.

So, let’s compare Carnival’s return on capital to the returns on capital of other well-known asset heavy businesses.

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Southwest (LUV) 4% 7% 4% 7% 6% 8% 2% 1% 5% 2%
Norfolk Southern (NSC) 3% 4% 6% 8% 9% 9% 11% 6% 9% 11%
Exelon (EXC) 7% 4% 9% 4% 7% 12% 12% 11% 10% 9%
Aqua America (WTR) 7% 6% 6% 6% 5% 5% 4% 4% 5% 5%
Carnival (CCL) 10% 8% 8% 9% 9% 9% 8% 6% 6% 6%


Those numbers include intangibles. As I mentioned before, Carnival’s return on net tangible assets are higher. They have intangibles on the balance sheet. For example, they overpaid for Princess.

Since Carnival’s numbers are so comparable to the other four companies there – the question is:

If Carnival has destroyed value over the last 10 years and you expect them to destroy value over the next 10 years, do you think the same about:

  • Southwest
  • Norfolk Southern
  • Exelon
  • Aqua America

I don’t. And I don’t see how Carnival’s future is obviously much worse than those companies in terms of future returns on capital. I just think that we have seen a trend in the last half of the last decade – high oil prices, bad economy – that if extrapolated into the distant future makes Carnival look terrible.

But I’m not sure why any macroeconomic trend of the recent past should continue in the future. And I don’t see any evidence of a competitive trend in the data.


Carnival’s Return on Capital Has Never Been Great – It’s Always Been Adequate

I’ve said before that Warren Buffett talks about return on capital of Berkshire subsidiaries using something similar to Joel Greenblatt’s ROC calculation.

Basically, Buffett uses a return on unleveraged net tangible assets.

Carnival has intangible assets. They’ve bought cruise lines in the past. And, yes, they overpaid for Princess.

How has Carnival’s return on net tangible assets looked in the past?

The worst year was 8%. The best year was 20%. Carnival’s return on net tangible assets has generally been very steady. In fact, by any statistical measure of variation you throw at it Carnival’s ROI generally will rank among the least variable of any publicly traded company outside of regulated monopolies.


Carnival Has No Pricing Power – But It Holds Real Costs Down

I think the best explanation of how Carnival tries to create value over time – despite having zero pricing power – comes from something Micky Arison said in a 2008 earnings call:

We were able to offset inflation during the year through economies of scale and increased efficiencies; however, as I’ve indicated on previous calls, our long-term track record of flat cruise costs per available berth day dating back to 1990 is getting harder to maintain in the face of moderate capacity growth. As a result, our goal for future cruise costs per available lower berth day is in the range of flat to one-half the rate of inflation.

It’s important to understand that Carnival has been pushing down real costs per person per night. That is their strategy.

How do they do this?


What Do I Mean When I Say Carnival Has Economies of Scale?

Carnival now serves about 9.6 million passengers a year. Carnival has some premium lines where passengers stay for over a week. So, on average, those 9.6 million passengers are each spending 7 to 8 nights with Carnival.

I understand why many people think things like food costs are something Carnival can’t control – but that’s not true. Carnival can control food costs. That’s actually one of the key parts of their business. If you are serving hundreds of millions of meals a year, who knows how many drinks, etc. there are economies of scale when you are purchasing and providing that much food, drink, live entertainment, etc.

If there were no economies of scale – we’d see real costs rising. After all, the stuff Carnival is purchasing – food, drinks, etc. – is not getting cheaper on retail shelves. It’s getting more expensive in nominal terms. In most industries, that’s exactly what happens. But even now, Carnival still tries to target cost growth per passenger below the rate of inflation.

This is what I’m talking about when I say “economies of scale”. I actually don’t mean combining corporate offices. In fact, Carnival does not move their subsidiaries’ main offices to their corporate HQ. Analysts always ask that question. And Carnival’s management always says that’s a bad way to save on costs because it disrupts that line too much. They’d rather try to save money on the actual cost of each voyage.

So, as silly as it sounds – when I say Carnival aims for economies of scale – I really do mean they aim to buy incredible quantities of shrimp for less than you ever could, put on live shows for less than others could stage them, buy lots of booze at rock bottom prices, get the best deals to drive volume without driving up travel agent commissions and transportation costs to the ship, etc.

This is very boring stuff, but this is the profit pool for cruise lines. This is where you make your money.


Why Carnival is a Company That Interests Me

Why I’m interested in Carnival can be stated simply in terms of 4 long-term qualities:

  • Long history of adequate (8% to 20%) return on net tangible assets
  • Strong competitive position
  • Favorable long-term prospects (low competitive risks, tech risks, etc.)
  • Management focused on the key metrics – costs – that drive economic profits in the industry


Why Now is a Time When Carnival Interests Me

For me, these 4 qualities make Carnival an interesting company. What makes now an interesting time to look at Carnival?

Looking at the last half decade or so:

  • Returns – excluding fuel costs – have not deteriorated
  • Fuel costs are as high in real terms as they’ve ever been
  • Interest rates are as low as they’ve ever been
  • The macro economy is as poor as it’s ever been
  • Cruise industry capacity growth is as low as it’s ever been

To put capacity growth in perspective, over the last 20 years Carnival has tended to grow capacity in the high single digits. Right now, they are expecting capacity growth to be a little less than 3%.

This obviously hurts their efforts to reduce per passenger costs. But it helps their expected future returns on capital. The slower supply increases in relation to demand, the more likely it is that future ROI will be greater than today’s ROI.


Is Now Normal?

And yet, Carnival trades at a completely normal P/E of 16. To me, it seems much more likely than not that Carnival’s current earnings understate Carnival’s normal earning power. And that the stock could rise quite a bit over the next – say – 5 years without any multiple expansion. This is simply because a lot of things can cause today’s earnings to rise:

  • Tomorrow’s fuel costs being lower than today’s
  • New borrowing being done at lower interest rates than old borrowings
  • Supply and demand being more favorable in the future than today

So raher than seeing Carnival’s next 10 years as an inevitable continuation of the last 10 years, I think the future is most likely to be brighter than the last few years. That’s because the last few years featured so many macro headwinds that will eventually even out over time.