Home Alternative guide Cruises may seem safe, but don’t go down with the ship

Cruises may seem safe, but don’t go down with the ship


As investors anxiously wait to navigate a receding pandemic, they may focus on stocks that will benefit from a return to normal – but they might find dangerous and unexpected undercurrents that thwart them.

Take stocks of major cruise lines Carnival (CCL), Royal Caribbean (RCL) and Norwegian (NCLH), for example. These have already fully returned to their pre-pandemic business valuations with no commensurate recovery in sight. This presents a serious problem for investors since the risk/return ratio is negative. Unlike most other industries, whose inventories have rebounded, the cruise industry is still incurring losses, sustaining significant Covid risks, and balance sheet leverage is adding structural impediments to restoring profitability.

Stock prices may look down from previous years, but dilutive capital raises and debt increases have boosted valuation significantly. Pre-pandemic cruise line valuations don’t have a magic formula for investors to follow, but the 2019 company values ​​offer a helpful guide. The fact that the valuation has been surpassed signals that investor enthusiasm is considerable and a full resumption of activity is largely expected. The probability of investor disappointment is high.

In a recent research report, Morgan Stanley warns that the Omicron variant will lead to a slower and weaker recovery than investors had expected. There is an increased risk that more capital raises will be needed to offset highly leveraged finances. Additionally, the tepid price environment undermines the bullish scenario of pent-up demand which is boosting pricing power.

The Omicron variant temporarily sent cruise industry stocks tumbling, but the negative impact on activity persisted. The Centers for Disease Control and Prevention’s warning to avoid cruise travel has disrupted the usual seasonal strength in bookings for first- and second-quarter trips. Continued uncertainties regarding international travel are likely to worsen service disruptions. A recent Morgan Stanley survey of travel agents reveals the biggest weakness in business over the past 12 months.

The profitability of the cruise industry is likely to be undermined by prevailing inflationary forces. Fuel, labor and food costs have seen significant increases, in addition to Covid protection expenses. Growing industry debt at higher interest rates has inflated interest charges. Royal Caribbean and Carnival will see annual interest payments increase by more than $1 billion from 2019 levels.

Another potential under-the-radar expense comes from reports that the International Maritime Organization is considering a new tax on shipping to help build a global network of alternative fuel stations for ships. The proposal calls for charging ship operators $100 per metric ton of carbon dioxide emitted per voyage. If implemented as proposed, the three cruise lines would incur estimated annual costs of $2 billion.

Hindenburg Research, known for its militant short selling, recently argued that Royal Caribbean’s fundamentals were permanently damaged by high debt servicing. Hindenburg warned that shareholders could be further diluted by capital increases.

Wall Street will face risks to the cruise industry that have never impacted stocks. The potential for severe operational disruptions should warrant a discount to the shares to account for the increased investment risk. Yet paying the same enterprise value now as before the pandemic leaves little room for future shareholder rewards.

Major cruise line bonds, with a yield of around 5% over four to five years to maturity for risky debt, would most likely be a better investment than stocks.

There are also better investments on the reopening spectrum, including airlines such as Delta (DAL) and United Airlines (UAL). They are still slightly below their pre-pandemic business valuations, and the outlook for strong cash flow generation is improving.

Strong cruise demand can certainly pick up momentum when the pandemic subsides. But in the short term, demand has waned and prices are weak. Trying to seize the reward of investing by seeing through this trading weakness for a brighter day is questionable given the degraded profitability outlook and current valuations. Expect choppy waters ahead.

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