Carnival: Get On Board At 10.7x P/E – Carnival Corporation & Plc (NYSE:CCL)

After the further pullback from the coronavirus scare, shares of leading cruise company Carnival Corporation (CCL) are looking like a great opportunistic purchase for long-term value investors in these frothy markets. Shares of Carnival Corporation have had a rough past couple of years falling around 36.4% from their highs of $71.61 at the beginning of 2018 when growth investors were valuing the company around 16.8x P/E. This fall now leaves the shares with a dividend yield of 4.2% while trading at 10.7x P/E based on the $4.25 midpoint of management’s guidance given in the Q3 2019 earnings release.

Data by YCharts

Why the Pessimism?

As outlined in the Q3 2019 earnings release, Carnival faces many current headwinds, including weakening economies affecting the Europe & Asia segment, U.S. government’s policy change on travel to Cuba, new capacity coming online in the industry, a strong dollar, and of course, the International Marine Organization (IMO) 2020 regulations. This commentary from management would of course now need to be updated for the coronavirus epidemic that will likely wreak havoc on global tourism.

Also of note is that since June 2019, both booking volumes and prices for the first half of next year have been running lower than the prior year even though the company expects capacity growth of approximately 7 percent. This increase in capacity would be one reason Carnival expects depreciation to be approximately 9.1% higher at $2.4B for 2020 next year compared to $2.2B for 2019. IMO 2020 regulations (which will obligate the company to purchase more expensive low-sulfur fuel to power its ships) will cause fuel expenses for 2020 to be around 12.5% higher at $1.8B compared to $1.6B expected for 2019.

Overall, as mentioned during the last Q3 release, the company expects full year 2019 adjusted EPS to be in the range of $4.23 to $4.27, reflecting recent fuel price increases, compared to June guidance of $4.25 to $4.35 and 2018 adjusted EPS of $4.26. The flat earnings would certainly be a cause for concern if investors were paying for that growth as they were back in January 2018 when the price was $71.60 and investors were paying 16.8x the then $4.26 forward EPS. But at around a valuation around 10.7x, I am perfectly happy with zero percent growth and willing to ride out a potential economic slump in this industry leader.

Introduction To The Company

Carnival Corporation & PLC is the world’s largest leisure travel company with 2018 revenues of $18.9B achieved through a portfolio of nine of the world’s leading cruise lines. The company operates 104 ships with 237,000 lower berths and is continuing to grow with a further 21 new ships scheduled to be delivered through 2025. This capacity means that the company can boast about carrying nearly half of global cruise guests. Besides the namesake Carnival Cruise Line brand, the company also operates under brands Princess Cruises, Holland America Line, Seabourn, P&O Cruises (Australia), Costa Cruises, AIDA Cruises, P&O Cruises (UK) and Cunard.

Profitable And Growing

Carnival did not become the global behemoth it is today without growing revenues at an average rate of 6.3% and 2.6% annual for the past 5 and 10 years, respectively. The company has also been able to achieve an average return on equity (ROE) and return on invested capital (ROIC) of 8.7% and 7.0%, respectively, over the past decade. This average level of profitability is within my rule of thumb of 6-9% ROIC, allowing me to be confident that, in my opinion, the company is able to maintain its intrinsic value over a business cycle. For those wondering, the company’s net income in 2009 (the earliest year shown of the graph) was $1,790M and represented the lowest earnings during the financial crisis with 2008 net income being a higher $2,330M. The lowest earnings years of the last business cycle were actually in 2012-2014 and are well represented in these 10-year averages.

Source data from Morningstar

That being said, the company’s ROE falls short of my 15% ROE rule of thumb for a great company because, being cyclical, Carnival chooses to play it safe and does not use a large amount of financial leverage to boost its ROE. More on financial leverage and interest coverage next. It should also be pointed out that the company chose to cautiously cut the dividend in 2009 during the financial crisis. Just a heads up for long-term value investors not be too afraid if the same thing were to happen again during the next large recession.

How About The Debt?

While slightly more financially leveraged than at the beginning of the decade, Carnival still currently looks to be in a strong financial position. With financial leverage currently at 1.7x and its interest coverage ratio a healthy 16.4x in the latest quarter, the company looks ready to handle the next cyclical downturn in my opinion.

Source data from Morningstar

Carnival does a great job returning cash to shareholders in the form of dividends and share repurchases. Since Carnival’s 2009 fiscal year, the company has bought back on average 1.9% of its outstanding shares each year as can be seen in the graph above. Adding these share repurchases on top of the current 4.2% yield would imply a total shareholder yield of 6.1%. Best of all is that these share repurchases have not been financed by dramatically changing the capital structure. While financial leverage has increased to around 1.74x in the latest quarter, it remains relatively unchanged from the 2009 level.

Getting A Sense Of A Cyclically Adjusted P/E Ratio

Investors shouldn’t be too quick to jump at embracing that the P/E of 10.7x based on the midpoint of management’s 2019 guidance can also be expressed as a 9.4% earnings yield. Value investors need to be conservative and remember that this is a cyclical company that experiences large swings in profit margins over a business cycle. What is far more informative to look at is an average ROE adjusted for the current price to book value in order to get an idea of what average long-term returns investors might be getting at today’s prices. This cyclically adjusted ratio is what I call the Investors’ Adjusted ROE.

With Carnival earning an average ROE of 8.7% over the past decade and the shares currently trading at a price to book value of 1.22 when the price of the U.S. listed shares are $45.27, this would imply a less appealing adjusted ROE of 7.2% for an investor’s equity at that $45.27 purchase price, if history repeats itself. This is slightly below the 9% that I like to see but adding 3% growth to represent this global behemoth in the leisure travel growing alongside global GDP could bring this return up to 10.2%.

Takeaway

Carnival is a strong company with nearly 50% of global cruise guests in their industry and a nicely economical average ROIC of 7.0% over the past business cycle. The flat earnings seen recently would certainly be a cause for concern if investors were paying for that growth as they were back in January 2018 when the price was $71.60 and investors were paying 16.8x. But at a valuation around 10.7x P/E, I am perfectly happy with zero percent growth and willing to ride out a potential economic slump in this industry leader.

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Disclosure: I am/we are long CCL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long CCL at an average cost base of $45.65

Additional disclosure: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.

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