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Morningstar | Slowing Yield Growth Hits Carnival Shares, Providing Margin of Safety; Modestly Undervalued

Narrow-moat Carnival's shares tumbled after company commentary suggesting that first-half 2019 yield growth could be slower than fourth-quarter 2018 guidance (1%-2%). However, further detail on interim pricing weakness implied that this was largely regarding Caribbean demand, lapping a serious weather season last year that affected 2018 regional demand. In our opinion, this issue should be transitory and is unlikely to repeat in 2019, especially since the Caribbean has experienced a relatively quiet hurricane season in 2018. Given that we already had yield growth slowing to 2% in 2019 from 5% in 2018, we don’t plan to make any material change to our $70 fair value estimate. We view the shares as 10% undervalued, trading at 13 times our 2019 estimate, near the low-double-digit earnings per share growth rate we expect over the next five years.

In our opinion, there were no metrics that warranted imminent concern about Carnival’s ability to drive demand creation or manage its cost structure. Our long-term yield outlook incorporates 2% average yield increases, above the flattish pace the company has been able to capture over the past decade, as we expect that improved revenue-management strategies and systems should lead to structurally higher yield grab than in the past. We have costs rising more than 1% on average, versus the flattish pace they have maintained on an as-reported basis over the past decade, as fuel and foreign exchange can weigh on the overall metric and have real impacts on cash flows. We expect these metrics add a normalized perspective to Carnival’s earnings power, adjusting for the cyclical silo that it operates within.

Third-quarter results were slightly better than we anticipated, with as-reported yield growth of 3.3% (versus our 3.2% forecast) helped by ticket that rose just below 3%, onboard spending that increased 5%, and healthy pricing on close-in bookings. The cost side led to greater outperformance versus our forecast, with costs per diem rising just under 3% excluding fuel versus guidance of 4%-5% and our 4.5% forecast thanks to better operational leverage. This led to EPS of $2.36, a dime ahead of our forecast. Our $0.69 fourth-quarter EPS projection was already within the company’s newly guided range of $0.65-$0.69, with our 1.7% yield projection well within the company’s offered range (1%-2%) and our cost ex-fuel outlook decline of 2.2% squarely in the 1.5%-2.5% downtick range that Carnival anticipates. This should allow the incorporation of third-quarter results to push our full-year EPS estimate to the high end of the company’s anticipated range, which was raised to $4.21-$4.25 from $4.15-$4.25.

Overall, the third-quarter financials and resulting fourth-quarter outlook were largely in line with our internal expectations. In our opinion, concern about pricing growth in 2019 is overblown; we think that the pricing model is intact and any weakness was a result of Caribbean overhang from a disastrous weather season last year. We still expect that cruising is a demand-driven story, and with low global penetration rates, the value proposition has the ability to connect with a rising cohort of consumers going forward. With a still-strong U.S. consumer, a key constituent base for the cruise industry, we don’t expect any imminent strain on demand to persist in the first half of 2019. In fact, given the solid close-in performance the cruise operators have been clocking in recent quarters, we expect there could be some upside to the initial insights that the company has provided.