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Morningstar | Royal Caribbean Grows Profits Despite Foreign Exchange and Fuel Price Headwinds; Shares Undervalued

Despite $0.55 in fuel and foreign exchange headwinds in 2018, narrow-moat Royal Caribbean is on track to deliver around 8% and high-teen sales and earnings per share growth, respectively. With commentary on par with recent quarters, noting that 2019 booked load and rate factors are higher than the same time last year, and a still-expanding booking window, we don’t foresee any imminent slowdown in the demand for cruising. We do, however, expect to lower our $135 fair value estimate by a single-digit rate to account for higher net cruise costs than we anticipated in the fourth quarter, with as-reported expenses set to come in around 5.0%-5.5%, versus our 3.4% estimate. About 500 basis points of the net cruise cost increase is attributable to Silversea, where costs are outpacing yield gains (yields are set to benefit 350 basis points in the fourth quarter from the brand), accounting for the difference between the company’s $1.45-$1.50 guidance and our prior $1.65 fourth quarter estimate.

We had incorporated faster cost than yield growth into our 2019 outlook previously, not only from Silversea, but also from inflated spend surrounding both the new cruise terminal in Miami and Perfect Day waterpark, which should ultimately support the company’s brand intangible asset and help bolster yields. Beyond 2019, we plan to maintain our normalized growth expectations for Royal, which includes average as-reported yield increases of around 2% and costs that rise 1.3%. Given the favorable long-term supply-demand dynamics of the global cruise industry, we remain constructive on Royal, which has recently tipped into undervalued 4-star territory, trading at 11 times the midpoint of 2019 guidance with midteens earnings per share growth forecast over the next five years.

Third-quarter performance was largely in line with our expectations on the yield front, as Royal captured 1.8% yield growth (versus our 1.5% outlook), composed of 1% ticket and 4% onboard increases as both onboard spend and close in demand performed well. Net cruise costs rose 0.5%, modestly higher than our flat projection. Third-quarter results led Royal to narrow its full-year earnings per share guidance to $8.75-$8.85 (from $8.70-$8.90 and our $8.93 estimate), despite $0.55 from the earlier mentioned headwinds. Without these headwinds, Royal would have been set to deliver nearly 25% EPS growth in 2018. Full year yield guidance of 4.5% includes 80 basis points from the inclusion of Silversea. But the Silversea gain on the yield side was more than offset on the cost side, where the brand is set to compress costs by 140 basis points, leading to expected full-year as-reported net cruise cost to be 150 basis point above our prior outlook. These contributions/detractions to the final quarter and full year imply that Silversea should be modestly dilutive to operating margins, however, with Silversea berths only comprising a low-single-digit percentage of Royal’s total berths, we don’t anticipate any visible profit speed bump.

We caution that investors could rotate to the sidelines on Royal shares with cost uncertainty over the year ahead. Not only are the earlier mentioned CocoCay and Terminal A investments set to weigh on profitability in 2019, but a plethora of other expenses are anticipated, including faster depreciation from both adding Silverseas to the mix and shorter life technology investments, drydock days that rise to 360 from 280 in 2018, and rising interest expense inflated by Silversea's 7.25% debt. In our opinion, our more-than 4% increase in 2019 cost in our model should account for these headwinds, many of which we surmise are transitory, leaving Royal with enough capital available to continue to return cash to shareholders via both dividends and modest share repurchases in the future.