Carnival sailing on thinning liquidity

The cruise operator’s Diamond Princess ship featured nightly on news bulletins around the world after infections spread through the vessel, which Japanese authorities quarantined at the port of Yokohama for three weeks. At one stage, more than half of the world’s confirmed cases outside China were on board and 13 passengers died.

Elsewhere, Carnival’s cruise lines faced problems getting people back onto dry land as some countries refused access to ports fearing ships were carrying infected passengers.

The Miami-based firm, whose shares have been dual listed in the US and the UK since it bought P&O Princess Cruise in 2003, had begun 2020 on a wave of optimism. It was forecasting growth rates of 4.5 per cent a year until 2025 but its share price slumped by 74 per cent in the first quarter, as the US Centres for Disease Control banned all sailings – a measure it kept in place until July 2021. Most other countries followed suit.

Staying afloat

Carnival entered the pandemic as the world’s biggest cruise operator, with 104 ships. In the year ending November 2019, it carried 45 per cent of all cruise passengers on its nine lines – including Carnival, Holland America, Princess, Costa, Cunard and P&O.

Overheads were also steep, with operating costs running at $17.5bn (£14.81bn). Despite launching a raft of staff furloughs, layoffs and pay cuts in May 2020 to reduce cash burn, the group still incurred cumulative pre-tax losses of almost $20bn (£17bn) over the past two years. 

But beyond the collapse of its market, Carnival’s main problem was that it had committed huge sums to fund new vessels. Between its November 2019 year-end and May this year, the company spent $8.4bn on new ships, as well as $2bn on ship improvements and replacements, IT systems and other capital outlays.

It has only kept afloat by tapping capital markets for huge sums of money. In the 36 months to May, the firm issued more than $30bn of debt and raised $4bn from equity investors. A further $740mn was recouped through ship sales.

Carnival suffered a net cash outflow of $1.9bn in the six months to May, but with most of its fleet back on the water and demand for bookings increasing, management has indicated that the worst is over.

Indeed, the phrase “inflection point” was used three times during an interim earnings call on 24 June, as outgoing chief executive Arnold Donald noted cash flow from operations had turned positive during the second quarter of the year.

At that point, sailing capacity was at 91 per cent of pre-pandemic levels and occupancy rates were heading toward 80 per cent. Booking volumes for future cruises had also picked up: second quarter bookings for all future sailings were at the highest level since the pandemic began, although still below pre-pandemic levels, chief financial officer David Bernstein said.

The company still posted a net loss of $3.7bn for the first half, only slightly better than the $4bn loss recorded a year before. Bernstein blamed extra expenses in getting ships back out to sea, with higher inflation and the costs of meeting tighter health and safety protocols, but estimated adjusted earnings before interest, tax, depreciation and amortisation (ebitda) would turn positive during the company’s current quarter, “which after everything we’ve been through will be something worth celebrating”.

Even this low bar isn’t a given, however, considering the weight of inflation. While a greater than doubling in volumes accounted for most of the more than three-fold jump in fuel costs in the first half to $910mn, a 79 per cent increase in average fuel prices hardly helped.

Payroll costs also more than doubled to $1.04bn and although the company said it was “making progress” in resolving staffing challenges, both the Princess and P&O lines have had to cancel voyages in recent months due to a lack of staff.

Cost pressures mean analysts are much less confident about Carnival’s short-term prospects, particularly as it elects not to buy fuel hedges, unlike peers.

UBS cut its target price on Carnival shares from $23 to $12 last month, with higher fuel prices accounting for about $8 of its reduction and higher interest changes a further $2.

Meanwhile, Stifel lowered its 2022 ebitda forecast from $103mn to a $244mn loss, and cut its target price by a third to $20, arguing short-term weakness masks what its analysts see as an “incredible” long-term trade. Indeed, although the shares are down 48 per cent year-to-date, their recent rally suggests the investment bank may be right when it suggests long-only investors are buying in ahead of an overall break-even cash flow.

Getting up to speed

As Stifel notes, investors have two near-term concerns: the sustainability of current bookings in a worsening consumer outlook, and debts. On the former, the bank believes booking patterns are “mostly healthy” and that the tight labour markets and high savings rates mean any imminent recession will be atypical. Last week, Carnival Cruise Line said its daily booking level doubled after it updated its policy to admit unvaccinated guests if they can present a negative PCR test.

How much demand persists if the state of the economy becomes more perilous is a key issue, given Carnival’s reliance on North American and European markets. Together, these made up 85 per cent of 2019 and 98 per cent of FY2021 revenues, thanks to continuing closures at many Australasian ports. Two consecutive quarters of shrinking US gross domestic product, and fears of winter energy shortages on both sides of the Atlantic, have some economists forecasting deep recessions.

Morgan Stanley cut its target price on the stock to 575p at the end of June. Should the industry face further demand shocks, its analysts think equity investors could face wipe-out.

The main concern is liquidity. While the $7.5bn available at the end of May might seem like a huge number, future commitments are also hefty. Capex commitments come to $5.6bn and $4.3bn this year and next, respectively, interest payments alone are running at $1.6bn a year, and as of May, $4.1bn of debt was set to mature by the end of 2023. Some ships sales have helped, but the trade-off is a cut to the long-term sales growth target to 2.5 per cent.

Berenberg thinks that even if the second half swings to profitability, Carnival will have burned through $3.2bn of cash this year and $5.5bn by the end of 2023. This would make mean drawing down some of its $2.7bn revolving credit facility, which is also due to expire in 2024.

“To put the balance sheet back on an even keel, we estimate that Carnival will need to secure a further $3bn of long-term financing,” the bank’s analysts recently wrote.

And while the average interest rate on Carnival’s debt is around 4.5 per cent, the 10.5 per cent coupon attached to May’s $1bn unsecured bond offer shows debt investors are drawing red lines. S&P Global has assigned Carnival a debt issuer rating of ‘B’ – below investment grade – with a negative outlook, while Morningstar analysts interpreted July’s surprise $1bn equity raise as a sign that “acquiring incremental debt at the current juncture is becoming prohibitively expensive”.

Few expect that capital markets will abandon the company entirely, but if appetite for the company’s debt weakens as interest rates sail ever higher rise, it will be equity investors Carnival turns to once more as seeks a way through the storm.