Foreign Exchange, Fuel Headwinds Hurt Carnival's 2018 Profits

Shares of narrow-moat

Carnival CCL tumbled after reporting strong second-quarter results that included a downtick in full-year earnings per share guidance. With EPS now expected to fall between $4.15-$4.25 (from $4.20-$4.40 prior, and $4.00-$4.30 at fiscal year-end), investors are resetting their near-term expectations for the business. Moreover, third-quarter earnings forecasts are likely to come down nearly 10% given Carnival's $2.25-$2.29 guidance versus our $2.47 forecast (and consensus outlook for $2.48), which we believe is the key issue weighing on shares.

We contend that the factors driving this change are out of the company's control--the $0.10 downtick in the midpoint of EPS guidance stemmed from $0.09 of second-quarter outperformance and share repurchase accretion that was more than offset by higher fuel and foreign exchange costs of $0.19. However, all in, the constant currency outlook calling for yield growth of 3% (up from 2.5% prior) and a cost increase of 1% for the full year was largely unchanged. We don't plan any material change to our $70 fair value estimate, which includes average yield growth of 2% and cost increases of just above 1% in 2019 and beyond, leading to EBITDA margins that expand to 32% over the next decade from 28% in 2017, as our long-term supply and demand factors remain intact.

While some concern continues to linger surrounding close-in Caribbean bookings given last year's aggressive hurricane season and its impact on key ports like San Juan, we don't think the commentary surrounding demand for cruising warrants excessive worry. Carnival noted that since March, booking volumes for the forward three quarters have been slightly ahead at prices that have been in line with the year-ago period. Given the strong booking cadence pre-2017 hurricane season, this still implies that the cruise business continues to attract consumers at a healthy pace and that demand for the product is not waning.

Carnival's market is underpenetrated, with less than 4% of the domestic market ever having cruised. With low domestic penetration rates and even lower international recognition (less than 3% in Europe), upside potential remains significant. The repositioning and deployment of ships to faster-growing and underrepresented regions like Asia-Pacific should help balance supply in high-capacity regions like the Caribbean, which should provide for more lucrative pricing strategies globally. In our opinion, Carnival has the best ability to capitalize on these underserved international markets, thanks to its global reach and tailored fleet.

Domestically, the aging population remains key regarding the supply/demand imbalance in the cruise industry, in our view. This segment will drive demand and create a disconnect between the demand in the market and the supply of berths for at least the next 10 years as the 65-and-older demographic grows faster than overall cruise industry capacity. The stable employment situation should also boost lower-income consumers' willingness to spend, helping the namesake Carnival brand continue to deliver double-digit returns on invested capital (with the firm surpassing our weighted average cost of capital estimate in 2019).

The firm is set to receive 18 ships between 2018 and 2022, boosting supply growth over the next five years. In our opinion, it can still lower costs through improved procurement expenses and better fuel efficiency; ships using liquefied natural gas come into service in 2018. It can also improve revenue via the revenue management optimizer it implemented across six brands in 2016, which should help improve EBITDA margins to 32% from below 30% over the next decade.

We assign a narrow economic moat to Carnival, based on efficient scale, cost advantages, and intangible brand assets. Carnival captures about half of the total current capacity in the cruise market, and the three biggest constituents of the cruise market--

Royal Caribbean Cruises RCL , Carnival, and

Norwegian NCLH --control around 90% of the North American market. The significant share of capacity that these three companies represent is enough to prevent most would-be rivals from entering the marketplace and directly competing with the incumbents, as the emergence of a new entrant would probably have a dilutive impact on returns on invested capital across the entire category. The capital-intensive nature of the business also discourages potential competitors without significant access to capital from attempting to take share in the segment. We believe it would be virtually impossible for any new competitor to enter the market and scale up quickly, given that large ships cost around $1 billion and there is currently limited worldwide shipbuilding capacity.

Carnival's position as the largest cruise operator also allows it to leverage items like port commissions, marketing, general overhead costs, and maintenance efficiencies across the industry's largest fleet of ships. This allows Carnival to generate best-in-class returns without gouging its customer base with high prices. Carnival's cost advantages, through leverage, lead to lower break-even pricing than any new entrant would probably be able to achieve.