It has been a tough start to 2014 for cruise industry heavyweight Royal Caribbean Cruises (NYSE: RCL ) . An outbreak of norovirus on its Explorer of the Seas ship in late January led to stomach flu for approximately 700 people and an early return to port. Compounding the company's troubles, billionaire Richard Branson's Virgin Group media empire is reported to being raising funds to enter the cruise line sector, following in the footsteps of fellow media empire Walt Disney (NYSE: DIS ) ; this will likely lead to more competitive pricing for the industry.
Royal Caribbean has recently unveiled extra low priced specials, including a recent cruise offer that equates to $32 per night, based on double occupancy. With challenges abounding, is Royal Caribbean a good bet for investors?
What's the value?
Royal Caribbean has built the no. 2 position in the cruise line industry by offering customers a widening array of geographic destinations and price points for its cruises. It features a portfolio of 41 ships that sail to 490 destinations on every continent.
The company has anecdotally benefited from consumers' perception of a cruise as a better value proposition than a land-based vacation due to an all-inclusive price that traditionally includes food, accommodations, and certain activities. That favorable value proposition has led to a rising base of cruise-going passengers around the world, estimated at 21.7 million industrywide in 2013. This has allowed Royal Caribbean to slowly raise average prices, including a 3.2% gain in 2013.
In its latest fiscal year, Royal Caribbean posted decent financial results. It reported a 3.5% top-line gain that was aided by an increase in total passengers and a substantial pickup in sales of ancillary onboard activities. More importantly, the company was able to improve its operating profitability. This was due largely to its success at managing its fuel and food costs, the source of roughly 20% of its operating budget. The net result for Royal Caribbean was higher operating cash flow during the period which fueled investments in additional ship capacity, including the expected delivery of six ships over the next few years.
Of course, with greater than 100% reported occupancy, Royal Caribbean's main problem isn't attracting customers. Instead, the company's biggest problem is maintaining a favorable pricing environment that will lead to higher operating profit. Unfortunately, the news on that front isn't so promising. Existing players and new entrants in the cruise industry seem to have grand plans for new capacity.
Like Royal Caribbean, industry kingpin Carnival Corp. (NYSE: CCL ) has been actively investing in additional ships. The company has outstanding orders for eight new ships which when complete will expand its current industry-leading portfolio of 101 ships.
Carnival did not have as good a year as its smaller competitor in 2013, reporting flat revenue growth versus the prior year period due to heavy promotional activity. This was necessary to overcome ongoing negative publicity resulting from the capsizing of the company's Costa Concordia ship in 2012.
On the upside, though, Carnival has similarly benefited from higher consumer demand, evidenced by its reported occupancy of 105% in the 2013 fiscal year. This has allowed it to continue generating a solid level of operating cash flow and fund its long-term growth initiatives.
Cruising as a side business
Given the inherent risks of the cruise line industry, aptly illustrated by the Costa Concordia tragedy, investors would likely find a better risk/reward ratio with an industry player that views the cruise line segment as a complementary component of its overall business mix, like Disney. With a portfolio of four ships, the company is clearly not looking to be a major player in the cruise space as it is in its core movie studio, broadcast television, and cable network businesses. However, the cruise line business is a profitable extension of Disney's brand into an ancillary market. It is also a key component of its Parks segment, the second leading source of operating income for the company in its latest fiscal year.
The bottom line
Judging by the muted market reaction to Royal Caribbean's large norovirus outbreak, investors don't seem to be anticipating any long-term value destruction from the incident. The reaction probably makes sense, given that large virus outbreaks aboard cruise ships actually declined in 2013; there were only nine incidents during the year, down from 16 incidents in the prior year, according to the Centers For Disease Control (CDC.)
Rising competition and additional industry capacity are larger threats to Royal Caribbean's profitability. Worse, these are not cured by a shot of antibiotics. As such, upside in shares of the company may prove to be elusive and prudent investors should seek shelter in more diversified plays, like Disney.
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