Cruises make up only a small sliver of the global travel and leisure sector, but the leading companies in that space offer significant potential for investors.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Dan Kline take a look at the global cruise industry, including its three biggest players: Carnival (NYSE:CCL), Royal Caribbean (NYSE:RCL), and Norwegian Cruise Line (NASDAQ:NCLH).

A full transcript follows the video.

This video was recorded on Feb. 20, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, February 20th, and I'm your host, Vincent Shen.

Earlier this month, we talked about recreational vehicles, RVs, learning about Thor Industries and Winnebago in our first show of 2018 dedicated to travel and leisure. Today, we're going to continue our coverage of that sector, but this time, our focus will turn to the sea and the three major cruise operators. Those are Carnival, Royal Caribbean, and Norwegian Cruise Line.

Joining me for this discussion in the Fool HQ studio is Motley Fool contributor, Dan Kline. Hey, Dan! Good to see you again so soon!

Dan Kline: Hey, Vince! How are you?

Shen: You're back three weeks later in studio with us.

Kline: Fresh off a cruise, as well.

Shen: There you go. You have some recent firsthand experience to speak to us for this. To get our conversation started, I think it's important that investors that are new to this industry, this business, that they understand some big picture things about the industry. Dan, feel free to chime in as I walk through some of these numbers here. It's really interesting, actually.

First, I'm going to give some scale. The global ocean cruise fleet I could find is 310 ships with a capacity for about 540,000 passengers. And that number is growing as new ships come online. There's actually an estimated 90 new ships that will be delivered between now and 2025, and that totals an investment of $55 billion.

Kline: It's also important to remember that doesn't always raise the total. Ships do come out of circulation.

Shen: Absolutely. Some of our operators, for example, will retire about one or two ships a year as they bring in new ones.

Kline: And ships generally move down the line. The three major companies we're talking about today will buy a ship, use it for its lifespan, sell it to one of the smaller companies or regional operators, and then eventually it will come off the sea completely.

Shen: So the scale again, that capacity, with over 300 ships, 540,000 passengers, it sounds pretty impressive, but you have to keep in mind that cruising only represents a small portion of the global travel and leisure industry. Various sources value global annual bookings in this industry for total travel and leisure at $1.2 trillion, but the cruise industry revenue last year was only about $30 billion, that's only about 3% of the total. By comparison, commercial airlines accounts for closer to $800 billion travel spending. You could consider this a niche within the sector.

Kline: You also very rarely take a cruise to get to a business meeting.

Shen: Yes, that's very fair. Overall, the cruises are becoming more popular worldwide, they're seeing strong growth rates. Average annual passenger growth since 1980 has been about 7%, and if we go back only 10 years, it's been about 4.5%. A lot of that is coming from newer developing markets like Asia.

The second thing I want to focus on beyond scale is who the customer is in this industry. There's definitely a concentration of them here in the U.S. In this corner of travel and leisure, there are over 1,000 port cities, there are destinations across dozens of countries. I think cruises will stop in every single continent. But the U.S. consumer is by far the leader in terms of cruise travel. The cruise industry only started to resemble its current state once cruises became more popular in the North American market. A few decades later, U.S. cruise travelers number about 11.5 million in a year. The next three largest markets are Germany, the U.K., and China. They each account for only about two million. That's out of about 26 million passengers annually.

Kline: It's a mature market in the U.S. There's growth potential.

Shen: Absolutely, and we'll get to that.

Kline: [laughs] Then I won't say it now.

Shen: [laughs] So the point I wanted to make on that is, close to you, Dan, Port of Miami is the largest cruise port in the world. They handle about five million passengers each year. Because of the concentration of popularity in the U.S., the most popular port destination in the world is not too far away, it's the Caribbean and the Bahamas, which make up one-third of all cruise capacity each year, while the Mediterranean, which is the next biggest destination, makes up about 15%. I was pretty surprised by that.

Kline: The Caribbean is sort of a starter cruise. That's where I went. I went in a family cruise. You can have a short itinerary. You can do a three day, a four day, we did a six day. And it doesn't take much. You don't even need a passport when you get off in most countries. The first cruise you go on, and the industry sort of knows this, is almost like where you get your sea legs. You figure out how it works, you understand how the ship is, what the ports are like. And then they're more likely to sell you on a more exotic destination.

Shen: Absolutely. And management speaks to that, about how the Caribbean and the Bahamas, for example, they feel like a safer destination for the U.S. consumer. It's close by and it's much more accessible in that way.

Kline: And there's nothing particularly adventurous about it. Most of those itineraries include a day at a private beach where it's very simple. You get off the boat, there's a barbecue, there's a beach. You're not exploring ancient ruins. The excursions are not anything particularly daring, maybe a zip line or a hotel pool or something. But if you've never been to a big resort or a theme park before, to go to one for a couple of days, you're probably going to have a better experience the next time, and the industry is absolutely understanding that one cruise is the gateway to another.

Shen: The third thing I wanted to talk to you about in terms of high-level takeaways is the long-term potential for this industry. Even though the U.S. has a relatively high penetration, two-thirds of Americans have actually never been on a cruise, which actually also surprised me. Only 3.5% of U.S. consumers will travel on cruises annually, and that number drops to less than 2% for Europeans, and again, the opportunity for Asia, 0.1% for that region. As you can imagine, with the low number in Asia, that market, and China especially, is a big opportunity for these companies. And it gets mentioned in just about every single earnings call, industry outlook, and financial report that I could find.

The last thing I want to touch on is some of the more specific industry dynamics and things to know about how management teams plan out each year. A big part of that is seasonality, if you could touch on that, Dan?

Kline: Basically, we're in the heart of the booking season. They call it the "WAVE" season. It's not an official period, but it's roughly three months, where the goal is to fill the ships at the best price possible. For a consumer, that tends to be maybe a little higher than you'd get at the last minute, but you get the most perks, usually, if you book early. Everything is about taking that boat and going, seven months from now, 12 months from now, whatever it is, it varies a little bit, up to about maybe about 18 months, we're at 60% capacity before anything has happened, or whatever the profitability number is, we've broke even.

And then they work their magic. Then you start to get, Dan has booked, and he's booked the cheapest possible cabin. For an extra $5 a day, do you want the next best cabin? Because that will free up a low-price cabin, which they can then market. Or maybe all the balconies have sold out, so they upmarket you a suite. It's a very intricate dance that starts in this season. And they push very hard, because they have to plan. You can't build a cruise ship in a day. As a matter of fact, you can't build one in six months. [laughs] I mean, I could, but they can't. So they have to figure out what their capacity is going to be. And if they have specific cruise lines, a seven-day trip that's not selling, they could cancel that trip, they could move the capacity elsewhere, they could reposition the ship. There's a lot of different ways. It's a very far-thinking industry.

Shen: I'll add to that that right now, the first three months of the year, that wave season that a lot of management teams will speak to, is the heavy booking season. The people who are booking trips, the busiest time of the year is obviously dictated by the summer months in the Northern Hemisphere. They account for by far the most demand, the best ticket prices that these companies can get, and also the largest share of their operating income coming from this period.

Kline: And they also use a very smart strategy. We talked about this a little bit before. If you're booking a Walt Disney World vacation, you generally have to pay for it. You have to buy your airline tickets. Maybe you don't pay for the hotel all at once, but you order your Disney tickets, you're paying for that within a couple of weeks, for all three pieces of it, or all at once. What the cruise lines do, specifically the more mass-market cruises, is this time of year, they let you book with a low deposit.

Shen: Get the reservation.

Kline: So it locks you in. Maybe it's $150, $200 a person. Maybe at a low-level cabin, you're getting $50 in onboard credit or free something for doing that. Then you can pay as you go. The brilliance of this is, by the time you get to the cruise, of course, you've paid it off, and you never wrote a big check. You most likely paid it off in little chunks. Which makes you feel freer when you get there about your ability to spend money. So then maybe you book some excursions, maybe you buy more drinks, maybe you up-sale a restaurant. It's a very smart strategy where at no point, if you want to do it this way, do you ever feel the pain of, "Oh, my god, I just spent $2,000 on a vacation."

Shen: Sure. So the last thing I'll get into in terms of high-level stuff in the industry before we start looking at those three companies. If you're an investor, with these companies, you're going to be able to compare the common financial metrics that we talk about, things like revenue and earnings growth, what their margins are like, what their return on invested capital is. But the big number that the industry monitors is revenue yield, or revenue per available passenger cruise day. Different companies call it different things, but ultimately what this tells us is how much the company is making across its fleet given the availability of rooms on each ship, and then the length of the cruising season for that ship. 

So with that background, we're going to look at some of the actual players now. For our purposes, the three companies that really matter here are Carnival, ticker CCL, Royal Caribbean, ticker RCL, and Norwegian Cruise Line, ticker NCLH. Together, they claim over 80% of the market share in this industry. It's pretty impressive. Let's start with Carnival.

Kline: It's important to note, too, that Carnival is the big boy.

Shen: Yes.

Kline: By passenger total, not by revenue, Carnival has about half of the total cruising market.

Shen: Yes. 50% market share by passengers. As you mentioned, 12.1 million that they handled in 2017. They have by far the largest fleet, too, over 100 ships. Their passenger capacity is about 230,000, which is really cool. They operate a number of different cruise lines in their portfolio.

In addition to their namesake Carnival line, they have Princess, Costa, and additional cruise lines that will target specific geographies usually. Carnival, for example, operates almost entirely out of U.S. homeports. Costa is in Italy, France, and Spain. AIDA for Germany. The company had $17.5 billion of revenue in 2107. And for this industry, you'll see their net income margins, for example, usually around 15% to 20%. These companies spend a ton of money in their capex building out new ships, but they also generate a ton of cash. Carnival, for example, last year, had free cash flow of $1.5 billion, and that was after $3 billion of capex spending on their investments in current ships and new ones.

Kline: And their return on investment in a new ship is quick, much like when a new hotel opens at a theme park. It's pretty much the same. People want to stay there. So when a new Carnival ship, especially the biggest classes that have new amenities, they will sell out faster at higher prices. So you might hurt yourself down the line in taking away what would have been lower-paying business from older ships, but in general, there's a huge push when a new ship comes out.

Shen: So that metric that I mentioned, the revenue yield, the gross revenue yield for this company is growing. I should also mention that 2017 was a very strong year for the industry overall. To give you an idea of what they're dealing with here, their gross revenue yield hit about $210 in 2017, so it was up 3.9%. Keep in mind, in terms of the revenue breakdown for these companies, their passenger ticket revenue usually makes up about 75% to 80% of the top line, and everything else is onboard. The extra pass at the bar, and the excursions, and things like that.

Kline: It's a little harder for Carnival, because the ticket prices tend to be lower, so in the mix, the onboard is a little bit more important.

Shen: Then, something else to note that I thought was really jaw-dropping is, as of November 30th, the company has 18 cruise ships on schedule for delivery between 2018 and 2022. That adds for them passenger capacity of over 72,000. That's not net, because as you mentioned, some older ships will drop out of the fleet in that time.

But the thing that I've seen with Carnival, and also the other cruise operators, too, they say outright that their largest long-term growth opportunity period is the Chinese market. And Australia and Asia accounted for only 15% of their revenue last year, so there's still quite a bit of opportunity there.

Kline: There's absolutely a risk of having too much capacity. And just because ships are ordered, there are points where they could be canceled. So yes, they have their long-range plans. But the other thing we didn't mention about the past year, which was very strong, and it speaks to the revenue model, is we had a terrible hurricane season. And the hurricanes devastated many of the traditional ports.

One of the nice things about the revenue model is, I booked a cruise eight months ago. Pretend I did. The hurricane season happens, and we were supposed to stop in Nassau, well, the port in Nassau was destroyed. It wasn't, but let's pretend it was. The cruise line already has your money. You're already booked. Maybe you have travel insurance. Maybe you paid for the ability to cancel. But they don't cancel that cruise. They change where the cruise is going. And they have a period of time to market, "Hey, just because this happened doesn't mean we aren't cruising, doesn't mean you won't still have fun." So they have a little bit more, call it long-term flexibility. If a theme park loses a week due to a hurricane, there's kind of no way to make that up. But with the cruise ships, they don't sail through hurricanes, they move them around so they don't get hit, they can change itineraries, they can market to you, "Hey, I know you're not going where you think you were going, but it's still going to work for you."

Shen: And that's something that I think appeals to a lot of people who invest in these cruise stocks, there is still that stability in their business model.

Kline: They can fix a mistake.

Shen: So they have that seasonality, and there's going to be lumps there, obviously, in terms of the demand with the seasons. But we haven't really seen a big downturn for this industry since the financial crisis.

Kline: And actually, all three of these companies, though didn't look like they do now, they were all very resilient during the crash partly because there's a certainty to the price you're paying, at least in your head, and people were booked before their stocks tanked.

Shen: So they will take their blows, for sure, when there's a broader economic downturn. But overall, keep in mind that these companies also, with Carnival and Royal Caribbean, they returned lots of capital to their shareholders. The company pays I believe a 2.5% dividend or so, and they repurchased 63 million shares, about $3.1 billion, since late 2015. So just in the past couple of years. And they're operating with a very reasonable payout ratio, so that's not something that's really at risk. Again, I think that's something that really appeals to the investors that like that more stable business.

Otherwise, before we look at the comparable operations and details for Royal Caribbean and Norwegian, I want to talk about something that a lot of the operators are investing in, and that's the integration of technology on these ships. Hopefully can speak to that from your recent experience.

Kline: Absolutely.

Shen: Carnival has something called the OCEAN experience. They've been rolling that out very recently with a Medallion, it's Bluetooth enabled, it offers things like streamlined boarding to get rid of pain points in the vacation process like waiting in line, keyless access, they offer guides to the different activities that are happening on board, you can stay in contact with your fellow travelers. Last time I was on a cruise, this stuff wasn't really available.

Kline: And we're sort of at a midpoint now. Carnival is just rolling out the new technology. When you're on a cruise, everything is based on your key. Your key is your ability to buy a drink at the bar, you can take out an advance at the casino if you want, whatever you're going to do on board. On a cruise ship now, you get your key, which I wore on a dumb looking lanyard around my neck. And you're wearing it at the pool, you're wearing it because you don't want to lose it, it's a long line to get a new one. 

And most of the cruise lines now, Carnival certainly, have an app. When you're on board, the days where you have to wait for a paper newspaper to tell you what's happening tomorrow, that's gone. You can look at the whole itinerary for the trip. You can see, there's sports trivia three days from now and I want to go, and one of the dinner choices tonight is venison, and boy I'd like to try that, so I'll go to the dining room. And you can communicate.

We've talked about this before. For a $5 additional fee on Carnival -- and everything is seemingly an additional fee -- you can have a ship-based chat app that lets you keep in contact with your group. Your phone is just in airplane mode on the ship wifi, and I can send you a text message, "Hey, meet me at the pool, meet me at this bar," and it takes away a major pain point, especially for parents who are traveling with children. My son could be getting a pizza at two in the morning, and I would have some sense of where he was. Or at I least could ping him. And that happened. [laughs] 

Shen: Going to the other two players now, smaller but still the dominant ones in this industry, first we have Royal Caribbean. They're the second-largest cruise operator. They have owned and partnered brands that combine for 49 ships and capacity of about 123,000 passengers. Royal Caribbean, I think, is notable in their fleet, because they have some of the biggest ships. Their largest ones can accommodate over 5,000 passengers. I was looking at the list of largest cruise ships in the world, and I think something like the top five out of six, for example, are all the Royal Caribbean line.

Kline: They're pushing the boundaries with things like ice skating rinks and rock climbing walls in addition to water parks on board. We parked next one, or berthed next to one, and it was really impressive to look at.

Shen: Royal Caribbean, I mentioned to some of those owned and partnered brands. They have their namesake Royal Caribbean, Celebrity, and Azamara Club Cruises. They also partner with, in Germany and Spain and China, some other companies as well. Again, to give you a sense of how confident right now the management team seems to be in terms of growth for this industry, and the increased capacity that they want to be able to deliver, they have nine ships that are expected to be delivered between 2018 and 2022. That would add over 30,000 in passenger capacity to their fleet. Not net, again, because they're going to retire some older ship, most likely. The metric that we've been talking about, the revenue yield, for Royal Caribbean, was incredibly strong in 2017.

Kline: They've been laser-focused, since 2014, on doubling their return on invested capital and doubling their earnings per share. That's been all they talk about in every earnings call.

Shen: The double-double, yeah.

Kline: And they've reached it.

Shen: That revenue yield number was up 5.9% in 2017. This was the eighth consecutive year of yield growth, very impressive. And then, with that double-double milestone that they reached, the company is granting equity bonuses to all of its employees, except corporate officers, that equal about 5% annual salary. So it's interesting to follow.

Something else I noted is, the companies will also calculate, on the flip side, their cost yields. For example, here, while their revenue yields were up, like I said, about 5.9%, really strong growth, cost yields were only up about 2%. So profitability for Royal Caribbean has been really strong. Their gross and net income margins were up over three percentage points each in 2017. Again, dividend payer, very manageable payout ratio. They've repurchased about $1 billion of stocks since 2014. The actual raw gross yield number was about $237 last year, compared to $200 for Carnival. We're going to see for this last company we talk about, Norwegian, how it goes up due to a bit more of a focus on a premium clientele, premium experience.

Last one, Norwegian Cruise Lines. $5.3 billion revenue in the trailing 12-month period, so the smaller of the three.

Kline: And about 25 boats.

Shen: Yeah, 25 ships.

Kline: So, a quarter the size of Carnival.

Shen: 50,000 berths, or passenger capacity. I wanted to hone in on a specific piece of their business recently. They've been talking a lot about the Norwegian Joy recently. This is a recent ship that was delivered last year. It caters specifically to the Chinese market. A big part of the ship that they've touted is, for example, the technological integration, this one zone with different gaming and virtual reality experiences and things like that, really appeals to the consumers in that market. But I also thought it was really interesting, management spoke to some quirks, call it, with Chinese consumers, that they're still adjusting to. It seems like all the operators are kind of working to adjust the business model to this.

Kline: The technology, we should also talk about, it isn't just for customer enjoyment. There's an analytics aspect to it.

Shen: Yes, absolutely.

Kline: So, what they're figuring out, in the U.S. market, they have a long history of, when a person who looks like me, traveling with one child in a family group, they know what I'm going to spend, they know what I'm probably going to do, they're going to have to figure that out, but the technology makes it faster. They can see, Dan browsed this excursion, but he didn't buy it. And then, if they're light on that excursion the next day, maybe I get a coupon. Maybe I got a deal. So they're going to come up to speed in China a lot faster than they've come up to speed in other markets.

Shen: And the analytics aspect of it is really big. As they serve more passengers in that market, they learn more about the consumer. But a few things but they've noted, higher food costs. Chinese cruise passengers love to eat. They've noticed a little bit higher food cost in that region. But they've also been hurt in some ways, because, we're talking about that onboard revenue, usually about 25% of the top line for these companies, more of the revenue in the Chinese market is coming from shopping and less of it is coming from excursions. They're not as interested in those port excursions, and that's hurting some of their profitability.

Kline: And some of it is just cultural. We've seen, things like pay-per-view have not worked in the Chinese market, because there's not a history of paying for add-ons. That's sort of the same things that cruise ships have to figure out. And they might have to do things like, the price is going to be higher, but this add-on is now included. And you do see that in the U.S. market, where you could pay twice as much for a cruise but it's all you can drink, and the internet is thrown in. It's really just getting that data and tweaking it to hit how you price, whether it's onboard revenue or ticketing revenue.

Shen: Last point, Carnival, gross yield $200. Royal Caribbean, $230. Norwegian, about $300. So, take from that what you will in terms of how they target the different --

Kline: And it speaks to ticket price. That's basically the order of low-end, medium-end, and high-end in the industry.

Shen: I want to end now, just a couple of more minutes, talking about some of the strengths that really speak to the stability and how favorable it is, the operating conditions, for the top three companies here in cruising. If there's any industry out there with high barriers to entry, I think this is definitely one, considering a new ship can cost $500 million to build. Not only that: Even if you have the money to build the ship, there's a very limited shipbuilding industry that can put together these massive ships. And they operate at capacity with commitments with the major operators for years and years, so it's really tough to even get your name into the queue, essentially.

Kline: Which is why ships get cycled down the line.

Shen: And something else is the logistics involved in operating a cruise line. Going through the annual report for these companies, it's fascinating to see all the different things that they keep in mind in terms of building the ship, the food and services on board, safety regulations, staffing, finding ports, the marketing. It's jaw-dropping, how much complexity there is in the logistics. Again, another barrier to entry, and why it's very favorable to be a Carnival, for example, with 50% market share in this space.

Overall, I think travel and leisure is definitely positioned to benefit from the Baby Boomers, who are looking to travel more. Gen X and Millennials -- there might be some debate around this in terms of the appeal of cruising. We were talking about this before the show.

Kline: Cruising has a reputation as being older folks. And if you go on Princess or certain lines, that's still what it's going to be in. If you go now, when kids are in school, of course there's going to be older folks. I went during Christmas vacation. Yes, there were absolutely plenty of grandparents, but it was largely a family atmosphere. So really, for the industry, they're running a lot of two-day cruises to try to attract younger people. And they're very much booze cruises, and the goal is to party. But the more you get people familiar with it, we talked about this a little, I don't see that as they get older, younger people aren't going to want to do it. Every vacation can't be rock climbing once you get to 50.

Shen: Sure. They say that Millennials, especially, spending more money on experiences and less on material goods, that's definitely a benefit overall for travel and leisure.

Kline: And a cruise is like a sample pack.

Shen: Yes.

Kline: If you go on a seven-day cruise with a Caribbean destination, or, my son and I are looking at a Cuba cruise this summer, you can go someplace and spend either part of the day or sometimes an overnight --

Shen: Get a sense of what it's like.

Kline: Yeah, and then decide if you want to take a vacation there.

Shen: Absolutely. So, these management teams in the short to mid-term, they're thinking about that seasonality that we talked about, they're thinking about the ships that are going to be coming online soon, there's always weather concerns with things like hurricane season, and fuel cost is always a big thing these companies are thinking about, too. But it comes down to, I think, long-term, all three of these companies are definitely in a position of strength, especially with the low penetration even in the established markets like the U.S. But, how that can grow in Europe, and of course in China and Asia, where you have this massively growing middle class, strong economy.

Kline: You can also grow the market by adding ships to ports that were previously underserved. Where I live in Miami, Fort Lauderdale, that's the hub of cruising in the U.S. People fly in to hit all those destinations. There aren't actually that many cruises that leave from the West Coast. And you're starting to see companies target West Coast itineraries, at least seasonally. So you're going to see, you can cruise from Boston, New York, all sorts of different markets. When you take away the need to get on an airplane in addition to getting to your cruise, right then and there you've increased your market capacity, because when I'm pricing out a vacation, if I have to take a family of three and add $1,000 in airfare, that might make a cruise not viable. So when they open in a port near here and you can take a cruise without having to fly, that will increase the industry. And they've been slowly adding capacity to different ports.

Shen: There you go. Thanks a lot, Dan! That's all the time we have today. I appreciate you joining me. I'm sure we'll be updating on some of these companies in the near future.

Kline: Thanks for having me!

Shen: Thanks for listening, Fools! Austin Morgan is our man behind the glass. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks again for listening and Fool on!

Daniel B. Kline has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Walt Disney. The Motley Fool recommends Carnival and Thor Industries. The Motley Fool has a disclosure policy.