Geopolitical tensions and shifting consumer preferences are just two of the many headwinds facing the cruise industry, but long-term focused investors might find some gems here if they can look past the near-term storm clouds. On the July 23 episode of Industry Focus: Consumer Goods, host Shannon Jones and fool.com's Dan Kline dive into the cruise industry; namely its two biggest players, Carnival (NYSE:CCL) and Royal Caribbean (NYSE:RCL). Learn how those cruise lines have responded to strict Cuba sanctions, what makes these companies unique, what cruisers are doing to try to get more millennials aboard -- and why most millennials aren't champing at the bit to set sail -- as well as which of these two stocks looks like the better buy now. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 23, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Tuesday, July 23, and we're talking Consumer Goods. I'm your host, Shannon Jones, and I am joined via Skype by Foolish contributor, really Fool of all things, Dan Kline. Dan, so glad to be back in the studio with you, especially for today's topic.

Dan Kline: Very happy to be virtually here! Wish I was there, but happy to be here nonetheless.

Jones: Here in spirit, and I can hear your voice, and that's all that really matters, Dan.

Kline: Works for me!

Jones: Alright, today's show. I know you and I have been talking about the cruise line industry for a long time now. We've been talking about doing a show. Dan, you're an avid cruiser. I'm a cruise convert thanks to the Disney Cruise Line. But we've been talking so much about it. We really wanted to come talk about the big cruise operators, talk about what's going on in the industry, how they make money. And so finally we are here, Dan. You came back from a cruise. I could probably say that to you about any week and it would be true.

Kline: [laughs] I had never done a cruise until about a year ago, December, I begrudgingly went on a family cruise. And it was fun. It was on a lower-end ship. But I sort of liked the experience. So my son and I did it again. And then I tried a different cruise line and realized, there's some more -- and when I say adult, I don't mean adult in the R-rated sense. I mean, more music, more grown-up related things. And now, I've found that not only is it something I enjoy doing, but when you live in South Florida and you gamble, it's also something you can do at a lower cost than people who don't live here. So it's sort of like my relationship with theme parks. Maybe I wouldn't spend all the money to do them, but because I live here and it's accessible and inexpensive, I've taken like six or seven cruises in the last six months.

Jones: That is amazing! One day, I can get to your level, Dan. But while we wait, just to give our listeners some perspective, I came across a few stats to frame the scope and the size of the global cruise industry.

The cruise industry is indeed the fastest-growing category in the leisure travel market, estimated at about $45.6 billion in 2018. That's huge. Also in 2018, the cruise line industry welcomed over 26 million travelers. That's mind-boggling to me, Dan, and that's up 3% from 2017. This year, that number is actually expected to hit 30 million. The industry itself is pouring goo-gobs of money into these ships, building out new fleets, building out new terminals. Estimated about $65 billion will be invested into building all of that out between now and 2029. 

On the one hand, Dan, I look at stats like this, and I think this is an industry, fastest-growing within the travel segment itself, but yet, there are still some questions and challenges and even some opportunities that the major cruise operators still need to figure out. What are those key questions?

Kline: There are major questions. When we talk the cruise industry, for shorthand, we're largely talking about Carnival and the associated brands it owns, and Royal Caribbean. Those are the two big players globally. There are many others. They own a lot of sub-brands. But that's the shorthand for the biggest part of the industry. 

What's scary about it is capacity. If you look at a market like Las Vegas, during a big trade show, say the Consumer Electronics Show, hotel rooms go for $400 a night, it's hard to book, you have to plan six months in advance. But a lot of the year, there's an awful lot of capacity. But there are fixed events, you have to go during those times. The cruise industry sort of works the same way. There are fixed events like school vacations where prices go up. But in general, its prices are set by demand and capacity. So when you're adding five or six major ships to the two big cruise lines each year, you run the risk of, what if you build too many? That's not a huge problem when you enter a new market. If they go to China, and, say, Royal Caribbean or Carnival has a joint venture in China, and it doesn't work, well, they can mothball that very expensive ship or move it someplace else. But if you're adding capacity out of Miami, Fort Lauderdale, Galveston, Texas, some of them major cruise markets, and all of a sudden there isn't enough demand, then you're going to lower prices across the entire industry. It's a very tricky pricing game. 

What happens with a cruise ship is, they are trying to fill it to capacity. Capacity doesn't mean every room is filled. It doesn't mean every berth is taken. It means that, based on the amount of rooms they have, there's two people in each one. You might have an inside room that has a family of four that's full, and then you might have a balcony that never sells that's empty, but that ship could still be at capacity. When you start seeing openings, that's where things get a little tricky. That's why I've been cruising so much -- because they canceled Cuba, the U.S. government made it illegal to stop in Cuba, a lot of people got the right to cancel their cruise, or get half price, or book another one. So, what the cruise line does, the first thing when they have capacity that they know they're not going to be able to fill quickly, is they go to loyal customers. They go to gamblers, they go to people who live within the market, and they say, "Hey, would you like to go at a reduced price?" And when not enough people take them up on that, they say, "Would you like to go free?" And so far, that has not only kept all the ships at capacity, it's also kept revenues growing, because yes, if I get a free cruise, I am not paying for the ticket, which is 50% to 75% of overall revenue. But what I am paying for is, maybe I eat at a specialty restaurant, maybe I gamble and lose some money, maybe I buy a T-shirt or a watch, or who knows what. I've never bought a T-shirt or watch. 

So, it's a very complicated picture that's kind of a house of cards in some ways.

Jones: So, capacity and demand, that is certainly something to watch over the long term. You mentioned Cuba. All the major cruise lines had some exposure to Cuba. I think all in all, because of the U.S. sanctions that were tightened in reference to communist Cuba, about 800,000 bookings were affected as a result of that ban that came in June. For something like this, I feel like this is more of a short-term headwind, because a lot of these cruise operators have either been able to cancel or reroute the ships to other places. Norwegian probably had the biggest exposure, about 3% of their annual capacity was set for Cuba. But I feel like something like Cuba, in reference to capacity and demand, that seems more short term in nature.

Kline: It is short term, but if you figure that most people are planning on a cruise about a year out, it has a ripple effect. What happened was, once it became no longer legal to go to Cuba, Royal, Carnival and Norwegian had boats that they had specifically either purchased or retrofitted, and in some cases purchased back, to go to Cuba, which is a smaller port. So, instead of the 5,000-passenger mega ships, think maybe like 1,800 or 2,000 passengers -- smaller ships. So, they send you an email that says, "Hey, we can't go to Cuba. By the way, all of the places you might like to go are booked up and planned out. We can't go to our private islands. So now, we're stopping in Key West and Nassau," because Nassau has an endless capacity for cruise ships, it seems. There's always six or seven docked. 

So, passengers in most cases were either able to take a discount, usually half off, or book any other cruise they wanted with a credit for what they paid. And a lot of those -- in the short term, six months to nine months -- they weren't able to rebook interesting itineraries. I don't mean to dis Nassau, but it's kind of the most pedestrian of cruise line stops. Even the private islands only have so much capacity. Royal Caribbean just redid theirs, so while they could land two ships there, they generally haven't been doing that. So, it did create some heartache in passengers. I was on a ship that was supposed to go to Cuba. And people were fairly humdrum about it, because they were on a ship that maybe didn't have all the top amenities, and it wasn't going to the place that they wanted to go. But, yes, a year from now, they're going to have figured that out. 

It is a negative. You're a millennial, or at least closer to a millennial than I am. Cuba was an exotic travel destination, whereas a lot of the cruise stops in the Caribbean and Mexico are more just cruise ports. So it was kind of a hook to bring a new generation in. And I do wonder if that's going to have a long-term effect of maybe 2% that would have tried cruising and liked it, maybe they won't, and that's going to create some marketing issues for the cruise lines.

Jones: You brought up a good point. Another key consideration is that millennial demographic. In 2019, millennials are actually expected to surpass baby boomers in terms of population, 73 million vs. 72 million this year. We talk about baby boomer population driving a lot on the Industry Focus: Healthcare show. But from a cruise line industry, the question is, how can they attract and continue to build that loyalty among millennials? Cruising historically has been thought of as something for an older population, or a family with kids. It's really about, how do they attract millennials? So, what do you see, and how are they addressing this particular issue?

Kline: It's a challenge. On one hand, Royal and Carnival are very much party lines. You see your families, you see your older people, but it's a festive atmosphere, there's a lot of drinking going on. You don't see a ton of millennials -- and again, I'm speaking anecdotally from having been on a bunch of cruises across both of those lines -- you don't see many families that aren't there with their kids. I could see the price of it having some appeal. You can have a fairly all-inclusive vacation at a relatively low price compared to, say, a city trip or a theme park trip. But in many cases, you're not getting that adventure destination. Like, if you land in Cozumel, maybe you're taking an excursion to a beach or walking around some shops. You're not really getting an experience of being in Mexico. My son and I are stopping in November at the Royal Caribbean private island in Haiti. And yes, technically, it's Haiti, and you could say you've been to Haiti. But all you've seen is a walled-off part of Haiti. I think to attract the millennials -- and I've talked a lot about this with Dylan Lewis outside of Industry Focus -- you're going to need to have destinations where they go interesting places and maybe stay overnight. So, you can go hiking, you can experience the culture, you can do a little more than browse duty-free shops and go to a water park. It's going to need to be some fundamental changes. And you are starting to see some of the amenities on the ships be a little more appealing to people with younger kids, or millennials. There's laser tag on ships now; there's aqua theaters where people are doing elaborate productions; you can ice skate, there's robot bars, all sorts of stuff that maybe tries to break the stuffiness. I'll say, Royal and Carnival have both very much relaxed the dress code. The old days of having to dress up -- pretty much, you could wear what I'm wearing now any night on a Royal or a Carnival ship. And you might see someone next to you wearing black tie, but you might also see someone wearing flip flops and a tank top. So, there are subtle changes. But I do worry about whether the overall concept appeals to younger travelers, at least until they have kids.

Jones: I totally agree. For millennials, they're looking for more authentic experiences. The millennial generation tends to be much more price-sensitive as well. And ultimately, they want unique and relevant onboard activities as well. I think this is a tougher demographic to target. But I do like to see where Royal Caribbean is going with that. 

Let's also talk about the final key consideration. That is, of course, as always, related to fuel prices. How is that impacting the cruise line now, and especially heading into next year, too?

Kline: In a broad sense, for the first six months of the year, Carnival and Royal both had stupendous quarters. Numbers are up. But profitability hasn't necessarily held up. That's due to fuel prices. The industry is very sensitive. There's not that much you could do. They're modernizing, they're adding technology that improves fuel efficiency. But it's not like you can have an electric cruise ship. Maybe you can someday, but you can't right now. The industry is very sensitive to that. They do hedge fuel prices six months, a year out, I'm not sure the exact number. But if we saw fuel spike 25%, 30%, it's unlikely they're going to be able to raise prices comparably because the cruise industry is fighting against resort vacations, Vegas vacations, beach vacations, all the other options where, yes, an airline ticket might go up, but in most cases, if you're taking a cruise, you're doubly exposed to fuel prices. Not in my case, because I can drive to the cruise terminal. But if you have to take a plane, your air ticket goes up because prices have gone up for fuel, and then you get on a cruise -- the cruise line has much less pricing power than the airline does.

Jones: Also, beginning in January of 2020, the International Maritime Organization, or the IMO, is actually set to enforce new emission standards designed specifically to curb pollution produced by so many of these massive cruise liners. Basically, this will force these cruise operators and even ocean freight companies to switch from a high-sulfur, sludge-like fuel, pretty much what's at the bottom of the barrel, to more refined, lower-sulfur diesel fuel. It'll be interesting to see heading into 2020, in terms of the pricing issues. Will they have to start raising prices? If so, will that price a lot of these consumers, especially millennials who are more price-sensitive, out of the market? We'll have to wait and see on that one, but that's something else to keep in mind there as well.

Kline: I think you can somewhat have your cake and eat it too. There are certain times of year -- any of the school vacations, any of the holidays where kids are off -- where yes, you're competing with other kinds of vacations, but everything is expensive. So, I think you can inch prices up during in-demand times and actually lower prices during some of the lesser demand times. September, because of hurricane season and because school's in session, is not as heavily in demand, so I'm getting amazing offers, everything from free for short trips to very low-cost for longer trips. And in that case, they're not hurting themselves by offering a little bit of a deal overall, as long as they can make that up during the busy times. It's a very tough market to price as a consumer.

As an investor, you really have to keep an eye on what the promotions are. It's also very tricky. There's a lot of buy-one-get-one deals where you have to really do math. It's one of the few areas of travel where I tell people, maybe you want to go through a travel agent, because it is hard to navigate, and that's intentional deception -- deception is such a lousy word, but intentional confusion -- of the market in order to get the most out of every person.

Jones: Fair enough there, Dan. Alright, Dan, let's turn our attention to the biggest cruise operators, the biggest of which we'll start with first. That's none other than Carnival, ticker CCL. Dan, from a high-level perspective, how's Carnival doing?

Kline: As we talked about a little bit before, they're doing very well, but they're using a cautious optimism. Booking numbers are up, revenue numbers are up, everything is going along swimmingly with the minor exception of having to revise down a little bit for fuel prices and the loss of Cuba. But when they talk, the company does not want to say everything is great, because it's very fragile. If you look at the fact that they're committed to 19 new ships by 2025, that's a lot of added capacity. It's a lot of new markets. It doesn't take that much for that to fall apart. They did slightly bring down their full-year revenue, but it's still very robust, and bookings are tracking ahead of the previous year. So it's smooth sailing ahead, but you never know when a storm is going to come up.

Jones: Truly never know when a storm is going to come up. I know they've also had to deal with some headwinds on the European front. You've got Brexit, concerns in Italy. It sounds like all in all, basically, Carnival knows that there's going to be some short-term headwinds, but that's not stopping them from investing into their fleet and continuing to build out the massive amount of ships that they have under the banner.

Kline: In addition to building 19 new ships, they've also done some major renovations. The ship I'm actually going to be out in December, they've done much to it, a multi-hundred-million dollar renovation, that they're changing its name. Why is this important? Because Carnival makes about 75% of its revenue from you buying a ticket. The other 25% comes from onboard revenue. Royal Caribbean, it's closer to 50/50. So, if you're a Carnival, and you can redo your ship to add more for-fee restaurants, more experiences that cost money, more shopping opportunities, another place to play bingo that they charge you $20 and keep about half the revenue compared to the prizes -- the more they can add that's going to entice you to spend money... they're also adding free venues as well, and experiences that don't cost money. But the more they can get you to spend, they can keep the same amount of passengers and up their profit. I don't know what the profit is when you buy a $7 Starbucks drink on a Royal Caribbean ship, but I'm going to guess it's very, very high compared to drinking the free coffee that's included. 

All of this investment is about, generally, having the bigger ships that wow people, that generally sell for the highest prices, because people want to try all the new stuff, and targeting certain markets. Some of the European ports cannot take a 6,000-person mega-ship, so you need a 2,200-person capacity ship that still has a lot of the bells and whistles and ways to make revenue. That's how Carnival, and to a similar extent, Royal Caribbean, are engineering their fleets. 

It's a huge investment. It's kind of that Amazon model where it pushes off some of their profits, because they continually have to invest. If Carnival adds this experience, then Royal has to add that one. You're seeing it with like the Broadway-style shows, instead of the old school musical production numbers, the standalone comedy venues. It's very much an arms race where people say, "What am I going to get for free?" You mentioned Disney earlier. Well, you pay double to triple the price, but you're getting Disney entertainment, and everything is included. There's a lot of financial pressure to be bigger and better.

Jones: So true. Speaking of Royal Caribbean, ticker RCL, Dan, I feel like I can't go a day without seeing a Royal Caribbean commercial on the television, touting their brand-new island, touting their ships and the latest and greatest feature on their ships. This is a company, even though it's smaller than Carnival, honestly, it has been impressing me more and more. The more I dig into this company, it seems like they are firing on all cylinders.

Kline: I think they've done a very smart job in targeting families. You mentioned the private island. Pretty much every cruise line owns one or more private islands. What that generally means is, it's a strip of sand, maybe there's a volleyball court, a playground, a couple of bars, usually the bars cost extra, they'll throw a barbecue, that'll be included, and it's kind of a nice beach day. What Royal Caribbean did in their Caribbean island, and they're going to be doing this to their other islands, is they put in a water park. That's an added fee. They built out five or six beaches, one of which has a lovely swim-up bar that I highly recommend. They put in the biggest pool in the Caribbean. And they added all sorts of included bars and restaurants. So, instead of just being a place you could chill on the beach for a few days, there's family activities. The water park, which is maybe $40 a ticket, is good for my teenage son, who was pretty thrilled that they had free funnel cakes and other theme-park-style food. Whereas I was more than happy to chill out by the bar, and the bar is included if you get a drink package, which wasn't previously the case on private islands traditionally. So, they've really made a move to make it a real value to families instead of a day where it's like, "OK, I can get the kids to the beach for 90 minutes, but they're not going to be that interested." You can get off. And you're starting to see that on the ship. The teen areas are being amplified. They're making it more fun for the whole family. The last thing they want you to do is be in your cabin. The cabins are very, very small -- 180 square feet would be considered a large inside cabin. So, if you're a family of four, that's very tight. But if they can entice the teenagers to be in the teen club, and the 7-year-old is in the 7-year-old area, and Mom and Dad are in the adults-only pool, they've ramped that up, and Royal, I think, has done a very good job in carving out that fun for the whole family environment, and, while it is a drinking-heavy atmosphere, keeping things PG-13.

Jones: As a result, all the focus on the onboard entertainment and even with the private island, bookings have hit record levels consistently. Occupancy level ticked up for the third straight year, rising to 109% from 108%. This has been the case. Dan, can you explain how exactly occupancy rates can be over 100% on cruise lines?

Kline: We talked about this a little bit earlier. A ship is considered at full occupancy if all the regular rooms -- let's not consider suites, because the economics change, but every regular room has two people at it. That means, if I'm going alone, but you have two people with you, together, that's four people across two rooms. Those two rooms are both considered full. A ship might have a "maximum occupancy" of 4,500, but can actually sail with 5,200 people on it. Why would you want more people? More people spend more money, they gamble more. But if you leave at 100% -- and pretty much every cruise ship, aside from some of the ones that were meant for Cuba is leaving at 100% -- you can be at full occupancy. 

One of the things both cruise lines do incredibly well is, once they have you they market to you extensively. On the cruise, there is very heavy incentives to book your next cruise. And you're having fun, maybe you've had a couple of drinks, it's easy to sit down and put a deposit so the vacation never ends. When you land, you start getting hit, I would say two or three times a day in some cases, if you're on a casino list and a regular list, with new offers. "Here's $100 off!" You get something in the mail, "Here's $300 off!" Once they have you, they try very hard to keep you. And in theory, that's building an audience. Maybe that will create that next generation of cruisers. If I take my kid on a cruise and he likes it, maybe when he's 25, him and his buddies will go on a cruise, though I have yet to see that. I don't see a lot of people under 30 not traveling with their parents, with the exception of, you do see some bachelorette parties.

Jones: So true. Thankfully for the Disney Cruise Line, that's the only one I've been on far, although you are pushing me highly into the direction of Royal Caribbean, so that's on my list. But Dan, if you had to choose between Royal Caribbean and Carnival, to close us out, what would be your top, both as an investor and as a traveler?

Kline: As an investor, I like what Royal has done from a marketing point of view a little bit better. I think they've staked out a very unique place as fun for the whole family. Whereas Carnival has a vague branding. As a casino patron, Royal paints it as very glitzy, even though they're not, they're $10-a-hand blackjack tables. Carnival's casino mailing is like a caricature of an old lady. She sort of looks like the Shoebox Greetings old lady. I don't know who that's appealing to. If I was that age, I wouldn't want to be depicted as a caricature, but also, that's not very appealing to me as a 45 year old. 

In terms of the actual cruise experience, I enjoy them both. Carnival has, I would say, slightly better entertainment in terms of the nightly major shows. They also have standalone comedy clubs, which I find very enjoyable. Royal, on the other hand, has wonderful smaller musicians. For example, in their British pub concept, there's usually a guitarist doing quiet covers. Sam, my guitarist friend, on the Navigator [of the Seas], the last ship I was on a couple of times, attracted a following. It was different than being in the big venue. They often have a funny pianist. Whereas Carnival is more on the bigger experiences. But they're very comparable. I would say it's the private island for Royal that tips it. The food is maybe a tad better on Royal in the dining room. Again, both are pretty good values. You do want to think about destination. If it's important to you to go to European sightseeing, well, that's very different than going on Caribbean or Mexican island stops, which are much more beach days or, as I said before, a collection of duty-free shops and chain restaurants. 

It's not really close from an investment point. From an investment point, I like what Royal is doing better. From a travel point, it tips toward Royal, and I won't pretend that isn't it influenced by the fact that Royal has been throwing a lot of free stuff my way because I gamble, because I live in Florida. So maybe that has biased me just the tiniest of bits.

Jones: Maybe just a little bit, Dan. Always good to have you on the show, Dan! Not only do you give investing tips, you also gave some great travel tips to all of our listeners out there. Thank you! Always a pleasure to be chatting with you! And thank you to all of our listeners for tuning in! That'll do it for this week's Industry Focus: Consumer Goods show. 

As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is being mixed by Dan Boyd. For Dan Kline, I'm Shannon Jones. Thanks for listening and Fool on!