The pandemic almost took down Carnival Corporation (CCL -0.66%), but the cruise line has survived and is back on its feet. The company gave an update on its business for the first quarter and disclosed that its operations turned cash-flow positive and customer deposits hit $5.7 billion, a first-quarter record.
Some investors may now be wondering how high the stock could go given that it remains more than 85% off its former highs. While Carnival could see smooth waters over the long term, the investment picture is more cloudy. Here is what could keep Carnival from delivering the returns that some investors dream of now.
Carnival's debt probably won't sink it
Most investors are aware of the company's enormous debts, which it accumulated to keep the business alive during COVID-19. You can see below that debt more than tripled from pre-pandemic levels. While not ideal, it's not the existential threat to Carnival's business that some might think.
Carnival's business has rapidly improved as travelers return to the waters. Free cash flow burn has slowed to $687 million, and management declared it has $8.1 billion in liquidity, about $5.4 billion in cash. At last quarter's rate, Carnival's cash alone could last roughly two years before running out.
CCL Cash and Short Term Investments (Quarterly) data by YCharts
The fact that operations turned cash-flow positive in the first quarter of 2023 signals that cash burn should continually improve. The company's record Q1 bookings show that filling its ships shouldn't be a problem.
But it could drown Carnival's earnings growth
The real problem is Carnival's costs to service that debt -- that is, the interest accumulating over time. Interest expense was $1.65 billion over the past four quarters. Interest on debt subtracts from the bottom line, hurting free cash flow and net income. Perhaps that's why management is guiding for $4 billion in EBITDA in 2023, which excludes interest payments.
Carnival generated $2.37 billion in free cash flow during its best-ever year, so the interest expense is a tremendous weight on the business.
CCL Free Cash Flow (Annual) data by YCharts
Management plans to use excess operating profits to pay down debt, which will alleviate the interest expenses over time. Interest rates across the economy have ratcheted higher over the past 18 months, so investors must hope Carnival can avoid refinancing debt into higher rates.
Several headwinds could further pressure profits
That's not to say that Carnival can't do it; analysts believe the company's earnings-per-share (EPS) will turn positive at $0.77 in 2024, according to consensus estimates. The stock traded at a price-to-earnings ratio (P/E) of more than 24 a decade ago. Applying that valuation against next year's EPS estimates generates a hypothetical share price of $18, nearly double today's price.
But investors should remember that the company's balance sheet could easily depress the market's valuation of Carnival. If the economy enters a recession, the resulting pullback on consumer spending could also impact Carnival's business, which is discretionary spending, a category that consumers cut from budgets when times get tough.
The stock could wind up a long-term winner, but it's not the slam dunk case it might look like on the surface. Carnival's debt and interest expenses could significantly impact its bottom line for the foreseeable future, so temper your expectations until you see some real traction on improving the balance sheet.
