Seeing a rebound story in the works, the market has been flocking to Carnival (CCL 1.06%). The cruise company neared bankruptcy during the pandemic, but the stock has since rallied hard and is now approaching a 52-week high. Still, the stock remains more than 80% off its pre-pandemic peak.
So, are investors sailing the high seas to stellar investment returns ahead, or is there an iceberg on the horizon? The reality is that Carnival's stock has some problems beneath the surface, so read on to find out why investors might want to sell or steer clear of this hot but troubled company altogether.
Why Carnival probably won't revisit its highs anytime soon
Carnival nearly went out of business when COVID-19 forced the company to shut down operations. It had to furiously raise funds to survive, including issuing new shares and borrowing a lot of money. The number of outstanding shares has increased by 66% over the past three years, and debt has grown by 41% to $35 billion.
That has bloated Carnival's enterprise value, which is its market value plus its net debt. You can see below how the share price and enterprise value were tightly correlated before the pandemic but diverged in 2020. That's the impact of adding new shares and borrowing.
CCL enterprise value; data by YCharts.
So while the share price is more than 80% off its former high, the company's enterprise value is just 23% off that high. In other words, the share price doesn't accurately reflect how much Carnival's valuation has increased since the pandemic lows. The share price going much higher from here would mean Carnival is achieving a valuation much greater than anything it has traded at before.
The biggest underlying problem: interest expenses
Carnival might reach a new all-time high valuation, but there are some reasons it probably won't. Justifying a higher valuation will likely require the business performance that supports it. The company earned net income of $3.2 billion in its best year ever.
You can see below that while the business is bouncing back from its pandemic lows, there is still a multibillion-dollar gap to close before the company makes a cent in profit. And it's now paying interest on that $35 billion debt on its balance sheet.
Interest was minimal during Carnival's best year, when the debt was much lower. Now it's paying $1.6 billion in annual interest, enough to wipe out half of the profits from its best year.
CCL net income (TTM); data by YCharts. TTM = trailing 12 months.
This will only become a bigger problem for Carnival. The company burned $687 million in free cash flow in its most recent quarter, so cash profits remain a ways off. There's plenty of cash (about $5.4 billion on hand) to support operations, so keeping the business running is not the issue.
Instead, it's about how Carnival can address the debt. Interest expense could eat up profits for several years, making a higher valuation for the stock seem irrational today.
What should investors do?
How long can a stock support a high valuation without any profits? Carnival stock seems more like a game of musical chairs than a viable long-term investment until it can turn a profit. It's not the company's fault the balance sheet is in this situation. Management had limited options for keeping afloat during an unprecedented crisis.
But eventually, the stock will trade on its fundamentals, and investors shouldn't risk being too slow to take a seat. Shares are up 62% in 2023, a good opportunity to lock in some profits if you haven't already. And if you're on the outside looking in, think carefully before buying shares.
