When the pandemic eased, it seemed everyone wanted to travel. Hotel and airplane prices started to soar as consumers -- especially Americans with pent-up stimulus savings -- were free to spend their money. Investors noticed and started buying shares of these stocks on a reopening theme.
This theme has continued into 2023, and one of the biggest beneficiaries has been Royal Caribbean Cruises (RCL 2.27%). The leading cruise company is up 112% so far in 2023 as its revenue, bookings, and profits continue to grow.
A booming share price has made Royal Caribbean one of the top-performing stocks in the S&P 500. But does that mean you should hop on the reopening train and buy shares?
Strong Q2 results
In late July, Royal Caribbean put out an earnings release that sent its stock up close to pre-pandemic levels. Revenue grew 61% year over year to $3.5 billion, driven by higher prices in both North America and Europe. With a limited amount of ships available for sail and millions of passengers looking to buy tickets for excursions, Royal Caribbean has been able to implement a tremendous amount of pricing power in recent quarters.
Despite seeing inflationary costs on inputs such as wages and energy, these price increases have led to a strong profit inflection for the company.
Operating income hit $772 million in the second quarter, up from an operating loss of $219 million in 2022. Over the last 12 months, the company generated around $1.4 billion in operating income and is likely on its way to posting more than $2 billion in profits for shareholders this year.
The near-term demand outlook also looks solid. In its Q2 report, management said bookings for 2024 excursions are up significantly compared to any prior year, and at record prices. Further pricing power should lead to even better profit potential for Royal Caribbean, all else equal.
RCL Operating Income (TTM) data by YCharts
Long-term industry growth
Looking beyond next year, the cruise industry is set for steady growth this decade, according to industry analysts. Passenger volumes are expected to reach 36 million in 2024 and then 39.5 million by 2027. These numbers -- if hit -- would be up 21% and 33%, respectively, compared to 2019 levels.
For Royal Caribbean, this could mean strong double-digit earnings growth this decade as long as these projections are hit and the company is able to consistently raise ticket prices.
Don't get fooled by a soaring stock price
With soaring profits and an industry tailwind at its back, you might think Royal Caribbean is a slam-dunk investment opportunity. In fact, the stock doesn't even look that expensive at a market cap of $26.5 billion. That is just 13x its 2023 earnings if it can reach $2 billion in operating income this year.
But this omits a crucial part of the story: debt. Royal Caribbean has a massive amount of debt on its balance sheet that it accumulated during the pandemic to stave off bankruptcy.
At the end of Q2, the company had $18.7 billion in long-term debt and $1.7 billion in current debt (meaning debt due within 1 year). A lot of this debt comes with interest rates at 10% or higher. Total interest expense for Q2 came in at $355 million, which lowered its operating income from over $700 million to a net income of $463 million. That is a material difference in profitability.
It is going to be a tight squeeze for Royal Caribbean to repay the principal on this debt, too. Every year from 2023 to 2027, the company will need to pay back at least $2 billion in loans, which will need to be funded by free cash flow. Royal Caribbean has only ever generated more than $2 billion in free cash flow one year in its history, 2017.
High ticket prices and growing capacity could lead to record free cash flow generation for the next few years, but that assumes no global recession materializes. It also leaves little -- if any -- cash available to be returned to shareholders, which puts doubt on whether the stock should be valued at $26.5 billion.
If Royal Caribbean hits even the slightest hiccup in its growth trajectory, the stock could be in a world of hurt. Don't take this downside risk on a heavily indebted company, buy some steady blue chips for your portfolio instead.
