Shares of Carnival Cruise Lines (CCL -0.66%) sold off hard following its recent third-quarter earnings report last week.
Yet for some perspective, Carnival's stock is actually still up a whopping 70% on the year. But that's also misleading in the grand scheme of things, as shares are still off 80% from their all-time pre-pandemic highs.
Carnival's stock is still vulnerable due to its massive $30 billion-plus debt load it had to accumulate during the pandemic. Now that we're on the other side of the pandemic and getting back to "normal," it's no surprise there's volatility. On the one hand, when companies successfully pay down their debt, their stocks can skyrocket, as more of their enterprise value goes to equity holders, and the lower risk after paying down debt can often result in higher multiples.
However, heavily indebted companies can see their stocks plummet when there's a setback. Unfortunately, even though Carnival continues to see the strong demand that fueled optimism earlier this year, investors are learning that the de-leveraging process will be a long, hard slog.
Oil prices are weighing the profit recovery in Q4
It might seem strange at first that investors sold Carnival's stock after the report. After all, revenue and earnings per share came in ahead of expectations and well above the company's June guidance. Carnival also posted its first positive net income based on generally accepted accounting principles (GAAP) since the onset of the pandemic, which is a milestone to be applauded.
However, management also gave underwhelming profit guidance for next quarter and the full year. This was, unsurprisingly, due to the big increase in oil prices we've seen through this quarter. Management noted a 20% increase in oil prices compared with June. The increase in both oil prices and the U.S. dollar will cost Carnival an extra $130 million in the fourth quarter, which will undo most of the $200 million outperformance ex-fuel and ex-currency compared with the original June guidance, management noted on the conference call with analysts.
Of note, Carnival doesn't hedge fuel prices, as most of its competitors do. That has left it vulnerable to the recent oil price spike.
Over the long term, that may not be such a bad thing, as hedging does have a real cost as well. And instead of hedging, management has been focused on making its fleet more and more fuel-efficient and using less oil over time. CEO Josh Weinstein noted that Carnival already has the most fuel-efficient fleet in the industry by a wide margin, and is looking to widen the gap. Due to those upgrade and efficiency efforts, Carnival uses 16% less fuel per available lower berth day (ALBD) than 2019, which has saved the company $375 million this year alone.
Nonetheless, the lack of a hedging program does leave the company vulnerable to extreme short-term moves in fuel prices from time to time.
Cruise lines are hit by a recent increase in oil prices. Image source: Getty Images.
More dry-docks next year
In addition to the volatility in oil prices, management also noted 2024 may be a muted year for debt paydown for two additional reasons. One is that there are 580 dry-dock days next year for Carnival's fleet, which will be up 18% over 2023.
Dry-docking is exactly what it sounds -- when a ship must go to a large structure that will lift it out of the water so it can undergo repairs and maintenance.
It's not surprising that many ships will need dry-docking next year. Cruise ships typically need them every few years, and since all cruise companies were slashing as many expenses as possible since the 2020 onset of the pandemic, it's no surprise many are now in need of dry-docking all at once a few years later.
And more ships coming next year will drive up new builds
In addition to 2024 being a larger maintenance year, Carnival will also be taking possession of three new ships, which will increase its capacity 5% over 2024. New capacity will lead to some incremental costs, and then obviously more "growth" capital expenditures, even with some offsets due to export credits.
This portfolio growth, combined with the dry-dock days, will eat into next year's free cash flow, even if Carnival continues to show the strong demand it has. Thus, management said that while it still expects to lower debt by $8 billion by the end of 2026, it will probably not happen in a straight line.
But management does note that Carnival only has one new ship it's acquiring in '25 and no ships in '26, which will leave more cash available for debt paydown in those years. That keeps its long-term target of $8 billion in debt paydown through 2026 intact, at least for now.
More delay, more risk
It should be noted that it was certainly not all doom and gloom for Carnival shareholders in the report. In fact, the most important thing, which is demand and pricing power, seems to be on track. Importantly, management noted the cumulative advanced booked position for full-year 2024 is well above historical levels, and at higher prices.
Questioned throughout the call, management noted that despite economic concerns, there has been no letup in onboard spending either, with per-diem spending up more than thought last quarter and into this quarter. While this could change, it's also noteworthy that cruises tend to be cheaper for the amount of places one sees than going by land. So, cruising may be more "resilient" to other forms of travel in an economic downturn (outside of a pandemic, of course).
This is why management and, apparently, the company's bondholders have expressed confidence. Last quarter, Carnival was able to refinance and extend maturities of some of its debt at lower rates -- in fact, the lowest-rate debt of any cruise line in the past two years, before the recent rapid increase in interest rates. That, combined with the strong advance bookings, convinced management to use more of the company's balance sheet cash to pay down even more debt than expected last quarter. Currently, 80% of Carnival's debt is fixed-rate, with an average coupon of just 5.5%.
That being said, Carnival's still-high debt load does mean that when unexpected cost increases happen, the company's de-leveraging can become delayed. And when a company is as heavily indebted as Carnival is, delays lead to greater risk of something bad happening, such as recession, another pandemic, or some other setback.
If oil prices cool off and Carnival continues to execute, there is lots of upside in the stock. Just be aware that leverage works both ways, so any more hiccups could be magnified to the downside as well.
