As investors look forward to a navigating a receding pandemic, they may focus on stocks that will benefit from a return to normal -- but they might find some dangerous and unexpected undercurrents pulling against them.
Take the stocks of the major cruise lines Carnival (CCL) , Royal Caribbean (RCL) , and Norwegian (NCLH) , for example. These have already fully returned to their pre-pandemic enterprise valuations without a commensurate business resumption on the horizon. This presents a serious problem for investors since the risk/reward skews negative. Unlike most other industries, whose stocks have recovered, the cruise industry still experiences losses, maintains significant Covid risks, and the balance sheet leverage adds structural obstacles to regaining profitability.
The share prices may appear down from prior years, but dilutive equity raises and debt increases, have added significantly to the valuation. The pre-pandemic cruise-lines valuations don't have a magic formula that investors need to abide by, yet 2019 enterprise values offer a useful guide. The fact that the valuation has been surpassed provides a red flag that investor enthusiasm is considerable and that a full business recovery is mostly baked in. The likelihood of investor disappointment runs high.
In a recent research report, Morgan Stanley cautions that the Omicron variant will lead to a slower and weaker recovery than investors anticipated. There is an increased risk that more equity raises are necessary to offset the highly leveraged financials. Plus, the tepid pricing environment undermines the bull case of pent-up demand driving pricing power.
The Omicron variant temporarily pushed the cruise industry stocks down, however, the negative impact on the business has persisted. The Centers for Disease Control and Prevention's warning to avoid traveling on a cruises disrupted the usual seasonal strength in bookings for the first- and second-quarter travel. Continued uncertainties of international travel are likely to add to service disruptions. A recent Morgan Stanley survey of travel agents finds the highest business weakness in the past 12 months.
The cruise industry profitability stands to be undermined by prevalent inflationary forces. Fuel, labor, and food costs have experienced significant increases, in addition to Covid protection expenses. The industry's mounting debt at higher interest rates has ballooned interest expenses. Royal Caribbean and Carnival will see annual interest payments rise over a billion dollars from 2019 levels.
Another under-the-radar potential expenditure comes from reports that the International Maritime Organization is considering a new tax on shipping to help build a global network of alternative fuel stations for vessels. The proposal calls for charging vessel operators $100 per metric ton of carbon dioxide emitted per trip. If implemented as proposed, the three cruise operators would incur an estimated $2 billion in annual costs.
Hindenburg Research, known for activist short selling, recently made the case that Royal Caribbean's fundamentals were permanently impaired by servicing the high debt load. Hindenburg cautioned that shareholders could be further diluted through equity raises.
Wall Street will have to grapple with risks to the cruise industry that have never before impacted the stocks. The potential for severe operating disruptions ought to warrant a discount in shares to account for the increased investment risk. Yet, currently paying the same enterprise value as pre-pandemic leaves little room for future reward for shareholders.
The bonds of the major cruise operators, yielding around 5% for four to five years to maturity for the junk rated debt, would most likely be a better investment than the stocks.
There are also better investments on the reopening spectrum, including airlines, such as Delta (DAL) and United Airlines (UAL) . They're still slightly below their pre-pandemic enterprise valuations, and the outlook for generating solid cash flow is improving.
Strong demand for cruising can certainly gain steam when the pandemic fades. But in the near-term, demand has softened and pricing is weak. Trying to capture the investment reward by seeing through this business weakness to a better day is questionable considering the impaired profitability outlook and the current valuations. Expect choppy waters ahead.
