City Insider: Carry on cruising – but watch the oil price

City Insider - A City perspective on the travel industry from FT journalist David Stevenson

Carnival’s numbers are promising for the company and the cruise sector – but it isn’t all plain sailing, says our business and finance columnist

Perusing the second quarter results from cruise giant Carnival last week, I was struck by a simple truth. Mass market operators are struggling to edge up net margin by cutting capacity, yet the likes of Carnival seems to be able to up margins by increasing capacity.

This clever trick probably helps explain why the market attaches double-digit multiples to shares of Carnival and single-digit multiples to Thomas Cook (no more within the FTSE 100) and Tui.

If ever an investor wanted a definition of what consistutes, in the simplest sense, a ‘growth stock’, this is it: grow capacity and charge more. 

But dig beneath the numbers and you’re also struck by another plus. Carnival has spent billions investing in new capex (ships to you and me) which will lead to huge increases in depreciation and open up more cost-cutting initiatives and bulk buying opportunities. That in turn will help squeeze costs even more.

That should all flow through into big bottom-line cash inflows paid out as dividends to shareholders in a few years hence. 

Yet we shouldn’t get too dazzled by these dizzy long-term thoughts. Carnival isn’t making plain sailing out of the recovery, and arguably the cyclical rebound in sales at the big tour operators has been stronger. Carnival announced earnings per share of $0.32, only a little above company guidance of $0.26-$0.30. But net yield growth was positive at around 3% per annum – the first decent numbers since late 2008. 

The other big news from these numbers was the strength of Carnival’s brands in Europe. According to vice chairman Howard Frank:

“Our European brands grew 13% while our North American brands grew 4%. … Our European brands experienced 1.2% lower local-currency ticket yields, which were in line with our expectation.

“Our European brand bookings during the last six-week period had held up extremely well, with significant improvement in booking volumes and solid improvement in year-over-year local currency pricing.

“This is yet another example of how the European consumer appears to be more resilient to geopolitical and economic events than is their American counterpart. … Currently pricing for Europe brands is slightly higher year-over-year, which is a very positive sign given the 8% capacity increase in our European fleet during the quarter.”

Crucially, the outlook in Europe is also very positive:

“Europe itinerary pricing on a local currency basis is nicely ahead of last year, with slightly better occupancy. Bookings continued to be strong for the fourth quarter, and we are forecasting that by the time the fourth quarter closes, Europe brand local currency pricing will be higher year-over-year, which is a very good result, considering that 10% plus capacity increase that we had during the quarter”. 

So that’s yet more vindication of the idea that Europe is the great growth market for cruise-based holidays – expect yet more increases in capacity and new brand-based ideas.

But these Q2 numbers also contained one absolutely crucial bit of bad news: fuel prices. According to Frank, fuel prices this quarter were a staggering 64% higher than last year, “costing us $162 million or $0.20 per share”.

Think about that number for a moment. A large part of the entire earnings flow from operating a cruise line can be destroyed by a big increase in oil prices. Oil as a percentage of total costs in the quarter moved up from just 9.3% of the total mix to 16%, a massive move that opens up a number of questions.

The first is that fuel surcharges for the key North American market – directly levied on customers – must be fast approaching. Also bear in mind that any business that is so operationally geared to oil will eventually pay a heavy price on the global stockmarkets – investors like their growth stocks to have an organic business expansion model unencumbered by big external factors. The price for this volatility will be eventually be a lower share price as investors demand a margin of safety.

Last but by no means least, I’d suggest that if Carnival and its peers can’t pass all of that volatility on to customers, it must come up with a cunning plan to either reduce oil’s impact on the bottom line by increasing overall prices, engage in some massive and risky hedging or think about new technologies and energy sources.

I don’t subscribe to the idea that oil prices will continue to rocket as we approach peak oil, but I do think oil will continue to trade in a $50 to $110 range. If the big airline guys are seriously considering the idea of an all biofuel plane, surely we must be only years away from the first cruise ship powered entirely by biowaste.

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