After years of struggles in the face of a global pandemic and macroeconomic uncertainty, cruise line operators have been bouncing back. Cruise stocks have enjoyed some tailwinds, and Royal Caribbean Group (RCL, Financial) has been no exception.
Royal Caribbean’s share price has risen by just over 100% since the start of the year, marking a major turnaround for a stock that had been severely beaten down during the pandemic era and subsequent years of macroeconomic shakiness and market uncertainty.
Yet while Royal Caribbean’s fortunes may appear to have turned around for good, there is also good reason for investors to remain skeptical.
Summer season surge
Royal Caribbean’s momentum has continued apace in recent months, with its stock surging up by 58% in the last three months alone. These latest gains can be attributed in large part to analysts’ increasingly upbeat expectations about the summer vacation season. The growing analyst positivity toward Royal Caribbean has translated into a number upgrades for the stock, most recently from Stifel Nicolaus, which raised its price target from $100 to $120 in a June 23 update.
Cruise lines have been slower to rebound since the pandemic compared to other land-based vacation options, but they are finally catching up. However, cruise pricing growth continues to lag behind such things as hotel rates. This could represent a significant tailwind for some time, as UBS analyst Robin Farley noted on July 3:
“If you compare it to demand for land-based travel, hotel rates are up about 17 percent since 2019…the start of the pandemic. Yet cruise prices are up only single digits this year. So there is still a significant gap in price between cruise and hotels, so we do think we are going to see cruise demand until…that historical gap in prices closes.”
Investor sentiment has been stoked further by Royal Caribbean’s own guidance and comments. Management sounded an especially bullish note on the first-quarter earnings call in May, raising full-year earnings guidance for 2023 to between $4.40 and $4.80 per share.
Given these tailwinds, investors are probably safe to expect Royal Caribbean’s positive momentum to continue through the current summer vacation season at least, barring any unexpected macro shocks to disrupt the industry.
Profitability problems persist
Not all is smooth sailing for Royal Caribbean, however. The company faces a number of ongoing challenges that could threaten not only its recent market gains, but its financial survival.The biggest problem facing the company, and all cruise stocks, is achieving sustainable profitability on an ongoing basis. Royal Caribbean was forced to suspend its dividend in 2020 as part of its efforts to weather the storm of the Covid-19 pandemic. The company was also forced to take on significant new debt in order to survive. Royal Caribbean’s long-term debt load more than doubled in the course of a single year, from $8.4 billion at the end of 2019 to $18 billion at the end of 2020. Long-term debt continued to climb from there, albeit more slowly, eventually peaking at $21.3 billion at the end of 2022.
Royal Caribbean has touted its recent efforts to pay down some of its debt, which fell 2.7% to $19.4 billion during the first quarter, but the overall debt load remains considerable. With a debt-to-equity ratio hovering around 6.4, Royal Caribbean’s ability to service its obligations over the long run is very much an open question. Management has sought to allay concerns highlighting its strong cash position, which stood at $3.9 billion at the end of March. Yet even that level of liquidity may not be enough to keep investors happy should the company’s profits dip again.
Royal Caribbean’s margins are rather thin to support its level of debt, and its ability to achieve sustainable profitability is unclear. While improving profitability may be able to help further reduce its debt burden, Royal Caribbean has yet to prove whether it can deliver sustainable earnings growth. Given the nature of its industry, which is highly cyclical and capital intensive, even a mild recession could be enough to devastate the company’s bottom line. That is a cause for concern regardless of its current liquidity position.
My take
In my assessment, the recent positive run of the stock has left the cruise line operator looking considerably overvalued on a fundamental basis. Consequently, the stock faces considerable exposure to a potential bearish reversal down the line. Even if Royal Caribbean’s share price simply experiences some mean reversion, which is something that tends to happen to stocks of all types eventually, investors might find their gains erased in short order.
More broadly, the company faces significant issues with its debt burden that it will need to resolve before it can establish itself on a firm financial footing. Like many of its fellow cruise operators, Royal Caribbean is currently carrying an awful lot of debt on its books, and it is far from clear whether it will be able to service it over the long run.
From a value investing perspective, it is hard to justify holding Royal Caribbean given the uncertainty created by its unsustainable debt levels. Until it can demonstrate sustainable, long-term profitability that is sufficient to meet its debt obligations on an ongoing basis, the stock should be given a wide berth.
