Many investors have fallen in love with cruise stocks. The sector has crushed the market this year, with companies such as Royal Caribbean Cruises (NYSE: RCL) up around 100% in the last 12 months and approaching their pre-COVID highs.
With most world economies finally getting past the pandemic, consumers are using their savings to spend big on vacations, which helped Royal Caribbean grow its revenue by 66% over the last 12 months.
But a nice narrative from Wall Street and fast-growing revenue do not mean Royal Caribbean is a foolproof stock. Far from it, actually. Here are three reasons to avoid buying Royal Caribbean shares at today’s prices.
To save itself during the pandemic lockdowns, Royal Caribbean was forced to take on massive amounts of debt. This kept the company out of bankruptcy but has weakened its balance sheet considerably.
The company has been able to pay down some of this debt in recent quarters, but total loans outstanding stood at over $20 billion at quarter’s end, around double its debt load from before the pandemic.
The interest expense on this debt is sizable as well. In the first six months of this year, Royal Caribbean paid $715 million in interest, which almost wiped out all its operating income for the period.
What does this mean for investors? A few things. First, you should not value Royal Caribbean on its market cap, but its total enterprise value, which adds back its net debt.
Second, you should not use any metrics like operating income or earnings before interest, taxes, depreciation, and amortization (EBITDA) with Royal Caribbean. Its interest expense is real and will be a headwind for many years, if not indefinitely.
Sure, the company should be able to pay back and refinance its debt since it is now generating cash flow, but it will be a huge dampener on the cash that can be returned to shareholders, which is what drives the majority of shareholder returns over the long haul.
Royal Caribbean is perhaps the opposite of a durable, economically insensitive business. The cruise industry is highly cyclical, meaning that demand soars during times when consumers have healthy balance sheets (such as today), and it dips in times of economic hardship.
Cruises are a form of vacationing and are a pure discretionary item. People are going to give up their cruises before giving up their grocery, mortgage, and car expenses.
Investors should take a conservative approach when estimating Royal Caribbean’s earnings power. Eventually, the economy is going to falter, bringing down the company’s earnings with it.
There is also the healthcare aspect to consider. Cruise ships are one of the easiest places for viruses like COVID-19 to spread, which is why the industry was shut down completely for certain parts of the pandemic.
If and when we have another pandemic, it is likely that cruises will be shut down or demand from consumers will plummet. With Royal Caribbean’s high debt levels, this would present a huge risk for investors.
The last reason to avoid Royal Caribbean is its steep valuation. Despite being a cyclical business with a teetering balance sheet, Royal Caribbean trades at a premium to the market average. Over the last 12 months, it generated $1.8 billion in free cash flow.
This number is also temporarily elevated due to a huge influx in new customer deposits in recent quarters, something that will level out as growth normalizes.
Add back the net debt to a $25 billion market cap and Royal Caribbean has an enterprise value of approximately $45 billion. This gives the stock a ratio of enterprise value to free cash flow (EV/FCF) of 25, which is a much better earnings ratio to use compared to the standard price-to-earnings (P/E). An EV/FCF of 25 is almost exactly same as the S&P 500‘s average P/E at the moment.
This seems very expensive for a company operating in a cyclical industry, especially once you consider that its free cash flow is temporarily elevated from an influx of customer deposits.
Royal Caribbean could benefit from a few more quarters — perhaps years — of elevated demand. But there are major risks to this business that should keep long-term investors on the sidelines for now.
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