Cruising Past Its Peers: Norwegian Cruise Line Holdings

Norwegian Cruise Line Holdings (NASDAQ:NCLH) is a great, high-growth business currently trading at a good price, at multiples in line with its worse-performing competitors and below its historical average. Recent multiple contraction is due to macro/political uncertainty in the Mediterranean region, a reduction in guidance in Q2 2016, and overblown pessimism about the long-run cruising TAM in China.

The global cruise line industry is an oligopoly dominated by three players: Carnival Corp. (NYSE:CCL), Royal Caribbean Cruises (NYSE:RCL), and Norwegian Cruise Line Holdings. Market share by revenue is broken down as follows:

• CCL: 42.2%
• RCL: 22.1%
• NCLH: 12.4%
• MSC Cruises: 4.2%
• Others: 19.1%

Cruise lines sell their inventory through three primary channels: travel agencies, direct-to-consumer via corporate websites, and through large charter bookings.

Over the past twenty years, cruising has been growing in popularity, especially in the United States, taking market share from other forms of leisure travel. Between 2008 and 2014, cruising outpaced general leisure travel in the U.S. by 22%. The number of annual cruise passengers has been growing at a 5% CAGR since 2009. Supply growth, on the other hand, has been measured: total industry capacity as measured by berths (standard two-person cabins) has grown at a 3% CAGR since 2011.

Due to the long, multi-year lead times on new ship deliveries, each of the competitors has high visibility into oncoming supply in the rest of the industry, resulting in prudent supply growth. This transparency, along with the growing demand for cruising, prevents pricing pressure among the dominant players: over the two market cycles from 1999 to today, revenue per passenger per day has declined only a cumulative 8% in the face of an industry supply increase of 292%.

In terms of geography, ~33% of industry capacity is deployed in the Caribbean, 19% in the Mediterranean, 12% in Scandinavia/UK/Baltics, 9% in Asia, and the rest in other destinations including Australia, Alaska, and South America.

51% of industry customers are from the United States, 8% are from Germany, 7% are from the UK, 5% from Australia, and the rest scattered across Europe, China, and the rest of the world.

Two unique features of this industry make it particularly attractive from a free cash flow standpoint:

1. Customers book their cruises well in advance, often up to a year ahead of the cruise date. Cruise operators receive cash up front, which accrues to deferred revenues, and are therefore able to fund their operations out of working capital. Furthermore, up-front bookings provide occupancy, pricing and revenue visibility up to a year in advance, allowing the operators to redeploy their capacity to regions of the world experiencing the greatest demand so as to maximize return on capital.
2. None of the operators pay material income taxes because of a tax loophole allowing them to qualify their revenue as “shipping income.” Section 883 of the Internal Revenue Code states that qualified foreign companies are exempt from U.S. federal income tax on U.S.-sourced “shipping income.” CCL, RCL, and NCLH are domesticated in Panama, Liberia, and Bermuda, respectively. NCLH derives 75% of its ticket revenues from U.S. customers and paid a 2% effective tax rate in 2015.

The above factors allow NCLH to convert ~50% of EBITDA to levered FCF despite high maintenance and growth capital expenditures.

Lastly, a review of all three companies’ earnings calls (CCL, RCL, NCLH) suggests that management at all three are long-term oriented and particularly focused on hitting double-digit ROIC targets in the next 3-4 years. The proxy statements of CCL and NCLH reveal that management compensation is linked to EPS growth and double-digit ROIC targets specifically.

All three management teams, aware of the others’ supply growth, are confident in their ability to hit these return targets. Furthermore, they all explicitly articulate continued confidence in the fundamentals and growth potential of the nascent Chinese market, the biggest growth area for the industry and a point of unwarranted analyst concern in recent quarters.

I like NCLH over its two larger competitors for several reasons:

1. Best-in-class operator: formerly owned by a consortium of private equity firms including Apollo and TPG, NCLH outperforms its peers as measured by efficiency (filling available berths), pricing power (operates more luxury-oriented lines), growth (adding ships to a smaller base), and profitability (margins).
2. Insider ownership: Apollo, Genting HK, TPG, and management still own 16%, 11%, 2.5%, and 1.1% of the common equity respectively. On August 31, CEO Frank Del Rio bought 83,500 shares at $35/share for $3,000,000 total.
3. Recent price contraction: NCLH’s multiple premium over the competitors reached a high of 5x in 2015, but has shrunk to just a 1x premium as shares have traded down to $35 following terrorism concerns in the Mediterranean region and increased worries over China’s potential as a growth market.

NCLH is a $4.5B revenue, $1.3B EBITDA (28% margin) global cruise line operator with 24 total ships under three brands: Norwegian (14 ships), Oceania (6 ships), and Regent Seven Seas (4 ships). It was established in 1966, acquired by travel conglomerate Genting HK in 2000, and in 2008, Apollo bought 37.5% of the equity and TPG 12.5%. NCLH was IPO’d in 2013, and numerous Secondary Offerings by the sponsors have been executed since then.

Since 2006, NCLH has grown revenue at a 9% CAGR primarily through new ship deliveries. Significant operating leverage has led to an EBIT CAGR of 37% over the same period. Since achieving stabilized GAAP profitability in 2011, revenue has grown at an 18% CAGR, EBIT has grown at a 22% CAGR, EPS has grown at a 27% CAGR and levered FCF has grown at a 39% CAGR.

NCLH, while operating far under the scale of its two larger rivals, still achieves industry-leading profitability and efficiency. Any further gains in scale should widen the profitability gap between NCLH and its comps.

NCLH, and especially its Oceania and Regent brands, focuses on a more luxurious cruise experience than its competitors, often marketing its world-class on-board dining options, and is thus able to drive revenue per passenger per day of $271, 34% above the average of its competitors at $203. In 2015, it achieved this result while maintaining occupancy 500 basis points above its competitors.

Norwegian has four new ships under contract through 2020, representing more than 13,000 incremental berths (standard two person cabins). These deliveries represent a 7% CAGR in capacity through 2020 and should yield material operating leverage as NCLH spreads its corporate and marketing expenses over a larger revenue base and achieves greater buying discounts on its input goods (fuel, food).

It should be noted that NCLH is highly levered, and more so than the comps. Leverage is the norm in the cruise business, given high visibility of future cash flows and massive asset bases backing the debt. The debt-to-EBITDA figures for the three comps are:

• CCL: 2.4x
• RCL: 4.6x
• NCLH: 5.1x

However, over the past two years NCLH has maintained a 5.5x interest coverage ratio, comfortably meeting its financial obligations. Management also plans to use all available FCF in coming quarters to deleverage to 4x, which brings us to capital allocation.

Another reason I love NCLH is that management has articulated its capital allocation priorities very clearly for investors:

1. $634M net of financing to be spent on 4 new ships through 2020.
2. Partial deleveraging to 4x EBITDA by end of 2016, with a long-term target of 3-4x. On the Q4 2015 earnings call, the CFO described their willingness to take advantage of prevailing low interest rates, stating “it’s hard to choose to pay down debt at these kinds of rates.”
3. Execute the $264M remaining of the $500M share repurchase program. NCLH has bought shares back directly from Apollo in prior Secondary Offerings, and given that Apollo owns its stake in a 2005 vintage fund, the opportunity should arise again for NCLH to make a significant debt-financed block repurchase.

NCLH’s debt covenants prohibit it from paying dividends. CCL and RCL both pay modest dividends, which likely has contributed to the narrowing of the multiple spread between NCLH, a superior operation, and its dividend-paying comps in recent quarters as investors have fled to dividend havens.

The flipside is that the lack of a dividend provides NCLH management more financial flexibility to pursue rapid growth and opportunistic share repurchases in the medium term, as it has no obligation to spend FCF on an ongoing dividend program. Given that NCLH is still in a much more rapid growth phase than its comps as it seeks to achieve significant scale, the lack of a dividend program should come as no surprise.

Finally, valuation. Following a price surge from $35 to $44 per share in the last month, NCLH now trades at 18x EBIT, 11.5x EBITDA, 17x EPS, and a 6.1% FCF yield excluding growth capex. On an EV/EBITDA basis, NCLH is trading below its historical average of 16x, and at just a 0.5x premium to its comps. Again, NCLH, despite being dramatically subscale, outperforms its comps in efficiency, pricing, growth, and profitability.

I am modeling the business LBO-style, with the following key assumptions:

1. Capacity growth confined to what we know about the four incremental ship deliveries through 2020.
2. Pricing and occupancy growth per guidance/commentary through 2017, with occupancy steady (with seasonal fluctuations) thereafter and pricing growing at 2%/year.
3. Effectively no operating leverage, with EBIT and EBITDA margins actually slightly declining over time, allowing for rising fuel prices and increased marketing expenses as NCLH fronts the marketing cost of a push into the relatively new Chinese market.
4. Completion of the $264M remaining share repurchases.
5. Exit multiple of 11.5x EBITDA, roughly equal to today’s multiple.

At $44/share, NCLH seems to be approaching fair value with a 5-year IRR of 9% and a profit multiple of 1.6x (the implied share price in Year 5 is $68.64). When I did most of my analysis about a month ago, shares were trading at $35 or below, resulting in a 14% IRR and 2.0x multiple, a double in 5 years. Either way, significant upside is not baked into the model and could come from an increase in share repurchases and/or significant margin expansion with scale.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.