Carnival Corporation: The Perfect Storm (CCL)

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Investment thesis

Since the outbreak of the pandemic, Carnival (NYSE: CCL) has undergone a continuous deterioration that only recently appears to have stabilized somewhat, at least economically. On the one hand, revenues are finally on the rise again, but the financial structure now seems Completely compromised after 2 years of huge losses. Debt has more than tripled, and there are strict covenants limiting corporate manoeuvres. As low as Carnival’s price is right now, I would still avoid investing in the company because I’m concerned about its debt sustainability. Under current conditions, investing in this company means having a very high risk threshold, which I personally do not have.

Covid-19: Still persistent difficulties

To date, what remains of Carnival 2019 is very little. The cruise industry has been hammered by repeated hardships and there is still no end in sight. In 2020, COVID-19 destroyed the entire industry by paralyzing it for months: in the 4 quarters following August 2020, Carnival generated revenues of only $139 million. For a company that generated about $4 billion per quarter in 2019, that’s a financial disaster.

Initially, it was thought that once Covid-19 was fought, the cruise industry could restart as in the past, but the situation is more complicated. Demand for cruises is recovering rapidly, but there are still Covid-19 related issues preventing the business from returning to 2019 levels. This was discussed at length in the last Q2. Here are the words of Arnold Donald:

Encouragingly, demand remains strong, with our customers overcoming much more restrictive protocols than society at large and travel at large, resulting in booking volumes nearly doubling since last quarter, with short-term bookings outpacing even 2019. We have been encouraged by the close-in demand and remain focused on optimizing occupancy while preserving long-term pricing.

As the frictions of protocols are removed and society becomes more comfortable with managing the virus, we expect to see demand continue to increase, as we have already seen with the strength of cruises. closer to Carnival Cruise Line.

It seems from the words of Arnold Donald that Carnival is positive about future profitability; however, I think it is fair to put this in context with the latest reported data.

Revenue

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Although the improvement is evident quarter after quarter, we are still far from the values ​​of 2019: before, having a quarter with revenues of almost 5 billion dollars was the norm, today we are at around half of it. Getting back to previous levels will still take time, so the next 2-3 quarters won’t be enough in my opinion.

Inflation and recession

As if Carnival’s problems weren’t bad enough, 2021 and the current 2022 are years marked by high inflation. Fuel and raw material costs have only exacerbated an already problematic situation stemming from COVID-19.

income statement

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In fact, from what we can see, revenues are increasing but the loss on the income statement is still very high. Cost of goods sold is about $400 million lower than Q2 2019, but revenue is half that amount. The operating costs are even the same. The presence of fixed costs in Carnival’s business model and high inflation make the recovery process even more tortuous.

Finally, among the difficulties, I did not consider the possibility of a recession in the short and medium term, a possibility which becomes increasingly high by looking at the yield curve.

Predictions on the future of Carnival

Assuming that it is very complex to make predictions about Carnival’s situation, the company has released several expectations for the end of this year and next year. Here are a few:

  • Expected increases in revenue in 2023 per passenger compared to 2019.
  • Expected improvement in occupancy throughout 2022 and 2023.
  • Maintain guarantees and reserves at reasonable levels.
  • Expected moderation in fuel prices starting in the second half of 2022 and continuing through 2023.
  • Inflation and supply chain challenges are expected to continue to weigh on costs, although moderated by a larger and more efficient fleet compared to 2019.

Based on these guidelines, it’s clear that the company expects a marked improvement over the past few years, but we can’t be sure that’s the case. I personally believe that Carnival management is fully aware of the dire situation and is also doing a good job; however, there are exogenous factors that could reverse the upward trend. We don’t know precisely when the supply chain issues will be resolved and we don’t know if inflation has peaked. Also, with the US having had a declining GDP for 2 quarters and Europe hit by energy costs and inflation, we don’t know if this will translate into a recession. As weak as this company is financially right now, a recession could be a serious problem.

Carnival is currently trading at around $9.50 per share and in 2019 at around $50: this may sound like a bargain, but be careful. As far as I’m concerned, it would be a big mistake to think that if Carnival returns to $5 billion in revenue per quarter, it will cost $50 a share again: it’s been burning billions of dollars every month since 2020 and its financial situation has changed completely since then. Revenues may well return to what they were in the past, but the financial structure is now compromised. That doesn’t mean Carnival can ever recover, but before it returns to $50 a share, it won’t be enough to earn like it was in 2019.

Over-indebtedness

As I announced earlier, the most crucial aspect is debt. To meet its short-term debts, the company was forced to take on debt and dilute its shareholders. After all, there was no other way since cruise activity was restricted due to COVID-19.

There were 684 million shares outstanding in 2019, to date there are 1.18 billion. This is a huge dilution for shareholders, but less serious compared to the increase in debt.

Debt sustainability

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As we can see, net debt has more than tripled, and its growth has not necessarily stopped. Total debt/equity reached 440%, demonstrating the high leverage the company faces today. Considering that in the year 2019, Carnival generated a profit of $2.99 ​​billion, this gives even more of an idea of ​​the current amount of debt of $36 billion.

Plus, as if that weren’t enough, making matters worse is covenants. Here are the most important:

  • Maintain minimum interest coverage at the end of each fiscal quarter beginning August 31, 2023, at a ratio of at least 2.0 to 1.0 for the test date of August 31, 2023, 2.5 to 1 .0 for the test date of November 30, 2023 and 3.0 to 1.0 from the test date of February 29, 2024, or until their respective expiry dates.
  • Maintain minimum equity of $5.0 billion.
  • Limit the percentage of debt to equity from the test date of November 30, 2021 until the test date of May 31, 2023, to a percentage not exceeding 75%, after which it will be tested at levels which will decline gradually to 65% from May 31, 2023. Test date 2024 and following.
  • Maintain a minimum liquidity of $1.5 billion through November 30, 2026.
  • Limit the amounts of secured assets as well as secured and other debts.

As of May 31, Carnival was in compliance with the covenants and had no further sanctions. However, it can be seen that the obligation to comply with these capital adequacy limits will last much longer, in some cases until 2026. Currently, the company is experiencing many economic and financial difficulties, so it would not be ruled out that she might miss some of them. Failure to comply with these capital limits would lead the company to sink even deeper, as changing financial covenants can lead to increased costs, interest rates and additional covenants. This would affect not only the balance sheet but also the income statement, as the increase in interest payments would further reduce the bottom line.

You must monitor this situation very carefully if you wish to invest in this company, because compliance with the covenants is crucial in order not to trigger a vicious circle.

Conclusion

Even though Carnival is one of the best companies in its industry and has respectable management, I personally wouldn’t buy this company. Although the income is gradually increasing, the difficult financial situation makes me stay away. It is true that $9.50 per share is a historically low price for a company that easily reached $50 per share, but the disastrous results of the last 2 years create permanent damage to the financial structure. Debt level is a key factor to consider before investing in a business, and Carnival does not have the right conditions for debt sustainability. It’s true that at $9.50 a share it may be a bargain, but is it really worth speculating when you can invest your money in a thousand other ways?

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