Chit Chat Stocks - Royal Caribbean (Ticker: RCL) Not So Deep Dive

Episode Date: September 19, 2023

Royal Caribbean (RCL) is a major cruise line operator known for its diverse fleet of ships and global itineraries, but it has faced significant challenges in the wake of the COVID-19 pandemic and ongoing regulatory concerns in the cruise industry. At the end of the month, we will publish an Arch Capital episode that will cover the company: Adyen. Listen closely as Brett and Ryan go through the history, financials, and future prospects of RCL. Enjoy the show! ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (3:32) Industry | (14:15) Management & Ownership | (23:33) Earnings | (26:37) Balance Sheet | (30:33) Valuation | (34:50) Our Analysis | (36:57) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome into Chit Chat Money. My name is Brett Schaefer, and I'm joined by my co-host, Ryan Henderson. Today is our Tuesday Not So Deep Dive episode, where we analyze one stock by

covering its business model, financials, ownership, future growth opportunities, and much more. The Not So Deep Dive title is a bit in jest as we try to go a little bit in-depth on the company, not just going over the superficial stuff, not just saying, hey, this trade's at a 15 PE, let's buy it. We're going to try to hopefully help you learn more about this business and get a better perspective on the company so you can decide whether to research it further, put it on your watch list, or nothing wrong with saying this one's not for me. And today we are covering Royal Caribbean Cruise Lines as our airline and cruise theme continues. we're kind of on a travel theme this month last week we covered ryanair next week we're covering

hawaiian airlines it's a short month so we're just doing three of those if you want to look at the charts and basically all the show notes any graphics we're going to include throughout this episode i would recommend subscribing to our free newsletter the link is in the show notes and you can find that over on substack it really helps along with these tuesday episodes ryan i'm going to let you get to it. But first, I want to talk about our sponsor for the last month, and that is the Science of Hitting Research Service. You're going to hear an ad again 20 minutes into the episode. So for whatever reason, you missed this part, you skip this part, you'll hear that again. We just want to reiterate, though, that today, as you're

listening to this, the morning of Tuesday, the 19th, is the last day to sign up for the Science of Hitting before his research service price rises. We love Alex. He's been on the show plenty of times. He really has a great grasp of doing fundamental research, providing a ton of value, especially for, it could be anyone from a small investment fund, a group of people like ourselves that, you know, would like to have some maybe outsourced analysis, and they can't afford a whole team of researchers. It really, really helps. He covers the technology industry, the media industry, consumer goods, covers a lot of retailers. For example, he's been on the show before talking Airbnb. He's been on here talking Roku. Very, very sharp on all those markets.

Ryan, anything to add on that before we get started talking Royal Caribbean? Again, today is the last day, so check it out before the price goes up. Yeah. No, I think you hit the nail on the head. I know we go long sometimes on these intros and people tend to skip, but if you're listening right now, this research service is truly worth it. So Brett and I actually pay ourselves. And if you do buy it today, you're going to get it before the price increase for life as long as you're a subscriber. So highly recommend doing it today if you're going to do it. But let's talk Royal Caribbean cruises. Last week, you tried to convince me out of this, but I think it's good that we went through this because this is my

first time really looking into a cruise operator. And so I actually had a lot of fun doing this and it can certainly be a good business. There's some unique advantages that cruise operators have that I'll talk about in a second. But as for Royal Caribbean specifically, they are the largest cruise operator by market cap. They are the second largest on a passenger volume and revenue basis behind Carnival Cruise Lines. And I think second largest on an enterprise value basis because Carnival has a little more debt. But for a little context on how the industry actually works, like the airline industry, the cruise operators themselves don't do the manufacturing. So there are three major shipyards across the globe. There might be some more, but I think there's three big

ones that Royal uses. And building a ship of this size is very difficult. And it obviously requires a lot of capital and the right equipment to do so. Think about maybe even similar to building an airline or airplane, that kind of thing. So they use the major shipyards and there's these really long lead times. So there's really good visibility into what the fleet is going to look like. You know how many cruise ships are being built at a given time. So I guess forecasting existing capacity for these cruise line operators are pretty easy, or is pretty easy because you know how many ships they have, you know how many bedrooms are in each ship, or they call them berths, and you know how many they're going to add in the next couple of years. But let's talk

about Royal Caribbean a little more specifically. They operate three different brands and combined, They have a fleet of 64 ships and more than 150,000 berths, but it's just a fancy word for – it's just ship speak for a place to sleep. But the three brands are Royal Caribbean International, which is the largest individual cruise brand in the world, Celebrity Cruises, and Silver Seas Cruises. Because Royal Caribbean themselves, they've got – so the Royal Caribbean International brand accounts for 63% of all of Royal Caribbean, the conglomerate, all of their room capacity, and it's 26 ships. These are more the family-friendly type experiences, a lot more fun things to do, I guess you could say, the kind of thing where you're going to want to bring your kids on. whereas Celebrity Cruises is a little more in the luxury aisle, I guess you could say. And it's the second largest segment for Royal Caribbean. They have 15 ships, account for 22% of overall capacity. And it's a little more, they describe it as a destination rich itinerary. So

I think this is more kind of the parents, fine dining, enjoy a nice luxury vacation. And then the last one is Silver Seas Cruises. So these are their smallest ships, but they are ultra luxury. I guess maybe I should have done this in the anecdotal evidence, but I watched a video one time, not even knowing that this was like a vlog of a silver seas cruise, but these are super high end, like top-notch facilities, really like fine dining experiences. And they go to really exotic areas. So places like Antarctica or the Galapagos Islands, they're really expensive. They only account for 3% of the actual capacity for Royal Caribbean, but because the tickets are so much higher priced, they make up a little more in revenue.

Then the last thing, they have a 50% joint venture with a German cruise operator, but it's not two materials Royal Caribbean's results. So I'm not going to focus too much on them today, but those are the basics. Those are the brands. And then in terms of operating a cruise, Royal Caribbean makes money in two ways. There's passenger tickets and onboard revenue. So when we think about passenger tickets, most people know this. It's pretty straightforward, but I think there's two things that are maybe unique and worth mentioning. So first of all, Royal Caribbean relies a lot on travel advisors for sourcing passengers, and they give those advisors incentives and commissions. Direct sales are going pretty quickly, but when you have the travel advisors, when you're giving them the commissions, it's going to be a bit of a, I guess, cost of revenue hit. And then the second one that I think is worth mentioning is reserving a spot on a trip requires

a deposit upfront, which those are typically made in, I think, six months to a year in advance. So at the end of last year, they had more than $4 billion in customer deposits. They're able to earn interest on that in the meantime. And it gives them a working capital advantage. Yeah, exactly. And then I guess that passenger ticket revenue accounts for two-thirds of the overall business. And then the onboard revenue, that just includes the sale of all things on the ship that aren't

included in the actual ticket price. So things like gambling revenue, sale of alcoholic drinks, some are kind of bottomless, some aren't. Gift shop items, internet services, they use Starlink. They talk a lot about that. that makes up about a third yeah the main thing is casino and alcohol for those add-ons oh plus the uh the excursions yeah and then there are also a couple of unique advantage advantages that cruise lines benefits from so first off they get cheap debt most of the time when they

buy a new ship from what are called export credit agencies these typically account for 80 of a ship's costs. So it's like these local governments, export agencies will give them cheap debt for up to 80% of the boat's cost. And I think they're doing that because if you're the local governing body and your shipyard employs a bunch of people, you want them having as much volume as possible. So giving them lenient terms for really the few cruise line operators that are actually out there is a way to keep those people employed. The other benefit is that there are virtually no taxes. So here's a snippet from Cruise Law News. It says, cruise lines take advantage of an obscure provision in the US tax code, which permits shipping companies to evade taxes by incorporating

overseas and flying the flags of foreign countries. That's why Carnival is incorporated in Panama, and that's why Royal Caribbean is incorporated in Liberia. So cheap debt and no taxes i'd say those are two pretty big benefits would you agree yeah i get a little bit nervous about being incorporated in liberia right because they could i mean it just there could be things that are hidden right they have some off balance sheet stuff that we didn't really we're not going to hit on this episode we can't really do a full investigation into a bunch of off balance sheet stuff there but yeah it's definitely an advantage from the tax perspective you pay no taxes that's that's a huge advantage versus competitors in the inner or in the travel space and vacation space

but when you like if you're in corporate i just come back to if you're incorporated in liberia i just get nervous automatically yeah i will say they've been incorporated in liberia since the 80s so that maybe gives a little bit of a confidence boost that they've been doing this for a long time it's not like there's going to be i think it's less likely if you've been doing it for 40 years there's less likely to be some newfound repercussion and they can always move there it seems like they could always move to panama yeah yeah it's not specifically liberia it panama's be the same i just it just makes me nervous just because of the laws in those countries compared to the united states from a business perspective but yeah it's probably not

the end of the world and clearly people are going on these ships you can see them you know they're not faking anything here would be more of a you know hidden liabilities hidden whatever hidden lawsuits stuff like that i guess we probably should have checked them i assume they're audited by one of the u.s big four but that it doesn't really matter sometimes you can still hide stuff from them. Anyway, let's go through the history. So Royal Caribbean was founded in 1968 by a hospitality entrepreneur from Wisconsin named Ed Stephan, I believe. It might've been Stephen. Stephen? I think it's Stephan. Ed Stephan. Ed served in the Korean War as a radar technician in the army. And then when he came back, he kind of worked his way up in the Miami hospitality

business. Eventually he ended up joining a small cruise line and I don't know what inspired him, but he had ambitions to build his own cruise line. So he traveled to Oslo, Norway in search of some backers. There's apparently a big shipping culture out there. And so maybe that was kind of the motivation to head out there. Here's a quote from his adventure. And I will say Ed passed away in 2019. There's a good kind of article about who he was and some, I don't know, some just nice pieces on how he built the business. It says, I went to Norway to look for principals to build new safe ships. I was having a lot of bad luck. One evening it was snowing like crazy. And someone said, there's a guy who basically sleeps during the day and drinks brandy at night, but he's very

interested in this. That night apparently turned into a meeting with Ed and then three Norwegian ship owners named Anders Wilhelmsen, which I believe is still the largest shareholder today, Sigurd Skaugen, and Gotas Larson. Those would eventually become the co-founders of Royal Caribbean along with Ed. And from there, Ed designed the first ship. It set sail for Miami in 1970, and they began to slowly add new ships over the years. So they've been around since 1970. So 53 years, they have 64 ships. Some have been retired, but it's been a steady grind of adding new ships, adding new capacity, and building up that brand and adding new routes as well. And there's obviously land excursions when you get on a cruise. So they've been trying to

incorporate that over the years. It's been a pretty simple blueprint, I'd say, in terms of how to expand the business. Pour money into new ships and make them bigger. Yeah, it's, hey, people like it. People like it. I'll talk industry and competition. It's a very interesting industry, especially because of the pandemic.

So there's a lot of dynamics here that I'm sure we'll discuss. So in 2023, the cruise industry revenue is projected to hit about $25 billion. So not a giant industry. I mean, it's nowhere near the size of the hotel industry, but still fairly large. And then if you look at market penetration, which I think is quite interesting, I'll try to include maybe some charts around this going historically, if we can, if we can find some data in the newsletter, but they give this in the annual report and it's the market penetration for the three key markets, which are North America, Europe and Asia Pacific from 2015 to 2019.

So pre-pandemic. In North America, market penetration grew from 3.36% to 3.89%. Europe was 1.25% to 1.4%. Asia Pacific was 0.08% to 0.2% over that time period. So as you can see, the most mature market or the most engaged market in the cruise industry is North America, but all the key markets are growing. I think here's the discussion question I have is, should we expect the industry to grow along with growing gdps in these regions essentially saying as these countries get wealthier should we expect a cruise industry to grow yeah i was kind of spending some time thinking about this which is like is this a secular growth industry if so why and then on the flip side is there the risk that

maybe it's tied to kind of just good economies during that period i think it's more the latter but obviously the last hundred years economic growth around the world has been very strong so you know more people have discretion in that sense everything's a secular industry everything yeah that's growth well yeah i mean i guess maybe i'm using it's not like industry transition to streaming video right where you're yeah it feels like more i guess this is anecdotal but more and more people are going on cruises but like i guess there's some evidence of that in the numbers but it's kind of hard to tell you probably have to look at really long-term trends i'm sure it's gone up over time but yeah it's definitely gone over time i mean it

has grown but i think i wonder how much it's outpaced gdp growth or if it's very similar i think also as these ships get bigger as they build these massive like the ship i'm going to talk about today that they're in the process of of taking in right now um the memes the the one that is yeah yeah i mean it's massive 5700 bedrooms i think one of their biggest i'm sure the cost to get on those ships as a percentage of people's the median income has probably come down because the cost to operate that ship operate one huge ship is a little cheaper than operating four ships a fraction of the size because i mean the ships have certainly gotten bigger over time it's kind of a weird way roundabout way of thinking of it but i would imagine the

the cost to get on the ships has kind of come down yeah affordability yeah for sure for sure It's not a very expensive trip, at least the shorter ones, especially if you live by one of the ports. But if we want to go back to the industry, one note that I think we'll talk about throughout the episode is that typically companies have to plan their shipbuilding 18 to 28 months in advance. There's a ton of forward planning in the industry. I would make a note of that, any listener, as we kind of talk about the cyclicality and how COVID affected them, stuff like that. Now, as Ryan mentioned, there are two unique characteristics that make it cheaper than traditional travel he already talked about not paying taxes but i would also have on here

since they're in international waters they really have a global pool of labor to go after to manage these ships so they have very cheap labor compared to traditional hotels and you know on average right and all the majority of their workers and this is data from their annual report are from india southeast asia so places like the philippines indonesia those southeast asian countries that there are quite a few of and then india so that's an advantage i don't know how sustainable that one is and again the tax loophole is just a loophole that could be closed at some point right and i think there's been a lot of lobbying to get it closed but for the time period it gives them a bit of an economical advantage versus other travel and entertainment options wait sorry what's this

from the cheap labor part is from their annual report didn't it say like 60 of their workforce is caucasian north american no that's corporate i'm saying oh okay yeah all right makes sense so if we look at their competition it would be uh pretty it's pretty easy one to understand you have carnival norwegian and then everyone else it's a very like it's probably a case study market whereas it's almost exactly how you kind of look at you where you have the leader carnival 40 market share royal caribbean just over 20 market share and the norwegian at just over 10 percent market share. If you have those up, the companies dominate the industry by volume. If we look at revenue, there are going to be some other luxury competitors out there that'll

compete with the Silver Seas and stuff like that. But if you look at the traditional Royal Caribbean line, there won't be that much competitor. And then there are some upstarts, which would be like Disney and Virgin that should be watched out for, but they're today much, much smaller than Royal Caribbean's consolidated brands. Another discussion question I had that maybe we can talk about now is do the barriers to entry with the heavy capital expenditures and the big timeline, right?

You need a lot of capital to get a ship onto a route. You need a lot of workers, thousands of workers. Does that give these companies an advantage? Yeah, I think so. I mean, obviously the average ship runs in what, half a billion dollars? a lot of money to buy a new ship so not a lot of people can afford that i think too like actually operating these ships is difficult in its own right you know having the workforce um knowing

how to treat the customers or the the onboard patrons and the gambling halls i mean you're running a casino too like i mean it you know there's some real barriers to entry just in in terms of like knowing how to efficiently run one of these things so um i think there's some high barriers to entry and i think that's why you see the consolidation over the years unless you have a really differentiated experience like a disney because they can leverage their own ip it's got to be hard to break into this yeah i agree i agree uh and i don't know how someone could start from scratch well they probably could if they had enough money but i'm you know that limits the amount of people that could get into this and want to get into this because it is a

hard business, which on the one hand, you're like, okay, well, it's a hard business. Is that a stock I should buy? But on the other hand, the competition might not be that sharp. Hey, everyone, before we move on, I want to talk about our friend, Alex Morris. He founded the Science of Hitting Investment Research Service. And one of the benefits of being host on a podcast is that typically your sponsors will comp you the service. whatever they're selling, they'll usually give you an example of the product. Alex did that for the first year with his product a couple, I think it was a couple of years ago. And since then, Brett and I have both decided to buy it ourselves. We are loyal followers of his

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checking it out before those price changes go into effect on tuesday anyways i think that's enough brett anything to add i would say that if you're listening to this episode it is probably on Tuesday the 19th, so you should check it out today. If you like Alex, you've probably heard him on the show before. If you like his research, this is the time to try it out. Subscribe, and you'll get grandfathered in with that lower price for life. We really think it's worth the money, so check out the service at thescienceofhitting.com. That's thescienceofhitting.com.

Now, if you look at management and ownership, Royal Caribbean is now run by Jason Liberty, who became CEO in early 2022. He was previously the CFO and has generally worked in their finance department for 16 years. Before that, he was at an accounting firm. I forgot to write it down, but I believe it was KPMG. So really, if you look at this, you got an accountant running this company. Could be the best thing right now, given the balance sheets difficulties they have. It seems like he helped them stay afloat, not go through bankruptcy, as Ryan will probably talk about it in more detail during the balance sheet section so it seems like you know he has a decent track record here and they were in a really tough spot and he might be the best guy out there or

person out there to run this thing if you look at their executive compensation um i believe that well this may be the most complicated compensation packages out there i there were so many variables and there were so many different things that people were looking at that I was like, I don't think any of these executives could recite to you how they get paid because, man, I got confused just looking at all this stuff. But one thing to note, I think this is the big investor takeaway, and it's an example, I believe, of misaligned incentives,

is that if you look at their comp stuff, the big thing that pops out is one of their largest performance compensation metrics is adjusted earnings per share. Now, if I look to the definition of their adjusted operating income, which is just writing the annual report, you just kind of control left that, you can really easily find it. It has, in 2022, 13 adjustments. For example, and there's plenty of these like this, quote this is what gets adjusted out here's the quote loss contingency recorded in connection with the ongoing havana docs litigation inclusive of related legal fees and costs so they're basically taking out a lot of legal fees they're basically taking out a lot of like damage stuff

they're taking out a lot of other things which don't make sense to me so you incur those charges as a shareholder but they don't incur it as an executive right that brings me uh that's a great transition to my last point here, which it makes me worried that Royal Caribbean executives will get paid by the company for growing their adjusted earnings per share, while not actually creating much value for shareholders. That would be the big takeaway for me. In this section, if we look at their ownership table, it's very interesting. As Ryan mentioned, the Wilhelmsen family are still sizable outside owners. And there's a lot of owners here that are not index managers. For example, we have capital international investors, 12% owners, capital research global investors, 11%.

Don't know if that means much, but this isn't just going to be your typical index heavy shareholder table. Insider ownership is quite small, I believe. But I think that's enough talking for me. Ryan, let's hit earnings. Yeah. The other thing I'll say is you look at the proxy statement. I don't. So I end up seeing this for the first time a lot when you report it, but I could just

tell there was going to be misaligned incentives when you listened to some of the executives speak on the conference call. I was like, I just have a feeling they're going to be wasteful. A lot of adjustments, a lot of adjustments, a lot of adjustments. One of the cruise line executives was on the call was like, yeah, I'm in my swimwear right now on the conference room in the conference that that was honestly kind of funny it was funny i don't know if you should say that when you're you're balanced like you have 20 billion dollars in debt and they're generating no earnings but interesting it was interesting that that's for

sure i would maybe we'll share that it was great it was a great quote from that well we can yeah we can kind of talk about that after we discuss earnings so as you can imagine covet hit the cruise industry really hard. So year over year comps are kind of meaningless right now. For example, the trailing 12 month revenue was up like 150%. Obviously that's not normal. So it's going to be, you want to kind of cop it against 2019 and just really gauge how many cruise goers do they get relative to their capacity and are they able to raise prices and control costs? So over the last 12 months, they did $12 billion in revenue. That's finally back above their 2019 levels. Prior to COVID, Royal Caribbean was averaging 18% operating margins. Keep in mind, operating margins don't include interest expenses. Interest expenses are a big part of this business because, especially now, they've got a lot of debt. Their enterprise value, I think, is more than twice their market cap or roughly twice. So a lot of debt. The most recent quarter, they reported a 105% load factor.

Load factor is just the passengers divided by the capacity. And so people might think like, how does that get above 105%? Most of these rooms are designed for two people. So if three people occupy a room, it can push it above 100%. They're still selling tickets for that. So that's kind of the difference there. They did $1.4 billion in operating cash flow this quarter on $3.5 billion in revenue. just kind of looking big picture here they've raised prices a lot they have really strong

demand across pretty much all their itineraries and it's a really good time for them and they're using all that cash to pay down the debt quickly so um we're going to talk about this in a second with the balance sheet but they added a lot of debt during covid prior to covid they had roughly $10 billion in net debt, or sorry, total long-term debt. Now they have roughly 20 billion. So they doubled their debt position in a matter of really two years. Now, this might seem anathema. I think I'm using that word correctly. If not, I think people will understand it to what we usually talk about. But do you think that they should go lean more into stock-based compensation given where the stock is. It's super elevated

and their need to conserve cash. I feel like increasing SBC might be the right move here. Yeah. And they have done some equity offerings. So shares have gone up. I think that's the right move. Share price has risen a lot because there was so much uncertainty and they're coming out of this with a lot of travel demand. So they're in a good spot and I think they're doing the right thing in terms of capital allocation. But let's talk about the balance sheet first here, and then we can talk about management's approach. So liabilities, they have pretty much $20 billion in total debt. They've done a really good job restructuring some of that or refinancing it so that it's termed out. Most of it, 56% of it is due after 2026. So they've got time to pay this

down. The vast majority of the debt is fixed rate, but the interest on some of it is quite high. Weighted average interest rate was just over 7%, but they've got some variable rate debt that they've worked hard to pay down quickly. Customer deposits is now up to $5.7 billion. So they're able to earn a little bit of interest income, but it's nowhere near their interest expenses. And then they used to have like, well, they've kept their cash balance pretty lean as they pay down this debt. So they've got just over $700 million in cash. Last quarter, for example, they had $1.4 billion in operating cashflow. They spent $1.6 billion to pay down their debt. So they're really working to kind of restructure this balance sheet into a more

comfortable position. The other thing that's maybe worth mentioning, I'm not sure how valuable this is, but they've got $30 billion worth of property and equipment, which is the value of their ships. When you think of illiquid, this is maybe as illiquid as it gets is a billion dollar ship. So maybe if they had to raise capital, they could try to sell some of their ships to a different cruise line operator or something like that. But that's a difficult thing to sell. And any buyer will know that they'll know why they're buying it and they'll know that they can get a good deal on it. So anyway, it's just on the balance sheet, $30 billion worth of property and equipment. It's meaningful in any sort of a liquidation scenario.

Prior to COVID, they were doing just under $4 billion in operating cash flow a year. They've done $3.2 billion over the last 12 months. So in total, as far as the balance sheet goes, if you think they can get back to their previous operating cash flow levels, which I do think is achievable, it looks like they're well on their path to do that. You're looking at basically a net debt to operating cash flow multiple of five times. And they're in a more manageable position. But if you listen to the conference call and you listen to some of the analysts and even the executives, it feels like they've maybe gotten a little ahead of themselves because all the analysts are like, wow, congrats guys. What a quarter. This is awesome. We're great. We're in a great position. the executives are like, yep, yep. I got my swimwear on. I'm on the cruise ship right now, probably comped by the shareholders. And yeah, life is good, but you're still running at five times leverage. Some of that is a variable rate. So if rates go up and the consumer gets

pinched, you are back to a very precarious position. So I don't know. It feels like people are cheering a little early. Yeah. I'd say two things there. One, if you have the president getting some anecdotal evidence on the ships, I don't think that's necessarily a bad thing, but Ryan's probably right about those downsides. There might not be the right moment. I guess they're excited, they're optimistic, and it's better than just being locked away in your corporate headquarters. Other thing, I would look at interest expense as a percentage of operating income. I'll probably try to make a chart of that for the show notes, which you can get by signing up to the newsletter.

And the last quarter was quite high, even though they supposedly had some record numbers and really a lot of the earnings power is just going to pay down this interest. So yeah, there's a lot more progress to be had. Kind of look at a chart of their total debt. It's coming down, but it's going to be until they get to a more manageable position

where they can actually generate cash and not just have it pay interest expense. It'll probably be multiple years, two to three. i'd guess all right valuation tricky one here uh i'm gonna use a few different things and i would first note always is enterprise value given the high debt load here if you look at what we probably want typically to use for a company like this would be ev to earnings just because they have high interest expense and depreciation and amortization is real it's kind of meaningless right now because they have basically $0 in trailing total month earnings. If we look at

EV to free cash flow, it is 24.7. Now, typically you would say, oh, why don't you use that? That's the better term of cash earnings, but you need to remember that this is being greatly helped by an inflection of customer deposits. So this would really overstate their true earnings power. Yeah. Customer deposits were like two times what they were last year. Exactly. Exactly. It's a working capital advantage, but it's like saying the deposits that Airbnb got in when they have that one quarter that has crazy free cashflow is like their true earnings potential. It's not. Last one. I think this one is the most indicative of where they're actually trading right now is EV to operating income

with a 15% margin. So if we look, for example, pre-COVID, they got slightly higher than that, but hey, let's just be a little bit conservative. So if we take EV to operating income trailing 12 month at a 15 margin they're trading at 24.6 and remember though this is not including the interest expense so i think to sum things up the stock is still expensive based on the trailing numbers yeah and you know it's going to grow quickly i imagine that the next one should be higher than the trailing 12 months, but still, I mean, the interest expense is huge. The one good thing here is that pre-tax profit and after-tax profit, there isn't much of a difference. So sometimes you have to use net profit as opposed to earnings before taxes. It doesn't make much of a difference

here. Let's do anecdotal evidence. You just went on a cruise. Did you use Royal Caribbean? no i was uh on a virgin cruise which is a small one that for some reason richard branson seems to think he needs to start up a company in every consumer product category but he did and i'm glad they're giving out stuff at a discount because my what we don't need to go into details there my friend got a nice discount that we all got to go on but i think they're fine my cruises are fine you know it's a nice little mix-up it's a little gluttonous but you know some people out there like scoff at cruises right and they're like oh this is just people that don't actually want to experience the world they're all tightened up on the screws but from an investing perspective

people enjoy these things i think that's the only thing that matters right and kind of like i said they're kind of like a spectacle like just to see a ship that big yeah for sure for sure um But yeah, I didn't support Royal Caribbean. And I think demand generally should grow as long as the global economy continues to get wealthier. There's a lot of people out there that do not have much disposable income. And as that, you know, the number of those people with disposable income grows, it's pretty simple to think that some of those people are going to like cruises, some will go on cruises. one thing though and the health stuff we haven't brought up yet much from a discussion perspective do you think covid has put a permanent dent in demand for cruises are some people out so i think might be a small portion that are out but generally if we look at the numbers now it's not too material but there's definitely some people that aren't going to go anymore yeah maybe uh it's just not material to the business 105 load factor last quarter

you've got more than come up with a different they gotta come up with a different turn than that it's it's you know just like occupancy maybe yeah uh i think the surge in demand that they're currently seeing could be around for a while a lot of people delayed their cruises during covid i know family that did that i know you just went on a cruise post covid and now you aren't really delaying it but it's a really unique adventure there are there's honestly i didn't realize this but there is a loyal base out there that are like serial cruisers oh yeah and i got family that is they can they can go direct from they can go direct to royal caribbean sites if they enjoyed that experience and there's no commission through advisor fees

or TripAdvisor commission. So I think they have a really solid global base of customers. And you showed the numbers earlier, it's a growing base. So I think cruise demand will be there for a while. Yeah. And we'll talk about how it's not necessarily linear historically, but I think that's for another section. Let's talk future growth opportunities.

ryan you teased yours but what do you have yeah icon of the seas this uh i recommend looking it up because it's a cool looking ship it's got this like massive dome on the top you've probably seen pictures of it so it's it's gonna be this right yeah yeah it's gonna be the second largest ship in their fleet they're receiving this boat in the fourth quarter of this year and sailings will start in january of 2024 here's some commentary from the recent conference call the ceo says there is incredible demand for our new ships and icon will certainly break and has broken i think probably every record in the book it doesn't surprise me that the ship will do well and i'm sure people are like yeah no obviously adding a new ship is gonna help the fleet but i mean when you only have

64 ships most of them are pretty small especially relative to this one not not really small but relative to icon of the seas this can be substantial like this can add a decent chunk of revenue to their to their business yep and the one thing that i think is just up in the air is are they managing the supply and demand balance you know optimally right because they do need to have not extremely elevated prices but they do need to have a little bit of pricing power in order for these things to work it'll be interesting to see how popular this one is mine is going to be a little bit different and it's the land-based assets so pre-covid they were investing heavily into exclusive land-based excursions for their passengers for the royal caribbean brands maybe

they were doing stuff with the other ones but i'll talk specifically about royal caribbean the brand is called perfect bay and i think the first location is coco bay okay okay oh yeah i I don't know, it's weird. I thought it was Coco Bay. Whatever. What it is, is that it's a, you know, it's an exclusive place, right? That's off the ship. That's where people can go off the boat and have a fun, if that's their definition of

fun, you know, beach themed club. And it's obviously going to cost passengers more money too. Apparently, millions of guests have visited Perfect Day with plans to open up more of these in the Caribbean in due course. It does take a while to do this. They've only had a couple. But for the right customer, these places could be a great way, I think, to widen the value proposition for Royal Caribbean versus any upstart and increase kind of that average revenue per guest, which is important to them. If they have the firepower, because first they have to pay the money to get the capital expenditures to get the ships and pay down the debt.

But if they have the cash on the balance sheet available, I would like to see them invest more into these because I do think it's a great way. And yeah, it's like, you know, some people, again, would scoff at this stuff, but they're not the ones that are going to be taking these cruises. It's the people that enjoy this type of stuff. And I think it's a great way to widen any sort of moat they may have. All right. Yeah, I find it weird that people scoff at the cruises because it's like the space. Well, some of the stuff. Would you ever go to a resort?

I mean, it's not that different. I don't know. As someone who just went on it, some of the stuff is a bit wild, but... What, just the gluttony? The sheer gluttony? Yeah, exactly. But you can make fun of it. People still like it.

All right. Highlights and lowlights, Ryan. I think it's pretty clear what there is to like about these businesses and not to like, but let's go through them one more time. Yeah, the no taxes is nice. The same with the cheap debt. But the other thing that I think might help a little bit, and I don't know if we've really had the chance to see it yet, is they bought Silver Seas, I think, in 2018.

I'll confirm, yeah. But having that ultra luxury brand, I think will hopefully help eliminate some of the previous cyclicality issues. It's not going to completely smooth it out because Royal Caribbean International is still the biggest part of their business. But I think the people that afford the ultra luxury cruises are the really high end income earners. So I don't think they would be as affected in sort of a recessionary environment. So probably Royal Caribbean's earnings or revenue could be a little smoother than they would have been previously. the other i mean or one thing to add there you were right july 2018 they took a big stake in them but they didn't fully consolidate which might be interesting until july 2020 so they

might have been a bit distressed during that time period and i guess now is probably the only time they're fully you know in control of that business low lights for me uh very indebted due to covid it i think like i said earlier feels like people you know you know that meme of the guy shooting the three and turning around and like holding up his hands and then like it rims out it feels like there's risk that something like that happens where all the analysts are really happy the executives are really happy and if there's any sort of really bad recession obviously a lot of companies would be impacted, but I think they would be extremely impacted because of their heavy debt load. So I would just say they're not out of the woods yet,

would be my only concern. Yeah. And to add onto the debt part, which I don't need to talk about again in the lowlights, you have debt, the high debt stuff that we talked about, cyclical industry, which I guess we may talk about at the end here, and capital intensive. That's not the best combo. The other thing is historical returns are really not that good all time i think it's up ninefold since the 80s yeah and no it's fine but for like one of the leading and sort of an oligopoly i would have thought returns to be better in a market that's growing yeah for sure all right my highlights we talked about it before but there's a long-term industry tailwind that could really see no signs of slowing down over

the next few decades, I'd say for the broader cruise industry, which would be barring a global depression, of course, which for almost all companies that will affect it, but especially I think it highlights here that it is discretionary income. So people need to have discretionary savings in order to purchase these things. Go look what happened during the great financial crisis. It's a good example. The stock went from, I'll pull it up here, but I think I want to say 90 to five dollars pulling it up now yeah i mean man it's almost at 90 right now no no sorry not 90 uh basically from like 38 40 dollars to yeah five dollars at the bottom in in a matter of a year purely from the financial crisis i mean if the consumer is pressured like we talked about

So if your budget starts tightening, you probably don't need a cruise. It's probably one of the first things to go. 100%. Now, another highlight in there is that the balance sheets of at least the American consumer, which is their core market, are still quite strong. You might have seen the narratives about depleted savings, blah, blah, blah. The recession is coming, whatever. And that might be true eventually.

But right now, and let me share a screen here, a lot of those narratives you see are completely wrong. So we've seen it dip a little bit, but if we have, and I'm sharing this chart here for any viewers can watch this, but if we have household checkable deposits and currency, which is basically just, you know, how much currency people have, we're at about 4 trillion. Yeah. 4 trillion. I believe it's down a little bit from about four and a half trillion earlier this year, but it's significantly higher than pre-COVID, which is about a trillion. So I mean, we're probably not going to go, given inflation and stuff like that, we're not going to go back entirely to pre-pandemic levels, but is there about $2 trillion left in excess savings

out there? I think, yeah. And does that mean Royal Caribbean is a good business? No, but I think over the next few quarters, I would guess they're going to do quite well. i think that's a fair assumption to move on to bull case bear case yeah let me pull up my notes do i have anything else there that we haven't hit yet uh okay here's one here's one one more low light they have to make the capital outlay decisions 18 to 28 months in advance yeah i think it's pretty clear why that's tough okay what's your bull case ryan uh pricing growth moderate capacity growth so adding new ships steadily continued load factors or occupancy rates above 100 100 i mean that's kind of what's happening right now but if that continues i think

there's a real clear path to them generating potentially a legitimate two billion dollars in after-tax profits or even somewhere between one to two in the next i'd say two to three years so i mean if they're doing that it's you're it's potentially trading at an ev to earnings if they're doing 2 billion i'm what's the enterprise value today i'm guessing it's mid-teens multiple that's not too crazy yeah ev today is 44 billion but you would assume that a lot of the debts paid down so maybe it'd be closer to 35 or something like that right in the you know three maybe it'd four to five years from now, but you really need that, I would say, probably at least $2 billion in earnings, right?

Probably a little higher for the stock to work. Yeah. Or at least to be, you can't expect, you can't be like betting on a 30X earnings multiple. Yeah, I agree. If those three things happen, I think you're going to get okay returns. I still don't think it would be a market beater. Yeah, it's price for perfection right now. And hey, if you think, if you can run the numbers and say, hey, they're going to earn

three, $4 billion a year, by all means, stock looks cheap. I'm kind of in the same boat. So bare case, maybe I'll just go. I mean, it's pretty easy to see here why, you know, there's a lot of things that could go wrong. And it's why so many people are short Royal Caribbean. I mean, you can see it on Twitter. Like there's a lot of people we follow.

They're like, oh yeah, I'm shorting Royal Caribbean here. um i would check out a lot of the historical vic write-ups uh just for any caution around shorting royal caribbean because they didn't go well most of them didn't go well you have a sickle industry here with a ton of operating leverage which means in reverse not so great and then a teetering balance sheet so if even one of the next three years are bad it's possible this is a zero yeah but i would hesitate anyone to say that like there's a lot of smart people we know that are shorting this thing i don't know if this is the right time given the balance sheets of consumers yeah the the thing that i saw that made sense was buying the bonds because it feels like

those would get paid back and they're yielding i think it was like seven and a half percent i don't know if it's or it was yielding 11 but i imagine the bond right because of the prices prices came up um bear case for me i mean if the obviously this is a bear case for a lot of companies but if the fed does continue to raise interest rates even by a little it'll hurt the variable rate debt that they have but i think that would quickly tighten consumers budgets more so than like some of that travel demand that they're seeing and that exuberance they seem to have right now feels like it would go away pretty quickly yep all right more interested or less interested ryan final thoughts yeah less interested for me it is kind of cool

to look at and just see a business that's so unique where every asset is so huge like they're literally you know these huge lead times every similar similar to vegas similar to vegas casinos honestly yeah and and they get the unique benefits of being a maritime company or being you know a shipping company uh i'm putting shipping in air quotes there but it was fun but i'm just less interested i'm really less interested this price and i'm less interested just in in owning this business it doesn't feel like it's provided good returns for shareholders over kind of the the last four decades and i don't see why that changes especially at this price yep i am less interested as well if i am looking for ways to get attached to the global growth and travel

and vacationing i am much more interested in researching airlines and airports and there's not that many airports out there but a lot of a lot of airlines and stuff like that i think that's a better way to play it i can call me crazy but i like those businesses a lot better they're not great businesses but at the right price which little tease you know we're going to study hawaiian airlines next week that i just it's just a little more exciting to me and i think a little bit more durable but obviously kofi really changed that for a lot of these businesses next week though yeah we are covering hawaiian airlines should we say hawaiian shirts for the for the recording i I know only like 10% of the people watch the episodes, but that can be fun.

Sure, I'll wear a Hawaiian shirt. I've got one. That's pretty easy. Yeah. If you need one, I got quite a few. No, I don't have that many, but I have a couple. All right. All right.

Let's get to the disclosure. Remember, we are not financial advisors. Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you everyone for tuning in and we will see you next time. Thank you.