Motley Fool Hidden Gems Investing - Investors Shrug Off Inflation Fears

Episode Date: July 13, 2022

You'd think the phrase "record inflation" would chill investors, but Wall Street seemed to shrug it off. (0:21) Bill Mann discusses: - The prospect for more acquisitions and deploying of capital - Optimism being suspended this earnings season - Why he's watching homebuilders, especially Lennar (12:29) Travel spending is heating up! Could that mean a rebound for cruise stocks? Lou Whiteman and Jamie Louko engage in a Bull vs. Bear debate over Royal Caribbean Cruise Lines. Stocks mentioned: CSU, MSFT, CRM, LEN, RCL, CCL Host: Chris Hill Guests: Bill Mann, Lou Whiteman, Jamie Louko Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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I'm Chris Hill, and joining me in studio, because for the first time in 28 months, We are in the studio. It's Motley Fool senior analyst Bill Mann. It's so good to be here in studio with you, my friend. It's the first time since March of 2020 that we've been here. And the man behind the glass, Dan Boyd, is here as well. It's fabulous. It's so great to see you. You know what's not fabulous? The fact that inflation rose 9.1% in June. It was higher than expected. I have to be honest, my reaction when this came out, because I knew the number was coming out this morning. Yeah, you've bought groceries.

I've bought groceries. I've filled up the car and spent an arm and a leg to do so. But my reaction, Bill, honestly, when it came out was, OK, but this is a backward-looking number. This is for the month of June, and we're in mid-July, and we've already seen plenty of data around gas prices, around mortgage rates, and other places as well that says, yes, this is bad, but prices have been coming down for a couple of weeks now, if not more. Now, I'm going to make an economic argument here. I'm going to lose people, maybe you, maybe even myself, so let's strap ourselves in. There are two types of ways that inflation are measured primarily, there's CPI, and then there's core CPI, consumer price inflation.

Core CPI was 5.9%, and they expected 6% for this recent release. The difference between the two is that core CPI eliminates food and energy. Whatever your consumer energy costs and whatever your consumer food costs are, those are the most volatile part of the curve. and so they tried to ignore them to look at something more core. Now, Chris, I know that, like me, you can't get by without no food and no energy, so it's a little bit of a squirrely number. It doesn't really exist. But it does show that, not that 5.9% inflation isn't really, really high, but it does give you a little bit more information as to what is actually happening. We're going to get to earnings season in a couple of minutes. But before we do that,

what, if anything, does this type of data do for you as an investor? Does it factor in for you at all? I don't want to say background noise, because that just sort of dismisses it. But does it simply go in the category of, this is interesting, I want to know this data, But ultimately, I'm focused on businesses, and maybe I'll factor it in, but in general, this isn't really swaying one way or the other whether or not I buy shares of a company. It does to some degree. If you think about it, let's make a very simplistic argument. Right now, at a 9.1% inflation rate, with the money that you are being paid by the company

you work for, one month's worth of it is evaporating to inflation. It's basically 9% of every penny you make is disappearing. Yes, it matters a great deal. In some ways, though, what we've seen in not just the stock market, but almost every market, is that almost all of the asset classes have dropped. Not energy, maybe not the U.S. dollar, but almost everything else, which tells me that the reaction to this very real economic phenomenon that we're dealing with right now, people are reacting without a whole lot of forethought. They're just getting out. They're removing liquidity as quickly as they can. What you want to see right now, and this is something that's actually healthy. It doesn't feel good, but it is, in fact, healthy.

Companies that have cash-rich balance sheets, companies that have pricing power right now are in a position to go out and either increase their lead against competitors or they're able to buy up certain other companies, extend their brands, extend what service offerings they have on the cheap, which has not been available for a long, long time. So, in some ways, what is happening doesn't feel good, but it's entirely healthy and the strongest companies are going to benefit mightily from it. With that in mind, when it comes to capital allocation, do you want to see companies you own shares of that meet that criteria, that are profitable, they've got the healthy

balance sheet, do you want to see them going out and making acquisitions? Or, from a capital allocation standpoint, is your mindset more along the lines of, what is your capital allocation superpower? What I mean by that is, some companies are really good at consistently raising their dividend. Some companies have a great track record of acquisitions. I'm wondering if your mindset is, go the acquisition route, get rid of some competition, or is it, no, no, no, whatever you're good at in terms of capital allocation. I want to see you doing that. It's a little bit of both. It's a case-by-case basis. There are companies out there like

Constellation Software, for example, which is a Canadian company, that have a long, fantastic track record of acquisitions. They've got to be walking around like kids in the candy store right now. They're acquiring companies for cash. So, to me, when I see companies that are now starting to acquire companies, that's one of the key things that I look for. What are they using? Are they using their own stock? As we just talked about, everybody's share price is down. Or are they using the cash that's in their balance sheet? I would much, much rather see them using their cash than using stock at this point to acquire companies. Ultimately, companies that go out and acquire, there are companies that are good

at it and there are companies that are not. But they do give you a little bit of a signal by what they use. Earlier this year, I want to say it was six months ago, I may be off on that. That was, in fact, earlier this year. Well done! You did it! And that ends our math portion for the show. I was saying to you that when Nvidia came out earlier this year with a great earnings report and good guidance, Nvidia, a big, profitable, important company, when they came out with that kind of report and shares of Nvidia sold off 8% that day, that was the moment for me personally when I thought, oh, OK, everyone on Wall Street has decided that no matter

what a company has done in the past, no matter what earnings and guidance they come out with, nothing is going to be good enough, and we are in for some pain. With that as a foundation, what is your mindset for this earnings season? You and I have talked about this. I've certainly seen people on CNBC talking about this. Expectations are kind of across the board pretty low for this earnings season. No one's really expecting anyone to do anything all that impressive. What are you expecting? As a market, we are in a suspending optimism phase. You say something optimistic as a company, and the market's initial reaction was, well, that's not going to happen. I don't know if you see what else is going out there.

But one of the things that I'm really specifically looking for is for those companies that have retained big cash balances to give a little bit more of guidance for what it is that they plan on doing. I can guarantee you that there are companies out there that are looking at this environment, and they're looking at what they have and they're saying, we are now able to make some decisions that, in the next year to five years, will transform our business in a very positive way. I think you're going to see it in the SaaS segment. Some of the biggest companies, even Microsoft and Salesforce, I think that you will see them getting very, very active in taking out companies at a much lower price point that may be much more valuable

within the framework of these larger companies. And you have to assume that some of those smaller companies are much more amenable to those conversations. Just give me a bid! Yes. Bound to be. And I laughed when you said it. It's not 100% funny, But it is, in fact, the case that at this point in time, these companies came out, and I think this is fair, they came out in a period of time in which it was really easy for companies to continue to raise money as they were growing. And that time has stopped. It is absolutely the case that raising additional capital is going to be very difficult for them. they are in a new stage right now. What is it that we do so that we can continue to fulfill

our mission, given the fact that we do need additional capital? And so, for these big cash-rich companies to come calling, that is something that they absolutely positively will be listening to. I asked Jason this on Monday, I asked Asit yesterday, let me ask you before I let you exit the studio, what is a company you're going to be paying particularly close attention to this earnings season, and why? You know, to me, it's the homebuilders in particular, because what we've seen is home pricing ... oh, you said company, I'm sorry. No, you can pick a category. I said homebuilders, but let's call it Lennar.

Homebuilding is an industry that, from a price-to-earnings basis, it looks very, very cheap because they have been earning super-normal profits on building for the past couple of years, definitely over the last year. You're starting to see inventory building up in a lot of urban areas in the country. Redfin the other day came out and said that 40% of its listings have in fact already cut prices. That impacts and competes with the new home builds. To me, That's really going to be a sign of just how much froth has been in the system and just how far we have until we recover. Was that the same report where Redfin said that in the month of June, they had 15% cancellations on existing home sales?

Yeah. They've had an enormous number of cancellations, which is a contract that's been entered into. Mortgage rate locks are down 50% for second-home purchases. People are pulling back in a hurry. It will be really, really interesting to see how this is actually impacting the biggest homebuilders. Great seeing you! Thanks for being here! Fantastic to be here in the studio with you, Chris! If parts of the broader economy are stumbling, one thing is certain, travel spending is heating up. Is it possible this means a rebound for cruise stocks? Our latest bull versus bear debate is on Royal Caribbean Cruise Lines. With more, here's Ricky Mulvey.

Welcome to Bear vs. Bull. We find some analysts, pick a company, flip a coin, and then you get to decide who made the better argument. Today, the company is Royal Caribbean. Our analysts are Lou Whiteman, Jamie Luko. Good to see you. Thanks for being on the program. Glad to be here. Yeah. Thank you, Ricky. All right. Let's just get it started with the bull case for Royal Caribbean Cruise Line. And with that, it's Lou Whiteman. Lou Whiteman. Thanks, Ricky. First of all, I should say, I am really glad to be a Foolish investor when making this call because near-term, next few months, next few quarters, I'm really not sure how things are going to go. Inflation is out there,

there's recession fears, COVID is still out there, we have higher fuel costs. It could be an ugly couple of months for this business. But for long-term investors, people who can look past the near term. There's a lot to be bullish here. Let me tell you why. First of all, for cruising in general, there is massive pent-up demand. Bookings have come back. A AAA survey from earlier this year, 20% of people who have cruised before currently have a trip booked. That is up from pre-pandemic levels. 61% of respondents who have never cruised would like to try it. That's only fallen about 1%. The pandemic has not killed the desire to cruise. Royal Caribbean's fleet of 62 ships operated about 68% of rooms filled in the first quarter.

They expect that to go over 70%. People have come back. Cruising is still a popular thing to do. It's not dead, far from it. That's the bull case for cruising. But why Royal in particular. Glad you asked. First of all, Royal Caribbean is a top operator. One of its brands celebrity was named U.S. News Best Cruise Line for the money. Another brand Royal Caribbean International, they finished tied for second. Secondly, this is the best balance sheet in the industry. The company has been aggressively paying down the debt that it took on during the pandemic. Debt right now is just one times equity. That's compared about 1.4 times at Norwegian and 2.2 times equity at Carnival. Royal Caribbean had $3.8 billion in

liquidity cash on hand at the end of the last quarter. That's reassuring based on all that talked about at the beginning, where the next few months could be ugly. For all the gloom of the current environment, Royal Caribbean did say the cash flow turned positive in April. As of May, it's still expected to be profitable in the second half of this year. We'll see soon when earnings come up, whether or not that's changed, but this is definitely a company moving in the right direction. But the biggest reason to be bullish right now is the Royal Caribbean's pre-pandemic effort to use technology to boost profitability. It appears to be working. Revenue per passenger was up by 4% in the first quarter compared

to pre-pandemic, the first quarter of 2019. Management attributes that to its new pre-cruise system that incentivizes greater spending. Their customer deposit base hit $400 million over the course of the quarter. That is future revenue coming in. That's a sign that they are still bringing business through the door. In Royal Caribbean, you have best-in-class in terms of brand, innovation, use of data, balance sheet. One more thing I should mention, there's already so much negativity priced in here that the next few months, maybe we can get through it. The stock right now is trading at levels similar to March of 2020. That's when ships weren't even sailing. Quite frankly, we didn't know if they'd ever sail again. For all of the uncertainty we

have now, I'm pretty comfortable in saying the outlook today right now isn't as bad as the outlook in March 2020. Bottom line is Royal Caribbean is a survivor in an industry that still enjoys robust demand. This is a stock that was at $135 per share prior to pandemic, trading below $40 today. On an enterprise value, yes, adding in the debt, it's still down 30% pre-pandemic. I think Royal Caribbean is set up well to get back to the levels it once was as the recovery takes hold. If it does, it should pay off handsomely for investors. Lou Whiteman, thank you for the bull side. In the bear corner, we have Jamie Luko. Jamie, take it away. Thank you, Ricky. I'm going to concede with Lou that I think

I think, potentially, the second quarter could be a really good quarter for Royal Caribbean, because like Lou said, there's a lot of pent-up travel demand, and that's coming out in all shapes and sizes. You know, other travel companies like Airbnb are seeing a lot of success, and I think that Royal Caribbean will also benefit. But as we look farther out, more than just one or two quarters, I think the picture gets more worrisome. You know, for one, we have the fear of a recession in the U.S.

Now, whether or not you believe that we're currently already in a recession or not, what's clear is that there's a lot of fear about a recession coming. Now, what does that mean for consumers? Spending is going to decrease, especially on discretionary spending like cruises and especially when it comes to more luxury cruises or trips like Royal Caribbean offers. Therefore, Royal Caribbean will probably see a big slowdown in bookings in the coming quarters and the rest of the year. And even if consumers are dead set on going on cruises, maybe this year or next year in 2023, they're going to opt for cheaper tours. And instead of going to Royal Caribbean, they might go to cheaper competitors. And then if you add on inflation and

rising prices on need to have goods, you get a pretty bad picture for Royal Caribbean over the coming years. With this uncertainty in the economy, the next year or two could be pretty underwhelming for Royal Caribbean, and the company will likely disappoint. Now, this might be why Wall Street analysts are expecting only $8.87 billion in 2022 revenue. This is down both from 2019, where they had about $11 billion in revenue, and 2018, where they had just $9.5 billion in revenue. In other words, revenue from 2017 to 2022 is expected to increase just 1.14%. And then additionally, if the U.S. economy does get worse and perhaps the country does fall into a recession, I wouldn't be surprised if Royal Caribbean's revenue comes in below these estimates.

But hey, if their top-line growth doesn't scare you, maybe the rest of their financials will. In Q1 2022, their losses surpassed revenue. Q1 total revenue was about $1.06 billion, and their Q1 net loss was about $1.17 billion. In other words, for every $1 they made in revenue, Royal Caribbean lost $1.10. Additionally, their balance sheet is really ugly. They have about $2 billion in cash, and in short-term debt alone, they have over $2.5 billion, and in long-term debt, they have almost $20 billion. That is an upside-down balance sheet, if I've ever seen one, and it's cause for concern over the long term.

This would be concerning even in a great environment, but even in this scarier environment, that's even more worrisome. If Royal Caribbean's activity and therefore its revenue slows, that means less money is going in to pay off this debt, which is especially concerning given Royal Caribbean doesn't even have enough cash to pay off its short-term debt right now. Additionally, Royal Caribbean has an operating cash flow of negative $529 million in Q1, so it's burning cash, too. That could change, but compared to most recent quarter's numbers, that is pretty scary. So here's what we have. A cash-burning company that is facing an uncertain and likely painful year or two with a balance

sheet that has some major red flags. Yes, this company could have a nice second quarter, maybe even a third quarter due to pent-up travel and vacation demand. But if we look at the macroeconomic environment and we look further out than a quarter or two, the problems really start to pile up. As a long-term investor, I'm going to keep my distance because of these structural issues. And I think a lot of other long-term investors will do the same. Jamie Luco with the bear side coming in hot. Lou Whiteman, thank you for the bull case. It's very important for you to go on Twitter

at Motley Fool Money and decide who made the better argument because the winner is going to win this fabulous prize after all the stock talk you might need a vacation enjoy five nights at the courtyard by marriott at the toledo airport located just 20 minutes from downtown toledo you'll enjoy the sights and sounds of ohio's glass city your stay includes free wi-fi a shared balcony and breakfast at an additional charge make sure you fuel up before you spend a day at the Toledo Zoo at your own cost. And enjoy two standing room-only tickets to a Toledo Mudhens baseball game. All of this could be yours if you win Bear vs. Bull. As always, people on the program may have interest in the stocks they talk about,

and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.