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|  | JULY 8, 2004
By Michael Eidam How Shipshape Is Carnival? The cruise operator has charted the soundest course in the industry, say analysts, who also caution that near-term risks cloud the horizon The past five years have been rough sailing for the cruise industry, with a handful of outfits taking on water and going under. But Carnival managed to stay afloat, and now -- after acquiring P&O Princess in April, 2003, and building a record number of new ships -- the Miami-based giant holds 47% of the market, with 77 ships operating under 12 cruise brands. The expansion is already producing results. On June 17, Carnival (CCL ) reported a record net income of $332 million for the second quarter, or 41 cents earnings per share. That was 6 cents above analysts' estimates. More impressive, net revenue yields (net revenue per available lower berths on a given day) grew 13.2% on an increase in capacity -- an indication of strong pricing power. That was much higher than expected, demonstrating that neither global violence nor rising fuel costs -- one of the main drags on Carnival's momentum -- were enough to submerge profits. Wall Street has taken notice. Investors bid up Carnival's stock over 50% in the last year, to around $47 as of July 7 -- a 128% jump from its 2003 low of $20.60 before the war in Iraq began. GROWTH PAINS? Success carries its own risks, though, and now that Carnival is trading at over 21 times earnings -- well above its historical average -- some analysts think the stock may have gotten ahead of itself. "We believe there is little pricing or occupancy upside to [their] numbers, following the strong [economic] recovery anticipated this year," wrote Prudential Equity Group analyst William Lerner in a note to investors on June 17. Lerner has an underweight rating on Carnival and a price target of $48. Perhaps even more worrisome: Carnival's growth spurt pushed cash flow into negative territory for 2004. After increasing capacity 22.4% year-over-year, Carnival may have grown too fast. If demand doesn't keep pace with capacity, those extra berths may prove expensive to carry, forcing the company to lower prices in order to fill ships and dragging down profits. But J.P. Morgan analyst Dean Gianoukos, who holds an overweight rating on Carnival, believes it remains a good long-term bet. He writes in a June 2 report, "We view CCL...as pricey in the near term, but...we are expecting significant EPS growth...over the next three years." Gianoukos predicts Carnival's earnings per share can increase 112% in that period. ROUGH WATERS. Still, Gianoukos says the stock's ride could be bumpy in the near term. Cruise lines tend to have seasonal trading patterns: "Since 1994 (excluding 2000), CCL has returned, on average, 6.5% in the first quarter, 6.6% in the second, negative 5.0% in the third, and 14.8 in the fourth," he writes. If that remains true this year, investors might be better served holding off and looking for a dip in the next three months. A 5% drop would put the stock around $45. Gianoukos omits the year 2000 for a reason -- it was a rough time for Carnival. It was flooded with bad news and saw its stock price sink 50% in the first quarter. Investors might want to note some similarities between then and now, including higher fuel costs and rising interest rates that might erode margins as capacity increases. Carnival bulls believe the outfit will return to positive cash flow in 2005 and pay off expansion costs within five years. "You should see cash flow increase substantially," predicts A.G. Edwards analyst Timothy Conder, "and they'll use that to pay down debt." ROOM TO NAVIGATE? Conder, like many other analysts, is still calling "all aboard," when it comes to Carnival stock. They believe the cruise industry remains in its infant stages, accounting for only 2% of global tourism. Conder notes that just 16% of all North Americans and less than 1% of Europeans have taken a cruise, leaving ample room for growth. Gianoukos disagrees, noting that the rich price tags on cruises mean not everyone can afford to take one. He estimates the target market has been penetrated 30% to 40%, which is considered high. And Carnival's efforts to expand abroad could be tricky, he feels. "Growth in Europe may not come cheap," writes Gianoukos. "Margins and returns could come under pressure as they enter this market." Bulls note that Carnival's heft in the industry gives it economies of scale that allow higher operating margins than its competitors -- Carnival's 27.3% EBITDA (earnings before interest, taxes, depreciation, and amortization) is the highest in the cruise business. This buying power also enables Carnival to be the industry's low-cost operator and puts it in a stronger position to compete for the European market and other first-time cruisers. SEA CHANGES. Company spokesman Tim Gallagher says cruise demand is growing, pointing out that industrywide, "There are not nearly as many new ships in the pipeline as there were two years ago." Indeed, while Carnival has built 11 new ships in the past year, others have held off, giving Carnival the chance to grab market share at a time when industry capacity isn't expanding. Still, while pricing power in general looks strong right now, cruise lines are subject to risks beyond their control -- like war, weather, and changes in maritime law. Carnival's ambitious expansion, along with ongoing higher fuel costs and rising interest rates, could make its business trickier to manage if demand fades. For investors seeking a stake in this industry, analysts say Carnival merits consideration. Yet today's geopolitical uncertainties and the stock's valuation make it a bit iffy in the short term -- unless investors are prepared for choppy seas.  Eidam is a correspondent in BusinessWeek's Atlanta bureau Edited by Beth Belton
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