High-end cruise lines stay strong

With holiday season now on the distant horizon, can the yearly vacation be far from people’s minds? We checked in with Zacks senior travel & leisure industry analyst Sean P. Smith to see how things are going in the cruise line market these days.

Were there any major earnings surprises in the just-reported quarter among companies in your coverage?

Royal Caribbean (RCL) reported second-quarter earnings results that were in line with our estimate, while Carnival Cruises (CCL), (CUK) posted second-quarter results that exceeded our expectation by approximately 15%, or $0.07 per share. Despite these results, however, we reduced our full-year estimate for both companies, lowering our 2008 EPS estimate for Royal Caribbean by roughly 8% and our estimate for Carnival by approximately 13%.

Looking out to fiscal year 2009, we left our estimate for Royal Caribbean unchanged, and lowered our estimate for Carnival by approximately 15%.

What issues do you see having an impact on the industry in general?

At the moment, the price of fuel is by far the most critical issue facing the cruise line industry. As one might imagine for ships of such enormous size, fuel is a critical input expense, and as prices have risen over the last year, the operating margins of the cruise lines have been pressured.

Carnival’s management team expects that increased fuel prices will cost the company approximately $0.92 in earnings per share during fiscal 2008. For reference, our current earnings estimate for the company is $2.69 per share. Clearly, the higher price of fuel is taking a significant chunk out of the company’s overall earnings.

Royal Caribbean is also being significantly impacted by rising fuel expenses. Unlike Carnival, however, Royal Caribbean hedges a portion of its fuel needs, locking in prices for future expenditures. This hedging has provided some level of protection, but higher overall fuel expenses are simply unavoidable.

On its second quarter conference call, the company estimated that a $10 per barrel change in the market price of crude oil for the remainder of the year would lead to a $20 million change in the company’s total fuel expense, or approximately $0.10 per share. Given that crude prices have fallen somewhat since mid-summer, we expect that some of the expense pressure has eased, but in comparison to last year, the prices today are still significantly higher.

In what ways has the slowing U.S. economy had a direct impact on the companies you follow?

The cruise lines have been fortunate to this point in that top-line demand has remained relatively strong. Booking trends have remained favorable, and occupancy rates continue to be solid. Certainly, as the recession continues to impact consumer spending, the cruise lines may begin to see occupancy rates and pricing power soften. Thus far, however, it appears that many consumers would prefer to cut back on other day-to-day expenditures as opposed to forgoing an annual vacation. Additionally, the perceived value offered by the cruise lines remains high, relative to other potential vacation trips.

What ratings do you currently have on the major cruise lines?

We currently have a Buy rating on shares of Royal Caribbean, based primarily on valuation. The shares trade at a significant discount to Carnival, and we project solid growth going forward. Additionally, the company will introduce what will be the largest cruise ship in the world at the end of next year, and we anticipate that this addition to the fleet will give the company a significant competitive advantage in the Caribbean market.

We rate the shares of Carnival a Hold at this time. Although the company is largest in the industry, we believe that the share price accurately reflects the current state of operations at the company. Carnival will report third-quarter results later this month, and we will update our outlook at that time.

How would you advise investors looking to increase exposure to this industry in the near-term?

For most of the year, the stocks have traded in the same general direction as the price of crude oil, given the significance of that input on the companies’ overall financial performance. We expect this trend to continue somewhat, although steps taken by the companies to improve fuel efficiency have helped to some degree. In the near term, we would advise investors to keep an eye on the demand picture.

If the companies can keep their revenue generation strong throughout the recession, they should be poised to benefit from increased pricing power once the economy improves. If, however, demand starts to weaken, the impact of higher fuel expenses will be exacerbated, and we would expect earnings estimates to fall.

Sean P. Smith is a Zacks senior analyst covering the travel & leisure industry for Zacks Equity Research.