Royal Caribbean: Not Gloomy, Not Bright (NYSE:RCL)

Introduction

Royal Caribbean (NYSE:RCL) stock has seen a stellar year in 2023. The company successfully capitalized from a strong travel demand as a record number of consumers were looking to cruise at a premium. As 2024 starts, many investors are starting to be cautious of the travel industry in general likely because the industry is highly cyclical. Travel is one of the first discretionary spending consumers tend to forego in times of economic uncertainty. As such, I am downgrading my rating on the company from a buy to a hold. However, despite a slow build-up of macroeconomic challenges in recent quarters, I do not think it is time to sell Royal Caribbean. Despite macroeconomic challenges, the travel demand continues to be strong, and Royal Caribbean’s unique operations allow the company to manage costs better than other leisure or discretionary industries such as hotels and airlines. Therefore, while I am downgrading Royal Caribbean’s rating from a buy to a hold, I am still not convinced that the cruising demand is over for Royal Caribbean warranting a hold thesis.

Macroeconomic Headwind

Consumers’ financial health has been declining over the past few quarters, reflected by the loan delinquency rates. Looking at the data from the St. Louis Federal Reserve, the consumer loan delinquency rate has continued to increase with no clear signs of stopping or even slowing down, which reflects the weakening of consumers’ financial health. Also, I do not think describing the current loan delinquency situation as normalization is correct. Not only has the delinquency rate surpassed the pre-pandemic level, but the rate at which the delinquency rate is increasing quarter-over-quarter is not slowing down.

The first evidence of these macroeconomic conditions taking a toll on the travel industry came from Delta Air Lines (DAL). When Delta Air Lines reported 2023Q4 earnings, investors were disappointed by the lower-than-expected earnings outlook for 2024. Instead of a guidance of over $7 in earnings per share, the company is expecting $6 to $7, which would mean there will not be any meaningful bottom-line expansion in 2024 compared to 2023. Thus, I believe Delta Air Lines’ earnings report is one of the first evidence of macroeconomic conditions impacting the travel industry.

Overall, due to these macroeconomic reasons potentially creating headwinds for Royal Caribbean’s demand environment in 2024, I am downgrading the company’s rating from a buy to a hold.

Demand and Cost Environment

While the macroeconomic conditions and initial airline earnings suggest that there could be a demand headwind impending for Royal Caribbean, I am hesitant to believe so for a few reasons. First, cruise bookings and demand have been strong up until the previous earnings report. Second, Royal Caribbean and the cruise industry’s cost increases cannot be compared to that of the airline.

During Royal Caribbean’s 2023Q3 earnings report, the company touted strong current and future bookings. As a result, the management team said that “the company is also increasing its full-year 2023 Adjusted EPS guidance to $6.58 – $6.63, driven by strong demand and continued strength in onboard revenue.” Thus, up until October 26th, the company’s prospect of the industry and Royal Caribbean’s business was extremely positive.

Further, for Delta Air Lines, the major reason for the company trimming the earnings forecast was the cost and demand increase imbalance. While the operation costs show continued increases from new labor contracts and other miscellaneous operating costs, the macroeconomic environment has likely curbed the travel demand barring the company from being able to raise the prices enough to protect the bottom line.

This is not the case for Royal Caribbean. During the 2023Q3 earnings report, the company said that the net cruising cost is expected to be up 7% to 7.5% including the impact from Israel while the net yields are expected to be up 12.9% to 13.4%. Royal Caribbean’s ability to carry over the costs to consumers is far greater. It should also be noted that the cruise industry and the airline industry are inherently different. Each plane carrying a few hundred passengers requires at least two pilots and one flight attendant per 50-passenger capacity the plane has, which is expensive and vulnerable to impactful cost increases coming from renewed labor contracts. For Royal Caribbean, the passenger-to-pilot ratio is far smaller while the majority of the crew is not getting paid the US employee standard at sea allowing Royal Caribbean to manage labor costs more efficiently.

Therefore, considering both the demand and cost environment for Royal Caribbean, I believe it is premature to give a sell rating on the company. While it is true that the trouble may be brewing due to the macroeconomic conditions, Royal Caribbean may not feel the impact if the storm does not get stronger.

Valuation

Since publishing my previous article, the stock price has appreciated about 81.8%. Due to the massive increase in the company’s valuation, some investors may point out that Royal Caribbean is overbought. However, while the company is certainly not undervalued, I believe it is an overstatement to say Royal Caribbean is too expensive. The company has a 2024 forward price-to-earnings ratio of about 13.5. Considering that the company’s price-to-earnings ratio fluctuated between the 12 to 15 range throughout 2015 up until the pandemic, I believe the current valuation of Royal Caribbean is fair.

Summary

Going into 2024, the macroeconomic environment surrounding the travel and cruising industry as a whole will likely create a headwind. More specifically, consumers’ financial health is getting weaker, suggesting that discretionary spending like cruising and traveling could decline. One of the potential early signs of this came from Delta Air Lines reducing its earnings guidance for 2024. Thus, on potential macroeconomic risks relating to travel, I am downgrading my thesis on Royal Caribbean from a buy to a hold; however, I do not believe the macroeconomic environment alone warrants a sell thesis due to Royal Caribbean’s strong cost control measures, expected demand, and fair valuation.