Cruise Operators
SECTOR REVIEW
Making the Case for Cruise
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We are adopting the thesis that cruise will outperform within destination
travel owing to (1) evidence of solid demand elasticity in North American and
European source markets; (2) a strong absolute and relative value
proposition to exploit a clear consumer trade-down trend; (3) lack of
corporate exposure; (4) more muted historical pricing gains vs. land-based
alternatives; (5) flexibility provided by asset mobility; (6) an intact global
penetration opportunity and (7) direct earnings benefit from lower fuel prices.
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Our fundamental call is that indications of a reasonable wave season
including evidence of stabilization in ticket-price declines needed to stimulate
fill increases visibility on our 1H estimates (booking curve still measured in
months) thus making the bear case suggesting 300-500 bps of incremental
yield degradation this year appear less likely.
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Assuming in-line 1H trends, we estimate 2H net yield would have to decline
an incremental 800 bps for both Carnival (2H -21% y/y) and Royal (2H -18%
y/y) for the mid-point of the bear case scenario to play out. Even under this
scenario, potential offsets include incremental cost takeout and likely share
shift from weaker players becoming distressed. Consistent with our stance,
incremental contingencies do not appear to be in play at either Carnival or
Royal Caribbean.
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We are upgrading best-in-class market leader Carnival (CCl/CCL.L) from
Neutral to Outperform with a $30/2073p target ($26/1760p prior) on revised
category stance and limited downside from balance sheet strength and
share capture facilitated by potential competitor distress if fundamentals
deteriorate further.
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We are upgrading Royal Caribbean (RCL) from Neutral to Outperform with a
$12 target ($10-12 prior) on trading opportunity provided by combination of
revised category stance, diminished liquidity overhang from expected
finalization of Finnish export financing and pervasive pessimistic sentiment.
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Catalysts include confirmation of demand elasticity at stable levels of
discounting, increased visibility on even the low end of existing guide,
increased risk appetite or an early-cycle rotation, and potential share shift
from a secondary or tertiary operator becoming distressed.
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Critical variables include magnitude/duration of leisure travel downturn and
change in fuel prices and f/x. Visibility also remains limited and we expect
leveraged consumer plays to continue to be extremely volatile.

Investment Summary
While it may seem counter-intuitive, we are adopting the thesis that cruise will outperform
within the destination travel category owing to (1) recent evidence of solid demand
elasticity in both the North American and European source markets; (2) a strong absolute
and relative value proposition to exploit clear evidence of a consumer trade-down trend;
(3) lack of corporate exposure that is a primary culprit of incremental land-based RevPAR
degradation; (4) more muted historical pricing gains vs. land-based alternatives; (5)
flexibility provided by asset mobility including the ability to broaden sourcing opportunities
and respond to regional demand dynamics; (6) an attractive primary demand stimulation
opportunity afforded by an intact global penetration opportunity; and (7) the direct earnings
benefit from lower fuel prices that have been a material drag over the last several years.
Relative to prior cycles, cruise also benefits from (1) the development of a European
source market that was virtually non-existent at the beginning of the decade and
represents a highly attractive primary demand stimulation opportunity; (2) an improved
distribution platform including a motivated travel agency channel with limited other
commission opportunities and a material inbound and outbound direct capability that was
nascent at the beginning of the decade; (3) a large number of already developed nontraditional
homeports and short-cruise itineraries that increase the product’s value
proposition (time and money); and (4) a larger base of repeat passengers that are fully
aware of the value proposition and typically respond very well to promotional activity.
Our fundamental call is that indications of a reasonable wave season including evidence of
stabilization in ticket-price declines needed to stimulate fill increases visibility on our 1H
estimates thus making the bear case suggesting 300-500 bps of incremental yield
degradation less likely. Assuming in-line 1H trends, 2H net yield would have to decline an
incremental 800 bps for both Carnival (2H -21% y/y) and Royal (2H -18% y/y) for the midpoint
of the bear case scenario to play out. Even under this scenario, potential offsets
include incremental cost takeout and likely share shift from weaker players becoming
distressed. Moreover, Carnival’s EPS would still be roughly $1.80 while Royal would still
be profitable at ~40￠ of EPS.
The corresponding rating changes on Carnival and Royal Caribbean primarily reflect our
revised category stance and each offers a different value proposition for investors. Our
upgrade of best-in-class market leader Carnival is a risk/reward call based on our relative
over performance category stance and limited downside from enviable balance sheet
strength/financial flexibility and share capture facilitated by potential competitor distress if
fundamentals deteriorate further. Our $30 target ($26 prior) is consistent with a yearforward
range of $27-32 and implies 12x our 2010 EPS estimate. We believe Royal
Caribbean’s historical-low $6 stock price is forcing us to take a view and our upgrade
takes the other side of recent incrementally bearish calls. For investors willing to tolerate
extreme volatility associated with hefty operating and financial leverage in the current
environment, we see an attractive trading opportunity provided by the combination of our
more bullish category stance, a diminished liquidity overhang from finalization of requisite
Finnish export credits and pervasive highly pessimistic sentiment (equity share price, short
interest, CDS, bond yields, etc). Our $12 target (range of $10-12 prior) is consistent with a
year-forward range of $9-12 and implies 8x our 2010 EPS estimate.
Catalysts include continued evidence of demand elasticity at stable levels of discounting;
increased visibility on even the low end of existing guide; increased risk appetite or a
rotation into early-cycle plays; and the potential for a secondary or tertiary operator to
become distressed. As we witnessed post-September 11, travel agents tend to quickly
shift share away from operators perceived to be in distress. For Royal Caribbean, we
would also add improved financing dynamics including finalization of outstanding export
credit authority (ECA) financing for both Royal Caribbean International (RCI) newbuilds.

Strong Price Elasticity
We are encouraged by evidence of a reasonable wave season and solid price elasticity in
both the North American (strong precedent) and European (lack of precedent) source
markets. Recent channel and on-site industry due diligence also provide indications that a
wave season did commence in January and volume remains seasonally elevated. While
the environment remains driven by price action, feedback suggests solid close-in fill and a
largely stable – albeit compressed – booking curve. While Miami is awash in conjecture
about various contingencies and strategic changes being pursued by various cruise
operators, we do not believe any material operating model or fundamental changes are
currently on the table at either Carnival or Royal Caribbean. Management focus appears
to be concentrated on driving load factor, which also appears consistent with a decent
wave period.
Compelling Value Proposition
Despite land-based pricing degradation, cruise continues to offer an exceptional absolute
and relative value proposition positioning the category well to benefit from a clear tradedown
trend in discretionary in general and leisure travel in particular. The trade-down
mentality is clearly in place with multiple examples suggesting all inclusive/fixed price and
budget/moderate price is in favor in the current environment.
On both an absolute and relative basis, we consider the cruise product offers an
outstanding vacation experience at a very attractive price. There are measurable cost
savings for the consumer associated with opting for a cruise vacation rather than a
comparable land-based resort vacation. We estimate a cruise vacation can offer about 30-
40% savings versus a comparable land-based vacation alternative. We believe cruise
operators are able to offer lower ticket pricing than land-based resort alternatives due to
two major factors: (1) structural cost advantages and (2) a captive customer base. Cruise
operators are not subject to U.S.-source income tax, which provides a significant cost
advantage. Also, U.S. minimum-wage standards do not apply to foreign-flagged cruise
vessels, offering another source of cost advantage versus other vacation alternatives.
Cruise operators are also able to extract significant revenues due to the captive nature of
the onboard traveler. Although cruise itineraries feature frequent land stops, travelers
spend considerable time aboard the ship shopping, gambling, and spending money on
services not included in the original cruise vacation price such as alcoholic beverages,
casino gaming, and retail (in order of importance).
In addition to providing dollar savings, cruise vacations enable passengers to visit several
locations in an economical manner, and budget-conscious consumers can also gauge how
much they are going to spend in advance with minimal surprises. The outstanding value of
cruise vacations helps convert past cruisers into a missionary salesforce that recommends
cruise vacations to friends and provides valuable repeat business. Price is only half of the
value equation; cruising also delivers some of the highest satisfaction levels of any
vacation travel alternative, and the product consistently delivers satisfaction levels in
excess of comparable land-based resort alternatives. According to CLIA, cruising is the
top-rated vacation category and consistently exceeds expectations. Whether frequent
cruiser or first timer, the majority (60%-plus) rate cruising as better than other vacation
experiences.
Lack of Corporate Exposure
As a pure leisure alternative, cruise has virtually no exposure to the corporate travel
segment. Degradation in corporate profit growth has prompted dramatic reductions in
corporate and meetings and incentive-related travel that we believe are a material driver of
the continued degradation in lodging and RevPAR, particularly in hard-hit markets such as
New York and Las Vegas. Comparisons with other land-based models often fail to make
this distinction, among others. While many similarities exist between competing land

based lodging/destination resort and cruise operators, we have found that cruise,
particularly given its book-to-fill strategy, is a fundamentally different business.
The last-in, last-out argument regarding the timing of cruise’s relative recovery fails to
account for the fact that cruise yields held up into 2008 largely because of easier
comparisons off a negative Caribbean pricing cycle in 2006 and early 2007 (the reason we
downgraded the stocks in February 2006) and the benefit of a strong existing base of
business coming into 2008 owing to a lengthier booking curve. As we indicated a year
ago, cruise demand began to deteriorate in February 2008 with the negative net yield
impact mitigated by the aforementioned strong existing revenue build. Moreover, the
typical lag in easing of corporate travel restrictions suggests leisure travel including cruise
will show signs of recovery before corporate travel.
More Modest Historical Pricing Power
Pricing gains in the cruise category (as measured by net revenue yield) over the last six
years have also lagged pricing gains at land-based alternatives (as measured by RevPAR).
We attribute this to a number of factors including lack of corporate exposure, a prevalent
trade-up mentality favoring more expensive a la carte offerings and strategic differences
such as a book-to-fill strategy and desire to stimulate primary demand in emerging
markets such as Europe.