Cruising for a Bruising

Posted On December 1, 2015 10:30 am

It seems like fair winds and following seas for the cruise line industry. But beneath the smooth sailing there could be hidden shoals.

One of the big themes of 2015 has been the shift in consumer spending as people (not just those darn millennials) are taking Joie de vivre approach to their discretionary spending. This means not just taking advantage online purchases through Amazon (AMZN) to get of just in time/ just what I want but also the shift from “things” to “experiences”.

The latter has become abundantly clear as third quarter earnings reports from traditional retailers covering the gamut of economy and geography such as Macy’s, Gap and Nordstrom, all reported weakening sales and worsening trends. Their stocks cratered from already very depressed levels. But I’m not here to bury the retail dinosaurs, I actually think some are far from extinct and offer a good long term bargain proposition.

Nay, this article is a shot across the bow of Royal Caribbean Cruise Line (RCL) suggesting its path could take a turn south. Yes, once again I’m taking a contrarian view. In this case just when everything seems to be going swimmingly for the cruise industry I’m seeing trouble on the horizon, especially for RCL.

Bigger, Better But Maybe Too Much of an OK Thing

The trend over the past decade in the cruise has to build bigger ships that offer ever more diversions for the passengers. This has helped boost ancillary revenues from everything from WiFi ($4.95 a day extra) to rock climbing (with lessons extra) and operating drones to take “eye in the sky” selfies in (the purchase of prints costs extra) and very high end rooms which command premium priced of as much $29,000 for eight night trip. These are all high margin revenue streams which helps boost profitability allowing the company to keep the baseline travel ticket at a relatively low cost value proposition.

So far the plan has been working Royal Caribbean recently added the Anthem of the Seas, latest quartet of its biggest and most advanced ships ever that collectively cost over $3 billion to build. Collectively, the four ships comprise about 18% of Royal Caribbean’s overall capacity, which also includes smaller brands such as Celebrity Cruises and TUI Cruises.

During its third quarter earnings reported on 11/23/ RCL reported that ticket revenue, which is essentially how much people spend to board a ship, rose 4.9% year over year in the third quarter. And once they got on board, the spending didn’t stop. On-board revenue, which reflects spending by passengers at restaurants, retail shops and on extras such those mentioned above surged 8% from the year ago period.

But the fact remains these ships are a self-enclosed unit and offer little variety not only from destination to destination but also from their land based competitors of all-inclusive resorts. In fact I’d argue the land based options provide more variety and flexibility, such as single day boating excursions, golf and casinos, that keep the trip fresh and pad the resorts’ bottom line without the capital intensive outlay. Not only does building and maintaining these big ships cost a lot but its logistical nightmare of getting just in time supplies such as food on board within the short-turnaround time.

The upshot is that while these new behemoths are garnering good initial demand they also represent surge in capacity, RCL’s four ships added some 12,000 rooms, which may ultimately lead to discounting once the shine and allure of a new produce wears off.

Unfortunately I’d be remiss if I did not mention potential exogenous events such as foodborne related illnesses such as e-coli or salmonella which have plagued the industry in the past and have recently hit Chipotle (CMG) and Costco (COST).   The cost involved in taking a ship offline, sterilizing it, and reimbursing passengers in some fashion could wipe out a full season of profits.

Or worse would be a terror attack. I’m sure some suicidal nut job views these ships as a prime target. I don’t need to elaborate what the negative fallout from such an event would be.

Priced for Perfect Conditions

Against this backdrop we need to understand that shares of Royal Caribbean are priced to perfection. They currently trade at 39x next year’s earnings despite expectations for a mere 8% top line growth in revenues and a 23% increase in bottom line profit. It is far and away the most expensive stock in the sector.

In the recent weeks since the Q3 earnings report the chart has taken a negative turn as shares broke support at both the 50 dma and long term trend line. This sets up a good risk/reward entry point.

RCL chart 11.27.15

The Trade:

I establish a bearish position by using a basic vertical put spread out in the March 2016 expiration. Specifically;

-Buy March $90 Put

-Sell March $80 Put

For a $3.00 Net Debit.

These options expire March 18, 2016 providing over four months for the bearish thesis to play out. My downside target is for shares to hit the August lows at $80 per share.

To minimize risk I would use a close above $96 as stop loss for exiting the position.

This is what the risk graph of this position looks like:

RCL risk 11.30.15

The maximum profit of $7 or a 230% gain would be realized if shares are below $80 at the March expiration.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.