Full Steam Ahead for Norwegian

Our long-term thesis continues to evolve as Norwegian has returned to the Asia-Pacific market after a 15-year hiatus. This aids the company’s focus on itinerary scarcity (redeploying capacity to new markets and diversifying duration of itineraries) and should prevent Norwegian’s products from becoming commodified. We already viewed the company’s capacity as scarce relative to its peers, as the Norwegian brand will have only 17 ships in operation by the end of 2020, and the differentiated product (freestyle cruising), along with Prestige’s tilt to high-net-worth consumers, carves out a differentiated base of consumer demand than many of its peers.

Commentary across industry operators has been focused on firming pricing globally and improving returns on invested capital, which could help generate better profit results for Norwegian. However, peers could discount during periods of economic duress, forcing Norwegian to follow suit, although this could be tempered by its differentiated product. Prestige’s brands provide some insulation from broad-based discounting, as its luxury products are offered to consumers who tend to be less affected by economic cycles, leading to less close-in discounting.

Freestyle Product Sets Norwegian Apart We assign a narrow economic moat rating to Norwegian because of the company's brand awareness and presence (particularly in the Caribbean) as well as its cost structure, which we expect will improve as the company continues to expand capacity and leverages vendor and port relationships after acquiring Prestige in 2014. Norwegian's brand recognition is healthy, despite falling in the shadow of sizable peers Carnival CCL/CUK and Royal Caribbean RCL, which have more than 100 and 40 ships globally deployed, respectively (versus Norwegian's 25 since adding Prestige). We see this through the better capacity-adjusted yields Norwegian currently commands.

While the current balance of capacity can force Norwegian to be a price-taker in periods of economic or geopolitical distress in its namesake brand, we think the company can wield some influence over its consumers by offering a product (freestyle cruising) that differs somewhat from the traditional cruise product. As Norwegian’s capacity grows more quickly than its peers, we expect it can close the price-setting gap with its competitors and wield even more pricing power, particularly through the upscale Oceania and Regent Seven Seas brands. While the company currently earns more on a daily per-berth basis than its peers (it achieved capacity-adjusted daily yields of $241 in 2017 versus $187 for Royal Caribbean and $174 for Carnival), we suspect this could have to do with the previously limited supply of berths Norwegian currently has in the key Caribbean region (lower supply to meet demand), the market-to-fill pricing strategy, and the luxury/contemporary mix of berths. We also think the proportion of new berths relative to peers’ fleets helps drive a higher average price, as newer ships generally generate better pricing.

Additionally, we see Norwegian’s dedication to remaining prominent in the Caribbean region and building its brand (while competitors redeploy some capacity to Europe and Asia) as improving goodwill with its core consumer, as newer options in the region remain rather than decline. As more ships come on line (with Regent Explorer and Oceania Sirena launched in 2016, Joy delivered in summer 2017, and two additional Breakaway Plus ships--Bliss and Encore--in 2018 and 2019), we expect pricing growth to slightly flatten relative to recent periods; in the five years ending 2017, the company will have generated average yield growth of 6.6%, including the acquisition of Prestige. The supply/demand dynamic could shift and affect pricing negatively from the increased capacity but should be offset by the premium pricing that new ships generally command. Based on new commentary surrounding a more global deployment plan in periods ahead, Norwegian may be able to better control the cadence of flattening, supporting better longer-term yield growth, as it replaces lower-yielding itineraries with new, higher-yielding itineraries.

Returns on invested capital surpassed our estimated 10% weighted average cost of capital in 2015, and we forecast Norwegian capturing 13% ROICs in 2021 if the economic environment doesn’t deteriorate materially. Management continues to focus on improving ROICs as newer, more cost-efficient ships are deployed with a five-year estimated payback period, which is lengthening with the Breakaway Plus ships. With a heavy weighting to Caribbean cruising at the namesake brand, future expansion into other markets like Asia and South America creates a tremendous growth opportunity. While Norwegian will probably lose out on the brand-building that the first mover gets in some markets, it will be able to learn from others’ mistakes and tactically position itself, drawing on consumer analytics and the best practices of its new additions (Regent and Oceania) and prior sponsors (particularly Star Cruises in Asia). Additionally, the company’s ability to combine its negotiating power with that of other portfolio companies (for expenses such as food and other inputs) has helped the company achieve good expense control on a capacity-adjusted basis.

The top three publicly held cruise lines--Norwegian, Royal Caribbean, and Carnival--control nearly 90% of the North American market. This significant share is enough to prevent most new competitors from entering the marketplace, as a smaller entrant would find it difficult to leverage its costs across a small fleet and the nascent brand could prevent strong pricing, making it hard to break even. The capital-intensive nature of the business also discourages potential competitors without very deep pockets or the ability to obtain significant financing from attempting to take share in the segment. With more recent large ships costing nearly $1 billion and limited worldwide shipbuilding capacity, it would be difficult for any competitor to enter the market and scale up quickly. Given the long lead times to take a ship from design to market, it would take at least three years for a new ship to sail.

Although we expect Norwegian to generate ROICs consistently higher than its cost of capital in future years, we don’t think it has carved a wide moat. We believe the company will fortify its moat over the next decade as its brand presence becomes more visible in international markets and its cost structure becomes more competitive, particularly with the addition of Oceania and Regent, but we remain concerned that cruising still competes with land-based vacations, and with no switching costs among alternatives, the choices are nearly limitless.

Fleet Expansion in Early Stages Norwegian faces risks similar to its peers, including geopolitical uncertainty, commodity price volatility, and changes to the U.S. tax code, as well as company-specific issues. The company is still in the early stages of expanding its fleet and relies on proper financing to continue to order ships. We view additions to the fleet as imperative in order to continue to capture premium pricing. Additionally, the company still has concentrated ownership from Apollo and Genting (which owned 17% of shares as of 2017 year-end), whose best interests may be incongruous with those of outside shareholders.

Risks to pricing power exist, as the media have clung to negative publicity in prior years, threatening cruise brands’ ability to raise fares. With Royal Caribbean and Carnival able to cut prices when necessary, we see Norwegian as a price-taker in certain instances, primarily during longer economic slowdowns or times of geopolitical uncertainty. However, our concern remains somewhat tempered, as the domestic spending environment remains stable and the cruise companies seem adamant on holding pricing firm. Norwegian has some concentration risk as its primary source of consumers is the United States.

Norwegian is the most leveraged of the publicly traded cruise lines, funding its faster growth with inexpensive credit export facility-type debt. With 25 ships deployed in 2017 and three more on deck for delivery through 2020, we expect rapid capacity expansion in the next five years (6% on average over 2018-22). This will limit near-term deleveraging from current levels, after including debt for financing the Prestige acquisition. The Prestige acquisition cost $3.025 billion and was financed with $670 million in equity, some cash, and debt. The company has achieved its leverage target of below 4 times, which we believe will stay around 3.5 at the end of 2018, contingent on EBITDA expansion rather than debt paydown.

Interest coverage should improve as operating income grows faster than debt over time. Norwegian’s net debt/EBITDA ratio is higher than either of its closest competitors’, but we do not believe the company will have any concerns paying its near-term debt obligations, as most of the debt is amortizing.

We expect Norwegian will remain consistently free cash flow positive, allowing it to pay down debt at a measured pace. However, we do expect that management will continue to order ships for delivery approximately every 18 months (and one per year during 2022-25) at its namesake brand and will opportunistically finance new ships through either compelling pricing in the debt markets or low-cost export credit agency guaranteed loans.