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Crusin’ Into the Sunset

(January 15, 2009)

Dear Subscribers and Readers,

After a Lowry's 90% downside day yesterday (purportedly induced by a weaker-than-expected retail sales number and fears over Citigroup's liquidity situation), the market followed up with more bad news after the close, as sources indicate that Bank of America has approached the Treasury for more bailout funds and as Apple's Steve Jobs announced he will be taking a medical leave from his CEO job until June. The S&P 500 futures contract is down 8.00 points, while the NASDAQ 100 futures contract is down 17.50 points as I am typing this.  While the shorts are now salivating over the breakdown of the recent trading range (although it hasn't been broken in the Dow Industrials just yet), subscribers should note that the US stock market is already reaching extremely oversold levels on a short-term basis.  For example, the VIX closed at 49.14 yesterday, up 27% from last Tuesday's close of 38.56.  The NYSE ARMS Index also hit a reading of 3.48, its highest reading since the December 1, 2008 reading of 10.16 (when the Dow Industrials declined by 679.95 points to close at 8.149.09).  This short-term oversold condition is also evident in the relatively low percentage of NYSE stocks trading above its 20-day exponential moving average (EMA), as shown in the following chart, courtesy of Decisionpoint.com:

Percent of NYSE Stocks Above Their 200/50/20-EMA (3-Year)

As shown in the above chart, both the percentage of NYSE stocks trading at above their 20-EMA and 50-EMA are now in oversold territory (both at the 17% to 18% level).  What's more, history has shown that the stock market usually rallies for 2 to 7 days immediately after a Lowry's 90% downside day.  Whether this upcoming (inevitable?) rally would eventually turn into something substantial will depend on its initial upside breadth and volume.  As I mentioned in our latest weekend commentary, the upcoming stock market action will be news-driven, with investors waiting for the Intel and Genentech earnings report tonight, and of course, the Citigroup report this Friday morning (which has been moved forward from next Thursday).  The second part of the TARP is now sorely needed – and both the Obama administration and Congress now clearly know it.  With the central bank and regulators utilizing every tool they have to stem the liquidation in the financial markets, I expect the Feds to come in and “rescue” Citigroup and Bank of America if investors don't react well to their Citigroup's earnings release this Friday.  My sense is that any rescue will come in the form of another equity injection – and in addition, a “backstop” of some of their balance sheets' more toxic assets (in Bank of America's case, the Feds may guarantee a substantial portion of Merrill Lynch's balance sheet).

Let us now get to the gist of our commentary.  As you all should know, I am a great believer in understanding demographic trends and their roles in driving future geopolitical and industry trends.  There are many benefits to studying demographic trends – demographics are highly impactful, and more importantly, are highly predictable, as the mortality rate of a modern society tends to remain relatively stable over a 10 to 15-year period.  One industry I have been carefully monitoring is the global cruise liner industry – in particular, Carnival Cruises (CCL).  Following is my brief take on CCL – please do not hesitate to email me if you want to discuss this stock further.

Company

Founded in 1974, Carnival is a global cruise liner with its primary operations in North America, followed by Western Europe, and to a lesser degree, Asia/Pacific and South America.  It operates 85 cruise ships in three segments – contemporary, premium, and luxury – with a total capacity of 158,000 passengers.  During 2007, 7.7 million passengers cruised on Carnival's ships, up 9.5% from 2006. 2008 fiscal revenues were $14.6 billion, resulting in net income of $2.3 billion.  70% of Carnival's revenues come from cruise tickets, while the rest come from on-board activities such as casinos and beverage service, and shore excursions.

Investment Thesis

Dominant and extremely well run company in the global cruise line industry with a 53% market share.   Carnival has done well with its strategy of targeting the mass market, steadily gaining its market share through organic growth, strategic acquisitions, and acquiring troubled cruse liners.    Carnival has a dominant market share of 52% in the contemporary market (through its Carnival, Princess, and Costa brands), 56% in the premium market (through its Holland America brand), and 10% in the luxury market (through its Cunard and Seabourn brands).  The contemporary and premium segments collectively make up over 90% of the market.  Royal Caribbean is a distant second, with just a 25% market share.  The global cruise line market is effectively a duopoly, which allows Carnival and Royal Caribbean to manage industry ship capacity, provide high barriers to energy, and give them tremendous power over their suppliers.  The executive management team has an average tenure of 19 years with Carnival, and the CEO has been the CEO of the company since 1979 and Chairman since 1990.

Cruising is becoming more mainstream but is still a young industry.  The global cruise line industry has grown from 2 million passengers per year in the 1980s to 16.5 million today, for an annualized growth of 8%.  The industry has evolved over the last 25 years from a niche industry into an industry with a mass-market appeal, aided by the increase in onboard activities, improvements in ship designs, more points of departures, and greater customers' access to ports as the airline industry deregulated.  That said, this is still a very young industry with tremendous growth potential.  Its 21 billion in revenues in North America is very small compared to $133 billion the lodging industry, with only a 4.4% penetration in the US in 2007, compared to 15% to 20% in other vacation spots such as Last Vegas and Orlando.  The penetration rate in Europe, at 1%, is even lower.  More importantly, industry growth has been very resilient – with positive passenger growth in both the consumer recession of 1991 and the post-9-11 travel slump.  The last time the cruise line industry did not grow was during 1994 to 1995 (when growth declined by a total of 2%), when US vacationers instead flocked to Mexico (due to the Peso devaluation) and when the Caribbean experienced a very active hurricane season.  Even then, Carnival managed to grow its passenger count by 15.3% and 14.6%, respectively.  For the first nine months of fiscal 2008, the number of passengers on Carnival's cruises increased by 7.5%, which is strong given the deterioration in other parts of the global economy.

Demographic trends provide a structural tailwind.  The average age of a Carnival cruiser is 46, and cruising tends to become more popular as a vacation alternative as customers age.  With the youngest baby boomer about to turn 46 (in 2010), cruising will no doubt become a more popular vacation alternative as time passes.

Significant Value Proposition.  The average per-day rate of a cruise ticket is around $170, which is below its 1999 peak price.  By contrast, Las Vegas casino hotel room pricing has risen 79% while general US lodging rates have risen 21% from 2000 to 2007.

Lower input costs.  Assuming an average crude oil spot price of $40 a barrel, fuel costs for Carnival (which does not have any hedging policy in place) should decline by approximately $1 billion in fiscal 2009.  This will directly add more than $1.20 to the company's bottom line (Carnival pays minimal US taxes since it is incorporated in Panama) assuming no other changes to Carnival's revenue or cost structure.  A large chunk of this will be offset by Carnival's removal of its fuel supplements charged to passengers (which could add as much as 8% to passengers' basic fares), but presumably, the removal of these charges would also allow the passenger to spend more on other on-board activities.

Valuation.  Carnival Cruises is still a growth story so it does not have much free cash flow, as it has historically spent its cash flows on building new ships.  On a 2009 forward basis (assuming the midpoint of management's guidance, or $2.50 a share for fiscal 2009), Carnival is trading at a forward P/E of 8.7, compared to a forward P/E of 10.6 for the S&P 500.  It is also trading at a P/B ratio of 0.9 and a tangible P/B of 1.2, compared to a five-year average of 2.2 and 3.0, respectively.  Carnival's main competitor, Royal Caribbean (RCL) has a lower forward P/E of 5.6, but it also has a highly leveraged capital structure.  For example, its debt-to-equity ratio is 86% (compared to 49% for CCL), and its interest coverage ratio is only 2.8 (compared to 6.6 for CCL).  Royal Caribbean may also experience cash flow problems in 2009, as it has an upcoming $2 billion in debt repayment.  Finally, I believe Carnival will surprise on the upside in fiscal 2009 (and hit the high side of management's estimate), as lower fuel prices make it through to Carnival's cost structure and as the Obama tax cut kicks in.  The Obama tax cuts ($500 per individual and $1,000 per couple) are in the “sweet spot” of a short cruise in the Caribbean “contemporary” market, which Carnival is well known for.

Signing off,

Henry To, CFA

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