With the price of oil coming down to the $40 to $50 range, some companies that have fuel charges as a major expense are reporting profits that are higher than usual. You are seeing that with Carnival Cruise Lines which are seeing profits grow from $1.39 in 2013 to an expected $2.40 in 2015. The price of the stock has increased from $31 in 2013 to $47 at the end of today’s close. You do not want to hitch your family’s fortune onto the back of companies like this.
The reason why I say that is because Carnival carries high debt, has an indistinguishable moat, normally operates with high fixed operating costs, and is highly susceptible to high oil and gas prices. There is no need to ever buy a company that lives and dies according to a reverse cyclical relationship with the energy sector (i.e. when the cost of oil goes down, Carnival’s profits go up and vice versa).
There’s no way around the obvious: Carnival operates in an industry known for high debt loads, and maintains a high debt load even taking into account the company’s peer levels. Carnival carries $9 billion in debt, and only makes $1.5 billion in net profit. That coverage is a little bit worse than average for a company in a capital intensive industry, but the issue is compounded by the fact that Carnival’s current profits are higher than usual right now because of lower fuel prices.
In short, Carnival’s profit margins run around 19% or 20% when oil trades in that $45-$55 range, and tends to come down to 7-9% when oil trades in the $90-$105 range. If oil reverted to 2011 pricing in the $100 range, Carnival would see its profits come down to $1 billion or so (they have two new vessels coming out within the next twenty months, so Carnival might perform a bit better in the $1.1-$1.2 billion range if oil prices went up 60%).
The important thing, though, is to think about the stickiness of profits. Take Procter & Gamble. It makes $11.5 billion in profits per year. That number is not going to fluctuate because the profit margins for household products are pretty consistent over time, and the demand grows at a moderate pace in most years. Between 2008 and 2009, Procter & Gamble saw its profits decline by $800 million. That’s about the worst of it. Once we get past the “anything is possible” disclaimer, it would be extraordinarily unusual to see Procter & Gamble’s profits fall 50% to the $6 billion range because changes in the economic conditions don’t have that kind of outsized impact on its products.
There is a sturdiness to P&G’s profits over time that make it unlikely you will ever get burned holding the stock for a long period of time. The worst case scenario for the company is a period like right now where revenues have trouble growing and you get stuck in a pattern of 6-8% annual earnings per share growth and dividend growth in a similar range. It’s not some terrible hardship to double your money at twice the rate of inflation.
But Carnival doesn’t come with this sturdiness. It has to constantly reinvest retained earnings to maintain its status quo. When you buy a Gillette razor from P&G, that’s it. The end of the transaction. Then you go back the next time and buy some more. This type of business model lends itself readily to repetition, and that is why Procter & Gamble shareholders do so well over time. With Carnival, you have to build new ships to grow, and then build new ships to replace old ones. A lot of money needs to get spent just to maintain the status quo.
And this issue does show up in the numbers. Over the past ten years, Carnival has only been able to increase its profits by 1.5% annually. This is despite growing revenues by 9.5% annually over that time. Those are terrible metrics—consultants call this the “intoxication of sales” in which businessmen get excited about selling as much of a product as possible without focusing on the cold-hard cash that can be extracted from the business. It sounds so elementary, but there is a surprisingly large group of people that don’t realize it is better to sell sixty widgets at $50 each than to sell one-hundred widgets at $25 each, assuming the cost of production is equal. In Carnival’s case, it is not that management is asleep at the wheel but rather that rising fuel costs disproportionately eat up profits in a way that shareholders are not left with much.
These economic characteristics explain why Carnival has only compounded at 3.25% since 2004, turning a $10,000 investment into $14,000 today. That actually overstates the case because Carnival has seen its share price climb from $29 in 2012 to $47 today because fuel costs have declined and profits have risen. If you held Carnival stock from 2004 through 2012, you would have actually seen your money compound negatively at 1.72% per year, turning every $1,000 invested into the stock into $873. A loss of 13% was your reward for eight years of patience. Someone who buys Carnival now, while profits are high and fuel prices are low, will likely regret their investment choice if oil prices stage a meaningful recovery in the next few years.