A potential war, an uncertain economy, fuel-price fluctuations, terrorism threats, the outcome of consolidation - all potential sources of volatility for cruise stocks in 2003, according to financial analysts, who nonetheless appeared guardedly optimistic as this year's Wave Season began. For the most part, analysts' sentiments toward cruise stocks were summed up by Peter McMullin of yan, Beck & Co., who said his outlook was positive - "but the risks surrounding my outlook are a little higher than they normally are."

Political & Economic Uncertainty

"The biggest issue is the threat of war," said Tim Conder of A.G. Edwards & Co. The question, however, is how much cruise stock prices have already adjusted to that threat, and how the war - if there is one - will actually play out. "If you look back at the stock price of the only public cruise company at the time, from the invasion of Kuwait up until the beginning of the (first) Gulf War, Carnival Corporation's stock was down 39 percent, while the S&P was down 12 percent," said Conder. "Then, if you look at the time from the beginning of Desert Storm until a year later, Carnival rose 122 percent, the S&P rose 34 percent." Thus, at the beginning of the last Gulf War, the cruise stocks appeared to have already built in the war effect prior to the war, and showed the potential to rise dramatically in the event of a quick, decisive victory. In comparison, Conder noted that between May 2002 and January 2003, Carnival's stock had dropped 26 percent, Royal Caribbean Cruises' (RCC) had dropped by 25 percent, and the S&P had fallen 34 percent. But after drawing the comparisons, Conder commented, "The only thing we have to go on is the Gulf War, but will the future be a repeat of the past?"

According to Felicia Kantor of Lehman Brothers, 'The issue of the war and the issue of the economy go hand in hand. Uncertainty over the war may cause people to wait and see before booking their cruise or other vacations. I think people's trepidation toward cruising is less about being stuck on a cruise ship during a war than it is about economic concerns."  

"A lot depends on how long the war is and what the impact is on the economy," she said, noting that both Carnival's and RCC's stocks "had more room to go down" from their present prices.

Dean Gianoukos of JP Morgan Chase offered a similar opinion: "If war materializes, we believe that there will likely be a pause in bookings as Americans become preoccupied with the news. Although some of this is factored into the stock prices, we believe there could be further downside." In general, said Gianoukos, "We think the cruise stocks will continue to be trading vehicles. We continue to recommend investors buy on dips, which has proven to be a lucrative strategy with the cruise stocks."

According to Glenn Reid of BEAR STEARNS, "The Iraq situation has mostly been factored into the share prices, though I do believe that a relatively optimistic scenario is assumed (i.e., quick, painless, victorious). The Iraq situation has no doubt been an overhang on the cruise sector for the past couple of months. Its passing will only be a good thing."

McMullin also believes that the war effect has largely been incorporated into today's cruise stock prices. As he put it, "If we settled the dispute (with Iraq) tomorrow, cruise stocks would go up."

The timing of any potential war is yet another variable in the equation. According to Joe Hovorka of Raymond James & Associates, "A possible war could come at the most inopportune time - in the middle of the Wave Period." If so, he said, "the likely need to adjust itineraries will disrupt the booking cycle and put pressure on overall pricing."

A related factor is fuel pricing. The issue is particularly relevant for Carnival, which unlike RCC does not hedge its fuel purchases. Said Conder, "If you use crude oil as a proxy, it's up about 48 or 49 percent year over year. A lot of that has happened quite recently - three months ago it was up only eight percent." According to Conder, RCC hedges its fuel costs in the 40-60 percent range, with that figure "just under 40 percent around Christmas," while Carnival - which does not hedge - reported that fuel costs accounted for five to five-and-a-half percent of its revenues in the fourth quarter, versus the usual three to four-and-a-half percent, said Conder. But ultimately, some analysts believe the fuel factor will not be significant. "The issue of higher fuel costs will tend to dissipate over the next couple of quarters," said Reid.

03 Capacity, Pricing & Yield

"Overcapacity has always been our chief concern, " said Reid. " Over the past few years, we ' ve seen a steady decline in the capacity-adjusted profitability of the cruise companies and I don't really expect that trend to reverse itself until capacity growth slows down."

According to Erica Moffett of CIBC World Markets, "It appears pricing is holding at this point, even in spite of recent Norwalk-virus outbreaks, which do appear to have had a minor impact on bookings.

"In terms of capacity," explained Moffett, "the industry has generally historically absorbed capacity relatively well, and we believe demand continues to hold. With that said, the key risks are on pricing and that exogenous factors all hit at once. In other words, consumer sentiment falls off dramatically and without warning on top of an extended war scenario. In that case, there is risk to pricing, although the entire consumer sector would also be negatively impacted."

According to Gianoukos, "We are somewhat concerned about the capacity increase in 2003 and 2004, but given the weak comparisons (vs. 2002), we think that the industry should be able to digest it and get flat to slightly increased yields, unless the effects of the war or the economy are larger than we anticipate."

According to Hovorka, "Booking demand for 2003 appears to be strongest for the Caribbean and weakest for Europe. Our travel agent survey results indicate a decline in Europe demand." With Europe being "the fastest growing destination for the industry," he said, "relatively weak booking demand may point to possible yield discounting as the season approaches.

"We expect pricing to remain competitive in 2003," Hovorka continued. "Fears of war and a weak economy mixed with increased capacity is not conducive to strong increases in net yield for the industry. Although 2002 will be a relatively easy comparison because of the negative yield growth, we expect net yields to increase less than one percent in 2003 without an Iraq war. With a war, we expect net yields could be down slightly."

On a positive note, Kantor said that "Carnival's price today implies that net yields will be down seven percent in 03, and Royal Caribbean's price implies its own net yields will be down four percent. We believe that is overly pessimistic," she said, noting that net yields were down two to three percent during the first Gulf War.

The Merger

In general, analysts looked favorably on the increased consolidation of the cruise industry, and were upbeat regarding Carnival's ability to integrate P&O Princess Cruises (POC). "Carnival's management has a fairly decent track record for smoothly integrating its acquisitions," said Reid, "so I would look for management to deliver on its cost­ savings targets and overall synergies. On the other hand, I do think they'll have quite a bit of work to do to effectively position all of their new brands, which do seem to overlap somewhat."

According to Gianoukos, "We believe there will be significant synergies from the merger as Carnival sends its thrifty culture through POC's brands. The overall industry will not change tremendously," he believes, "but it should be a slight positive, as two companies will control a large share of the market."

Kantor offered another view: "I don't see Carnival-Princess as a synergy story. It's not like the savings will be passed through to the consumers. However, over time, I do think we should see Princess' EBITDA move closer to Carnival's."

Conder noted that with Carnival cross­ guaranteeing the future indebtedness of Princess, the merger would allow Carnival to go back and renegotiate Princess' existing debt. He added that Carnival's proclivity to allow lines to operate as relatively independent brands "minimizes some of the integration risk."

"Carnival has done this before, and has been quite successful at imposing its cost structure on acquisitions within the first two years," said McMullin.

"The merger will help (their results) in the first year, with a larger impact in the second."

Carnival Outlook

Analysts were quick to point out Carnival's strengths, in particular its strong balance sheet and the depth and longevity of its management team. Moffett underscored that Carnival was better prepared to handle 2003 's potential macro issues: "Carnival has historically fared better when pricing falls because of its leverage, and even with the merger and additional debt to finance, Carnival is a better name to hold during times of weaker yields."

Among those offering 12- to 18-month price targets for Carnival: Lehman: $32; CJBC: $34; A.G. Edwards: $34; and Ryan, Beck: $40 - or $41-$42 including merger benefits.

Several analysts voiced concerns over Holland America Line (HAL). According to Conder, ''HAL's demographic continues to be in the 50- to 55-plus range, but they'd like to get it down to 45. Looking at the first of the Vista-class ships, the Zuiderdam - it is not a premium product compared to RCC's Voyager class. So are they going for the 50- to 55-year-old mass market? How will they integrate this with Princess?"

Kantor voiced similar issues. "The Zuiderdam is a very different ship from the rest of the fleet. Getting current customers onto the Zuiderdam could be a challenge - or you could look at it another way: The challenge might be to get a totally different customer onto the Zuiderdam without alienating the existing HAL customers."

RCC Outlook

Meanwhile, analysts expressed a greater level of concern over issues facing RCC. As for the company's strengths, RCC is given high marks for its hardware, with repeated kudos for the new vessel classes of both Royal Caribbean International and Celebrity Cruises.

The 12- to 18-month outlooks offered on RCC: Lehman: $23; CJBC: $26; A.G. Edwards: $27; and Ryan, Beck: $30.

Regarding challenges, Kantor explained, "A lot of people like to talk about Royal Caribbean's debt, but they're fine in terms of their covenants." She noted, however, that given their balance sheet, "if they want to keep playing the building game, they're going to have to be creative."

RCC's greatest challenge, according to several analysts, is on the marketing front. "They need to get the message out on how good the Voyager-class ships really are," Conder stressed, "and to differentiate the Celebrity brand even more."

"They're also not getting the recognition they'd like for the Radiance-class ships," added Kantor.

Long-Term Outlook

Beyond the near-term uncertainty, analysts appeared optimistic that capacity growth would become more manageable in 2005 and beyond.

"Over a three-year horizon," said a CIBC leisure report, "we believe the cruise industry could outperform the broader market given its attractive long-term demographics and our belief that the cruise sector's impending duopoly is likely to help rationalize pricing and capacity."

According to Gianoukos, "We are comfortable that the industry should perform well in 2005, with an estimated North American capacity increase of 5.9 percent, and we expect orders to moderate somewhat moving forward."

Not everyone is wholly convinced the cruise industry will solve its capacity issue. "I believe that the cruise companies will tend to stick to a one-or-two­ ship-per-year pattern," said Reid, "and if all the major brands do that, we'll continue to have a situation of overcapacity, in my opinion."

"My gut tells me that the numbers in 05 and 06 (for newbuilding orders) will end up being higher than we see today," said Kantor. She would favor more of a breather in the building pace, ''because we're not going to see incremental price increases until capacity is absorbed." Yet Kantor underlined the importance of the new ships to the big picture: "This industry grows by building new ships and adding new amenities," she said. "I don't know that new customers are pulled to cruising - it's more that the cruise industry pulls customers to them."