Wachovia analyst says Royal Caribbean convertibles still attractive

By Ronda Fears

Nashville, Tenn., April 26 - Improved business fundamentals continue to make Royal Caribbean Cruises Ltd.'s convertibles attractive total return candidates based on stock valuation, even though the credit profile is weak, said Wachovia Securities convertible analyst Sri Nadesan.

"Clearly, both bonds have tightened from a credit spread point of view over the past few months. At this stage we do not believe further credit-spread tightening is warranted," Nadesan said in a report Friday.

"But still, based on our view that business fundamentals will likely improve further and that the current consensus EPS estimate is likely still low, we believe there is further upside to the Royal Caribbean stock. Therefore, the two Royal Caribbean bonds represent attractive total-return alternatives, largely driven by expected stock price gains, over the next 6-9 months."

In keeping with Nadesan's expectation that the leisure markets, especially those that are cruise related, are showing smarter and faster improvement compared with what most analysts believed, Royal Caribbean posted better first-quarter results. The consensus EPS for 2002 and 2003 is low, in his opinion, leaving room for stock price appreciation.

Royal Caribbean reported EPS of 27c, compared with the consensus estimate of 26c, and was helped by better yields, higher occupancy and lower SG&A costs. Yields declined 7% for the quarter, slightly better than the company's own expectation in March of a decline of 7% to 8%.

Occupancy was better than expected at 103.9% versus 103.0% for the year-earlier quarter. SG&A expenses were $102.1 million versus $112.8 million for the year-earlier period, even though revenue rose about 10%. SG&A expenses as a percentage of revenue fell 270 basis points to 12.8% compared with the first quarter of 2001.

There was a clear business improvement, Nadesan said.

"With first-quarter 2002 results showing clear proof that the cruise markets have rebounded quite a bit, the company said in its conference call that it expects second and third quarter yields to decline about 5% to 7%, versus the company's prior guidance of a 7% to 8% decline," the analyst said in the report.

Although all aspects of the business have yet to return to pre-Sept. 11 levels, he said the company has benefited from lower travel agent commissions and air travel expenses.

The consensus EPS is $1.32 for 2002 and $1.79 for 2003.

"We believe with improving business fundamentals the consensus estimate for both years will likely increase," Nadesan said in the report.

"We think EPS will likely be above $1.45 for 2002 and above $2.00 for 2003. We think that using 18 times current EPS and 14 times forward EPS leaves a further 20% appreciation potential for the stock."

Although the company did not release its balance sheet as of March 31, Royal Caribbean indicated on the conference call that its long-term debt was $5.5 billion, up slightly from $5.4 billion at Dec. 31. On the other hand, its available liquidity - cash balances and credit availability - was $1.4 billion, unchanged from yearend, the analyst noted.

For the quarter, the company generated EBITDA of $195 million and on a last 12 months basis EBITDA was about $794 million. Interest expense came to $68.3 million and for the last 12 months totaled $262 million. On a last 12 months basis, the company's leverage ratio was 6.9 times, slightly better than 7.1 times at yearend. Interest coverage was slightly above 3.0 times, about the same as at Dec. 31.

We expect credit ratios to improve slightly by year-end but still be weak for the company's rating category," Nadesan said in the report.

"By year-end, with the improvement in operating fundamentals, we think Royal Caribbean could improve its leverage ratio to 6.6 times and its interest coverage ratio to 3.1 times - both slightly better than at March 31."

Due to the possibility that Royal Caribbean could merge with P&O Princess, the analyst noted that S&P has the company's debt on positive watch, whereas Moody's has taken a more cautious view and has the debt on watch with developing implications.

"In general, we think the company's leverage is high for its BB+/Ba2 senior unsecured rating category," Nadesan said.

"On a stand-alone basis without assuming the consummation of the proposed P&O Princess merger, we do not believe Royal Caribbean's credit profile will improve significantly over the next few years given that the company still has fairly large capex outlays of about $1.1 billion in both 2002 and 2003 for new ship deliveries.

"Although there will likely be some credit improvement over the next two years, we think the company's credit profile would still be below the BB+/Ba2 rating."

The Royal Caribbean convertibles are cheap, though, and a good total return investment, he said.

Both Royal Caribbean 0% bonds are putable within about two and a half years, the analyst noted. Given the short put dates, he said a credit spread of about 650 basis points and stock volatility of 40% would make the 0% bond of February 2021 is about 2.1% cheap and the 0% bond of May 2021 about 1.2% cheap.

Royal Caribbean 0% due Feburary 2021

Convertible Price (ask): 38.125

Stock Price: $22.75

Yield-to-Put: 7.1%

Put: Feb. 2, 2005

Yield-to-Maturity: 5.2%

Fair Value: 39.7

Cheapness: 2.1%

Credit Spread: 650 basis points

Volatility: 49%

Investment Value: 35

Conversion Premium: 42.1%

Point Premium: 11.3 points

Royal Caribbean 0% due May 2021

Convertible Price (ask): 43.4375

Stock Price: $22.75

Yield-to-Put: 1.8%

Put: May 18, 2004

Yield-to-Maturity: 1.2%

Fair Value: 44

Cheapness: 1.2%

Credit Spread: 650 basis points

Volatility: 49%

Investment Value: 35

Conversion Premium: 21.9%

Point Premium: 7.8 points

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