Analyst View: J.P. Morgan suggests Royal Caribbean 0% due May 2021 for yield seekers

By Ronda Fears

Nashville, Tenn., Oct. 31 - There may be icebergs on the horizon of the cruise line industry, but J.P. Morgan convertible analysts say it's too early to jump ship. In fact, the analysts suggest there is opportunity for speculative investors to reap very high yields with modest upside participation in the Royal Caribbean Cruises Ltd. story. The analysts prefer Royal Caribbean's zero-coupon convertibles due May 2021 to the February 2021, however, due to its earlier put and lower conversion premium.

"In the aftermath of the terrorist attacks on Sept. 11 and concerns about additional attacks, prices for Royal Caribbean's Ba2/BB+ rated straight, convertible and bank debt have traded down to levels that suggest that the fixed income marketplace currently anticipates a high probability of default," said J.P. Morgan convertible analysts John Levin and Alexander Robinson in a research paper.

"Although we generally are confident that the risks to Royal Caribbean's credit are adequately compensated by a high yield, we remain watchful for several potential events. Royal Caribbean's balance sheet is under pressure and will likely deteriorate further due to lower cash flow generation and expenditure commitments," the analysts said. "Despite the company's assertion that it will not trip bank debt covenants, our analysis suggests there is modest risk that Royal Caribbean could trip some of them. However, we believe that in such an event the banks would agree to waive a covenant in exchange for value."

While the cruise travel sector and Royal Caribbean in particular face unprecedented deterioration in their business, the J.P. Morgan analysts said they believe the Royal Caribbean zero-coupon senior convertible notes putable in May 2004 offer speculative appeal for investors seeking a very high yield and modest upside participation in the common stock.

At a closing price of 28.5 on Oct. 30, the Royal Caribbean convertible due May 2021 produced a yield of 18.80% to the first put, representing a 1,604 basis point spread to Treasuries, and have a 74.4% conversion premium.

In addition to the shorter put and lower conversion premium than the Royal Caribbean zero-coupon convertible due February 2021, the analysts noted that the company has dedicated a $345.8 million backstop credit facility should it choose to pay the 2004 put in cash.

Prior to Sept. 11, the J.P. Morgan analysts noted that equity and fixed income investors were attracted to the cruise travel sector by generally high EBITDA margins, significant fixed asset values and the potential for revenue and earnings growth at higher than historical norms. Investors' concerns centered mostly on significant upcoming industry capacity increases estimated at 7% to 8% in 2002 and 11% to 12% in 2003, and the ability of consumer demand to keep pace with this new supply without negative pressure on pricing.

Since the attacks, however, most if not all of the attractions have disappeared. Immediately following the attacks, the analysts noted that reduced occupancy and a deteriorating pricing environment have disproportionately affected cruise operators that were more dependent on U.S. passengers with non-continental itineraries. Several cruise operators have repositioned ships away from the Far East and Mediterranean, further jamming supply in certain local markets, and there also has been a couple of bankruptcies in the industry. Renaissance Cruise Lines on Sept. 25, and American Classic Voyages Inc. on Oct. 19 filed for bankruptcy.

Not surprisingly, stock prices of the large, domestic cruise lines have fallen significantly. Since Sept. 11, Royal Caribbean's common stock has declined 51.1% and its largest issue of straight debt, the $500 million of 8¾% senior notes due February 2011, which had traded with about 425 basis points spread to treasuries before the attacks, now trade with spreads in excess of 1,000 basis points.

The Royal Caribbean converts due May 2021 closed Tuesday at 28.5 and the converts due February 2021 ended at 20, with the underlying stock at $10.43.

0% convertibles due 5/18/21 (Ba2 / BB+)

Amount: $883 million

Issue price: 39.106

Current accreted value: 39.941

Coupon: 0%

Yield to maturity: 4.75%

Conversion price: $24.96

Conversion ratio: 15.6675

Contingent conversion: 120%

Call: 5/18/06 at 49.452

Put: 2004, 2009 and 2014 at 45.020

0% convertible due 2/2/21 (Ba2/BB+)

Amount: $1.5 billion

Issue price: 38.163

Current accreted value: 39.556

Coupon: 0%

Yield to maturity: 4.0%

Conversion price: $32.58

Conversion ratio: 11.7152

Contingent conversion: 120%

Call: 2/2/05 at 46.272

Put: 2005 and 2011 at 46.272

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