Wachovia analyst sees Princess merger negative for Carnival, positive for Royal Caribbean

By Ronda Fears

Nashville, Tenn., June 21 - A merger with Princess P&O would be positive for Royal Caribbean but negative for Carnival and which suitor will prevail is still up in the air, said Wachovia Securities convertible analyst Sri Nadesan.

While Royal Caribbean's bid for Princess got clearance from U.K. regulators, the deal still awaits a decision by U.S. regulators due by the end of summer. And Carnival still has a bid on the table.

On Wednesday, the U.K. Department of Trade and Industry published the May 20 report by the Competition Commission that ruled that the proposed Royal Caribbean-P&O Princess Cruises merger will not be anti-competitive in the U.K. Princess has about a 23% market share of cruises taken by U.K. customers, whereas Royal Caribbean has a 3% share in that market.

Yet, Carnival management spoke confidently about its chances with the FTC and the European Union and said it expects both decisions to be rendered no later than the end of August, with the E.U. decision coming possibly by the end of July.

The FTC's decisions on the competing mergers are expected by the end of August. In addition to the FTC, the E.U. antitrust authorities are reviewing the Carnival-Princess merger proposal.

"If a merger, which is not assured, with Princess is approved, Royal Caribbean's credit profile will likely improve. Because Princess is less levered than Royal Caribbean, if the merger is approved we expect the Royal Caribbean bonds to benefit from the improved credit statistics at the proposed combined company," Nadesan said in a report Friday.

"A Princess merger, if it happens, is modestly negative for Carnival's credit. If the merger with P&O Princess is approved, the company may need to pay a portion of the merger consideration in cash."

The Royal Caribbean-Princess merger proposal has cleared all regulatory hurdles in Europe and at this point only the key U.S. FTC decision is pending.

"Given that the U.S. is the largest cruise market in the world, the FTC decision will have make or break power over this deal and the proposed Carnival-Princess merger," Nadesan said.

If Royal Caribbean's merger with Princess is approved, he sees Royal Caribbean's credit profile improving despite the structural complications of the proposed dual-listed company structure.

At the end of 2001, Princess's long-term debt was $1.39 billion and EBITDA for fiscal 2001 was $485 million.

Royal Caribbean's long-term debt at the end of the first quarter was $5.24 billion and last 12 months EBITDA at March 31 was $810 million.

Because of the difference in leverage at the two companies, on a combined basis the leverage ratio (long-term debt/EBITDA) would improve to 5.1 times from Royal Caribbean's stand-alone 6.5 times.

Interest coverage would improve to 3.7 times on a combined basis, from Royal Caribbean's stand-alone 3.1 times. These ratios could further improve from any cost cutting that may follow the merger.

Credit rating improvement may be slow in coming, however, the analyst noted.

"We believe Royal Caribbean's current credit statistics are weak for its senior credit rating of BB+/Ba2," Nadesan said.

"Therefore, even if the Princess merger occurs, the combined company's better credit ratings may not lead to an immediate credit rating improvement, in our opinion."

Credit spreads in the Royal Caribbean convertibles are currently fairly valued but could tighten 50 basis points to 100 basis points if the merger with Princess becomes a reality, the analyst said.

Both Royal Caribbean 0% bonds are putable - the February 2021 in February 2005 and the May 2021 in May 2004.

"Given the short put dates, we would suggest a credit spread of about 650 bps for the two Royal Caribbean convertibles," Nadesan said.

Using that credit spread and a stock volatility of 35%, he said the 0% bond of February 2021 is about 2.9% cheap and the 0% bond of May 2021 about fairly valued.

"Clearly, both bonds have tightened a bit from a credit spread point of view over the past few months," Nadesan said.

"At this stage, we do not believe further credit spread tightening is warranted, although we believe if the merger with Princess goes through, it will likely have a beneficial effect on Royal Caribbean's credit profile. Given the uncertainties in the approval process, we would prefer not to anticipate the merger as yet."

If the merger with Princess becomes a reality, though, he sees the Royal Caribbean convertibles likely expanding by 0.75 point.

"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," Nadesan said.

That largely comes from Royal Caribbean's rival, Carnival.

Continued evidence of improvement in the cruise markets was provided by Carnival's second-quarter results on Thursday, the analyst noted.

Therefore, the two Royal Caribbean bonds represent attractive total return alternatives, largely driven by expected stock price gains, over the next 6 to 9 months.

Carnival reported second quarter EPS of 33c, beating the consensus estimate of 30c.

The better results were due to revenue yields declining only 5.3% versus the consensus view that yields would decline 6% to 7%, but in line with the company's prior guidance of 4% to 6%. Carnival also benefited from lower advertising expenditures for the quarter due to timing issues.

Carnival has recovered, along with the rest of the cruise market, to the point that it managed to post a year-over-year EPS gain over the 32c recorded in the second quarter of 2001. Given how badly bookings declined in the immediate aftermath of Sept. 11, this year-over-year EPS gain, however small, indicates a degree of recovery.

In addition, the company said booking levels have returned to the levels of a year ago and the occupancy level of 101.9% for the quarter was only slightly lower than the 102.5% level of the year-earlier quarter.

Carnival is guiding for the net revenue yield to decline 3%-5% for the third quarter and to be "up slightly" for the fourth quarter, which Nadesan thinks is reasonable.

The analyst said Carnival's credit and liquidity position is comfortable.

Carnival indicated it ended the second quarter with $1.5 billion of cash and equivalents, up from $1.14 billion net of the current portion of long-term debt at the end of the first quarter.

In terms of debt, the company ended the second quarter with $3.1 billion, up slightly from $2.96 billion at the end of the first quarter.

Carnival's long-term debt/EBITDA was 2.2 times on a last-12-months basis, up slightly from the 2.1 times at the end of fiscal 2001.

Interest coverage ratio (EBITDA/interest expenses) was 12.7 times at the end of the second quarter, better than the 12.0 times level at the end of fiscal 2001 due to lower interest expenses in the first half of 2002 as a result of the issuance of the 0% and 2% convertibles in 2001.

There is adequate liquidity, he said, with $1.5 billion in cash and equivalents, $1.4 billion of credit availability and healthy operating cash flow of $1.24 billion in fiscal 2001, seen adequate to fund the capex program in 2002 and 2003.

The Princess merger, if it happens, would be modestly negative for Carnival's credit as Carnival might have to pay a portion of the merger consideration in cash.

Because of the option of stock or stock plus cash offered to the Princess shareholders, it is difficult to predict exactly how much cash Carnival will require to consummate the merger, Nadesan said.

Assuming that half of the shareholders choose the stock plus cash option, he estimated the combined company's leverage ratio would deteriorate to 2.7 times from Carnival's stand-alone 2.2 times in the second quarter of 2002.

The coverage ratio would deteriorate to 9.3 times from Carnival's stand-alone 12.7 times in the second quarter.

"This of course does not account for any cost-reduction program that the combined company might implement," Nadesan said.

"We hasten to point out that the Carnival-Princess merger proposal will likely receive close scrutiny at the FTC with approval by no means assured."

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