• Bocconi Students Options Club

Royal Caribbean: Call Bull Spread

Updated: Feb 1, 2021


This association and its publications are solely intended for academic purposes and should not be used as investment advice or be interpreted as such.

Company Presentation

Royal Caribbean (RCL) is the world’s second largest cruise service provider. By the end of 2019, RCL operated 61 ships (17.23% of the global share) with an aggregated capacity of 141,570 berths and managed itineraries that call on more than 1,000 destinations. It carried 6.5 million passengers, which amount to 21.85% of the global cruise industry, at an occupancy rate of 108%. As of Q3 2020, 67% of its revenue came from the US market.

Royal Caribbean targets the premium and upper-end market. In fiscal year 2019, among its 3 global cruise lines and 2 joint ventures, (1) 42.62% of the total shipping capacity was in Royal Caribbean International, which targets families and couples in the premium market and offers all- around sailing experience; (2) 22.95% was in Celebrity Cruise that provides award-winning onboard luxury services to affluent customers; (3) 4.92% was in Azamara Club Cruises, targeting up-market in North America, UK and Australia and operating exotic itineraries to ports which are inaccessible to larger ships; (4) 11.48% in the joint venture TUI cruise that tailored-made for Germany; and (5) 13.11% in the ultra-luxury and expedition cruise line Silversea Cruises. For reference, we detailed the evolution of cruise line strategies in Appendix 1.

Fundamental Analysis

1. The Cruise Industry as of December 2020

Being a very capital-intensive business, the entry barriers to the cruise industry are exceptionally high. In fact, as of December 2020 there are only roughly two dozen firms operating large cruise ships worldwide. And by digging deeper into the ownership structures of said firms, it becomes very apparent that the market is mainly competed for by three large players: Carnival, Norwegian and Royal Caribbean Cruise Lines.

Carnival Cruise Lines, by far the largest name among these heavyweights, is a parent company to another five enterprises including well-known brands in the likes of AIDA or the Holland America Line. This market structure leaves relatively large market power to the “big three“, yielding healthy returns on equity which are all within the span of 11-18% for the past three years. These strong numbers have been supported by a steady decline in oil prices as well (The correlation of the respective log returns for the years 2010-2019 equals –0.011).

The industry as a whole is very pro-cyclical (average market beta of 2.55) due to large income elasticities of demand. The provided service is non-essential in the sense that it is not a “necessary good“ as microeconomists like to think of it. Only onwards from a certain saturation point for these basic needs, additional income is being spent on luxury goods such as exotic cruise trips. Mass tourism targets especially middle-income households, which can easily move above or below said critical saturation point due to shifts in e.g. the labour market or consumer price inflation.

Subsequently, due to Covid-19 regulations as well as the connected economic downswing, the past year 2020 hit the cruise industry especially hard compared to the overall market (purple). It is worth mentioning that when comparing RCL (grey) to its peers CCL and NCLH, the stock fared substantially better in the past months. One explanation would be the fact that RCL (more than its competitors) targets the premium market for which the demand is less elastic as explained above.

Looking into the future, there lies important challenges and opportunities for the industry. As the global middle-class is continuously growing, foremost driven by the socio-economic developments in East Asia, especially these three firms could exploit and profit off that shift in the mid and long run. But first, the world economy must recover from the pandemic fallout. Given that the ongoing vaccination against the virus proves to be successful, there is reason to hope for substantial recovery in the industry by summer 2021. But there are more hurdles to overcome. While the industry is under increasing public pressure to reduce its CO2 emissions, city administrations all over Europe are determined to restrict cruise travel to their respective ports to circumvent the negative side effects of mass tourism. While cities like Bergen or Dubrovnik are already limiting the per year maximum number of cruise ships entering the city, more prestigious destinations like Venice or Amsterdam have already banned cruise travel altogether.

There is a case to be made that the stock of Carnival, Norwegian and Royal Caribbean Cruises can be classified as “value stocks “. They all are characterized by reasonable dividend returns and P/B ratios (see below) with growth perspectives somewhat capped. Those firms typically profit from higher inflation. While the pandemic served as a big deflationary shock to the global economy, central banks both in the US, Asia and Europe as well as many fiscal authorities tried to counteract by massive government spending, low (federal) interest rates and an expansion of quantitative easing. This has the potential to drive inflation backup to a region around 1.2 % ( Euro) by Q2 2021 according to the Bundesbank.

2. Business Characteristics of RCL

Overall, the business is characterized by:

(1) excess sensitivity to economic cycle The company’s revenue is generated by passenger ticket sales (~70%+) and onboard sales (~20%+). Hence, consumer's willingness to sail and spend will have significant and direct impacts on cruise booking, cruise prices and onboard revenues. This assertion is also backed up by data. Generally, vacationers’ discretionary income and consumer confidence are affected by international, national and local economic and geopolitical conditions. As we can see, RCL is exposed to even more idiosyncratic risk than the other big players in an already highly cyclical industry. The main implication here is, that this metric provides evidence supporting the hypothesis that a possible economic upswing would disproportionately benefit RCL.

(2) high leverage structure The capital expenditures associated with Royal Caribbean’s ship purchases represent the largest funding needs. For example, in 2015 the company financed $742.1 million for its delivery of Anthem of the Seas, while net income of the year was $665.8 million. Likewise in 2016, RCL borrowed $841.8 million and $739.2 million to finance Ovation of the Seas and Harmony of the Seas, when the year’s net income was $1.3 billion.

Generally, RCL leverages to finance its Capex, and paybacks with operating cash flow and new fundings. Its financing agreements contain covenants that require RCL, among other things, to maintain minimum net worth of at least $9.9 billion, a fixed charge coverage ratio of at least 1.25x and limit its net debt-to-capital ratio to no more than 62.5%. Overall, the ability to pay back loans and borrow largely depend on operating profit, which is subject to economic cycles. Any circumstance or event which leads to a decrease in consumer cruise spending, such as worsening global economic conditions or significant incidents impacting the cruise industry, could negatively affect RCL operating cash flows.

(3) and is subject to increased compliance cost Environmental regulations are getting stringent. The United States and various state and foreign government or regulatory agencies have enacted or may enact environmental regulations or policies, such as requiring the use of low sulfur fuels, that could increase direct cost to operate in certain markets, increase cost for fuel, limit the supply of compliant fuel, potentially causing Royal Caribbean significant expenses to purchase and/or develop new equipment and adversely impacting the cruise vacation industry.

There is also increasing global regulatory focus climate change and greenhouse gas (GHG) emissions. These regulatory efforts, both internationally and in the United States are still developing, may adversely affect the company’s business and financial results by requiring it to reduce emissions, purchase allowances or otherwise pay for emissions. Such activity may also impact the company by increasing operating costs, including fuel costs. While RCL have taken and expect to continue to take a number of actions to mitigate the potential impact of certain of these regulations, there can be no assurances that these efforts will be successful or completed on a timely basis.

3. Medium-Term Upsides to Watch

Combined with our industry views, we’re negative on the cruise industry and therefore Royal Caribbean’s long-term performance. Yet in the medium-term, admittedly there are several upsides to watch:

(1) Q3 2020 bookings updates and positive news from vaccines boost recovery hopes

Booking activity for the first half of 2021 is aligned with the company’s anticipated staggered resumption of cruises. The cumulative booked position for sailings in the second half of 2021 is within historical ranges with prices that are down slightly year- over-year (yoy) when including the negative yield impact of bookings made with future cruise credits (“FCCs”) and about flat when excluding them. Meanwhile, more than 65% of the 2021 bookings are new and the rest are due to the redemption of FCCs and the “Lift & Shift” program. Royal Caribbean continues to provide guests who were booked on a suspended sailing with the option to request a refund, to receive an FCC, or to “lift and shift” their booking to the following year. With vaccines almost ready for 2021, we can expect increasing consumer confidence in taking the sail. In fact, if we take reference to 2010, when the global market slowly recovered from the financial crisis and the H1N1 virus in Q3 2009, Royal Caribbean actually saw its stock price inflated 85%.

(2) Its high correlation with overall equity market performance makes price gain even more likely We studied Royal Caribbean’s past 10-year performance and were able to arrive at the following conclusion: its stock price is highly correlated with the market’s, while to participate, investors must be aware of what kind of return he/she wishes to earn. In Appendix 2, we outlined equity return/loss drivers in the past 10 years. Just to name a few: Despite positive earnings, expansion to the high-end market and effective countermeasures toward stringent regulations, RCL lost 16% at the same time global equity market experienced correction particularly in the 4Q2018. In 2019, however, RCL gained 40% during which the global equity market saw impressive gains and fund inflows, while earnings only grew ~3%. In comparison, share price from 2012 to 2015 gained 223% cumulative returns as a result of steady and sustainable improvement in profitability and ROIC.

(3) Low base number in 2020 makes any growth in 2021 seem impressive As we can also refer to the historical period of the 2009 vs 2008 crisis, and 2013 vs 2012’s large impairment loss. Also from the latest updates in bookings there’s already signs of recovery.

(4) Stronger liquidity position as compared to peers Royal Caribbean’s current liquidity position would allow it to run through 2021. As of September 30, 2020, Royal Caribbean had liquidity of $3.7 billion, consisting of cash and cash equivalents of $3.0 billion and a $0.7 billion one-year commitment for a 364-day term loan facility. Liquidity is able to cover 346.8% of short-term debt. The company further amended its export facilities and certain non-export credit facilities, to extend the financial covenant waiver through and including, 4Q2021.

Maturity structure of existing debt is also manageable, despite a growth of 108% in long- term debt, which amounts to 75% of total liabilities. For the next 5 years from Q3 2020, the company will have $1.38 billion due in 2021, $4.3 billion due in 2022, $4.3 billion in 2023, $3.5 billion in 2024 and $5 billion thereafter. Another aspect to observe the company liquidity health was its recent M&A. On July 9, 2020, RCL acquired 33.3% non-controlling interest in Silversea Cruises, the ultra-luxury and expedition cruise line. As a result of the acquisition, Silversea Cruises is now a wholly owned cruise brand and further extends Royal Caribbean’s footprint in the affluent and luxury market. In contrast, the industry biggest player Carnival had announced plans to sell 18 ships.

(5) Company’s new program demonstrates confidence in sustainable growth Royal Caribbean gained 117% annual return in the equity market in 2014, as a result of the launch of its Double-Double program. This program aimed to inflate, by the year of 2017, ROIC to double digits and its adjusted EPS 200% vs 2014 result. Under current leadership, Royal Caribbean successfully accomplished its ambitions and share price raised 173% during the 4-year period. In 2019, Royal Caribbean launched its new initiative: the 20 -> 25 by 2025 Program, which refers to the multi-year program designed to communicate and motivate employees to work towards company specific goals. The program includes five goals by 2025: delivering $20.00 adjusted earnings per share; further reducing the company’s carbon footprint by 25% against a 2019 base; delivering strong returns on invested capital; and continuing to improve on record guest satisfaction and employee engagement metrics. Though there are uncertainties in the years to come, this program demonstrates the leadership’s commitment to a more sustainable and rewarding growth.

4. Potential Downsides

To conclude this session, we provide potential downside risk scenarios:

(1) Unprecedented low level of advance bookings.

(2) Significant cancellations which has led to issuance of refunds to customers

(3) Increased impairment loss to further erode earnings estimates.

(4) Failure or delay of vaccine deliveries.

(5) Prolong sail ban.

(6) Liquidity emergency (which is unlikely according to our previous analysis)

(7) Negative market sentiments

Technical Analysis

The following table shows the values calculated by several technical indicators, together with the correlated Buy-Neutral-Sell signal.

1. Oscillators

2. Moving Averages

On the technical side, several indicators suggest that this might be a good time to enter into a long trade. Indeed, by looking at both oscillators and moving averages we can notice some common signals.

Overall, after the loss in the first months of the year due to the covid shock, the stock has been trading higher spurred by the stimulus and vaccine hope. Of course, almost all moving averages suggest buy signals, as the steep decline needs time to be compensated before price converges again with its mean.

RCL has also been under significant volatility in the last months as the main market forces currently are news and hopes: a perfect environment for speculation and uncertain paths. Nonetheless, by looking at the graph it is possible to clearly identify the bullish trend. Also, a support and a resistance line are easily recognizable. The former being around the 46 $ level, which showed several retests during the summer. The latter instead is around the 72 $ price range. This resistance line is showing significant importance and we will see in the next week if it will become a new support line. Our analysis was conducted in different weeks: when we met at the beginning of December, RCL was trading at the 84-85 $ high and we correctly foresaw a price decline. Indeed during the last week the stock has been going down. If this direction continues to consolidate, with the resistance area crossed, a further decline in price is probable, creating a good entry opportunity for a long position. A rebound is in our views as there has been downwards pressure in the short term leading us to expect a rebound for the stock to pursue it's upward dynamic in the midterm. (The negatively sloped arrow on the graph was drawn on the beginning of December highs).

The Play

These are the option prices as of today: 29.12.2020. The first picture considers the 22 January expiration date, while the second the January 29th.

0. The Bull Call Spread

As the name suggests the strategy consists of a debit spread using calls with a bullish attitude. Indeed this strategy might be a great choice, as it lowers the entry cost due to the collected premium on the sold calls. Limited losses are, however, balanced by limited gains.

In our case, let's consider the January 29th expiration date and calculate: max gain, max loss and the breakeven point.

We are going to consider 3 cases A, B & C. As we know, with spreads the max gain and loss depend on the size of the spread itself.

From these 3 very simple examples we can see that, with little spreads, the strategy at current prices is not recommendable. In case A the max gain is negative, in B the risk/return is 294$/6$. This trend changes with larger spreads such as in C (5$). Let’s recall that the prices change from broker to broker and the values were taken at the open market on the 29/12/2020 21 AM. Ultimately we believe that RCH will rebound and hit $80 by our expiration. We therefore recommend buying 72c, selling 77c (as shown above), or potentially earning more and selling at 79c for a better returns.

1. Comparisons among bullish option strategies

In this session, we compared 4 bullish option strategies --- call, bull call spread, long straddle and wheel --- with their pros & cons to present our motivation and strategy analysis.

Calls Buying (uncovered) calls might be the most natural impulse when one has a bullish view. As always, returns are theoretically unbounded while everything one is willing to bet on RCL is on stake. A benchmark to reflect upon: Historical data shows that the probability of RCL gaining more than 10% in the span of 30 days is approximately equal to only 20%. Now of course we have reason to belief that the asset will do better than its historical average, yet an entirely unhedged play still comes close to gambling. Therefore, one could question whether this already qualifies as a strategy or just mere speculation.

Long Straddle A long straddle is a combination of buying a call and buying a put, both with the same strike price and expiration. Together, they produce a position that should profit if the stock makes a big move either up or down.

The Wheel The last contender in the race is The Wheel Strategy. To those unfamiliar to it, we highly recommend this explanation https://www.bocconioptionsclub.com/post/the-wheel. Summing up the strategy, the Wheel is all about waiting for a desirable asset to fall to an affordable price while getting paid in the meantime. The wheel starts by us selling uncovered puts for the asset, collecting the premium and repeat this until the asset falls below the strike price p1. Once it does, we actually own the underlying asset which allows us in turn to sell (this time covered) calls at a strike price p2 well above p1 and of course collect the premium again.

If our hypothesis that the stock will rebound is correct, we will have earned the difference between the two strike prices as well as at least two premiums.

A more realistic bad case scenario, comparable to spring 2020: 52 weeks low = $21 (market price of RCL shares) Put Price = $65 100 ∗ (Marketprice − Put Price) + Premium = $ − 4300 Remember, that these $-4300 are still unrealized since the stock is now our property. This implies that the asset would not recover like it did in 2020 and the holder would sell immediately.

We believe too much capital would be engaged with an insufficient return to risk ration. Events could harm the stocks rapidly with RCL's recovery being fragile. It's too much of a gamble with too poor of a return.