You’ll remember in the first post - The Anatomy of Stocks That Go Up - I said that stocks that go down (STGD) typically exhibit combinations of three characteristics:
Financial Leverage: Lots of debt
Operational Leverage: Lots of overhead
Cyclicality: Ebbs and flows across the business cycle
Now, it’s too restrictive to avoid all of these characteristics. Nearly every business you can think of has at least one of these qualities.
When looking for STGU, I tend to freely allow at least one of these characteristics without penalty. If a stock has a good amount of debt but otherwise low overhead and lacks cyclicality, it’s okay. It can still be a great investment.
If a company has two or more of these characteristics, the alarm bells start to go off. It is not that these are bad investments, but rather the risk factors are more numerous. It is these companies that can suffer irrecoverable loss. They go down and never come back.
In cases of financial distress, Companies with operational leverage start to hemorrhage cash and either mortgage their future with financial borrowings (add another risk factor) or kneecap themselves by shedding costs (in many cases talented people).
Further, companies with too much financial leverage (debt) will have to dilute shareholders “in the hole” with a stock offering or face bankruptcy (“hand over the keys”).
And finally, cyclical businesses can seemingly get hit by a tidal wave.
Let’s look at an example.
Carnival Corporation (CCL) | Floating Liabilities
I think we are all familiar with Carnival Cruise Line and their “Fun Ships.”
The business model is pretty simple. You build some ships, fill it with some Boomers under the guise of a relaxing vacation and then you try to extract every Penny, Pound and Deutsche Mark from them while they are captive to the ship.
Like we did in the last post, let’s look at the numbers.
Below is quarterly revenue compared with year over year growth and trailing 12 months operating profit compared with operating margin.
Source: Annual & Quarterly Filings
You’ll notice that over the last 10 years, Carnival has grown modestly, or “low single digits” in finance bro speak. Their growth has been a function of a couple of things: How many ships they have, how much demand there is from the public to cruise and how much they squeeze out of cruisers.
You can see that when the ships are filled, Carnival is a great business. With its current fleet of ships, Carnival is capable of making $3 billion a year in operating profit on $20 billion in revenue. That’s 15% operating margin, or in finance bro speak “mid teens margins.” Pretty good!
You will also see that operating profit is subject to some fairly big swings. Back in 2012-2014 the world had some economic hiccups, which are reflected in slightly lower growth in revenue and a seemingly large dip in operating profit.
Carnival is an interesting case study because it has some characteristics of a STGU, but unfortunately looks more like a STGD.
30 years ago cruising was a growth industry as Boomers were young, rich and ready to consume massive amounts of triglycerides. In 1990, cruising probably felt like an open-ended growth opportunity.
A young Micky Arison probably said:
“Dubra, look at these Boomers. That’s our customer. Each and every one of them is going to cruise on a Carnival ship.”
Today, the equation is a bit different.
The prototypical client is aged, meaning demand could become an issue. If that’s the case, adding a net new ship to the fleet in an economic way becomes problematic. Even filling existing ships could become a bit tenuous. This doesn’t feel like a recipe for geometric growth anymore.
You get the sense that Carnival is mature and, dare I say, vulnerable. Just look at the last quarter (we are talking pre-Covid) when CCL started to show scary signs of deleverage.
In the quarter ended February 2020, revenue growth decelerated from 10% in the prior year quarter to 2.5% in this year’s quarter. Okay, nothing wrong with that, a little deceleration in growth never hurt anyone! There just might be a slight problem.
The problem is that gross margin declined from 33% to 26.5%, 650 basis points. (Note: There are a lot of moving pieces in CCL’s margins quarter to quarter, so they get a bit of a break, but it’s still scary.)
Most people who are reading this are probably thinking:
“C’mon, 33% to 26.5% is not a big deal. Relax, everything is going to be fine.”
I’ll push back. If margins declined 600+ bps on a simple deceleration in revenue growth, what will happen to margins if… revenues decline?
Well, we can look to the past to get an idea. The last time CCL revenue flatlined and slightly decreased was in 2012-2014. Operating profit dropped by a third (see graph above). That is some wild deleverage!
For the uninitiated, leverage and deleverage are what happen when revenue and cost grow at different rates. If costs are fixed and revenue goes up a lot, voila! Leverage. If costs are fixed and revenue goes down a lot, look out below. Deleverage.
Unfortunately, Carnival’s business precludes the ability to have a variable cost structure. Said a better way, they have high fixed costs. After all, they do operate a fleet of floating fixed assets, which when underutilized do not disappear (despite Micky Arison’s current hope that they just might). If not enough people are on those ships, Carnival stands to lose hundreds of millions of dollars, if not billions.
Remember that $3 billion we said Carnival could earn in a year? It doesn’t take much deleverage before that $3 billion is $2 billion, or $1 billion… or $0.
Normally, you and I wouldn’t care if CCL made $3 billion or $2 billion or even a couple hundred million. It’s all good between friends, right?
Yeah that’s right, until you owe other people money. Then it really matters exactly how much you make. And this is where many companies, including Carnival find themselves these days, bit by the serpent of financial leverage.
Carnival owes a lot of people money. You can see in the graphic below that as of the February quarter end Carnival had nearly $13 billion in gross debt. That does not include the $4.7 billion of customer deposit liabilities they owe (people have paid upfront for cruises they have not taken yet and can ask for that money back). When you add it up, CCL owes nearly $18 billion to lenders and future customers.
$18 billion is a lot of Guy Fieri burgers to serve!
Source: Annual & Quarterly Filings
Don’t get me wrong, financial leverage by itself is not a problem. As long as a company can afford its obligations, there should never be an issue. But financial leverage amplifies any and all precarious situations as it adds to the fixed cost hurdle a company needs to overcome in order to profit.
With greater degrees of financial leverage, companies have to produce more with the same resources in order for equity holders to participate to the same degree. To use an analogy, financial leverage is kind of like turning the speed up on the treadmill. It’s harder and riskier.
You know how oil towns talk about booms and busts? That’s the cycle. Some industries are just that way - One day business is great, the next the bottom falls out.
Hospitality and leisure is one of those industries that is sensitive to a cycle. Leisure companies are sensitive to economic shocks (S&L Crisis, Dotcom Bust, Great Financial Crisis), terrorist attacks (9/11) and pandemics (Covid).
Sometime in mid/late March 2020, demand for cruising just went away. Just like that little town in Oklahoma where suddenly the oil wasn’t worth anything, the Guy Fieri burgers sit wilting in the Caribbean sunshine.
Not only did demand for cruising seemingly go away, Carnival responded to the pandemic by suspending operations for several months, which has now been extended to the end of September.
COVID | A Dash of Chaos
Just moments ago I said Carnival is a great business when the ships are filled. Well, when occupancy becomes a problem, these ships go from floating assets to floating liabilities real fast.
With Carnival we are seeing the cycle right before our eyes, which has set off a financial tailspin of sorts. The immense deleverage caused by Covid has sent CCL into survival mode.
While no business is structured to survive months on end with no revenue, the situation is made far worse by the operating leverage and financial leverage.
From a June press release from Carnival:
“During the pause in guest operations, the monthly average cash burn rate for the second half of 2020 is estimated to be approximately $650 million”
$650 million per month for a company that had $1.35 billion on its balance sheet at the end of February. That’s 2 months of runway!
Also if this keeps up for a full year, it’ll take more than 2 years for CCL to earn that cash back. Every day lost requires at least 2 to make CCL whole.
If you were the CEO of Carnival what would you do in response to all of this? I know what I would do: Anything I could to keep the cash from running out! They are doing just that.
Here is what they have done so far:
March 16 - Drew $3 billion on their revolver (+ 5 months of runway, increases financial leverage)
April 6 - Offered $575 million in stock at $8 (+ 1 month of runway, dilutes equity holders in the hole)
April 6 - Offered $1.95 billion in convertible notes (+ 3 months of runway, dilutes equity AND increases financial leverage)
April 8 - Offered $4 billion in secured notes at 11.5% interest (+ 6 months of runway, increases financial leverage AND operating leverage through more interest cost)
June 26 - Prices $1.86 billion and €800 million senior secured term loan L + 7.5% (+ 4 months of runway, increases financial leverage AND operating leverage)
To use the treadmill analogy from earlier, they’ve turned the tempo up quite a bit. In the absence of another choice, Carnival mortgaged its future to survive.
This is their one shot to survive. If this fails, they are Ace-Deuce (a term for crapping out in Vegas).
The Trifecta | Irrecoverable Loss
It is important to note again that in normal times Carnival is a great business. It is just a great business that happens to have operating leverage, financial leverage and cyclicality all at the same time. I contend that the Trifecta is a toxic combination for even the best businesses. Eventually they will be a company’s downfall.
If Carnival’s business model didn’t have such a high degree of operating leverage, they might be able to survive a shock like this. It wouldn’t be comfortable. They would have to lay people off and anchor the ships at sea in order to spend as little as possible. If their overhead were variable, they just might have survived on that $1.35 billion they had on the balance sheet.
Instead, they had to sell equity at its lowest point in years, nearly double their financial leverage at extremely high interest rates and pass all kind of rights and claims to note holders. The equity holders were already at the back of the line for claims, now there are several more parties in front of them.
The Trifecta leads to irrecoverable loss. This is what it looks like:
Considering the extreme levels of debt Carnival has taken on and the vast sums it is spending while in a holding pattern, the calculus required for the equity to return to prior levels gets harder by the day.
Is Carnival going back to $50? It would take a financial miracle.
The financially levered, operationally levered and cyclical companies go down and many of them never come back.
I hope you all enjoyed today’s post. In the next post we will talk about STGU that have had big drawdowns and why they are fundamentally different than STGD.