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Goldman Sachs upgraded shares of Carnival this morning.  Here's our take on some of its points.

In what amounted to primarily a valuation upgrade, Goldman raised its investment rating from neutral to outperform today. We're generally against valuation upgrades unless there is an associated catalyst.  Unfortunately, we don't see one on the horizon for CCL.  

Here are some of the main points from Goldman's upgrade along with our analysis.

Valuation

With the potential for upside to be much more dramatic than in many of our other sectors and the EPS still meaningfully depressed, we think CCL deserves a higher multiple. We are assigning a 17.8X P/E multiple (vs. 14.25X previously) to our revised 2014E EPS to reflect this. At 17.8X this is only 10% above its long-term average of 16.1X and a 38% discount from its peak achieved in 1999. Using this multiple provides a new 6-month price target of $42 (vs. $31 previously), suggesting 14% upside from current levels.

Stretching the historical valuation by 10% to get to only 14% upside is not very compelling in our view.  On a relative basis, should CCL really trade at a 6x premium (P/E) to RCL and 3x premium to NCLH? In the past 5 years, RCL has traded at a 2-3x discount to CCL.  Since the Concordia incident, that premium remains at 3x on average.  Yes, CCL's EPS may be more depressed but there is also more risk to its numbers.  Moreover, Goldman is projecting 50% EPS growth for the valuation year of 2014 so he is already assuming a big recovery.

Underperforming other leisure/travel names

We broadened our analysis of CCL’s performance to other travel sectors beyond the cruise industry, namely the US hotel industry and the Las Vegas Strip; our review yielded the same results, which is that CCL’s performance coming out of the recession has lagged. If we look at what has happened to other travel and hospitality operations, nearly all of them are back to their peaks.

The reason CCL has lagged behind many other travel/hospitality names is more firm-specific; so it cannot be a fair comparison.  We would argue that from an industry perspective, gaming was hit harder.  Umm, MGM was a $90 stock in 2007.

Arnold Donald

Mr. Donald has already begun to demonstrate a willingness to reexamine and potentially change CCL’s prior practices. For example, he announced that he is meeting with all of the operating executives to assess strengths and weaknesses and whether certain operations should be more centralized. He also stated that he is examining CCL’s capital allocation

strategy. Although his comments have been more general than specific, as it is early in his assessment, in our view he seems genuinely engaged and open to making the changes he deems necessary.

While we acknowledge how new management can be a refreshing opportunity for positive change, Mr. Donald's approach as described by Goldman doesn't appear to be anywhere near ground breaking.  It remains to be seen how far removed Micky Arison will be.  We would look favorably on a more aggressive cash return to shareholders, however.


Negative news shouldn’t impact the brands forever

While these negative events will likely continue to be a dark cloud over the brands for a period of time, we don’t think it will last forever. Management has already suggested its own polling indicates an improvement in brand perception. If we look at other brands that have been damaged, ultimately they typically recover. At this point, investor sentiment is low and as long as additional negative events do not occur we think comparisons are easy for CCL to show a return to net yield growth.

 

Who knows if and when the Carnival brand can ever regain its brand stature. Carnival’s depressed pricing to fill up cabins will last in the Caribbean for a while.  The company itself is alluding to a return to normalcy in the 2H of 2014 but that's a guess and what's the rush to buy into that theory?

Marketing spend

We point out that CCL has allocated more marketing dollars to the Carnival brand in the back half of 2013 to improve its perception among consumers before the booking focus starts in earnest in Q1 2014. In 2014, the company also plans to spend more marketing dollars beyond just the Carnival brand. The lack of a negative event during the wave season could be a very big positive, especially if the marketing programs make consumers more receptive towards the Carnival brands.

It will be difficult to change customers’ perception of the Carnival brand given that it’s been ingrained in their minds as the incident-prone brand. Carnival can always shell out heavy promotional deals to ‘build brand awareness’. The result is margin decline. North America Cruise brand margins have fallen for four straight quarters.

Macro

We expect accelerating GDP in both the US and North America, with Europe turning from negative to positive in Q4 2013.

We do not disagree with this one but there are a lot of stocks to buy if one believes in an improving macro environment. However, we would like to see if the positive momentum in Europe can be sustained for the rest of the year and into 2014.

Free Cash Flow

While we have noted that our contrarian upgrade is based principally on catalysts and a recovery from depressed results, we would also note some other positives. First, at 2.7% CCL’s dividend yield is one of the highest in our coverage universe. With $667mn of free cash flow in 2013E and $1,540mn in 2014E the dividend seems sustainable and could even show some upside. Carnival is slowing down its ship-building program and focusing on boosting same ship returns. The net result is higher free cash flow.

If you want to boast about the dividend yield, you have to look at Free Cash Flow after the dividend payment.  By our estimates, FCF post dividend will be negative in FY 2013 and FY 2014.

Sell-side Sentiment

This call is contrarian from a sell-side perspective (only 36% of the Street ratings are “Buy” versus 64% for RCL). Over the past four years, CCL has never had such a low percentage of “Buy” ratings vs. “Neutral” or “Sell”. CCL has gone from one of the most recommended sell-side stocks within the hospitality and travel sector to one that is viewed more critically

by both investors and the press. In our view, this negative perception creates upside potential to both earnings and sentiment.

We like to play contrarian against the Street as well but only when we have an unrecognized catalyst.  We don't think Goldman has one either.