Morningstar Magazine - October/November 2016 - 68

Strategies Sailing With a Tailwind A sensible acquisition, new ships, and a cheap price tag make Norwegian Cruise Line Holdings the darling of the high seas. BEST IDEAS: EQUITY Jaime Katz With the inclusion of Prestige in 2014, the capacity of Norwegian Cruise Line NCLH bumped up to more than 40,000 berths, making it an increasingly relevant competitor in the cruise industry. Capitalizing on decades of consumer analytics and best practices across brands, the firm can nimbly cater to changing trends, in our view. In addition, we view Norwegian's freestyle cruising as a differentiated product, catering well to an older demographic, who may want to take their families on holiday, and millennials, who want more options. While the experience is different than traditional cruising, the lack of switching costs among cruise brands is a restraint to the economic moat, rendering Norwegian a narrow-moat firm. With Prestige's brands, we think the firm could fortify its moat through increasing brand awareness and scaling costs. Our long-term thesis continues to evolve, as Norwegian now plans to return to the Asia-Pacific market after a 15-year hiatus and expand its presence globally. A focus on itinerary scarcity (redeploying capacity to new markets and diversifying duration of itineraries) should prevent Norwegian's products from becoming commodified. We already viewed Norwegian's capacity as scarce relative to its peers; the Norwegian brand will have only 17 ships 68 Morningstar October/November 2016 in operation by the end of 2019, and freestyle cruising along with Prestige's tilt to high-net-worth consumers carve out a differentiated base of consumer demand than many of its peers. Recent commentary across industry operators has been focused on firming pricing globally and improving returns on invested capital overall, which could help generate better profit results for Norwegian. However, peers could discount during periods of economic duress, forcing Norwegian to follow suit, which could be tempered by the differentiated product. The addition of Prestige's brands provides some insulation from broad-based discounting as its luxury products are offered to consumers who tend to be less affected by economic cycles, and changes to the pricing strategy (conveying the value proposition) help those who book early, leading to less close-in discounting. The Caribbean Advantage We have assigned a narrow economic moat to Norwegian thanks to the company's brand awareness and presence (particularly in the Caribbean) as well as the cost structure, which we expect will improve as the company continues to expand capacity and leverages vendor and port relationships with the inclusion of Prestige. Norwegian's brand recognition is healthy, despite falling in the shadow of its sizable peers, Carnival CCL and Royal Caribbean RCL, which have more than 100 and 40 ships globally deployed, respectively. Although the current balance of capacity can force Norwegian to be a price taker in periods of economic distress in its namesake brand, the firm can wield some influence on its consumers by offering a product that is somewhat different than the traditional cruise product. Over time, as Norwegian's capacity grows faster than its peers, we expect it can close the price-setting gap with its competitors and wield even more pricing power, particularly through the upscale Oceania and Regent Seven Seas brands. While the company earns more on a daily per-berth basis than its peers (it achieved capacity adjusted daily yields of $225 in 2015 compared with $173 for Royal and $167 for Carnival), we suspect this could have to do with the limited supply of berths Norwegian has in the key Caribbean region (lower supply to meet demand). We also think the proportion of new berths relative to peers' fleets helps drive a higher average price, as newer ships generate premium pricing. In addition, we see the company's dedication to remain in the Caribbean region and build its brand as a way to improve goodwill with its core consumer. As more ships come on line (recently taking delivery of the Regent Seven Seas Explorer and Oceania Sirena with a 2017 delivery of Bliss, and two additional Breakaway Plus ships in 2018 and 2019), we previously expected pricing growth to slightly flatten; the supply-and-demand dynamic could shift and affect pricing negatively from the increased capacity, but it should be offset by the premium pricing new ships usually command. Returns on invested capital have surpassed our estimated 10% weighted average cost of capital in 2015, and we forecast Norwegian capturing midteens ROICs by 2019 if the economic environment doesn't deteriorate materially. We note that management continues to focus on improving ROICs as newer, more costefficient ships are deployed (with a five-year estimated payback period, which is lengthening with the Breakaway Plus ships). With a heavy weighting to Caribbean cruising at the namesake brand, future expansion into other markets like Asia and South America creates

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016