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Don’t bet on smooth sailing for Norwegian

Recent days have seen news coverage of the solemn anniversary of the Costa Concordia shipwreck, a disaster that cost 32 lives and cast a pall over the cruise industry.

What better time to launch an initial public offering for a cruise-ship company? Amazingly, Norwegian Cruise Line Holdings Ltd. is set to debut on the Nasdaq later this week.

At first glance, it seems to be inopportune timing. But Norwegian has a compelling to story to tell, and many investors suspect consumers are slowly warming to more leisure spending. That may add up to a successful IPO.

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Will it also make Norwegian a good long-term investment? With apologies to the victims of the Costa Concordia, let's just say it may not all be smooth sailing.

First, the Costa Concordia was owned by Carnival Corp., the biggest of what will be three publicly traded U.S.-based cruise companies. The Jan. 13, 2012 accident immediately cut 14 per cent from Carnival's share price; from that point to its Dec. 19 high, it rebounded nearly 40 per cent. Competitor Royal Caribbean is up 36 per cent over the same period.

"People have short memories and investors seem to like the cruise ship business," says Francis Gaskins, an IPO analyst who runs the service IPODesktop. "A stronger economy is definitely a plus for Norwegian."

Indeed, there's little evidence bookings have fallen since the disaster; Norwegian's occupancy percentage was 102 per cent in its December quarter. (More than 100 per cent? This means that on average, all cabins were filled, and that three or more passengers occupied some cabins during the period.)

Norwegian is the smallest of the three operators, by far, with just over $2-billion (U.S.) in revenue in the last 12 months. Carnival recorded more than $15-billion in revenue in the last 12 months, and Royal Caribbean posted sales shy of $8-billion.

Norwegian's smaller scope might suggest it can grow faster than its larger peers. And indeed, it has three ships on order, with an option for a fourth, on top of its 11-ship fleet, Mr. Gaskins notes.

Norwegian claims a competitive advantage with what it calls its "freestyle cruising" model. "While many cruise lines have historically required guests to dine at assigned group tables and at specified times," Norwegian says in its prospectus, "'Freestyle cruising' offers the flexibility and choice to our passengers who prefer to dine when they want, with whomever they want and without having to dress formally."

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All this is adding up to a valuation, at the $17 midpoint of its suggested price range, comparable to Carnival and Royal Caribbean on a price-to-earnings basis, and higher on price-to-book-value measures.

So what's the problem?

While Norwegian reports better margin numbers than its peers in the last 12 months leading up to this offering, per a study in Standard & Poor's Capital IQ, a longer look back reveals many periods when it lagged one or both of Carnival or Royal Caribbean in gross margin, EBITDA (earnings before interest, taxes, depreciation and amortization) margin, or net income margin.

Because it's a private-equity-backed IPO, Norwegian sports significant debt ($3.1-billion as of Sept. 30), only about $350-million of which will be paid off by the offering's proceeds.

While the heavy capital costs of the business – a cruise ship can cost more than $1-billion – mean none of the companies is debt-free, Norwegian will remain at the top of the leverage list. The company has been using well over half of its operating income in recent years to pay interest expenses, a proportion easily higher than its peers.

That debt load also means Norwegian won't pay a dividend and has no plans to. Carnival currently pays a dividend that yields 2.7 per cent and Royal Caribbean yields 1.4 per cent.

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In the "risk factors" section of its prospectus, Norwegian notes an industry trade group estimates 26 new ships will come on line in the North American cruise industry by 2015.

"In order to profitably utilize this new capacity, the cruise industry will likely need to improve its percentage share of the U.S. population who has cruised at least once, which is approximately 24 per cent," the prospectus reads. An industry-wide increase in capacity without a corresponding increase in public demand means Norwegian and the entire cruise industry "could experience reduced occupancy rates and/or be forced to discount our prices."

Norwegian's debt-heavy balance sheet makes it ill-suited for such a downturn, and its shares seem set to make for an expensive journey. Watch this one from the shore.

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