On July 14, 2020, Silver Ring Value Partners LP released its Q2 2020 Investor Letter, a copy of which you can download here. The investment firm was founded in 2016 by Chief Investment Officer and Managing Partner Gary Mishuris. In its Q2 2020 Investor Letter, Silver Ring Value Partners LP reported 14 investments with a 5.0% cash level and a 78% option-adjusted net exposure. At the end of the quarter, the fund reached a 54% price to base case value estimate. You should check out Silver Ring Value Partners’ top 5 stock picks for investors to buy right now, which could be the biggest winners of the stock market crash.
In the said letter, Silver Ring Value Partners highlighted a few stocks and Carnival Corp (NYSE:CCL) is one of them. Carnival Corp (NYSE:CCL) is a cruise operator company. Year-to-date, Carnival Corp (NYSE:CCL) stock lost 67.4% and on July 14th it had a closing price of $15.04. Here is what Silver Ring Value Partners said:
“In early April, the stock price of Carnival dropped from a January level of $50 to $8. Given the COVID crises and a ban on cruising, the company quickly went from meaningful profitability to burning cash. Furthermore, management found it necessary to raise capital on distressed terms via secured senior debt and a small secondary equity offering. This capital provided the company with enough liquidity to survive for over a year even if cruising does not resume.
My analysis suggests that under most scenarios this business will return to normal at a future point. I have followed the industry for 15 years, and every time some health crisis scared off passengers, a year or two later business was back to normal. We can of course argue that this time is different, but the evidence is that it is not. The company is already seeing bookings for the 2021 season in the normal range (albeit with very favorable cancellation provisions).
We certainly don’t know how long it will be before cruising will return to normal or how much cash the company will burn in the meantime. There are some scenarios where the company will return to normal demand and profits, but that in the meantime the equity is wiped out or greatly diluted. All kinds of permutations of events (e.g. big second wave, the virus mutating into a new dangerous strain, etc) could wipe out the equity if the company, which has high fixed costs, is forced to not sail its ships for a long time.
We do know that this is an industry leader with ~ 50% market share which has earned slightly more than its cost of capital over the full economic cycle. Structurally the business has not changed, and once demand is restored the industry economics are likely to be similar to the past. If we look at the company’s balance sheet, the replacement cost of its fleet is over $40 per share after taking into account the debt. So as long as this business is a going concern and demand is restored to prior levels, a base case value of around $40 is reasonable. Without any cash burn the business would be worth north of $50, and we can treat the cash burn and the time value of money as getting us to around $40 of equity value.
I did not think that the equity at $8 was the best investment. The downside was $0 and I didn’t know the probability of that downside occurring. However, there were two securities that I did think were very attractive, especially in combination:
After the capital raise occurred, the October 2020 senior unsecured bond was yielding over 12% to maturity. Importantly, the company already had the cash on hand, set aside to payoff this bond from its recent capital raise, so the risk of default is very low. If a default does occur we would get our share of their ships at a fraction of their replacement cost, or more precisely our debt would likely become equity in a new company with a cleaned-up balance sheet. I made this a 2% position in April.
The September 2020 call option with a strike of $22.50 was trading at 50c. That meant that if I was right and by September the price to value gap closed to $40, we would receive a 35x payoff. Clearly there are many scenarios where this option expires worthless, but for reasons that I explained in the “Extreme Options” section earlier in the letter I analyzed the option to be much undervalued and an attractive risk/reward. I made it a 1% position in April. Since then, as the stock spiked I took out a small portion of the profits from the option to manage risk and recovered more than our original cost basis while maintaining our upside if the price/value gap continues to close.”
In Q1 2020, the number of bullish hedge fund positions on Carnival Corp (NYSE:CCL) stock decreased by about 9% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t seem to agree with Carnival’s upside potential. Our calculations showed that Carnival Corp (NYSE:CCL) isn’t ranked among the 30 most popular stocks among hedge funds.
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Disclosure: None. This article is originally published at Insider Monkey.