OneSpaWorld: Smooth Sailing In 2023 And Potential Balance Sheet Catalyst (NASDAQ:OSW)

The COVID era economy is one that is exemplified by massive bullwhip effects. One policy decision or business disruption that happens downstream has massive effects throughout the supply chain, amplified in end markets.

After global No Sail protocols were adopted in 2020, and various mutations of COVID throughout 2021 and 2022 that affected consumer behavior, cruise line operators are now enjoying record bookings growth and levels for 2023 and 2024 indicating that consumers are eager to get back to spending money on experiences after COVID restrictions were lifted.

Last week, Norwegian Cruise Line (NCLH) and Royal Caribbean (RCL) reported Q1 earnings, and the earnings commentary from each company indicated increasing load factors, strong bookings growth going out to 2024 and strong growth in onboard revenues versus the 2019 pre-pandemic period. Carnival (CCL) will likely report the same narrative when they provide an update on their next earnings call in June.

OneSpaWorld Q1 Results and Outlook

Similarly, OneSpaWorld (NASDAQ:OSW) is poised to be a prime beneficiary of the booming demand for vacations on the open seas. OSW enjoys a near monopoly ~95% market share for onboard spa services and counts NCLH, RCL and CCL as its top 3 partners. Renewal rates with its cruise line partners is nearly 100%, and contracts are staggered among its partners. The company is also expanding its offerings and partnered with Xponential Fitness (XPOF) and Princess Cruises (owned by Carnival) to provide group fitness classes.

(source: OSW May 2023 investor presentation)

The arrangement works for both parties because the cruise line operators can focus on driving passenger growth and managing its fleet while OSW manages the onboard spa experience for a large and growing captive audience. To that end, the cruise line operators enjoy a high-quality revenue stream from OSW with no operating expenses associated with the spa service while OSW benefits from a growing captive audience and minimal, if any, capex.

OSW beat its Q1 guidance of $160 to $170 million revenue, reporting $182.5 million revenue and $19.2 million adjusted EBITDA, and raised its 2023 guidance to $710 to $730 million revenues (from $660-$680 million) and $70 to $76 million EBITDA (from $64-$70 million). In my view, the guidance is still very conservative and will likely yield another beat and raise in Q2 as OSW enters its seasonally strongest period of the year. Additionally, OSW cruise line partners are rolling out 8-10 new ships in 2023 which will drive further revenue growth. I expect OSW to finish 2023 at better than $750 million revenues and $80 million EBITDA assuming the consumer stays strong, suggesting upside to current guidance.

Meanwhile, OSW is aggressively paying down floating rate debt. After quarter end, OSW reported that it had fully paid down is second lien loan balance which carried about a 12% interest rate. The only debt that remains is a $200 million first lien loan at LIBOR + 3.75%, currently yielding about 9%, and management indicated that it is likely to continue to pay down debt while it remains free cash flow positive for the rest of the year. In my view, OSW could continue to pay down debt at about $5 million per month given the high levels of cash it generates especially if OSW enters its seasonally strong period in Q2 and Q3.

Warrants, Additional Debt Paydown, and a Dividend?

In March, OSW announced it reached a deal to exchange 95% of public SPAC warrants and 50% of private SPAC warrants for common shares at a 0.175-0.20 per warrant exchange ratio (issuing about 3.85 million shares), leaving about 4.8 million SPAC warrants in the capital structure with an $11.50 exercise price and an $18 redemption price.

Moreover, OSW completed a $75 million 2020 PIPE with its largest shareholder, Steiner Leisure (“SL”), during the depths of the COVID crisis for the cruise industry. This capital raise also included 5 million warrants exercisable at $5.75 per warrant and a $14.50 redemption price.

Given the OSW SPAC sponsor Haymaker Capital features three OSW board members and SL also has 3 board members, I believe there could be a situation whereby the remaining 4 million private SPAC warrants and the 5 million 2020 PIPE warrants are exercised by Haymaker and SL. Exercising the warrants would bring in $46 million ($11.50/warrant on 4 million SPAC warrants) and ~$29 million ($5.75/warrant, on 5 million PIPE warrants), collectively ~$75 million in fresh capital that could be used to immediately pay down the first lien credit facility with a 9% interest rate, thereby saving OSW $7 million per year in interest costs.

The company also indicated in its 10K that it is in discussions with lenders to renegotiate its debt, I’m assuming into fixed rate obligations.

To that end, if OSW warrant holders were to exercise their warrants, which are all in-the-money (the SPAC warrants expire March 2024), OSW could pay down its first lien loan to roughly $125 million. When coupled with ramping 2023 EBITDA to ~$80 million and 2024 to ~$100 million (estimate from sell-side firm Stifel), OSW would only be levered about 1.25-1.5x gross debt/EBITDA which seems like a very strong balance sheet given OSW’s proven ability to generate significant free cash flow from its asset light operating model coupled with booming demand for spa services onboard cruise liners looking out to 2024.

Moreover, I estimate if these transactions were to occur, OSW could reduce its annual interest expense from its current $18 million run-rate to something closer to $9 million ($125 million at 7.5%). Those additional interest savings would result in about an extra 8 or 9 cents EPS, and given a 20x multiplier, would result in a $1.50-$2 per share in stock price and would materially benefit Haymaker and SL given their heavy stock ownership.

The combined ownership of Haymaker directors (2.5 million shares across Andrew and Steven Heyer and Walter McLallen) and SL (5.9 million common shares and 13.4 million non-voting common shares), covering roughly 21.8 million shares – or roughly 30.8 million if the combined 9 million warrants are exercised — of the 100 million fully diluted shares outstanding.

What I’m saying is there should be an aligned economic incentive for Haymaker and SL to exercise the warrants in order to allow OSW to aggressively delever given it saves considerable interest expense, all the warrants are in-the-money and there is risk that the company could redeem the warrants for a nominal amount if OSW common shares reach $14.50 and $18, respectively. If the stock re-rates to $20 per share, Haymaker and SL would enjoy roughly $160 million in unrealized gains from the current $12.30 stock price.

Moreover, once OSW debt gets to $100 million or less, I assume the company would be able to implement a dividend as EBITDA and FCF ramps into 2024. Stifel estimates 2024 could be $100 million EBITDA which seems like a reasonable estimate given bookings growth in the cruise line industry. Given the low capex and high FCF conversion of the OSW model, I assume they could implement a 10 cent quarter dividend which would be about a 40% payout ratio on 100 million shares out on $100 million EBITDA (they were at $0.04 per quarter dividend before the pandemic halted the dividend). That would generate significant ongoing returns to Haymaker and SL based on their share ownership as well, further aligning incentives in order to exercise the in-the-money warrants sooner rather than later.

Technicals

Technically speaking, OSW stock chart is an in a clear uptrend on the daily chart, and closed Friday just above its 8 day SMA and 9 day EMA which are considered short term support levels for traders. Additionally, OSW shares broke out of a consolidation zone on Monday May 1 on 2 million shares of volume which was about 3.5x normal daily volume. The stock has had a low volume pull back the last several days and appears to be forming a bull flag on the daily chart.

On the monthly chart, OSW is clearly challenging a resistance zone around the $13 level in part because of short selling and hedging the SPAC and 2020 PIPE warrants. I assume that once the warrants are exercised, it will take off considerable pressure from the stock and it could move appreciably higher given OSW is operating at record levels of revenue and EBITDA and because OSW has a very visible and positive forward outlook given industry dynamics in the cruise line industry.

In terms of short interest, OSW remains fairly highly shorted, I’m assuming as a result of warrant holders shorting the common stock to hedge warrants held. Given the OSW warrant exchange happened on April 26 and the latest short interest report hasn’t been released yet, it will be interesting to see how many of the shorts were closed versus the 3.85 million shares that were issued in exchange for 95% of the public and 50% of the private SPAC warrants.

If there is still considerable short interest, any balance sheet transaction from Haymaker or SL could result in a situation whereby short sellers need to cover given OSW shares are tightly held among insiders and 5% shareholders, or nearly about 65-70% of the shares, leaving only about 30 million shares in the free float based on 100 million shares outstanding post warrant conversions.

Conclusion

OSW is poised to benefit from booming demand for its spa services onboard cruise ships globally. Given the bookings growth discussed by NCLH and RCL last week, it appears like visibility for growth over the next 6-12 months is quite robust for OSW coupled with the potential for signing up new cruise line partners given the OSW value proposition for operators.

When coupled with a potential near term balance sheet catalyst by two large OSW shareholders converting in-the-money warrants into common shares (thereby removing the remaining warrant overhang on shares), OSW could enjoy a $75 million inflow in capital to help reduce its manageable debt balance even further.

The result of this action would be a clean capital structure, significant interest expense savings and accretion to OSW earnings per share which would also help the warrant holders see potential more appreciation in OSW shares vs the exercise prices of warrants held.

I think a good price target is 20x 2024 EBITDA of $100 million, or $20 per share based on ~100 million shares outstanding.