DANAOS CORP DAC
February 08, 2023 - 8:57am EST by
FuzzyLogic
2023 2024
Price: 61.61 EPS 23.2 21.9
Shares Out. (in M): 20 P/E 2.8 3.0
Market Cap (in $M): 1,247 P/FCF 2.3 2.3
Net Debt (in $M): 541 EBIT 491 454
TEV (in $M): 1,788 TEV/EBIT 2.8 2.6

Sign up for free guest access to view investment idea with a 45 days delay.

Description

Danaos Corporation is an incredibly cheap charterer of container vessels to liner companies. It trades at 0.48x NAV and 3x EV / EBIT and will earn its current market cap in cash over the next two years. By end-2025 an undemanding 5.9x ex. cash P/E exit multiple (0.78x price-to-book) on normalized (much lower) forward earnings should yield a total return of 2.5x money back (38% IRR) for investors at current prices. The substantial NAV underpin also gives investors a large margin of safety to the downside. One can have reasonable confidence in the outcome since 2/3rds of the revenue is already contracted to 2025 at the peak pandemic rates with liner customers that are in excellent health due to a few years of very high spot rates, resulting in prodigious cash flow and debt paydowns. The current average contract length for Danaos’s 69 vessels is 25 months. 

Danaos is the owner and long-term charterer of container vessels to liner companies. The liner companies (like Maersk, MSC and ZIM) handle the point-to-point logistics of transporting freight across the oceans. They deal with customers and are exposed to freight market spot rates. Liner companies typically lease about half of their ships from charterers like Danaos (owning the other half themselves), which gives them operational and capital structure flexibility and reduces their overall risk. As the owner and lessor of vessels, Danaos is not directly exposed to freight spot rates and makes its money through longer-term contracts with the liner companies, typically through time charters where Danaos charges for the vessel and separately for the crew, lubricants, insurance, etc.

At first glance many may choose to pass on any company in the shipping industry since they are typically exposed to the whims of supply and demand, are capital intensive, typically earn fairly low returns on that capital and have no long-term moats to keep competition at bay. But at the current price Danaos presents an unusually attractive opportunity. It is currently valued at near a 15 year low in term of its enterprise value despite being in its best financial health ever: substantially under-geared (close to net cash by year-end ’23), having more than its current enterprise value in contracted EBITDA locked in over the next five years, a fairly young fleet and credit-worthy customers that are just coming out of a cash flow bonanza. 

The two main questions (risks) for an investment in Danaos relate to 1) the rates they will achieve on the vessels that come off contract in the coming years with a recession potentially looming and ports now functioning more normally, and 2) what management will do with the substantial amounts of cash the business will earn:

  1. On the first question, I’ve assumed that rates revert to the much tougher 2019 period (about half of what they are currently) as each vessel comes out of contract. (Danaos provides vessel-by-vessel rates and contract terms so this is easily projected.) This assumption will only apply to about 1/3rd of the revenue in the next three years with the balance still on current contract rates. The risk of a recession reducing demand is balanced by the shipping industry implementing environmental regulations that will force many vessels to sail more slowly to reduce emissions. This naturally limits supply in the industry, albeit that new vessels are being brought into the market in 2023 to 2025.
  2. On capital allocation there is a 5% dividend in place and management have initiated a $100m buyback of which they’ve already used $28m by September 2022. In 2021 management did also commit to building six new vessels for delivery in 2024 for a total cost of $530m, easily paid for with their cash or with debt, having ample capacity for either option. These new vessels will replace some of the older vessels in the fleet that are nearing the end of their useful lives. But on average the Danaos fleet is only about 16 years old with a container vessel expected to be useful for 30 – 35 years (depreciation is over 30 years). Besides the dividends, buybacks and new vessels, management are likely to be cautious with their cash having been under tremendous strain during the decade before COVID as a result of an extremely high debt load of (over 8x EBITDA coming out of the GFC) in a low charter rate environment. They will be opportunistic, picking up younger second-hand vessels if they are attractively priced, like they did in 2021 when they bought 6 vessels for $270m yielding more than 10% in EBITDA (unlevered) before rates were negotiated much higher. I don’t expect management to go empire building and splash massive amounts of money on a whole new fleet, but at the same time I think they might sit on more cash than most shareholders would want them to and be slower to distribute it. Either way the outcome should be more than acceptable.

With 39% of the equity, the CEO Dr John Coustas will call the shots. He’s a shipping guy through-and-through having inherited the reins from his father 30 years ago, so may slightly favour growing his company over returning massive amounts of capital to shareholders. But with a large portion of his personal wealth in the equity, he is likely to think like an owner.

It should be noted that this is not a high-quality business. Its capital intensive and although exposure to volatile daily charter rates is more muted as a charterer as opposed to a liner company, returns on capital are low at 6% - 10% historically. For this reason I do not expect a high multiple on eventual normalized earnings. But as a deep value play with a high degree of certainty over the medium-term earnings and minimal debt, this should work out quite nicely and is very unlikely to result in a permanent loss of capital, making the risk low. The NAV underpin provides comfort in this regard.

I’ll start with a discussion of the current contracts, look at the overall supply and demand environment for container shipping, show how a conservative view on rates produces a fantastic amount of cash for Danaos (and returns for investors), and end with a look at management’s view on capital allocation.

 

How reliable are these customers of Danaos that have locked into long-term contracts?

This is a key question since the investment thesis hinges on the certainty provided by the existing contract backlog of Danaos. What stops the customers of Danaos from defaulting on or renegotiating these contracts as the market charter rates drop? I can’t really say it any better than the Chairman and CEO of Global Ship Lease (a competitor to Danaos) in their Q3 earnings call:

  • Georgios Youroukos (Chairman): “…I would say that the counterparties in container shipping, all the liner companies, they are in the better -- in the best shape they have ever been historically financially. And actually more than that. So they're all, I would probably say, net debt 0 and lots of cash in addition to that on the side. So we're not worried about our counterparties because we also have only first-class names in our portfolio.”

  • Ian Webber (CEO): “Further, we have industry standard charter contracts, they're noncancelable. We only deal with the really good names. We've never had a bad debt in GSL. It kind of doesn't happen in our industry by and large, anyway. Liner companies are desperate for these ships. They need the charter fleet to run their scheduled services. Without the ships, they don't have services. So it's in their own interest t`o behave properly. And as George said, they're in the best financial shape they've probably ever been in. So we're not at all complacent about it, but we're -- it doesn't keep us awake at night.”

From the perspective of Danaos specifically, their major customers are shown below in the split of their charter backlog and are all the same companies that GSL mentioned:

 

 

 Outside of distress (bankruptcy and restructuring) these lease contracts do not have any precedents of being renegotiated, even during the GFC and the recent 2012 – 2018 shipping downturn. In the case of ZIM’s bankruptcy in 2013/14 the vessel owners received debt compensation and large equity stakes which eventually yielded substantial returns for Danaos when they sold that equity during the recent upturn for ZIM stock. When HMM was restructured in 2016 vessel owners received 100% compensation in the form of unsecured bonds and equity. Only in the case of Hanjin’s bankruptcy in 2016 did almost all creditors get wiped out. And as the GSL Chairman said, the liner companies are in the best financial health they’re ever been so those contracts seem like a reasonable bet for the next few years.

 

How will containership supply and demand affect charter rates after roll-off?

The rates that charterers are able to achieve are largely affected by the supply and demand dynamics for containerships by end customers. From a demand perspective, economic activity which drives global trade is probably a fair indicator for general demand. From a supply perspective, containerships require a large capital outlay and take 2 – 3 years (or longer) to build. In addition, containerships age and are scrapped towards the end of their useful economic lives, typically between 25 and 35 years. These supply and demand activities can also have some regional nuances. For example, the major lanes from East Asia to the USA via the Pacific and from the USA to Europe via the Atlantic tend to have the larger containerships (10,000 TEU+) whereas other regions (the Mediterranean, South East Asia, the Persian Gulf and the Caribbean) also use many of the smaller TEU vessels.

Trying to predict the charter rates by forecasting the supply and demand dynamics for containerships is a fools game. But I think it is instructive to have some idea of where the industry stands to make sure that an investment into a containership company is not being done at an absolutely irrational point in time. So this section will just discuss some of the main supply and demand elements for containerships as they stand today and this discussion will remain fairly general. As mentioned I’ve assumed 2019’s average charter rates when the current contracts roll-off which should provide some margin of safety. (I’ve taken all of the graphs in this section from the Q3 results presentation of Global Ship Lease.)

From a supply perspective, the rate of ship scrapping over the last few years has fallen to almost zero. This makes sense since the port congestion contributed to a practical shortage in supply which drove up the spot (and charter) rates making it feasible to run older ships for just a few more years very profitably. The following graphs show this scrapping behaviour for the global fleet as well as a very low idle fleet ratio:

 

 

New vessel build orders were non-existent during the COVID uncertainty but these have since been placed with expected delivery in 2023, 2024 and 2025 amounting to almost 30% of the current fleet capacity. But most of these new vessels are for large containerships and the smaller vessels (below 10,000 TEU) are only adding about 15% to their capacity over the next three years. Companies like Danaos and GSL have most of their fleet below 10,000 TEU whereas Atlas Corp has predominantly large vessels. 

If you consider the smaller vessels coming online against the age of the existing smaller vessel global fleet (likely resulting in some scrapping of older vessels), the net increase in capacity may well be less than 15%. (I would take the second graph below with a pinch of salt as that may be GSL management talking their own book to some extent – there may be some scrapping of older vessels but many may run beyond 25 years for as long as the charter rate justify it).