Danaos Corporation (NYSE: DAC): No Ship, Sherlock
Danaos Corporation (DAC) is a Greek shipping container company, incorporated in the Marshall Islands, that owns and leases large container ships to global shipping companies
DAC is currently valued at $90.2m ($3.64/share at the time of writing), representing a Price/Earnings multiple of c.0.7 against 2019 Net Income of $131.3m
I believe that, although the looming debt schedule is daunting, and macro trends may prove to be a headwind, the huge discount to book equity is unwarranted, and this company is worth buying at today’s price
DAC owns and operates container ship vessels, which it leases on long-term, fixed rate and multi-year contracts to international shipping companies, such as Maersk, COSCO, ZIM and Hyundai Merchant Marine. The ships are leased on a daily rate, which excludes any days of inactivity that is a result of things for which DAC is responsible, such as scheduled maintenance. DAC has one of the largest fleets in the industry, 57 containerships, and runs with one of the lowest daily operating costs of an average of $5,506 per vessel in 2019. At less than 1.0x earnings, this company warrants investigation. To learn about their core operations and history, I’d have a read of their most recent annual report (Form 20-F); for now, I’ll delve into the balance sheet, and why it offers both cashflow headwinds and downside equity protection.
Debt is an important part of the capital structure, and a key component to understand, with both positive and negative considerations. The fleet of vessels is worth $2.4bn, at the latest valuation reported in their Q1 2020 6K, and DAC also has about $97m in cash. In the context of the core operations of the company, however, the debt load of around $1.6bn, with a further $180m in leaseback obligations, makes sense: the company purchases vessels and leases them for a yield, taking a spread between the cost of financing (i.e. debt) and net yield. Given that (i) these are physical assets, which have both a market value (i.e. what competitors or shipping companies themselves will pay for these vessels) and a residual value (i.e. the scrappage value of the ships) and (ii) these vessels are leased on very long-term contracts to large, global shipping companies, it makes sense to leverage their cash flows with reasonable levels of debt. With debt at c.68% of fleet value, the leverage seems similar to a Senior Mortgage on a property, contextualising the type of asset and the appropriate financing structures. In addition, DAC has an excellent cash-conversion capability, with positive Free Cash Flow (FCF) in each of the last eight years, all of which were in excess of reported Net Income.
That investors might have fears about debt levels, however, is understandable: in 2018, DAC undertook a massive debt restructuring, wiping off $551m in debt and diluting common shareholders with the issuance of 7,095,877 shares (current NOSH now stands at 24,789,312, for context). In addition, modelling out DAC’s FCF shows that a refinancing cliff approaches for the fiscal years to 31st March 2024 and 2025, with principal debt payments of $770m and $300.9m due in each period, respectively. These will almost certainly outstrip FCF not only for those periods, but for all the years up to March 31st 2025, too. Over the long term, the value of the assets DAC owns, and the cash flows due from them (conservatively modelled, and depreciating according to DAC’s schedule with no asset purchases) are more than enough to cover these payments: over the next ten years, FCF comes to c.$480m including debt repayments. The problem may arise should DAC find itself unable to refinance the 2024/2025 cliffs, which will prove difficult to finance without asset disposals. Nonetheless, we can take a vulture-like reassurance from the strong asset base of the company: in the joint events that (i) credit markets are not accommodating, and (ii) creditors unwilling to extend the terms of existing facilities at attractive rates, insisting on foreclosure, DAC as an entity still contains enough value to pay all claims in full upon liquidation and leave c.$900m for shareholders at the end of the party. That this equity costs only $90.2m at market provides mind-boggling margins of safety.
Pursuing a more optimistic train of thought, we can suppose that DAC is able to tap debt markets to refinance these cliffs to more manageable chunks, reflecting the cash flow profile of its asset base. DAC earns something approximate to 7.0% p.a. ROE on an unlevered basis (using the portion of our forecast that is post-debt maturity payments and incorporating the real asset depreciation costs). In reality, DAC can finance these with debt, juicing ROE to historical levels of c.15% p.a., reasonably high for a mature business. Without debt, DAC will earn a fair ROE – not magnificent, not terrible. At today’s price, however, the earnings yield on invested capital skyrockets when you are only paying c.10% of book equity value; this is a fair company at a wonderful price, to borrow from Buffet’s vocabulary. Suppose that earnings fell 50% for the full-year 2020: for every $100 I invested, I would still be earning c.$71.5 in 2020, after a 50% fall in net income. If that drop were more precipitous, say 80%, the operating earnings due to my shares would still be c.$28, a significant premium to the earnings yield available in the market in general. And this is a serious downside earnings case. Assuming that earnings don’t drop, but never grow – and parking cash-flow issues relating to refinancing for the moment – we have to apply a discount rate of something in the region of 142.5% p.a. to arrive at today’s market price. For an asset-backed business with long-term contracts and industry-leading margins, that doesn’t seem justifiable.
Let’s think even more optimistically, and prophesise that Mr. Market awakes from his slumber to agree that DAC is undervalued: what happens to the price of our investment under various downside earnings scenarios? If earnings fall 50%, but the market re-rates DAC to a (very) conservative 5.0 P/E multiple, you are looking at c.250% increase in your investment. At 10.0 P/E, you make over 600%, if earnings fall 50%. The market is pricing in enormous earnings erosion, which I believe is unwarranted given the market-leading position of the company, and the strength of the asset base. If the market is correct, and DAC will lose earnings power, well, then, this is priced in, and investors make the market return; the downside is hard to see, given that investors stand to gain enormously from a bankruptcy or liquidation.
One final comforter that investors can take away is the sheer size of the ownership that is held by the founder and CEO, and the executive team more broadly. John Coustas, the CEO, owns 31.2% of the company, followed in ownership stake size by Board Member George Economou at 10.8%, COO Iraklis Prokopakis at 10.8% and CFO Evangelos Chatzis at 8.9%. If that’s not shareholder alignment, I don’t know what is. Management can be expected to act like owners because they are owners, in significant amounts. Investors may also like the fact that the second largest ownership stake is now held by Stephen Feinberg of Cerberus Capital Management, who owns 12.66% of the company.
Is this a valuable company, at today’s prices? Amory thinks so. Let’s see how this plays out.