Danaos: Favorable short-term outlook and significant upside potential (NYSE: DAC)
Danaos (NYSE: DAC) the Greece-based container ship rental company has seen its share price more than triple since early 2021. At the same time, charter rates have skyrocketed since the start of last year. This analysis concludes that despite the recent increase in the price of inventory, DAC remains undervalued by around 60% as it will benefit greatly from the high charter rates that they can lock in on long-term contracts with their customers.
Changes in the structure of supply and demand
In the past, the rental of ships was a very volatile and risky business. Charter rates were highly volatile, resulting in significant write-downs on their vessels of $ 415 million in 2016, $ 218 million in 2014 and $ 75.8 million in 2012 for Danaos. As a result of these volatile earnings for Danaos and its peers, the entire industry has experienced underinvestment, meaning the backlog to fleet ratio has been relatively low in recent years. However, as the covid pandemic slowly became more under control, the demand for container ships increased, which took the industry by surprise. In response, charter rates have skyrocketed, as shown in the chart below.
Danaos is in a favorable position where most of its charter contracts expire next year or have already been renewed for the most part for double the original charter rate. Since charter contracts are concluded over several years, these significantly higher charter rates are blocked for a long period. Currently, the remaining average contract term is 3.3 years. This implies significantly higher cash flow for Danaos in the near future. Currently, Danaos has a charter backlog (contract revenue) of $ 2.1 billion through 2028 against a market cap of $ 1.5 billion. They also have an order book to fleet ratio of 23.5% which includes deliveries through 2025.
Source: Q3 2021 presentation slides
Now, one can wonder what is the risk of a future oversupply as we have seen before. Indeed, the order book for the year 2021 is significantly higher than that of previous years. It is important to note that ships ordered in 2021 will not arrive until 2023. Therefore, the current supply shortage will not be resolved immediately and will most likely persist until 2023. Danaos expects rates normalize by 2023, but they also expect rates to stay at historically higher levels.
The risk of supply exceeding demand for container ships in the medium term is reduced by two main factors:
- Even though an increase in deliveries is slated for 2023, there is uncertainty about upcoming environmental regulations for container ships. The target for the container industry is expected to be carbon neutral by 2050, but how this target should be achieved is not yet clear. Due to the long lifespan (30+ years) of container ships, buying a ship now will last until 2050, which is too risky for many buyers. Instead, the focus has shifted to extending the life of old ships, instead of investing in new ones that might become technologically obsolete before the end of their life.
- There has recently been a wave of consolidation among the liner companies. The number of liner operators increased from 20 in 2015 to 9 in 2021. In addition, the remaining liner companies have formed a number of alliances. Today, 84% of the world fleet is controlled by one of these alliances. This reduces the likelihood of over-ordering as there is better visibility into the competitors, their capacity, and their strategy.
Of course, that doesn’t mean that container ship leasing has suddenly become a predictable, non-volatile business forever. The points set out above should only explain why Danaos is in a favorable market position in the short to medium term. No assumptions are made about the long term.
With the information provided, a DCF analysis was performed. The sources of income have been divided into three parts:
- The income contracted from the charter book
- Assuming an EBIT margin similar to the past
- Estimated revenues from vessels not yet under charter
- The conservative assumption is made that newly contracted vessels will have charter rates 50% higher than vessels which are currently under contract until 2026
- EBIT margin increases because higher revenues do not come with higher operating costs
- Estimated revenues of newly ordered vessels
- Assuming newly ordered vessels will represent 23.5% of current fleet revenue (order book / fleet ratio 23.5%)
- EBIT margins are also higher due to higher rental rates through 2026.
After 2026, it is assumed that contractual charter rates will slowly normalize again, and as a result, margins will contract even below normal levels to account for a possible oversupply after the current undersupply.
Source: (own Excel file)
From this starting point, the estimated FCF for each year was calculated (presenting the entire DCF analysis would blow up the scope of this article, but if you are interested just drop me a message. direct). The discount rate was set at 11%, which is equal to the average long-term stock market return, and the growth rate of cash flow at breakeven was conservatively set at 0%.
It is also important to note that Danaos owns 7.2 million shares in ZIM Integrated Shipping, which is also one of the Danaos. At market value, these stocks are worth around $ 400 million.
Source: own excel file
Source: own excel file
Takeaway for investors
With these entries, our DCF analysis implies an increase of 48%. It is important to note that the terminal value was purposely constructed to be quite small (high discount rate and no terminal growth rate). Since the industry in which Danaos operates has been very volatile in the past, we do not want to make overly optimistic long term assumptions. However, in the short and medium term, Danaos is in a very favorable position. Charter rates have more than quadrupled since October 2020, allowing Danaos to lock in those much higher rates into long-term contracts. Since operating costs do not increase much, most of the revenue from the higher charter rates will go directly to the bottom line.