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). 

The final major factor to be aware of from a supply perspective is the environmental regulations. This starts to come into effect now in January 2023. Essentially ships will be rated according to their carbon intensity and these ratings will tighten over time. If a vessel is consistently rated poorly it won’t be allowed to sail without corrective action. Many ships will have to slow down in order to hit their targets as a slowdown in speed results in a disproportionate reduction in carbon emissions. This is especially true of the “older” less fuel-efficient vessels which account for 80% of the global fleet. As most of the ships slow down, it effectively reduces global supply since it takes longer to get goods to their destinations. It is estimated that a slowdown of 1 knot by the global fleet effectively reduces supply by 6%. The two largest liner operators, MSC and Maersk, have said that they estimate the regulations will effectively reduce supply by 10% and 5% - 15% respectively.

There has also been a consolidation in the container shipping industry over the last decade. The multiple smaller players have been acquired or went bankrupt resulting in a larger concentration amongst the larger liner companies. This greater supply-side power may contribute to higher freight rates in future, which naturally would spill over to the charterers through higher contract rates. The following graphs show this shift in market concentration:

So to summarize the supply side:

• Many vessels have been run for longer recently and the fleet is ageing. This may result in a higher-than-average scrapping of older vessels in the next few years. 

• In addition the environmental regulations will likely take effective supply out of the market and this will increase over time. 

• There has also been an increase in market concentration amongst the liner companies over the last decade which may contribute to a higher level of rates in future.

• To counter these supply-tightening effects there is a significant orderbook that will be delivered over the next three years. A lot of these orders will be in the largest containerships above 10,000 TEU. Danaos’s recent purchase in 2021 and new build orders for delivery in 2024 are all below 10,000 TEU.

From a demand perspective economic activity is likely to slow down. An increase in global interest rates to fight inflation is likely to have a negative effect on consumption and global trade. This may be somewhat negated by China opening up again after their pandemic lockdowns. But the general economic demand outlook is certainly more negative than positive.

All of the discussions above will affect the charter rates that Danaos can achieve as the current contracts roll off. Its not possible to predict the path that these rates will take but the factors likely to affect rates are not all negative. Importantly, Danaos can afford to be patient with the rates they lock into for their charters which was not the case before the pandemic. Fortunately the current price of Danaos stock does not require a rosy rates environment to produce a good outcome. An average or below-average rates environment will be just fine.

The following graph just provides a little context for the current short-term charter rates that have been achieved recently in the market, spiking during COVID, coming down now (with spot rates but not as quickly) but still well above the rates seen in 2019. 

Assuming 2019’s charter rates on contract roll-off seems like an assumption that is appropriately conservative for the base case. The downside case is more severe but still yields an acceptable investment outcome.

Contracted rates for the medium term give a high degree of certainty

As mentioned, Danaos has done an excellent job locking in its revenue at the high recent rates seen in the market. Despite this, the stock seems to be treated similarly to other companies in the sector where the market is watching the precipitous fall in daily container rates and selling shipping stocks accordingly. In the case of Danaos this does seem like a baby-and-bathwater situation. 

For context, the following graph shows the container shipping rates (those charged by the liner companies which indirectly then impact charterers at contract renewal) over the last few years. The COVID period truly was an outlier for the industry:

 *Freightos Baltic Index (FBX) – door-to-door rates for 40 foot containers (fbx.freightos.com)

Due to the short supply of container vessels partly created by the port congestion during COVID, liner companies were scrambling for supply and willing to lock in to charters for long periods despite the high rates. The following graph shows the total revenue for Danaos split between currently contracted revenue, my base case forecast revenue on roll-off of current contracts based on 2019’s much lower contract rates, and my assumption for the new vessels being delivered in 2024. This is done on a ship-by-ship basis. The rates assumed on contract roll-off from 2019 are based on the average rates achieved by Danaos from that year for each vessel category.

As you can see from the light blue area of the graph, much of the revenue for the next couple of years is known (90% for 2023, 68% for 2024 and 43% for 2025) which takes much of the guess work out of any forecasts. In addition, the rates used from 2019 are probably conservative since that was a particularly poor period from a rates perspective. Danaos can now afford to be more patient since they don’t have a heavy debt load to service, having paid down substantial amounts of debt in recent quarters. 

When comparing revenue from the start of the pandemic (low $40m per month) to that being forecasted by 2026 (±$60m per month), keep in mind that they bought six second-hand 5,500 TEU vessels in 2021 and sold two 6,400 TEU vessels in November 2022. Six brand new vessels are also being delivered in 2024 as shown by the light grey area on the graph. Also be aware that the high pandemic rates locked in for long periods continue to boost overall revenue into 2028 as compared to that earned pre-pandemic.

You’ll notice from the graph that there is a slight difference between the actual reported revenue (dotted line) and the revenue from current contract rates. Where the calculated revenue is higher it stems from downtime for repairs and maintenance of the vessels. Where the reported revenue is higher, some vessels may have come off contract and were chartered at the market spot rate which was particularly high in 2021/22. To cater for this difference I’ve assumed a 5% “downtime” in my revenue forecasts below and only taken 95% of the calculated revenue (which is consistent with management’s expectations).

As mentioned, the rates assumed are for different vessel categories. Danaos generally reports on its vessels according to their size, determined based on the TEU (twenty-foot equivalent unit) count or number of twenty-foot containers the vessel can take. The following table provides a summary of the vessel categories and the rates that Danaos has achieved. My base case assumption (2019 average rates) and downside case assumption (2019 minimum rates) are shown relative to current rates. Note that in some cases the smaller vessels have higher current contracted rates – this is largely a function of when the vessel came out of the previous contract and the market’s appetite for charters at the time:

With the exception of the smallest vessels, the fleet is fairly young meaning that a large replacement program should not be necessary over the next few years. For the nine smallest and oldest vessels I’ve assumed that they are scrapped at the end of their current contracts without any allowance made for residual scrap value (they’re on the books for about $25m collectively). However, assuming Danaos can get decent rates for them I expect them to keep running for a while longer as container vessels have an expected useful lifetime of 30 – 35 years (or at the very least Danaos will get some scrap value from them – Danaos base their depreciation on $300 per ton of scrap value). With regards to the new vessels, they should command a premium to other vessels their size considering they are brand new and fuel efficient so will fit nicely into the new environmental regulatory regime.

The key take-out from the table above is just how high the current contracted rates are relative to those achieved in 2019 (almost double). This has and will continue to lead to super-profits and (more importantly) cash flows for as long as these contracts run… some up to 2028. From a valuation perspective it then becomes important to determine more normalized earnings sometime in the future after factoring in the substantial cash earned up until then.

Financial projections highlight the deep value opportunity

The value of Danaos is as dependent on the near-term cash generated as it is on the eventual normalized earnings and associated exit multiple thereon. This is comforting from a valuation perspective because the near-term earnings are highly certain. I consider 2026 to be the first year of more normal earnings since they turn upwards again thereafter under my assumptions. Revenues are modelled on a vessel-by-vessel basis as discussed above. From a margin perspective I’ve assumed that the current high GP margins come down to historical lows of 71% with EBITDA margins following suit as operating expenses grow at 4% annually. But what is certain is that reality will turn out differently from the figures modelled – I’ve tried to be conservative to be on the right side of the actual outcome.

The following table provides a financial snapshot of the income statement and key balance sheet metrics (especially the buildup of cash over time):

A few things to draw your attention to working from the top down:

• The 2026 EBITDA margins are at 10 year lows, highlighting the conservativeness in the margin assumptions.

• Depreciation decreases in 2023 with the sale of 2 vessels in November 2022 and then increases in 2024 and 2025 with the purchase of six new vessels. I’ve made no adjustment to the depreciation for the scrapping of the nine smallest vessels at the end of their current contracts as their current book value is only about $25m collectively.

• We have clarity on the debt repayments which, with the exception of a $263m 8.5% 2028 note, are contractually amortised over time. The interest on the debt is fixed on the $263m unsecured notes, LIBOR + 2.5% on the $450m Citibank / Natwest facility running to 2027 and RFR + 2.16% on the $125m BNP Paribas facility also running to 2027. I’ve added a 1% additional buffer to the current interest rates for the two linked facilities to allow for further interest rates increases. I’ve also assumed 2.5% interest on positive cash balances, remaining flat over the term.

• The drydocking capex shown is in excess of that already included in the cost of sales. The accounting methodology amortizes the drydocking capex over time as an expense but there are years where the cash outlay exceeds this amount. By 2025 I’ve allowed for 1/3rd of the vessels to be drydocked each year at $1.5m each – this seems conservative based on the history.

• I’ve assumed that the dividends, buybacks and some of the payments for the new vessels are funded from cash. The balance of the new vessels are paid for with debt in 2024 which adds about $313m to the debt then, resulting in 60% debt funding for those new vessels that cost $530m in total (see capital allocation section for a discussion on the funding of the new vessels by the CFO). Despite this additional debt funding and the reduction in the EBITDA over the next few years, the total-debt-to-EBITDA ratio (excl. cash) remains very manageable, peaking at 1.8x in 2025. Management have said that they don’t want to go above 3x EBITDA so there is still plenty of room remaining. Keep in mind that this industry tends to be fairly highly geared, with debt secured against the vessels, in order to earn a decent return on equity despite low unlevered returns on capital. From the main listed competitors, Atlas Corp is currently at 5.2x net debt to EBITDA, Costamare at 2.7x and Global Ship Lease at 2.3x all off fairly inflated recent EBITDA figures (all off elevated EBITDA figures). By year-end 2023 Danaos should be close to net-cash so is certainly an outlier. 

• I’ve grown the dividend per share by 15% per year. Management have said that they want the dividend to grow steadily over time and this is the easiest way for them to distribute some of the cash on the balance sheet to shareholders. By 2025 the dividend payment is $88m which is a 32% payout ratio based on 2026 normalised earnings, so still very much maintainable. A steady increase in the dividends, currently yielding 5% on the stock, should act as a catalyst for the stock price. 

• Regarding the buybacks, I’ve assumed that the buybacks in Q4 match those in Q3 of 2022 and that the remainder of the $100m buyback authorization is exhausted in 2023. In Q4 2022 shares are assumed to be bought back at current prices and for 20% more in 2023. A further key catalyst for the stock could be an increase in the buyback authorization (not modelled above) which is what I’d like to see from management when the current buyback authorization is exhausted. I'll be looking out for mention of this at next week's earnings call.

• There is unearned revenue that should be deducted from cash to get the true cash value. I don’t view this unearned revenue as debt – it is contracted revenue paid in advance for some of the vessels. In reality this unearned revenue will come down over time and cash will be slightly less but I’ve just kept it flat and allowed the cash to grow in line with EBITDA. The net effect is the same.

• Most importantly note how the cash builds on the balance sheet. I don’t know exactly what management will do with all this cash so I’ve let it build. Consider the cash of more than $1bn (net of unearned revenue) in 2025 compared to the current market cap of $1.2bn – its extraordinary value at current prices. And this while arguably being under-geared at that point considering the tremendous asset value of almost $3bn in addition to the cash.

Given the expected earnings and cash flow, what could an investment in Danaos yield for investors?

As mentioned, for me it was important to get to the point where earnings normalize. Without that how can one put a multiple on the business? I see this happening in 2026 so have worked accordingly. The valuation can be looked at from a number of perspectives namely: 

• An EV / EBIT multiple based on normalized earnings to factor in the cash and debt on the balance sheet, as well as the substantial depreciation in the business. This is to approximate a normalized pre-tax cash earnings yield.

• An ex. cash P/E (assuming debt at fair levels) because the business does not pay income tax so an EBIT multiple perhaps doesn’t fully reflect this benefit

• A price-to-book value, since this provides an underpin for value

• And comparing the above to similar companies in the market

The following table shows the return from today based on an 8x EV / EBIT exit. The base case uses the 2019 average rates after current contract roll-off and the downside case uses the 2019 minimum rates. 

Take note of the relatively small gap between the base and downside case returns despite a 23% difference in normalized earnings. This stems from the significant cash build-up (in either scenario) from the current contract rates, which reduces the reliance on hitting a specific exit multiple and determining what the eventual normalized earnings will be. Cash makes up more than half of the EV in 2025 under both scenarios.

The exit multiple of 8x EV / EBIT seems to be on the lower end of a fair range for this business based on normalized earnings – this is a 12.5% pre-tax yield in what I assume is a 6%-ish long-term government bond rate environment. The following graphs for comparative companies provides some support for this multiple. The price-to-book and ex. cash P/E are also useful metrics to consider for Danaos. By end-2025 the business has 1.8x gross gearing and is still trading 22% below book value and 5.9x ex. cash forward P/E at the market cap shown in the base case. (For context, based on the normalized earnings in 2026 the business has an ex. cash return on equity of 11% which strikes me as conservative based on its history.)

Also note that the exit multiple is based on forward (lower) earnings at which point I expect them to start trending upwards again. I’m assuming that the market becomes more aware of the tremendous value inherent in the business within 3 years. If one waits till 2026 to apply the multiples then the business will earn a bit more cash in the interim year, increasing the times money back (2.8x) but lowering the IRR slightly (31.9%) due to another year of discounting.

The following comparative graphs provide some context for the reasonableness of the exit multiple assumed above. (Note that in two of the examples the multiples have come down which is what you’d expect from businesses that are over-earning right now.)

• Atlas Corp is the largest competitor charterer with a market cap of $4bn, a $10bn EV and about 3x the TEU capacity of Danaos. Its average EV / EBIT over the last decade is above 13x with an average price-to-book of 0.86x:

• Costamare is the second largest listed competitor with about 25% more TEU capacity than Danaos, a similar market cap and about $3bn EV. Its average EV / EBIT over the last decade is just over 11x with an average price-to-book of just over 1x: 

• The last listed comparable is Global Ship Lease. It is about 25% smaller than Danaos from a capacity perspective and is also trading very cheaply right now (although not as cheap as Danaos) with a market cap of just under $700m and an EV of $1.5bn. GSL has an average EV / EBIT of 8.5x and average price to book of 0.5x over the last 10 years.

*Source for graphs: tikr.com

Capital allocation: opportunistic vessel purchases, increasing dividends and hopefully increased buybacks

As mentioned, management will use the cash building up on the balance sheet for three main purposes: paying a regular dividend, buying back stock and investing in vessels. Danaos increased the dividend by 50% in March 2022 and are committed to paying a regular sustainable dividend. They announced the current $100m buyback program in mid-2022 as well and I expect them to have used $51m of that capacity by end-December ‘22. As investors we would prefer to see more of the excess cash coming back to us, especially through buybacks at the currently low valuation, but one must view the current buyback program in the context of the size of the free float since 41% of the equity is held by insiders who are long-term holders. That means that at a market cap of $1.2bn the buyback authorization is about 14% of the free float which is sizeable. 

Management definitely want to keep a “fortress balance sheet” to take advantage of opportunities as they come – that means buying vessels as much as it means buying back stock. So I wouldn’t expect a massive increase in the return of cash already announced. They may extend the current buybacks and gradually increase the dividends over time. Right now Danaos is certainly under-levered and they’re away of that.

In terms of exactly how management thinks about capital allocation I think its very instructive to read what the CFO said in an interview in mid-2022. This is rather a long, wordy section but really shines a light on how they view the use of cash in the business:

Regarding the size of the share repurchase authorization:

• “We will use it when we consider it appropriate. We will monitor the share price and we will act accordingly. Its up to the discretion of the management to execute on it when it considers it appropriate.”

• Why the $100m number and not more? “$50m was too little, $150m sounded too aggressive, we don’t want to hurt the float, we want to maintain the liquidity trading characteristics that the stock has…”

Regarding the economics of the new builds and overall target leverage:

• “Of course the new builds will be financed. In terms of getting the best possible financing terms, if anything it’s the new builds that are going to get them. And we’re very conscious about securing competitive financing arrangements. So the new builds will be financed. Actually we are sort of deleveraging at this point using all the cash that’s coming in in order to de-lever much of the older fleet and this is a work-in-progress. We’re mindful of the overall leverage which at this point net-debt-to-EBITDA its below 1x, its going to be closer to 0.5x at year-end. We don’t intend to remain at those levels. Obviously this is gonna go up and it will be a function of financing for the new buildings and of course if the market turns, the market softens, and EBITDA falls in 2, 3 years time we’ve said we don’t want to be above 3x net debt to EBITDA through the cycle, so we are mindful of corporate leverage. But definitely new buildings will be financed… we have not yet secured charters for the six ships because it is our view that we will maximise returns if we wait it out a bit and I believe within the next months, probably within the year we will ultimately fix the ships and we will get a better outcome if we have fixed them concurrently with the signing of the contracts. John said we can afford to do this because even in a worse case scenario we can fund them all with equity anyway. So we’re not going out on a limb ordering 20 ships without a charter that, if we cannot charter them then the financing would be a problem.” Then he went on to say “We have already circulated the specs of the ships. There is quite a bit of interest. We’re taking our time, we’re not in a hurry. My expectation is that within this year we will end up fixing them. But we can afford to be patient and again maximise the outcome so that’s what we intend to do.”

• “We are targeting double-digit unlevered returns, ok, that’s our target [for the new vessels]. And depending on leverage you could get equity returns in the high teens. That’s what we’re looking for. And this is why we did not pursue transactions that others did which is not a good fit for us.”

On the amount of leverage when financing the new vessels:

• “It could go up to 70 or 80%, easy. And especially when you have a good charter in place you can maximize leverage. Although maximization of leverage is not always the sole target right? As I said before we’re mindful of the development of overall corporate leverage. We care about our credit rating. We were recently upgraded by both S&P and Moody’s. We’re conscious of the credit quality that we need to have in order to have, also, better access to the public debt markets. And actually for the specific financing of those ships we want to get the lowest possible cost right, because these are top technology vessels, they will have very good charters, and so whether we lever them at 65 or 75 or 80%, the extra leverage is not going to solve any problem for us. But if we can secure much better terms at 65 or 70% we’ll go for them. Its not that the sole objective is to maximise leverage.”

On concerns by investors as to whether Danaos is just going to blow their cash on building their fleet instead of giving the cash to shareholders:

• “We have historically built many ships and the general rule of thumb was that we build them on the back of charters. So I don’t really see that we’re going to have an expanded new building program all on speculation. So we will do a bit of mixing and matching. It depends on many factors, on when you place the order, how the new building prices are moving, when the vessel is due to be delivered because the further out of course the bigger the risks. In this instance for the six ships deliveries are reasonably soon, lets say 2024, where we felt pretty confident that people would fix those ships within the year. If you offered 2025 / 26 slots it starts being different. And again, building on speculation, a big order book, is not what we’re in the business of doing. So you should expect more, not necessarily very soon, but you know it is on our minds. We need to renew the fleet. We need to find the right balance on capital allocation between reinvesting in the business and rewarding shareholders. We care about long-term value. So you cannot put all your eggs in one basket. It would be the easiest decision in the world to splash out the money to shareholders right away. Its not how we think. We’ve made that very clear. We’re trying to be very transparent about our thoughts on capital allocation. We want to invest in the new technology of ships that are gonna be, ummm, you know they will form the next generation of containerships. We’ll do so gradually. We are gonna be very mindful of striking deals that bring us the appropriate returns. We are not gonna grow for the sake of growing if that’s what people are concerned about. We care about profitability and we have demonstrated that because we’ve only done six new buildings. We haven’t done 76. And the reason for that partially has to do with uncertainty on future technology around fuels and also sticking to our return targets because we have seen a number of new building projects offered with charters that generate low single digit equity returns on the back of 90 or 95% leverage. We don’t believe these projects make sense, that’s why we haven’t entered into any of them.”

On taking advantage of opportunities and keeping some powder dry:

• “You need to strike when the time is right. Typically in shipping, and that’s what people sometimes forget it, in shipping you make money not when you’re investing at the top of the cycle, but when the market softens. And that is when you want to have the balance sheet to source accretive growth opportunities and offer outsized returns.”

• “Borrowing from Jamie Dimon, we want to build a fortress balance sheet. And that’s what we’re doing. The market is offering us the opportunity to do so. Not just because we want to have a nice balance sheet, but exactly because we want to be able to use this balance sheet and take maximum advantage of opportunities that will present themselves going forward no matter how the market moves."

So in summary I think management are going to keep cash on the balance sheet to try take advantage of attractive opportunities that the market offers up. They are aware that they are currently under-levered and will almost certainly finance a portion of their new vessels in 2024. They have overall return targets of double-digit unlevered returns and high-teens equity returns that they are aiming for, and because of their current financial health are in a position to be patient and strike at the best possible times for both new vessels and buybacks. They do not seem likely to go out and indiscriminately splash their cash to build a whole new empire while ignoring returns on capital / equity. 

Conclusion

This is a cyclical and low-return-on-capital industry that is vulnerable to global dynamics outside of its control. It is normally deeply unsexy from an investment perspective. However in the case of Danaos there is tremendous value to be generated in the next few years from its current contracts that will produce large amounts of cash for the business. Even without massive additional buybacks, a steady dividend and build-up of cash on the balance sheet should slowly pull the stock price upwards to a more fair value. If management does find ways to spend the cash on hand it will likely be on vessels with charters in place that will grow earnings. The NAV inherent in the business acts as a value-underpin which, together with the current cash makes a permanent capital loss from here unlikely, barring a major war or some equally devastating global catastrophe. All round this is a deep-value play with a fairly high degree of certainty, heavily skewed in favor of investors at this price.  

The outcome could arguably be better than that shown in the base case above. Higher future rates (than 2019), more buybacks, a 10x EV / EBIT exit multiple or simply a faster recognition of value by the market could yield even higher returns. Keep in mind however that once fair value is reached then it will probably be best for investors to sell and move on because of the quality of the business / industry.

Catalyst

Value should be its own catalyst here over time, especially has more and more cash builds up on the balance sheet. As the market recognises the continued strong earnings (from existing contracts) despitethe freight rates, I think this value should start to be recognised. In addition I expect increases to the dividend and more share buybacks to act as catalysts.