Danaos ($DAC)

Danaos is a containership lessor that I originally heard about from J Mintzmyer who said it was the "strongest conviction buy of my career" in September 2022. He gave it a $125 fair value estimate when it was trading at $63. Two years later we're at $82 with a 41% total return. Although that's a decent rate of return, the story hasn't fully played out yet and it remains a compelling opportunity.

It's important to understand that the Danaos thesis is not dependent on a resilient containership market and it's not based on a NAV discount (I’m completely ignoring the NAV in this analysis). The company signed several years of strong charters during the post-COVID boom, so a large revenue backlog is more or less locked in and the valuation can be estimated with a DCF analysis accounting for each of the charters.

The current charters will roll off over the next few years, so there is still some dependence on the fate of the containership market, but the current charters will cover it well through 2026, which will help insulate it from a potential upcoming period of market weakness due to the large global orderbook of newbuilds. The diagram below shows the fraction of the Danaos fleet covered by charter contracts each year as of June 30, 2024.

Although charter coverage in 2027 and beyond is relatively low, the stock is cheap enough that it still has upside even if there are no new charters signed until 2030, as long as we assume that rates return to normal levels by then, which is not a very demanding assumption. And this is an extremely pessimistic scenario considering that they have still been signing strong charters over the past two years up through the latest quarterly report, though not at the same level as the 2021-2022 boom. Every contract they sign boosts the worst-case valuation of the stock and increases the alpha. It is very rare that these contracts are broken outside of bankruptcy and liners have fairly strong balance sheets after the post-COVID boom and Red Sea disruption so bankruptcies are not a major risk in the near term. If the contracts are renegotiated with struggling lessees it will likely be on terms that are valuation neutral.

The containership market has actually been surprisingly resilient over the past two years despite many ship deliveries and many more to come. The disruption in the Red Sea has been a large factor in this, as attacks have diverted ships that would normally use the Suez canal to longer routes. But even assuming a long-term Red Sea disruption, analysts initially expected that newbuild deliveries would quickly overpower the effect of the Red Sea disruption and cause rates to fall. So far that prediction has been wrong due to stronger demand than expected, but it seems bound to happen eventually.

The containership orderbook recently hit all-time highs in terms of TEU capacity at around 8.4M TEU, with around 1.7M TEU delivering each year over the next 4 years (and some beyond that), versus a current fleet of 31.5M, which gives an orderbook to fleet ratio of 26.7%. And this is after already absorbing unusually high deliveries in 2023 and 2024. On top of all this, Alphaliner says “the pace [of newbuilding] is not likely to slow.” It sounds like a disaster waiting to happen, but let’s try to understand what is happening.

There are several reasons (or possible reasons) for the large orderbook:

1. Owners have a lot of old ships and they need to renew their fleets to stay competitive without shrinking the size of their business.

2. Environmental regulations are putting pressure on operators to use newer, more efficient ships and ships that use cleaner fuels.

3. Owners were flush with cash after the 2021-2022 boom and had money to pursue growth or wanted to try to maintain market share while others were growing.

4. The containership market has remained resilient and owners may be reacting to current conditions more-so than anticipating the future.

I don’t see any of this as preventing a decline in rates given the size of the orderbook. BIMCO estimates 2025 container cargo demand growth at 3-4%, and a 5-6% decline in containership demand if the Red Sea situation resolves or a 3.5-4.5% increase if the Red Sea situation remains the same, versus 4.8% growth in containership capacity (assuming an increase in scrapping) after adding 9.3% in 2024. If the Red Sea remains disrupted for several years and demand stays strong there’s a chance the market could remain resilient, but that doesn’t seem like a safe assumption.

Some investors and analysts believe that the large orderbook won’t be a problem because there are 3.2M TEU of ships older than 20 years that are being replaced. If all are scrapped over the next 5 years, fleet growth from the current orderbook can be limited to 14%, which lines up with reasonable estimates of demand growth. The problem with this argument is that owners aren’t going to scrap ships until the rates go low enough for long enough to convince owners to scrap. In Mintzmyer’s recent interview, GSL management said that their 20+ year old ships were cash cows and they wouldn’t even necessarily scrap their 25 year old ships if rates hold up. Although some scrapping is occurring, recent scrapping has been of very old vessels; MSC recently scrapped a 38 year old vessel and Wan Hai scrapped ten 30+ year old vessels. Owners don’t scrap ships that are making money and they also don’t scrap immediately after a ship dips into the red; they need to be convinced that it has negative value. However, it is true that these older ships will help reduce the duration of a downturn because an owner will scrap a 20 year old ship in a weak market but they won’t scrap a 10 year old ship. The older the fleet, the quicker scrapping will happen and the quicker rates will bounce back.

For Danaos, a downturn for a couple years to flush out some of the oldest tonnage has relatively little impact on it’s valuation because it has good contract coverage through 2026 and much of the value is in the long-term earnings, extending past any short-run downturn. Even if it gets exposed to a couple of bad years after the contract coverage ends, this will impact the valuation, but not enough to derail the investment thesis.

Danaos also owns smaller vessels compared to most of the orderbook. The average capacity of Danaos’ vessels is 6400 TEU whereas 74% of orderbook capacity comes from vessels over 12000 TEU. Although there is a significant trickle-down effect, there is also some separation of size classes due to port size constraints and trade volume needs (it’s inefficient to use a half-empty ship on a smaller trade route). This could provide an additional bit of support in a weak market, especially considering that the smaller sizes make up the older part of the global fleet, so they will go to scrap and rebalance their market segment sooner.

Another consideration for investors is that lessors like Danaos are marginal tonnage providers in the sense that when there is less need for ships, liners can choose not to re-lease more easily than selling one of their owned vessels. This means that utilization of lessor fleets is likely to fall by a larger percentage than that of the global fleet in a downturn. Another way of looking at this is that since liners have ordered a lot of their own ships, they are likely to redeliver some of their leased ships to the lessors and they could go unutilized. As mentioned above, a period of lower utilization is not really a problem for the thesis unless it lasts for many years. And if there were a long period of low lessor utilization, this would likely correspond to a weak market and liners would eventually return to the lessors since they wouldn’t have as much funding for newbuilds to replace their aging fleets. While marginality probably has some relevance, I think it’s difficult to imagine that the current orderbook amounts to a permanent diminishment of the lessor industry, so I think this issue can be addressed with the same arguments used with respect to a general containership market downturn.

Below are valuations for various assumptions of magnitude and duration of a downturn. The year of each column is the year that the market recovers to historically normal levels. The first row assumes Danaos gets no new charters for the duration of the downturn. The second row assumes they charter ships at rates that just cover operating expenses during the downturn. The valuations use a 12% discount rate to ensure that they are sufficiently conservative for a scenario of riding through a weak market, though a 10% discount rate is probably more appropriate under normal circumstances due to the reliability that comes with the long-term contracts.

Again it is important to understand that these valuations are quite conservative in a context where the chartering market is relatively strong. These valuations have upside potential if they are able to sign more contracts at strong rates (and I expect we’ll see some in the upcoming quarterly results). Also it may turn out that rates normalize at higher than historical levels since rates were quite weak during the decade after 2008. I think anything below $95 seems excessively pessimistic, and $115 seems like where the stock should be trading, being appropriately conservative with a 12% discount rate and accounting for a deep but moderate duration downturn. Although this is slightly below Mintzmyer’s 2022 target of $125, this is largely due to more conservative assumptions in this analysis, and there have also been $6.20 in dividends since his article. With a 10% discount rate and no downturn my model yields a non-conservative valuation of $138. Taking Mintzmyer’s $125 target and un-discounting by 10% for two years gives $151 and subtracting $6.20 for dividends gives $145, which is not too far from the $138 non-conservative valuation from this model. Mintzmyer has also updated his fair value estimate to $130+ (as of August 2024).

The stability of the valuation over the past two years suggests that management has neither created nor destroyed much shareholder value over this period, therefore I don’t apply any management premium or discount.

Even with valuations like this, many investors may be reluctant to invest in a containership company when the market has a weak outlook. Practically speaking, this makes sense because the stock tends to trade with spot rates even though they have very little direct impact on its valuation. Regardless of whether it makes sense, if you expect spot rates to fall and you observe the stock trading with spot rates, it means you will probably have an opportunity to buy it cheaper in the future, so waiting might be the optimal move, though it comes at the risk of missing the opportunity if the market wises up or some other catalyst occurs.

Another reason why the stock has remained cheap is that the shareholder returns have been weak. It has been frustrating for investors to not see more buybacks when it was so accretive. The purchases of second-hand capesize vessels and containership newbuilds have converted some of the stock’s alpha into beta by trading cash in hand for a ship that might take a decade just to recoup the initial cost, and it increases dependence on long-run market conditions that nobody can reliably predict.

I don’t fault the management too much for the capital allocation strategy though; I think their approach makes sense if you view it from a very conservative/bearish perspective. If you put yourself in management’s shoes and take on the outlook that you are going to be weathering a bear market, the first thing you’d want to do is pay down debt to fortify your balance sheet. Then you’d want to try to diversify away from the containership market (e.g. dry bulk) so that you can generate some income that isn’t dependent on a weak market. And you could even order some more containerships as long as they are chartered for several years since this will actually increase your average charter coverage for the years under concern, effectively diluting the impact of the older unchartered ships. These are all things that management did instead of shareholder returns. If they had used all the cash for aggressive buybacks, it would have been great for investors, but then those investors would leave and management would be left to struggle through a weak market from a much weaker position without any cash to make these fortifications.

Based on this perspective, I remain hopeful that shareholder returns will increase significantly when it becomes clear that they’ve made it through the potential downturn. I don’t expect this to happen imminently, especially considering that they still have more newbuilds to pay for, so I think it will probably require more patience. Also, I don’t expect the market to price in the post-recovery value or the effect of higher shareholder returns until we actually reach that point.

However, there could be a near-term catalyst from pull-forward demand due to Trump’s tariffs and perhaps even an east coast port strike, with one analyst saying “2025 could be ‘craziest year we’ve ever seen’”. If that happens, it could drive spot rates up and motivate another wave of strong contracts and boost the stock’s worst-case valuation. Tariffs theoretically should reduce container trade and thus reduce the expected value of the stock, but since it is trading near the “worst-case” valuation, any contracts signed during a pre-tariff boom, even if the boom is very short-lived, should be beneficial for the stock.

I wouldn’t expect a take-private deal since management said in 2022: “we want to be a public company, we care about the trading of the stock. We want access to public equity, and debt.”

In conclusion, despite a bearish containership market outlook, Danaos is well insulated with multi-year contracts and valued cheaply enough that any fundamental downside scenarios seem excessively pessimistic. However, due to limited near-term shareholder returns it may still be frustrating to hold and may still require a multi-year time horizon to finish playing out.