Summary
- Danaos' fundamentals are very strong.
- The company has a very clean balance sheet and should be able to reduce its net debt to zero pretty soon.
- The valuation is cheap, but there are major uncertainties when it comes to future cash allocation policies.
Article Thesis
Danaos Corporation ( DAC ) continues to generate hefty profits and cash flows thanks to having locked in attractive rates in the past. The balance sheet gets stronger and stronger, and net debt will likely drop to zero a couple of months from now. This brings up a big question: What will Danaos do with all its cash? If the company makes shareholder-friendly moves, shares could be highly attractive at current prices.
Danaos: Still Benefitting From The Pandemic-Induced Logistics Issues
During the pandemic, when consumers bought more goods instead of services and when logistics issues, such as COVID measures at ports, caused major container traffic jams, rates for moving freight exploded upwards. That was highly beneficial for liners such as ZIM Integrated Shipping Services ( ZIM ) and its peers. These liners, in turn, decided to charter more ships, and since they were flush with cash and since moving containers across the oceans was highly profitable, these liners agreed to pay charter rates that are way higher than the historic average. Danaos and other container ship owners that charter their ships to container liner companies benefit from these increased charter rates, and they do so despite the fact that the underlying issue -- logistics disruptions that caused higher container rates -- is not in place any longer. Moving a container from A to B has become a lot less expensive in recent quarters, which is bad for the profitability of liner companies such as ZIM. But Danaos and its peers continue to benefit from the high charter rates they have locked in over the last three years.
In fact, Danaos will continue to benefit from these high charter rates for a long time, which is why profits will be very elevated versus the historical norm for a couple of years:
Analysts are currently predicting that Danaos will earn around $24 per share in the current year and next year. Relative to a share price in the high $50s, that makes for an earnings yield of 40% or so. In 2022, Danaos has earned more than $34, thus current analyst estimates imply a meaningful profit pullback this year, even though Danaos will remain ultra-profitable if these estimates come true. One can, however, argue that these estimates are too conservative -- after all, Danaos has locked in the vast majority of open days for 2023 already (93%), and the company's ongoing debt reduction efforts will lower its interest expenses drastically, which should be positive for profits. On top of that, Danaos also has a history of outperforming expectations. In 2022, Danaos has beaten earnings per share estimates by a total of $8 per share -- analysts had predicted profits in the $26 range, but earnings per share came in the mid $30s. In prior years, Danaos also has beaten estimates very reliably:
The company has beaten earnings per share estimates in 15 out of those 16 quarters, with some very sizeable beats in there. With analysts thus having a pretty obvious track record of underestimating Danaos' profitability, it would not be too surprising if the company outperforms expectations in 2023 and 2024 as well, I believe. I thus believe that earnings per share could come in well ahead of $24 this year and next year, but in order to be conservative we can assume that Danaos will not beat estimates going forward. Even in this scenario, a pretty big question comes up: What will Danaos do with all this cash?
Utilizing Cash Flows
In the recent past, Danaos' answer to the question of how its cash flows should be used was very clear: The company focused on debt reduction, while paying a smallish dividend on top of that. "Smallish", in this case, should be seen in terms of the small portion of profits that have been used for dividend payments -- less than 10% in 2022. The dividend yield is far from bad, however, at around 5.2%. Danaos stock, thus offers a very solid yield, but the dividend still seems like an afterthought for the company, as less than one-tenth of the company's profits have been used for dividend payments over the last year.
The vast majority of Danaos' profits and cash flows were diverted towards debt reduction. That does not generate the highest cash-on-cash returns, but still has a couple of benefits:
- A cleaner balance sheet positions Danaos well for a potential downturn in its market. Stomaching a crisis is easier when the balance sheet is strong.
- Paying down debt reduces interest expenses. Debt reduction thus generates cost savings, which positively impacts Danaos' net profits and cash flows, all else equal.
- If the company's enterprise value were to remain unchanged, reducing debt levels does generate equity value. Debt reduction can be seen as a way for the company to shift value from debt holders to equity holders over time. As equity holders, shareholders benefit from that.
Danaos has been very successful in reducing its debt load over time, as we can see in the following chart:
Danaos used to operate with a net debt position of more than $3 billion. But that has declined to less than 10% of the original amount over the last decade, as Danaos' net debt position totaled just $243 million at the end of the fourth quarter (the above YCharts chart runs through Q3).
$243 million in net debt is a pretty low amount, no matter how you want to look at things. Danaos' book equity is $2.56 billion as of the end of the fourth quarter, which means that Danaos operates with a net debt to equity ratio of just below 10%. That's very low, especially for a company with large long-life assets such as Danaos. Another popular way to gauge a company's debt load is the net debt to EBITDA ratio, or leverage ratio. Since Danaos has generated EBITDA of $850 million over the last year, its net debt to EBITDA ratio stands at just 0.29. That is, again, very low, especially when we consider that Danaos has locked in the vast majority of its revenues, profits, and cash flows over the next two years already. Even when we look at net profit, the current net debt position is equal to just 0.34x the profit Danaos earned over the last year. In other words, 4 months' worth of net profits are enough to pay down all of Danaos' remaining net debt.
When we calculate with lower net profits for 2022, per the (possibly too conservative) analyst estimate, the $243 million net debt position as of the end of the fourth quarter is equal to around 6 months' worth of profits. By the end of June, Danaos could thus be free of net debt. If the company sells some assets or if analyst estimates turn out to be too conservative, which wouldn't be very surprising, I believe, then the company's net debt position could decline to zero earlier than that. Since we are already half-way through February, it seems pretty likely that Danaos' net debt will decline to zero over the next couple of months. At that point, Danaos will have to find another use for its cash flows. Like many other investors, I would like to see Danaos pursue buybacks. Due to a very high earnings and free cash flow yield and a pretty low price to book valuation, buybacks should be immensely accretive. In theory, management agrees -- that's why a buyback program has been started in 2022. But so far, the company has not done a lot of buybacks, and it has not really committed to pursue buybacks at a more pronounced pace going forward. Higher dividend payments would be good as well, although dividends can be a less tax-efficient way to return cash to investors relative to buybacks.
There is, however, also the possibility that management does something less appealing with its future cash flow. Some companies have a tendency to chase growth even if it is not the best way to generate shareholder value. It is at least possible that Danaos goes for ship acquisitions or other ways of growing the company, even when acquiring ships would most likely generate a far lower cash-on-cash return relative to buybacks. I believe that the unclear usage of cash flows in the future is one of the reasons why DAC is so inexpensive today -- some market participants seem to fear that Danaos will not do what's best for shareholders.
Takeaway
Operationally and from a valuation perspective, Danaos looks very strong. High profits and cash flows are essentially locked in for the next couple of years, the balance sheet is very strong, and Danaos trades very inexpensively. But until we get a clearer picture about the company's future priorities when it comes to utilizing the massive cash inflows, uncertainty could keep Danaos' shares from rising. I personally am bullish on DAC and own a position, but the uncertainty about future cash allocation policies is a risk factor for sure. If Danaos pursues buybacks aggressively, that could be immensely accretive -- but if the company starts to chase growth, that would be an issue.
For further details see:
Danaos: Massive Profits And A Big Question