Summary
- In this article, I analyze the behavior of cyclical stocks using the example of Danaos Corp.
- Danaos stock priced-in too much of cycle reversal fears, in my opinion.
- We do not see a gap-up in the company's valuation even after a couple of years.
- Expansion of DAC's buyback program may lead to increased demand and limited supply of the stock, boosting the stock price.
- I recommend investors take another closer look at Danaos, as the almost guaranteed potential of FCF generation does not match with how the market currently prices the stock.
Almost 2 months have passed since my last bullish investment thesis on Danaos Corp. ( DAC ), during which time the stock has risen +16.85% (the S&P 500 Index is up +4.72%). The momentum the company deserves based on its huge contracted revenues and its approach to debt reduction and shareholder returns was finally starting to show. In today's article, I again urge you to pay attention to the company ahead of the upcoming reporting day as what the market expects from the company today does not match with how it is valued, in my opinion. I believe DAC's valuation is overly discounted, even taking into account the cyclical nature of the industry in which the company operates.
My Reasoning
I do not want to describe at length what you read in other articles on Seeking Alpha or elsewhere. Fundamentally, my argument would hardly differ from what I wrote about 2 months ago - since the release of the Q3 FY2022 quarterly report, there has been no significant news that has not already been covered on Seeking Alpha.
Instead, today, I want to talk about the specificity of business cycles and how they theoretically affect the valuation of cycle-sensitive firms. Let's open Damodaran's and McKinsey's valuation books to understand these companies better.
Valuing cyclical and commodity companies can be uncertain and unpredictable since they have volatile earnings and cash flows, as the value depends on where the current fiscal year falls in the cycle. Therefore, the stock prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies. From a chart I found in a McKinsey study (below), stock prices of such companies tend to follow EPS numbers ahead of time - the prices react a few months before the cycle turns, regardless of its way:
However, peak EPS and peak stock price coincide - stock price takes the leading role once the fact of peak EPS becomes visible to the general market. This happened with Danaos - its stock price rose sharply before the Q4 FY2021 report and then stabilized slightly; already after the Q1 FY2022 peak report [EPS of $11.36, +301.41% YoY] DAC started to decline sharply in just a couple of weeks and only found the bottom half a year later.
What drove the market toward the "end of the cycle" feeling? The increase in the HARPEX index - which reflects the worldwide price development on the charter market for container ships - seemed too overheated at the time.
World trade began to actively normalize after the pandemic bottlenecks in logistics - at some point the fall of the index became inevitable, and it fell more than fourfold in just a few months.
As a rule - Damodaran mentions this - cyclical companies start to borrow heavily at the end of their industry's cycle, which leads to lower EPS and FCFs. In anticipation of this situation, investors try to get out of their once-profitable positions as early as possible, without waiting for this to happen. Consequently, increased equity volatility arises. That is why those trailing twelve-month valuation multiples ((TTM)) of 0.5-2x that we see everywhere are meaningless - we have to look at the future EPS forecasts and the implied forward multiples while assessing cyclical stocks.
All the attributes described above, which were clearly brought to bear in relation to Danaos in the recent past, are too much overrated, in my view.
First off , the HARPEX index (indicator of future earning power) seems to have essentially bottomed out - last week it fell only 0.28% week-over-week, whereas 1-2 months ago it could easily fall 5-10% WoW.
Second , HARPEX is not currently the most critical indicator for Danaos. For example, in Q3 of fiscal 2022 , the company signed a whole new set of contracts that will run through the end of 2023 and even a few years beyond. In total, 88% of the fleet is already contracted for the entire FY2023, and at pretty high rates.
DAC's IR website, Q3 FY2022 results
The third point is that Danaos actively gets rid of its debts and does not accumulate them, as at the end of the cycle.
$382.5 million Revolving Credit Facility expected to be put in place within Q4 2022 will further reduce debt, to extent not drawn down to repay existing facility, and provide additional flexibility on capital allocation strategy.
Source: From DAC's presentation (Q3 2022)
This brings us to the last point, which shows how far the stock's price action has moved away from reality - the consensus earnings forecasts:
Seeking Alpha, DAC's Earnings Estimates
We do not see a gap-up in the company's valuation even after a couple of years - usually, the decline in EPS at the end of the cycle leads to a sharp increase in the multiples. Danaos, on the other hand, has a discounted valuation despite all of its free cash flow being virtually guaranteed - against the backdrop of falling EPS forecasts, DAC estimates have been rising for 3 months, which confirms my statement.
Seeking Alpha, DAC's Earnings Revisions
I suspect if the company expands the existing buyback program after bringing net debt to a reasonable level relative to EBITDA, the stock price will be in a situation where supply becomes limited and demand increases because everyone wants an income-generating asset.
Conclusion
I believe the company's valuation now diverges sharply from the industry cycle forecast for the next few years - this creates a fundamentally bullish setup for Danaos stock to recover.
Of course, there are some risks to consider. For example, the company operates in a fairly competitive market - with many well-established companies vying for market share, Danaos Corporation is facing increasing competition from both established companies and new entrants. ?I could also be wrong about the future prospects of the industry itself - perhaps the current EPS forecasts for Danaos are too exaggerated.
Despite the risks described above, I recommend investors take another closer look at Danaos, as the almost guaranteed potential of FCF generation does not match with how the market currently prices the stock.
For further details see:
Danaos: Off-Cycle Logic Brings Opportunity