Danaos Corporation's (NYSE:DAC) earnings has been distorted since 2008, due to interest rate swaps ("IRS") that the company entered into between 2006 and 2008, with a majority of them having effective dates in late 2008-2010. The 3M USD LIBOR has decreased by more than 500 bps since 2006 (See Exhibit 1), which has led the company to have yearly losses in excess of $100 million on these contracts.
As the IRS start terminating throughout 2014-2016, the company's free cash flow will increase and its EPS will increase by about 150% from 2013 to 2017. (See Exhibit 2)
Exhibit 2 support:
Background and business overview
Danaos Corporation is an international owner of container ships and is chartering its vessels to liner companies. Its customers include the world's leading liner companies. The company's strategy is to charter container ships under multi-year, fixed-rate period charters to a diverse group of liner companies. This makes the company's future cash flow easy to predict, as a majority of its fleet's charter contracts expire after 2020 (See Exhibit 3).
Source: Danaos Corporation Q3 2013 earnings release
The company has financed a great part of its fleet expansion, from 3 multi-purpose vessels in 1987 to 63 vessels as of September 30, 2013, through debt. This led the company's leverage ratio (debt / equity) to reach 8.56 by ultimo fiscal 2012. With the company's fleet renewal program concluded, the company's focus is now on deleveraging. Exhibit 4 shows the projected debt/equity ratio in 2013-2017, the chart is based on Danaos Corporation's debt footnote and the author's estimates.
As Exhibit 4 shows, the company's debt/equity ratio is expected to fall from Q3 2013's level of 6.8 to 2016 by 2016 and 2.2 by 2017, as the termination of the IRS will free more cash flow to the equity holders.
Termination of IRS
As illustrated in Exhibit 1, the company entered into a significant amount of IRS from late 2006 to early 2008, converting floating rate interest rate to fixed interest rate. The IRS was based on the 3M USD LIBOR, which has decreased from the 5.4% level in 2007 to the current 0.25% level. The IRS have effective dates starting from mid-2008 to end-2010 and termination dates from end-2013 to start-2016. See Exhibit 5 for full list of the IRS that the company entered to that converted floating rate to fixed rate.
This essentially means that the company bought at the top, only months before the 3M USD LIBOR started a multi-year decline to all-time lows. This has led the company to have +100 million annual losses on the IRS.
These IRS start terminating from late 2013 and through 2014 and 2015 and one swap contract terminates in 2016.
Given Danaos Corporation's huge backlog, one can fairly easy calculate the forward multiples for the company. Exhibit 6 illustrates the company's forward P/E and P/B multiples based on Friday's closing price of 5.49 and the company's backlog (see Exhibit 7). I have assumed in my model that the company will not be able to re-charter its vessels after contract expiration, for the sake of being conservative. Earnings could be elevated higher than my estimates if the company is able to re-charter its vessels.
As shown in Exhibit 6, the company is trading at a forward P/E multiples for 2015, 2016 and 2017 of 4.53, 3.54 and 3.35, respectively and forward P/B multiples for 2015, 2016 and 2017 of 0.85, 0.69 and 0.57, respectively. This can be compared with a peer group consisting of two other US-listed owners of containerships, Seaspan Corporation (NYSE:SSW) and Costamare Inc. (NYSE:CMRE).
As shown in Exhibit 8, SSW and CMRE both trade at a premium from a P/E perspective to Danaos Corporation, as they are trading at a P/E of 11.02 and 12.92, respectively. Compared with DAC trading at a P/E of 7.4.
This is explained by Danaos Corporation's higher leverage ratio (Net Debt / Equity) compared to SSW and CRME (5.32 compared to 2 and 1.07). With CMRE trading at the highest multiple and having the lowest leverage ratio and having a fleet close to the size of Danos Corporation's.
As Danos Corporation continue its deleveraging over the coming years, it likely to get assigned a higher P/E multiple, compared to its current P/E multiple. As the company's details its debt schedule in its 20-F filing and the company's large backlog, one can with fairly certainty calculate the future leverage ratio of the company. Exhibit 9 is a chart detailing the expected future leverage ratio (Note Exhibit 9 illustrates the projected development in Net Debt / Equity unlike Exhibit 4, which illustrates the projected development in Debt /Equity).
As the company deleverage throughout 2014 to 2017, the market might start assigning the company a higher P/E multiple in 2016 and 2017 if the company manages to deleverage successfully. The restructuring of the company's debt on January 24, 2011 (referred to as the "Bank Agreement", in the company's filings) has introduced new tighter financial covenants, which have made it near impossible for the company, to further expand its fleet before it has deleveraged (see the long-term debt footnote in the company's 20-F filing).
The quarterly mandatory repayments of principal under the Bank Agreement is specified and in addition to the specified mandatory repayments the company shall make an additional variable payment defined as:
"Furthermore, an additional variable payment in such amount that, together with the fixed principal payment (as disclosed above), equals 92.5% of Actual Free Cash Flow for such quarter until the earlier of (X) the date on which the company's consolidated net leverage is below 6:1 and (Y) May 15, 2015; and thereafter through maturity, which will be December 31, 2018 for each covered credit facility, it will be required to make fixed quarterly principal payments in fixed amounts as specified in the Bank Agreement and described above plus an additional payment in such amount that, together with the fixed principal payment, equals 89.5% of Actual Free Cash Flow for such quarter."
This makes us fairly certain that the company will deleverage. If the company successfully manages to honor the Bank Agreement, the company's leverage ratio will decrease to 2.18 by ultimo 2016, which is close to the current leverage ratio of SSW. Say the company gets assigned the same LFY P/E multiple as SSW's current of 11.02, the company could be trading at $19.56 per share at ultimo 2016 to early 2017 or a 46.04% IRR over the next three years from Wednesday's close.
The restrictive nature of the Bank Agreement limits the company's ability to expand capacity until the termination of the Bank Agreement on December 31, 2018. This will not materially affect the company's competitive position, as the company concluded a newbuilding program in 2012, which has resulted in a relatively young fleet, with a majority of the company's ships being built in 2010-2012. The company's TEU weighted age of its fleet is 5.86 years and the company's implied age from the depreciation schedule is 3.87 years. The average useful life of a container ship is 27-30 years. Taken this and the company's long standing relationship with its customer's (the world's leading line companies) into account, the capacity expansion restriction, will most likely not affect the company's competitive position negatively.
Why investors haven't given it a closer look
Imagine if the headline of this article was:
"Illiquid, Highly Leveraged Greek Container Shipping Stock"
You would probably have thought this article detailed a short thesis, but it doesn't.
Illiquid: The average daily volume of the stock for the preceding 3 months ("V3M") was 27,481 as of January 3, 2013. This doesn't pass the liquidity screen criteria for most investors. The stock has although experienced unusual large trading volumes January the 2nd and 3rd, with daily trading volumes of 411,730 and 152,258, respectively, or 15x and 5.5x times the V3M.
Highly Leveraged: As described above, the company's leverage ratio as of fiscal Q3 2013 was 5.32, which is higher than its peers. But this should decrease over the coming years.
Greek: The corporate HQ is located in Greece, while the company has crewing office in multiple other jurisdictions. The company is incorporated on the Marshall Islands, due to its favorable corporate terms to owners of ships. It doesn't even matter that its Greek as the company derives revenue from all over the world from its fleet. Its exposure to the Greek economy is limited, as Greece's impact on worldwide container shipping is limited.
Shipping: Due to the reduction in worldwide demand for products in general following the financial crisis, the demand for shipping decreased, which has pressured freight rates and charter rates. This combined with an order boom, due to the decreased price of ships have led to oversupply in the container shipping industry. As Danaos' charter agreements are longer term, its exposure to the short-term development in charter rates is limited. The liner companies have begun to manage the oversupply of ships, with among other initiatives the P3 network. However, the medium- and long-term outlook is still positive among a number of the world's leading container shipping analysts.
Many institutional long-only investors have a $5 minimum threshold on stocks that they are allowed to invest in, which is another reason behind investors not being able to invest. The following chart show the development in the stock price of DAC.
As shown in the chart above the stock closed for the first years in multiple years above $5 January 2, where it closed at $5.08. The shares have increased in price from $5.08 to $6.28 in the subsequent days. The company has a strong coverage of sell side analysts. The following analysts regular ask questions at the company's earnings conference calls:
- Omar Nokta - Global Hunter Securities LLC
- Gregory Lewis - Credit Suisse
- Urs Dur - Clarksons Capital Markets
- Amit Solomon - Neuberger Berman
- Mark Suarez - Euro Pacific Capital Markets
The rise following the close above the $5-mark might have been due to anticipation of institutional buying or institutional buying. No news about the company has been released in the period.
My thesis is dependent on the 3M USD LIBOR not rising to its historical higher level, as this would offset the cash flow the company would free as its IRS terminate. With the Fed's current historically accommodative monetary policy I assess the risk of such a rise in the 3M USD LIBOR as unlikely in the medium term.
The thesis is also reliant on the company being able to successfully realize its backlog, which it has done successfully since its establishment in 1972.
Danaos Corporation's earnings have been lagging for the last couple of years, mainly due to the interest rate swaps on its books. As the swaps terminate, the company will increase earnings and cash flow. The increased cash flow are planned to be used to deleverage the company, which are likely to earn the company a higher P/E multiple, together with increased earnings this have the potential of providing shareholders a 46.04% IRR to ultimo 2016. With the shares trading at a P/B of 1.2 as of Wednesday's close, the downside is rather limited.
Disclosure: I am long DAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.