Danaos And Global Ship Lease: High Conviction Longs, 1-Year Review

Danaos and Global Ship Lease: 1-Year Review

Last September, I wrote a public report calling Danaos Corporation (NYSE:DAC) and Global Ship Lease, Inc. (NYSE:GSL) "the strongest conviction buy of my career" based on a phenomenal risk/reward value proposition. I put my money where my mouth was, and these positions made up about 20% of my personal portfolio at that time. Over the past year, both positions have performed decently and have also outperformed the Russell 2000 (RTY); however, I am very disappointed with the overall level of total return.

Both Stocks Outperformed, But Not By Much...

On a one-year return basis, from 7 September 2022 through 6 September 2023, Danaos Corp returned 6.7% ($63.33 to $64.59 + $3.00 in dividends) and Global Ship Lease returned 9.3% ($17.97 to $18.15 + $1.50 in dividends). This is an average return of 8.0%, which compares to the Russell 2000 return of 2.3%. The average return of these positions was roughly equivalent to the S&P 500 (SP500), which returned about 10%.

Our long-only models have returned 39.6% in YTD 2023 alone, so clearly both positions were a drag on both my personal performance and the VIE models. Both positions are still significant for me, and make up about 12% of my current allocations.

What Went Wrong? What Went Well? Current Valuations?

The rest of this report will update my current valuation framework for both of these firms and review the previous thesis alongside a current assessment of ongoing market dynamics. I will begin with a general company overview for those who might be newer to the sector.

Business Overview

Danaos Corp. and Global Ship Lease are very similar businesses with the same general model as "containership lessors" or "tonnage providers." These firms own and operate the specialized vessels, which are designed to carry 20' and 40' container boxes and serve as the backbone for global trade. It is important to note that these firms are primarily owners and operators and they do not handle the point-to-point logistics or have direct exposure to shipping freight rates.

DAC and GSL lease all of their ships out to major global liner companies like Maersk, Hapag-Lloyd, CMA CGM, and ZIM Integrated Shipping (ZIM). The rates and terms they can secure depend solely on the supply/demand balance for the vessels themselves. During stronger market conditions, these lease durations can range from 3-years to well over 5-years. The underlying freight market rates (i.e., shipping costs) clearly factor into counterparty profits and overall counterparty credit risk over time, but DAC and GSL are otherwise isolated from the volatile freight markets. Therefore, while freight rates have tumbled over the past year, both DAC and GSL are on track to produce all-time record cash flows and earnings in 2023 and overall free cash flow might be even higher in 2024 due to lower debt levels and associated interest costs.

Danaos Corp. controls a fleet of 78 vessels (including ten newbuilds due between 2024 and 2026) and has approximately 19.7M shares outstanding for a market cap of roughly $1.27B with a current dividend yield of 4.7%. GSL controls a fleet of 70 vessels and has approximately 35.2M shares outstanding for a market cap of about $630M with a current dividend yield of 8.4%. Both firms have active repurchase programs.

Current Valuations: Record Low Levels

I have personally followed both of these firms for more than a decade and across a variety of market conditions. Similar to last year, the current enterprise valuation levels (vs. EBITDA, cash flow, earnings, or fleet valuations) are at the lowest point either of these firms have traded in their entire history (even lower than last year) while the balance sheets have never been stronger and contract backlog remains incredibly high. On a valuation basis, both companies are even cheaper today than they were last year even as balance sheets have improved and the revenue backlog remains formidable.

This valuation setup is only possible due to horrendous sentiment, investor misconceptions, and some questionable capital allocation (specifically at DAC). Both firms continue to carry an enterprise value (net debt + market cap of equity) which is below their secured EBITDA + fleet demolition value alone, which means the market is valuing the entire residual value of their fleet at below zero.

At this juncture, after increasing the discount value for contract EBITDA, utilizing a semi-bearish demolition rate estimate, and adding a management/capital allocation discount for DAC, I arrive at a 'fair value estimate' of $95/sh for DAC and $30/sh for GSL.

Review Since Last Year

The next portion of this report will go essentially section-by-section from last year's report and address developments over the past year along with current market conditions and overall valuations.

I urged folks last September to "hold me accountable," so of course, I must do the same for myself. Specifically (direct quotes):

These are among the best risk/reward setups I have seen in my career. If you do nothing else today, please set a one-year calendar reminder with: "J Mintzmyer: GSL $18, DAC $65." I am willing to stake a portion of my portfolio and my reputation as an investor and industry expert on the setup with these two firms. Regardless of how the markets pan out, I encourage everyone to hold me accountable and check back in a year to see how things pan out.

As I noted above, the performance over one year was an average total return of 8.0%. This was a positive return and it beat the Russell 2000 (small cap average) by around 6%, but it's clearly not the level of total return I had been hoping for. Although it may provide little comfort, I was heavily invested in these firms (and remain heavily invested), so I am right there with everyone else in terms of frustration with market results so far.

Shift in Enterprise Values Since Last Year

Last year, I illustrated how the plunging net debt and heavy free cash flow generation masked the valuation of these firms. Specifically, I argued:

Since net debt has come down significantly while assets and contract backlogs have surged, both Danaos Corp. and Global Ship Lease are significantly cheaper today at $65 and $18 than they were in 2020 at $6 and $5.

Keep in mind that both firms now have far larger fleets, their balance sheets are night-and-day, and contract backlogs are now the largest in company history. I have never seen a valuation discrepancy like this where a company goes through such a massive transformation and yet overall enterprise value goes down!

Once again, we have a situation where assets are improved (DAC has added 4 newbuilds, 5 dry bulk vessels, and a 15% stake in Eagle Bulk (EGLE); GSL has added 4 secondhand vessels), balance sheets are even stronger, yet share prices haven't meaningfully improved for either firm. Due to the significant y/y improvement in balance sheets, both firms are even cheaper in September 2023 than they were in September 2022.

This is a good reminder that cheap can always get cheaper. Without a catalyst or a significant shift to direct shareholder returns (heavy repurchases, special dividends, etc.), even well-managed cheap firms can remain cheap for a long time. In the case of both DAC and GSL, I was wrong when I expected both firms to raise their dividends in early-2023. Instead both firms kept their dividends stable and conducted a moderate amount of repurchases.

Although I cannot find any fault in capital allocation at GSL (which is part of the reason for their more generous 'fair value estimate' at this juncture), I have loudly critiqued DAC's decision to invest into dry bulk company stock via Eagle Bulk and by purchasing secondhand Capesize dry bulk vessels. In fact, were it not for DAC's questionable foray (some might say diworsification) into dry bulk, I would be targeting a "fair value" of around $130/sh at this juncture instead of $95/sh (20%+ additional discount).

Lease Contracts: Strong and Stable as Argued

Last year, I highlighted the common misconception that lease contracts are at high risk of being "renegotiated" if markets weaken.

These vessel lease contracts are extremely strong and have been tested in the past; there is essentially no way for terms to change unless the counterparty goes bankrupt or both parties enter mutual negotiations around a major financial restructuring. This model has been stress-tested twice in recent decades when freight markets have struggled: immediately following the 2008-2009 global financial crisis and again during the multi-year freight market downturn from 2012-2018. With limited exceptions for bankruptcy (Hanjin, ZIM) or restructuring (HMM), these contracts were honored during both periods with no shenanigans.

A year later, the evidence still strongly supports this viewpoint. We have seen zero disputes from any major liner companies and there have been only a tiny handful of vessels which have had contract issues. All of those (just 3 total vessels out of 500+ we track) were signed with extremely sketchy counterparties which have since went bankrupt. On the contrary, we have seen a couple small years where shipping firms have paid premium prices to shorten contracts with owners, including a few conducted with Zim Integrated Shipping and a few with Pasha and Costco (COST).

There is zero precedent for liners renegotiating rates just because market conditions have changed or liners "don't like" paying high lease rates.

Once again, there is still zero precedent. Obviously counterparty financial strength is a factor (as in any business in the world), but the contracts themselves are rock solid. With DAC and GSL trading below contract EBITDA and fleet demolition values, clearly the market doesn't believe this...

Current Rates Are Still Relatively Strong

As I mentioned last year, the market balance for the vessels themselves appears likely to remain tight through at least mid-2023:

Despite weakening freight markets and horrendous macro sentiment, the market balance for vessels remains extremely tight and is expected to be tight through at least mid-2023. The orderbook is elevated (roughly 30%), but the deliveries are weighted mid-2023 onwards.

Even today, as we are now past "mid-2023," the contract rates for new one-year charters remain significantly above EBITDA breakeven levels and are roughly 2x the level of pre-COVID rates. The below chart shows the one-year time charter rates for three midsized vessel types, obviously rates are significantly below the cycle highs, but are otherwise healthy and have been generally stable for almost all of 2023.

Although the charter rate decline was a little more sudden (I would have guessed December 2022 or January 2023) and violent (75%+ drops as opposed to a smooth decline), today's rates are actually stronger than I would have expected a year ago. I expected that new rates signed by late-2023 would barely be EBITDA breakeven at-best, and yet we are still seeing firms sign exceptional extensions.

Just within the past couple months, Danaos Corp extended three of their 13k TEU vessels for 3-years (mid-2024 thru mid-2027) at an eye-popping rate of $54,000/day! This is wildly above what I expected them to achieve. Meanwhile, midsize vessels are generally being extended for about one year, in-line with the index rates posted above (roughly $16-$25kpd depending on size and specs).

Environmental Regulations: Ongoing + Upcoming

As noted last year, although the orderbook (i.e., future supply) remains large at roughly 29%, there are significant upcoming environmental regulations which are likely to slow the global fleet and could synthetically reduce supply by up to 20% by the end of 2027.

the industry is facing the largest environmental regulation in history: EEXI and EEDI, which will phase in from 2023-2027. This regulation will require older ships to significantly slow down, which will create a bifurcated market between legacy tonnage and modern eco-design vessels (2014 or newer) while also reducing available supply capacity (ships x speed) by up to 20% over the next five years.

2023 is the initial phase-in year of these restrictions, which includes the carbon intensity index ("CII") measurement. No penalties are enforced this first year, so outside of setting a favorable baseline, there is little incentive to slow down yet. Starting in 2024 and in subsequent years (the standards increase each year), we should expect to see lower vessel speeds. I still expect the equivalent of about a 20% supply reduction by the end of 2027.

A new containership ordered today is likely due for delivery between mid-2026 and mid-2027. Therefore at a 29% orderbook, even if we see another set of orders over the next 6-12 months, we are looking at net supply growth of around 9-15% over the next four years. Hardly the 'massive supply explosion' most bears are expecting. Demolitions of obsolete tonnage between 2024-2026 alone should balance the market by the mid-2020s and if we do not face a major global recession there could even be a shortage of compliant small-size and mid-size tonnage (under 10k TEU) by 2025-2026, as highlighted in a recent presentation by Global Ship Lease.

Reviewing the Risk/Reward Framework

Last year, I spoke extensively about our 'risk/reward framework' at VIE and some high-level points are worth reviewing:

When I discuss this [risk/reward] concept, I am referring to the potential gains or losses across a variety of market scenarios. My typical target holding period in shipping is 12-24 months, but sometimes we get really lucky and an investment turns into a 'trade.'

As any seasoned investor knows, not everything goes according to plan with investing or trading. There can be bearish market and macro outcomes, which drag realistic value well below the initial base case. There can also be bullish outcomes, which shoot value far higher than initially expecting (e.g. ZIM in 2021 or STNG this year). Since I am certainly not infallible and I am prone to make mistakes judging future market conditions, the 'secret' to our massively outsized success over the years has been achieved by allocating to stocks with excellent risk/reward.

These are positions where even if I am totally wrong and/or everything goes against us, the losses will be minimal. At the same time, the base case has significant upside, and any potential bullish surprise leads to enormous gains. If you invest with great risk/reward, you only have to hit big winners a limited amount of time (i.e. 1 out of 5 or even 1 out of 10 times). This is because you never really lose much with the 'bad' ones while the base case also provides strong average returns.

Both DAC and GSL fit this framework perfectly last year and they continue to do so this year. The operational and capital allocation outcomes were primarily in-line with the "base case" whereas the market reaction was certainly bearish throughout much of the period. Despite this base-to-bear skew, both positions have provided positive y/y returns and the "coiled spring" of deep value is even tighter today than a year ago.

That said, I was clearly far too optimistic in my estimates of how the market would potentially react to strong operating results and surging free cash flows. Despite these strong outcomes (and zero counterparty issues), the market has continued to shrug off both of these firms. Overall I was clearly far too optimistic and rosy-eyed and this serves as a lesson learned to deliberately sandbag my future 'bull case' and 'base case' scenarios.

Overall Lessons Learned

To conclude, although both stocks ended up slightly positive and the validity of the "risk/reward framework" appears intact, I was clearly far too bullish or "rosy-eyed" in my assessment of these stocks last year. This leads to three core lessons learned for me to consider as well as for other investors and consumers of our research products:

1. The market might continue to ignore exceptional value

Just because I (or we) can understand the attractiveness of a high-value or strong risk/reward investment doesn't mean that 'the market' will come around in a timely manner. I primarily aim for 12-24 month time horizons with my investments and last year's report clearly reflected a bit of hubris as I expected the market to come around to 'my view' within a shorter duration.

There is still no guarantee that the market will come around to a stronger valuation of these firms even within the next 12 months (24 months total). I believe the odds are in our favor, but there's always the possibility that dead money will continue to be dead money. Without a clear catalyst, things can trade sideways for a long time... which leads to the next point:

2. Time value of money: higher discount rates are required

A 20% return in six months is worth significantly more than a 20% return in 18 months. In the same framework, "dead money" or even a "slightly profitable" investment over the course of 12 months is a painful situation for investors in a bullish market. Although the Russell 2000 only produced about a 2% return y/y, the broader S&P 500 returned closer to 10%. An investor could have secured a slightly stronger return with a lazy buy of the S&P 500 ETF (SPY) or perhaps an even stronger return in a growth sector like big tech.

If there isn't a clear catalyst beyond "one day the market will wake up to this extreme value dislocation," and there is a very reasonable chance of dead money for a couple years, then a much higher discount rate must be applied to all scenarios, especially the base and bull cases. If I had applied these higher discounts last year, I would have still been very bullish on both DAC and GSL, but my rhetoric would have been more muted and my convictions would have been more reasonable.

3. Management's capital allocation is always a wild card

Ultimately, an investment requires at least decent faith in logical and fair capital allocation by the management teams. I mentioned that a key issue with both of these firms is a clear lack of trust by the market. In the case of Global Ship Lease, capital allocation over the past twelve months has been nearly-perfect; however, their decision to not raise the dividend meaningfully in early-2023 (even though they could easily afford it) clearly blunted momentum and led to continued lack of faith from the market.

On the other hand, Danaos Corp has done a lot of things correctly (repaid all high cost debt, focused on high quality assets, steadily repurchased shares), but also conducted several questionable purchases by diversifying (perhaps "diworsifying"?) into the dry bulk sector. Danaos also failed to raise their dividend despite having ample cash flows and long-term sustainability to easily fund a 50%+ raise. Although the investments into the dry bulk sector, via a large stake in Eagle Bulk and with the investment into five secondhand Capesize vessels, might be logical to the management team, this has only further confused investors and it is less efficient than just sticking to share repurchases against the core fleet and business model of containerships.

When making an investment into a vehicle where the management team has not clearly laid out their capital allocation priorities, it is important to add discount factors, and to increase those discounts if management does not seem to be acting logically or fairly to all shareholders. In the case of GSL, I would grade their capital allocation an "A-", so no further discount is required; however, I would grade DAC a "C", therefore warranting a much higher discount factor to the underlying value estimates.

A more proper weighting of these risks and discount factors would have also led to a more balanced report and more reasonable valuation estimates in last year's report.

Updated Value Estimates: DAC- $95.00, GSL- $30

Our current "fair value estimate" at Value Investor's Edge is $30/sh for Global Ship Lease, which implies roughly 67% upside. Our "fair value estimate" for Danaos Corp (DAC) is $95/sh, which implies about 48% upside. This is a slightly lower valuation estimate from last year as I have increased EBITDA discounts, more heavily weighted challenging market scenarios, and added an additional management discount for DAC due to sub-par capital allocation over the past year.

I still believe both firms are incredibly attractive at this point and the bulk of the original bullish thesis still holds (albeit not the overly bullish valuation targets); however, I am disappointed in my strong rhetoric and over-conviction levels. It is important for investors to continually re-examine their thesis and conviction and to hold ourselves accountable for the cases in which we have been more wrong than right.

Thank you to everyone for reading and following these names and I look forward to engaging commentary below!

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