How To Turn Big Losses For Oil Companies Into Huge Profits For Yourself

• The dramatic plunge in oil prices over the past few months has produced huge losses for some investors in the sector.
• As often happens in investing, a bad market in one sector can create opportunities in another.
• A way to take advantage of the increase in discretionary income that low energy prices will hand to consumers.

The oil industry’s dark cloud does have a silver lining

The recent collapse in oil prices has created a flood of losses for investors in the energy sector as shareholders have sold stock in massive amounts due to uncertainty over how low oil prices could go and at what levels the oil producers can profitably extract oil from the ground. The recent decision by OPEC to maintain current production levels in spite of lower prices caused an immediate reaction in the energy markets and oil prices fell further.

However there are plenty of consumers and industries that will benefit from lower oil prices. The shipping industry is actually in a position to benefit not only from the lower fuel prices they are now enjoying but also from the additional discretionary income that consumers will now have in their pockets as a result of lower gas prices.

When consumers pay less for their gasoline, not only do they have more money in their pockets, they feel better about their economic circumstances and when they feel better about their economic circumstances and have more money in their pockets after covering necessary expenses, they tend to spend more money. If consumers are spending more money, suppliers need more products to sell and those products have to be delivered. In our global economy, we all know that a huge portion of what we buy travels to us from their overseas points of manufacture by ships.

It stands to reason if more products are being shipped to U.S. consumers from overseas points of origin, revenues of shipping businesses will rise. One of the largest costs faced by overseas shipping companies is the price of fuel. These costs are estimated to equal between 40% and 60% of the total cost of ocean freight. Imagine the double impact of increased demand for a business’ service at the same time it experiences a decrease of 30%, $100/bbl. to $70/bbl., in its largest operating expense item! At a mid-point of 50% of operating costs, this 30% fall in oil prices could add 15% to the net earnings of an ocean freight company. Best of all, this figure does not even consider the increased demand for their services due to rising consumer spending.

Moving from broad opportunity to specific choice

Identifying a broad opportunity and the catalysts that can ignite it are nice first steps, but it does little in the way of effectively allocating capital. How do we go from an attractive opportunity in a broad industry to a specific investment that will put profits in our pockets? We consider what business in the particular industry is positioned to realize a higher share of the overall benefits to be derived from the situation that has been identified. While it does not always hold true, there are times when the old adage, “Bigger is better,” does apply.

In this particular case, the larger the shipping company, the better positioned we can expect them to be when it comes time to negotiate fuel prices. Common sense and our own personal experiences should tell us that quantity discounts always apply. In the marine industry, where the average market capitalization of the businesses is $278.55 million, today’s pick, Danaos Corp. (DAC, Financial), is over 230% larger at $645.95 million.

Market capitalization is one gauge of size, but when it comes to fuel savings, we are really much more interested in the number and size of the ships Danaos operates. They own 54 container ships designed to haul standard 22’ stackable containers that can be hauled on land interchangeably by rail or truck. These 54 vessels give Danaos the capacity to haul 321, 435 TEU’s (22 foot equivalent units) of freight. Big customers like to deal with large suppliers who will have the capacity to deliver services when they are needed. The size of Danaos’ fleet gives the big users that assurance and Danaos a big advantage over small competitors. “If you have favored us with a large portion of your business, we have the size that will allow us to be there when the little guys can’t deliver. We take care of our customers who take care of us.” Don’t think these conversations don’t happen in all industries; I have sat on both sides of that table during those conversations, and it is simply the way business gets done. Size matters and businesses take care of customers and suppliers who take care of them.

No investment is worth making if the price is not right

Finding great opportunities with a catalyst is wonderful. Finding a good vehicle through which to allocate our capital in those opportunities is even better. But we must also be sure that we always enter new positions at the proper price level as that will ultimately determine our profits when subtracted from our selling price. Therefore, it is crucial to successful investing to make sure we are not overpaying for our new positions so we maximize our upside potential while achieving the lowest downside risk possible.

In industries where I lack actual direct experience in sales and acquisitions, I like to use comparisons of the business I am attempting to value to its overall industry. In the case of Danaos, it seems to stack up quite well.

TTM= Trailing Twelve Months

On a price to cash flow basis, not only is Danaos dirt cheap for any business, it is trading at only 40% of the average for the marine industry. Just to trade on par with its industry average in terms of cash flow, it would have to rise 250% from its current price.

In terms of price-to-sales and price-to-book ratios, Danaos’ share price would have to rise by 105% or 60% respectively to trade on par with the overall marine industry valuation. When you compare these industry average valuations to the broader market the industry as a whole is actually quite reasonably valued. When we find an industry with an overall reasonable valuation and one of the larger participants that is undervalued to the industry average, it should garner our attention and further due diligence.

The three analysts providing earnings estimates on Danaos for the year ending in December 2014 have an average estimate of $0.48/share for the company with a range of $0.46 to $0.51. Based on the $5.89/share price as of December 5, the $0.48/share consensus produces a P/E ratio of a very modest 12.27. If we look forward to next year’s expectations from the 4 analysts providing projections, the estimates range from a low of $0.72 to a high of $1.10 and an average of $0.92. Even using the low estimate of $0.72, our P/E ratio for next year would fall to 8.18 and if the average estimate of $0.92 is correct the P/E crumbles to 6.4.

Comparing a stock’s current valuation to its historic valuation is another excellent methodology to determine the current relative and future value. The table below provides some interesting insight as to the value we should expect from the shares based on the historic norms.

As you can see, in the coming 12 months, if Danaos simply trades at a P/E equal to its historic mean of 12.106 times earnings, the share price would need to rise to $10.80/share; representing an increase of 83% from the current level. If it were to happen to reach its all-time high P/E ratio of 38.25 times next year’s earnings, the share price would explode by 577% to $34. I am certainly not projecting an increase of almost 600% in the Danaos share price, but this calculation does illustrate just how cheaply Danaos is currently valued relative to how it has been valued historically and at its all-time peak.

This stock is currently cheaply valued compared to the overall market, its own industry and even its own historic value.

I almost never make my final investment decisions based upon research reports prepared by or recommendations from stock analysts because, overall, these people earn their living telling me why I should buy a particular stock and I maximize my returns by finding reasons not to buy a particular stock and only opening a position when my efforts in that regard are less than successful. Simply because I do not tend to base my final decisions on the opinions of analysts does not mean I do not read them. I do. But I only read the reports available to me that are produced by analysts with a StraMine Relative Accuracy Score of 70 or greater.

Starmine is a division of Thompson Reuters and focuses mostly on quantitative factor models for institutional investors. Their analyst ratings are based upon a measure of the relative historical accuracy of the firm’s published opions in the stock’s sector among its peers over the past 24 months. In simple terms it means that their rating of investment firm’s analysis is based upon how well their previous recommendations within a particular industry sector in the past two have performed.

Of the reports on Danaos to which I have access, only three of the firms producing the research had a StarMine rating of 70 or greater. Columbine Capital (72), Ford Equity Research (92) and Jefferson Research (70) are those three firms. Columbine Capital and Jefferson Research both rate Danaos a buy and Ford Equity Research has just released a new analysis dated December 5, 2014 that reiterates their strong buy rating. In addition to my own analysis, of the stock, we have the added support of three prominent firms with a track record of success in analyzing this particular industry. I don’t need outside reinforcement for my ideas but it doesn’t hurt my feelings any to get some from credible sources.

We now know why, but we still need to know: Why now?

We have now seen how the shipping industry will profit from the dual benefits of more discretionary income in the pockets of consumers and lower fuel costs for their fleet due to falling oil prices. We also have examined the size of Danaos compared to the industry average and the advantages that gives them in negotiating with both their suppliers and their customers. We have even examined the current price in relation to its industry and its own historic valuation levels. So we know why; we just need to understand why now. After all, even a great business can trade at a depressed valuation much longer than the patience of most investors so we need to understand why we would allocate our valuable capital at this time to an industry that has been in a slump since mid-2007.

In simple terms, the reason we need to buy now is that Danaos in currently operating in the first quarter where the results of the current falling oil prices will begin to show up on the company’s bottom line results. While the fourth quarter impact of this will have a limited effect on the 2014 results, the affects will be felt throughout the entire 2015 fiscal year. The improved operating results I expect for the fourth quarter of 2014 will simply draw the attention of investors and then the continued improvements throughout 2015 will begin to attract more and more investment and the momentum built on improving earnings will begin to feed upon itself.

The timing of these catalysts and improving earnings momentum make December the perfect time for new investors to open positions in this business prior any preliminary releases related to fourth quarter results or expecations.

Final thoughts and actionable conclusions

Danaos is an out-of-favor business in an out-of-favor industry. The high energy prices and low levels of consumer discretionary spending that have constrained earnings and stock prices in this industry for the past several years are rapidly beginning to dissipate and investors have an opportunity today to acquire new positions before the broader market sees the coming improvement that should begin to be revealed when Danaos reports its final operating results for 2014 and the improved fourth quarter operational performance becomes public knowledge.

New positions opened below $6/share now should expect to see a minimum return of 67% over the next 12 to 18 months and as much as several hundred percent if oil prices stay depressed for the next two years.