Investors have endured mixed results for shipping stocks so far in 2018. Some industry leaders (Seaspan, Kirby, and Matson) are up by double digits, while others (Frontline, Teekay, and Nordic American Tankers) are lagging even the mediocre returns of the S&P 500. None of these stocks has beaten the index in the last five years, and only two (Kirby and Matson) have posted positive returns in that span. Then again, maybe that just makes the shipping industry a prime source for stocks with epic turnaround potential.

I think that's an idea worth exploring, although somewhat surprisingly, I think the best stock to buy is also one of the year's worst performers. While analysts have a legitimate concern regarding the company's niche, I think the business still has plenty left in the tank for long-term investors. Here's why now is the time to buy shipping container leasing company Textainer Group Holdings (NYSE:TGH), and what has Wall Street worried.

Two ships on the water.

Image source: Getty Images.

By the numbers

While the stock is down nearly 20% year to date, it did deliver an astonishing 188% gain in 2017. That meteoric rise made it easy for Wall Street to head for the exits in mid-February when Textainer Group Holdings announced full-year 2017 earnings. The company reported an unexpected rise in operating expenses in the final quarter of last year, which ended a streak of consecutive quarters in which operating margin had grown.

That sounds potentially worrisome, but operating margin went from 35.8% in the third quarter of 2017 to 35% in the very next quarter -- not exactly noteworthy. It seemed like a harsh overreaction at the time, and recently announced first-quarter 2018 results only make the knee-jerk reaction look even sillier now. 

Metric

Q1 2018

Q1 2017

Change (YOY)

Revenue

$133.2 million

$116.7 million

14.1%

Operating income

$48.6 million

$20.0 million

143%

Operating margin

36.5%

17.2%

112%

Net income

$18.7 million

($6.9 million

N/A

Cash flow from operations

$65.1 million

$46.7 million

39.4%

Data source: First-quarter 2018 press release. YOY = year over year.

Profit margin and cash flow are up due to continued strong pricing throughout the shipping container industry, as evidenced by the dramatic mismatch in revenue and operating income gains. All the more impressive is the fact that the first quarter of each year is typically the weakest for the industry.

The stock price may not indicate it, but Textainer Group Holdings continues to expect a strong 2018 as the business rides tailwinds on the way to approaching historical levels of operating efficiency. One metric that demonstrates management's bullish outlook: The company ordered or received $428 million in new shipping containers through the first four months of 2018. Most are already entered into long-term leasing agreements at prices well above the current fleet average. 

Yet while the company thinks adding to the fleet is necessary to keep pace with strong demand, Wall Street isn't convinced it's going to end well.

What has Wall Street worried

The shipping industry finds itself in its current state of malaise due to its downright awful ability to manage supply and demand. In the last boom cycle (as in many before it), shipbuilders ordered new vessels to be constructed by the dozen. But since shipping vessels take years to build, these orders can't respond to short-term market conditions. That means the industry has been forced to put just-completed vessels (ordered years ago) into service, even though the current market is already oversupplied. That's why the shipping industry is stuck in a multiyear recovery phase despite an otherwise strong global economy. 

Shipping containers at port being organized by a forklift.

Image source: Getty Images.

A similar pattern of oversupply has occurred within the shipping container industry, which was also negatively affected by bankruptcies of vessel owners (when a shipping line goes bankrupt, it takes a lot of leased shipping containers down with it that have to be written off). That's what has Wall Street so worried about Textainer Group Holdings' continued purchases of containers. Although prices are high and margins healthy right now, analysts fear that company and its peers will overshoot future demand and bring about another industry downcycle.

It's a fair concern, especially since Textainer Group Holdings isn't the only company racing to order new containers. But it's important to note that shipping container leasing rates are being impacted by new factors lately such as new paint regulations in China. Then there's the fact that the number of new shipping vessels entering service is falling significantly in 2018 and 2019 compared to recent years. If daily shipping rates increase as a result, then it could provide additional positive pressure on container lease rates as well.  

There's also incremental upside already baked into the company's business. Leases expiring in 2018 (and for the next several years) are at rental rates considerably lower than current market prices. Textainer Group Holdings can release those containers at significantly higher prices, meaning the same assets will generate much greater revenue and income going forward. The most favorable scenario from expiring leases could come in 2021, when the lowest-priced rental contracts in the entire portfolio expire. While it's too soon to predict where the market will be by then, it's unlikely rental rates will be lower than the existing contracts. In other words, those expirations may have no real downside. 

Overhead shot of shipping containers on a ship at port.

Image source: Getty Images.

Is Textainer right for your portfolio?

Long-term investors are being handed a gift with Textainer Group Holdings stock being down 19% year to date. While shares had an epic 2017, they're still down over 40% in the last three years and more than 50% in the last five years. They're also attractively priced at the moment. According to Yahoo! Finance, the shipping stock trades at 0.9 book value and just 10.6 times future earnings.

While analysts have rightly identified the future risk of an imbalanced market posed by increasing container orders, there are considerable tailwinds supporting the shipping container industry's continued momentum. Those aren't likely to subside in the near term, which bodes well for Textainer Group Holdings' continued march toward its historical operating peak, when operating margin was 50% or more. That's why I think this turnaround stock a buy.

Maxx Chatsko has no position in any of the stocks mentioned. The Motley Fool recommends Seaspan. The Motley Fool has a disclosure policy.