CODA - Coda Octopus: DAVD To Drive Significant Growth Stock Still Undervalued After 50% Jump

2023-04-17 15:26:14 ET

Summary

• I have followed Coda Octopus for a number of years and have never been more bullish than I am today, even after the recent 50% rise in shares.
• The company has passed key hurdles with the DAVD system (diver augmented visual display) and the company has received formal authorization for naval use.
• The company estimates the US defense market alone for DAVD is at least $47 million, before complementary echoscope sales. For reference, the company generated $22.3 million in total sales in 2022.
• The company is highly profitable currently and the balance sheet remains rock solid with over $24 million in cash and zero debt.

Coda Octopus ( CODA ) has been a favorite of mine for some time now given the enviable positioning of the company in 3D sonar systems. I have covered the company multiple times over the last 2 years with my most recent article in September of 2022.

Since my last article, shares have gained well over 50% and logic would usually tell you that I would become less bullish as valuations rise. Well not today Satan... I believe that valuations have risen due to a realization that the company is on the cusp of the next chapter of growth, with the DAVD system firmly at the forefront.

In this article, I would like to cover why I believe the DAVD system has the potential to transform the company's revenues over the next few years and why I believe it may only be a matter of time before a defense major buys the company outright.

Overview

Coda Octopus Group began its existence in 1994 as Coda Technologies which specialized in software for subsea mapping and visualization. The company's current form of Coda Octopus Group, Inc. resulted from the acquisition of three companies, Coda Octopus Ltd, a UK company, Coda Octopus, Inc., a Delaware corporation, and the most vital, the acquisition of Coda Octopus OmniTech AS, a Norwegian company, in June, 2002.

Coda operates two distinct businesses, the marine products business, which manufactures and sells 3D sonar systems along with the new DAVD (diver augmented visual display) product and the engineering business, which operates as a trusted third party contractor for prime defense contractors.

Revenues for the marine product and engineering businesses are split roughly 50/50, however, the marine product segment provides over 90% of the income generated for the company given the vastly superior margin profile of the business.

The engineering business, though less profitable, remains vitally important, given the close coordination and access it provides the company to tier one defense contractors and allied militaries.

Coda claims in the most recent 10-Q filing that its echoscope products are literally the only products in existence able to perform certain, complex tasks in the markets served.

Our real time 3D/4D/5D/6D Imaging sonars are the only underwater imaging sonars which are capable of providing complex seabed mapping, real time inspection and monitoring and providing 3D/4D/5D/6D data of moving underwater objects irrespective of water conditions including in zero visibility (which is a common and costly problem in underwater operations). Competing products such as the multibeam sonar can perform mapping (but not complex mapping) without the ability to perform real time inspection and monitoring of moving objects underwater. We also believe our Echoscope PIPE® is the only technology that can generate multiple real time 3D/4D/5D/6D acoustic images using different acoustic parameters such as frequency, field of view, pulse length, and filters

Source: Coda Octopus 10-Q

For some time, myself and many others who have reached out to me have labelled the company as having the best technology, but also not having a market to sell it to. This is backed up by the extremely small size of the business currently. The company, in 2022, posted revenues of only $22.23 million and currently holds a market capitalization of just $88 million. This is truly a tiny company.

This small revenue profile may be about to change. The world is shifting and the need for 3D sonar is growing at a rapid pace with the advent of new classes of underwater vehicles, both military and civilian, growing offshore wind turbine installations and the need for increased oil and gas production.

In addition, western allied navies are facing increased pressures due to China's rapid buildup, the threat of a Taiwan conflict and the Russian invasion of Ukraine. Coda's DAVD product could not have come at a better time for the company in my opinion.

The DAVD Opportunity

Coda, in partnership with the US military, has developed what can only be called a revolutionary new diving system which allows divers to fully operate and communicate in zero visibility conditions.

The DAVD system provides a fully integrated suite of sensor data shared in real time by both the diver and the surface team. In addition, the echoscope product has been integrated into the system, allowing a diver to see, in real time, a 3D sonar image broadcasted directly to the AR visual display. This means that a diver can operate with near full visibility in the murkiest, deepest and darkest waters on the planet.

Clearly, this is a large opportunity for naval warfighters, however, this also has clear commercial applications given project dive failure rates are extremely high due to visibility, safety and water conditions.

In the Q1 earnings presentation, the company announced that the DAVD system has now been transferred from research, to operational status and is now an approved naval use item. In addition, the US Navy has established a budget line item and Coda expects to receive orders for the system in 2023.

The company also announced that the untethered system, considered the holy grail for warfighters, has been completed and fleet evaluations are underway during March and April of 2023.

The opportunity for this system is large and considering Coda's current small revenue profile, it can only be considered game changing if successfully deployed.

On the Q1 conference call, CEO Annmarie Gayle had an interesting discussion with an analyst regarding the addressable market that I would like to dive into. Below, please see the exchange (Note: slight transcription errors have been corrected).

Brian Kinstlinger

Got it. Thank you. And then with your comments regarding the targets for fiscal 2024, we can back into at least a rough expectation for the DAVD next year. Are you able to quantify the total addressable market for tethered and untethered DAVD and does a pending untethered DAVD have a different targeted audience or might some navies wait for this untethered product before ramping their purchases?

Annmarie Gayle

No, they're two different markets actually. You have the surface and the deep diving. The deep diving is really the untethered version. So we've been focused then on the U.S. market for the time being because then the product started as a U.S. project. And if I think about – it's a difficult question, but if you think about how many ( U.S. Navy) S eals there are, there are 2,500 Seals. There are in the U.S. Navy experimental diving unit, there's one 120, and then for others like combatant divers, amphibious support, there's 1,225. So in total, in terms of diving personnel, you have about 3,845.

Now, when I look at this, Brian and say, okay, for us what we have modeled as – because then when we think of how a technology is adopted, it's always going to be a phase adoption of the product. So because there's management risk, all of these for the customer, so we've kind of modeled something like 15% of that market over five years, and it might be conservative, but for just the way the adoption curve is, and as I said, when you phase in new technology, it will take time. And so 15% of that addressable market in the U.S. would be about $47 million. And we think that – and that's just 15% we have targeted.

Brian Kinstlinger

And that's just U.S.?

Annmarie Gayle

And that's just the U.S. based on those numbers that I gave you, 3,845 diving personnel. And I also want to clarify that $47 million excludes complementary Echoscope sales. This is pure DAVD, so I've not included within $47 million.

Brian Kinstlinger

Right.

Annmarie Gayle

The pairing of the Echoscope with the DAVD and the way we think that will go down for commands is it won't be a one for one, but certainly there will be a number of Echoscopes that we will introduce with the DAVD because as I had mentioned before, what the sonar data there in that environment, why it's important. Divers are diving in zero visibility conditions and that's really the Echoscope that's going to provide insurance from that.

During this exchange, Mrs. Gayle alluded to a market of $47 million JUST for the DAVD system, not including the echoscope product. As a reminder, the echoscope product is, in essence, what makes this system extremely valuable as it allows for complete visibility for the operator.

In addition, this represents 15% penetration of only the US defense market. The math of this statement works out to be roughly 577 systems generating the $47 million or roughly $81,500 per system. Please remember that this figure does not include the echoscope 3D sonar system.

Using publicly available information from Coda's website, we can see that the echoscope product costs between $250,000 and $300,000.

If we assume that the US military will purchase one echoscope for every three DAVD systems, using a $250,000 price for each echoscope, that creates another $48 million opportunity, or $95 million total for the DAVD system over the next 5 years.

A $95 million revenue opportunity for a company currently bringing in $22 million in revenue per year, can only be described as transformative.

I realize that many assumptions have been made to reach the $95 million revenue opportunity figure, however, the company, in my opinion, is currently priced as if this opportunity does not exist at all as it is currently highly profitable, cash flow positive and trades at a very reasonable 20.48 PE ratio, also, the company holds over $24 million in cash with zero debt.

I believe that it may only be a matter of time before a defense major acquires Coda, not only for the DAVD system, but for the echoscope product to be integrated into the plethora of AUV's that are currently in the pipeline. In my opinion, a $200 million or higher acquisition would be only a footnote for defense majors and would allow them to hold and perhaps better distribute this vital and patent protected technology.

Insiders own over 45% of the company, so ultimately, they do hold all of the cards to a potential transaction, however, in either scenario, I believe investors in the company will win regardless.

Risks

While the company appears to have a rock solid balance sheet and is consistently profitable, many risks remain when investing in a microcap company such as Coda.

The company is dependent on a small group of specialized customers and future growth is highly correlated to the defense market. Defense items are notorious for delays and budget risks and while the company appears to be making progress with the DAVD program, purchases and adoption by the military is far from guaranteed.

The supply chain is also a notable risk factor for Coda given the company's reliance on specialized semiconductors and parts for its products. Over the last two years, the company has been hampered by supply chain issues throughout the business and issues could remain or worsen.

Technology risk is abundant for Coda given that the company relies on its differentiated technology for the majority of its revenue. Should another company develop a technology that is superior to Coda, the company could face severe challenges in securing business.

Shares in the company are also rather illiquid and building, or disposing of a position is challenging and requires patience as the average daily volume is roughly 20,000 shares or only $160,000 per day currently.

Appropriate risk tolerance is absolutely required to invest in this company. Please perform your own due diligence, consult a licensed financial advisor and never rely on my personal opinion to invest in any security.

Bottom Line

I believe Coda may be on the verge of a substantial leg of growth by way of both the DAVD and echoscope products. The DAVD system holds massive potential in the defense sector and in commercial applications and echoscope has exciting and new market applications in both the defense and commercial markets worldwide.

The company, in my opinion, is on very solid financial footing with a bulletproof balance sheet, minimal share dilution and high profitability even absent DAVD adoption and I personally believe the risk reward in the name is quite favorable. In Q1, I have increased my position by over 50% and Coda is now within the top 5 holdings in my speculative account with a cost basis of $5.82.

Thank you for reading and I look forward to your comments below. Good luck to all!

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