CODA - Coda Octopus Trades At Fair Value But Is Not An Opportunity

Summary

• CODA develops, designs, and manufactures high-end sea and diving visibility systems. These are used in commercial and defense applications.
• The company is at the forefront of its sector in terms of technology. It enjoys a technological moat that has protected its margins and profitability.
• CODA's current product lines have peaked in sales, and the average profitability generated by these products does not justify the company's current market cap.
• However, the company has introduced two product lines that, although in its infancy, carry enormous potential. A review of competitors reveals they do not have comparable technology.
• For that reason, and considering the success of the previous product lines, I believe CODA is a fair value, but not an opportunity, at current prices.

Coda Octopus Group ( CODA ) designs and manufactures high-end sea and diving visibility systems.

The company has sustained a technological moat. That moat has been enhanced by adding two unique patented products significantly ahead of the competition in the last two years. Although these products are in their infancy, they promise to increase the company's revenues and expand its market share.

Although the company's shares trade at a high multiple to average earnings, I believe this is justified by the previous successful introduction of technologies, the technological superiority of newly introduced products, and the company's strong balance sheet.

However, the company does not provide an opportunity. The growth scenario is the most probable but is already discounted on the company's price.

Note: Unless otherwise stated, all information has been obtained from CODA's filings with the SEC .

Business description

Sea visibility systems : CODA develops technological systems for marine commercial and defense operations. They include imaging sonars (radars that can model what is found in the seabed), diving helmets, and positioning apparatus for ships.

Marine construction companies use the company's products to build marine cables and off-shore structures. They can also be used for monitoring these structures.

The products also find applications in marine defense vehicles and marine surveillance. As much as 60% of the company's revenue comes from defense contractors that use the company's products in military applications for the U.S. and the U.K.

Technological moat : CODA enjoys a technological moat that allows it to compete effectively in these markets. There are several indications of this moat.

First, the company has 16 patents currently in force, mostly related to software (algorithms to map sonar data to images). Second, the company has consistently enjoyed tremendous margins, averaging 19% at the operating level and 65% at the gross level since 2015. This suggests to me that the company is relatively insulated from competitors.

Cheap R&D operations : The company has two segments: engineering and products. The engineering segment is completely dedicated to military applications. The products segment is 40% oriented toward military applications and 60% dedicated to civil applications.

According to the company, the engineering segment develops solutions for contractors like Raytheon. The segment has lower margins and more volatility, but the R&D costs are charged to the clients as a service cost.

This allows the company to develop new technology at a low cost. For a company with CODA's technological moat, it does not spend a lot in directly expensed R&D. That is because most R&D is hidden as service costs for engineering (defense) applications.

After developing a product for a specific military application (the R&D of which is compensated by the client), the company still owns the know-how and sometimes a patent. This has allowed the company to build a strong patent portfolio without substantial uncompensated R&D expenses.

R&D tax advantages : The company has a significant R&D center in Edinburgh (where CODA was founded). In the UK, companies can get as much as 25% of their R&D expenses as a tax credit , on top of deducting it from operations to calculate their profits. For that regulation, CODA qualifies as an SME (less than 500 employees or GBP 85 million balance sheet), which provides even more benefits.

The company's average effective income tax rate has been 0% even though it has generated a profit every year since 2012.

Two frontier products : CODA has launched two technologies the company considers unparalleled in their markets.

The first is a 4D/5D/6D sonar system called Echoscope PIPE. The system allows operators to obtain real-time rendering of deep water structures, process millions of sonar points simultaneously, and capture raw data for post-processing.

According to CODA, no other 4D/5D/6D sonar is offered in the market currently, and no other product offers its capabilities (real-time, volumetric, and raw data capturing). The product was launched in March 2020 and is still in the introductory phase.

The second technology is a HUD for divers called DAVD. This is the first device allowing deep-water divers (human and drone) to share real-time images with their above-water crew. The technology also allows divers to receive orientation information and to project location images and instructions on display. Other alternatives only allow divers to share low-quality audio information with their above-water crew. The technology is currently being introduced in the U.S. Navy.

Both products are still in their infancy in market development but have unparalleled capabilities in their segment. For example, ECA Group, a French company, develops unmanned underwater vehicles for commercial and defense uses. Their vehicles do not have CODA's sonar capabilities . Chesapeake Technology's SonarWiz is significantly less powerful.

Closer, but not at the same level, is Teledyne's SeaBat . CODA's annual report mentions Teledyne as one of the competitors that could eventually develop a similar product.

However, companies like ECA or Teledyne serve a much larger market with a significantly wider product line, so they could incorporate CODA's technology instead of competing. For example, ECA could incorporate CODA's sonar in its unmanned vehicles.

Strong balance sheet : CODA has no debt and has accumulated cash consistently, reaching $23 million in holdings as of FY22 (October 2022).

Valuation

Cycle average earnings : CODA suffers from revenue and operating income cyclicality, as seen below. In 2017, the fall in revenues was caused by lower defense expenditures in the U.S., and in 2020 by the pandemic.

The cyclical average operating income generated by the company has been close to $4 million.

Multiples and growth expectations : CODA is currently trading at a market cap of $77 million. Applying an income tax rate of 20% over the average operating income generated in the past decade yields $3.4 million in net income for a P/E ratio of 22x.

This is not a low P/E ratio. To return a 10% earnings yield on its current market cap, the company should eventually generate $7.5 million in net income. Considering an operating margin of 20%, this implies $46 million in revenues, more than double the current values.

Growth in leaps : The company introduced its previous generation of sonars, the Echoscope, in 2009 . The company was generating heavy losses and was taken private after triggering a default event on its convertible debt. The company was relisted in 2017 and was already profitable, thanks mostly to the Echoscope product.

Echoscope took years to introduce in the market, but it opened a period of revenues and profitability higher than the previous period.

Technology is risky : Although the company may have developed a technological moat in existing products and claims to have unique new offerings, growth may not materialize.

In particular, given that the technologies were developed for defense use, their markets may not be big enough to sustain such an increase in revenue as current prices require.

For example, the new product may cannibalize previous products, implying no significant change in revenues or profitability.

Cash reserves : I tend not to subtract a company's cash reserves from its market cap as part of the multiple calculations because the company may not return those reserves to shareholders. However, the reserves represent a defense against a period of under-profitability and also a sign that management has been conservative before allocating capital.

Conclusions

CODA enjoys a technological moat and has protected its margins. Its recent product introductions, although infant, are very promising.

However, the company's current multiple over cycle-average earnings is high. It implies significant growth ahead. That growth has to come from the new product lines, given that the previous ones, introduced around 2009/10, have peaked at current profit levels.

Although CODA carries significant uncertainty ahead, I believe the current multiple is justified by the successful introduction of previous technology in the 2010s decade and by the superiority of the company's current products over those of competitors. The company provides further protection because it has a strong balance sheet and has operated profitably even during cyclical bottoms.

However, I believe the proposition is only fairly valued and does not provide an appealing investment opportunity. Because growth is the most probable scenario, it is already discounted in the current price and multiples. There is no asymmetric opportunity.

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