Brasil2
Coda Octopus (NASDAQ:CODA) is an underappreciated marine technology company with a functional monopoly on real time sonar imaging, and tailwinds in all of its major end markets including military, wind, and energy exploration. Downside is protected by a robust balance sheet with almost 40% of the market cap in cash, and a history of consistent earnings. At the same time the company offers enormous upside in the form of substantial operating leverage should the company’s business development plans pan out as management intends. In my view the company has a history of underperforming their potential, but this is already baked into the price. If they prove even remotely competent in their new focus on driving sales the shares should rerate significantly higher.
So that said on to a quick review of the business.
Coda divides its business into 2 verticals, a marine products business, and a services business.
Product business:
The products business offers real time underwater 3d sonar imaging, a technology the company still claims to have a monopoly on, and that addresses a multi-billion dollar potential opportunity. Sonar imaging is useful for underwater applications primarily because visibility is often limited in cloudy water. Coda’s flagship product the echoscope produces 3 dimensional real time imaging of underwater objects in near zero visibility where other solutions simply don’t work. The images and video they generate are stunning.
You can see some of the videos and images generated by the echoscope here.
https://www.codaoctopus.com/media-gallery
That real time image and video delivery has applications for numerous military and industrial purposes. As an example Coda has layered an AI software capability on top of echoscope for boulder detection when laying cable which is useful for construction in the offshore wind industry greatly saving time in what was previously a manual process.
The potential applications for echoscope are substantial, and the product is currently being used for critical infrastructure inspection, port security, underwater construction etc. Military applications are also on the table including AUVs and threat detection.
Also part of the products division is the company’s DAVD product or Diver Augmented Visual Display. This product was built in conjunction with the US Navy and embeds a glass heads up display into common diving helmets. The display allows users to see real time 3d images of their environment in either first or third person based on data provided by the echoscope product. The DAVD also allows communication and sharing of information between the diver and a surface crew allowing for the sharing of images, videos, text messages etc. The product is also being evaluated by NASA for the space program. Coda has not broken out specific revenues for this product, but rollout continues for both the military and commercial applications.
Services business:
The services business acts as a subcontractor, primarily to the defense industry participating in significant military programs like Raytheon’s CIWS system. Another example is decontamination units manufactured for air force use to protect equipment from chemical warfare agents. The services business also includes thermite a rugged computer system that was previously part of the Apache helicopter program. The company has been bullish on an uptick in orders for thermite after a product refresh that started a few years ago although the orders have not followed as the company expected.
What is particularly attractive about Coda is the operating leverage embedded in the business. The echoscope product is the largest source of revenue and supports both a sale model, and a very profitable rental model. These products are expensive leading some users to prefer rentals versus outright purchase, but this benefits the company as the margins on the product side are astronomical at roughly 85% in the most recent quarter. The services business runs lower margins, and has struggled a bit over the last couple years as covid lockdowns interrupted their sales process, and resulted in lower revenues, but services still sport a near 50% margin leaving the companies blended margin at 72% in the most recent quarter.
From a valuation perspective the company earned .16 last quarter, with $5.4 million dollars in trailing 12 month EBITDA, but the company has $20 million dollars in cash on the balance sheet or almost $2/share and no debt resulting in an EV/EBITDA multiple of just under 7X. Subtract out the cash, and you are buying a functional technology monopoly addressing a potential multi-billion dollar market as part of a company that has generated $5 million dollars in free cash flow for the first 9 months of the year for just $37 million dollars.
So where is the problem here? I think historically speaking the problem primarily lies with management. And when I say that I don’t mean the company doesn’t make money. They do, and have been consistently profitable for at least the last decade. Management can be trusted to make a profit. What they haven’t been able to do is unlock substantial growth despite owning the entire market for their technology. Revenue back in 2012 was $21.1 million and for the trailing 12 months sits at $22.2 million virtually flat. In my opinion they have run the company like the most profitable deli in New Jersey content to sit on their single location earning spectacular net margins while not developing the business, and growing sales.
The company would of course have a different take. They spent a good deal of money back in 2017 and 2018 improving their echoscope product reducing its size, weight, and power consumption with the idea of expanding the market for the product.
Here is their rather optimistic take for 2018 after the 2017 annual earnings results.
We invested heavily in R&D to position the Company for breakout growth in capturing a greater share of the multibillion-dollar markets for our products and services, and developing new markets across all our offerings in fiscal 2018-2019.
How did that pan out? Sales were flat, and actually down a fraction in 2018 versus 2017. Their thermite rugged computer product has had similar rosy outlooks and also failed to generate revenue as expected. So there is a good argument to be made here that the company always promises that next level of revenue generation that never seems to come.
At the same time let me present another interpretation. In 2019 sales did start to ramp up increasing from $18 million in 2018 to $25 million in 2019 or almost 40%. Then of course covid hit and sales struggled in 2020,2021 as they had difficulty traveling and selling their products. It’s possible the company was right here about the sales ramp up, and they were starting to see it prior to covid throwing everything into chaos. If that is the case its possible those sales ramp ups are in fact coming and with 70% margins will result in an avalanche of money flowing to the bottom line. Remember this is a management team that may not have grown sales, but they do know how to make money with net margins last quarter at unheard of levels of over 25%.
So which answer should we expect? Is it overpromise and underdeliver as is the norm or do we finally see the numbers break out?
As I see it there are gale force tailwinds favoring their business. Currently between the services segment and military uses in the product segment military accounts for 60% of their current business, and with the Ukraine war raging, delays in previous contracts, and competition with China there should be very positive macro forces on the defense side. Alternative energy and offshore wind applications also continue to grow of course and the big wild card is oil and gas exploration. Oil and gas went from being the vast majority of their business on the product side to almost zero as offshore exploration flatlined a few years ago. Any contribution from here is another tailwind to their business. Overall I can’t imagine a much better environment than servicing alternative energy, defense, and oil and gas with virtually no competition in your market.
At the same time the company revealed in their latest filing that they are pivoting from R&D to business development. While trying to sell your product is something that should be done in conjunction with R&D, and while they should have done this years ago, the pivot to actually trying to sell products is welcome. Macro tailwinds combined with the critical yet obvious revelation that more sales lead to more profits should bode well for better topline numbers going forward, and the company remains adept at turning sales into earnings. At this point it is their game to lose.
Seemingly in-line with this new focus on selling things, back in late 2021 for the first time I can recall the company issued revenue targets for 2022 and 2023. They targeted $28 million for this year and $40 million for 2023. The company has now admitted they will not make the 2022 target continuing their history of overpromising however at $6.3 million dollars in revenue for Q3 they did finally approach that $28 million on a run rate basis. If this trend follows we would expect them to approach quarterly revenue of $10 million at some point in 2023.
Ultimately I think some revenue growth here is likely no matter what. They are still recovering from the aftershocks of covid and revenues have not yet returned to 2019 levels. If the company is roughly accurate, but late in their revenue run rates as they were in 2022 we would see revenue run rates of close to $40 million dollars sometime in the next 12 months. Modeling a couple of high level scenarios here on annualized revenue run rates looks like this.
*Figures in USD (Millions) except EPS.
| Current run rate | 10% sales growth | 40% sales growth | |
| Sales | $25.2 | $28 | $40 |
| Gross Profit | $18.4 | $20.5 | $29 |
| SG&A/R&D | $10.4 | $11.4 | $15 |
| Taxes | $1.2 | $1.4 | $2.8 |
| Earnings | $6.8 | $7.7 | 11.2 |
| EPS | .60 | .68 | .98 |
| EPS Growth rate | 13% | 63% |
The above analysis assumes SG&A/R&D grow in line with revenues, and margins are held constant with a 15% blended tax rate. Now I don’t know where numbers will fall however I assume 10% growth from current run rate is a fair and conservative base case given the tailwinds in their markets, new focus on business development, and the dissipation of headwinds associated with covid. How those revenues are valued is an open question and subject to larger forces, but I believe targets of 12X 15X and 20X earnings are reasonable for each respective scenario yielding price targets of $7.20, $10.20, and $19.60 respectively. The last target would take the company to previous highs achieved at a point in time when revenues and earnings were not yet at the same levels. My base assumption is they wind up somewhere between scenario 2 and 3 in the next year with run rates in the 30 million dollar range. This would assume modest growth from the products division and a mere return to 2019 levels for the defense focused services side which generated $12 million in revenue for the year ending in October of 2019 versus a current run rate of 9 million.
Now the flipside of this is the company does not grow revenues perhaps even sliding back to the $20 million dollar revenue run rate range. In that case you would likely expect annualized earnings to fall to the $0.15 range. While this would be disappointing I would expect downside to be limited given the fortress balance sheet with almost $2 a share in cash, and very valuable IP. Also as stated previously they always earn something greater than zero. I would not expect the downside here to be worse than the $4 a share experienced in late 2017 when annual revenue was running just $18 million.
Putting that together I simply see asymmetric upside with upside being more likely than down given the very favorable macro environment for their products.
Risks
- The company has been fighting with the UK government over exports to China. Further export restrictions could harm the business.
- Changes in the macro environment. Specifically reductions in defense spending, or general economic weakness.
- Product competition. Their margins are largely a function of being the only game in town. Competitors will eventually shrink that gap. You can’t run like a mom and pop deli forever.
- Inflation impacts on input costs and SG&A.
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