Monday, May 4, 2020

Coda Octopus Group (CODA)

Coda Octopus (CODA) is an overlooked small cap that designs, manufactures, and sells solutions for the subsea market.  As the company operates in a narrow industry and has no analyst coverage to speak of, its unique technology, profitability, and potential acquisition are not accurately reflected in the share price.  Trading at 2.5x recurring revenue and a historical low 7.4xEBITDA, CODA is a strong long term buy.

Company Overview 
Coda Octopus began as Coda Technologies, a UK corporation formed in 1994 to develop software for subsea mapping.  In 2002, the company acquired OmniTech As, a Norwegian firm, and shifted much of its operations into developing the acquired sonar technology of a “method for producing a 3-D image," the predecessor of the flagship product it offers today.  The company has been headquartered in Florida after a reverse merger in 2004 with The Panda Project, Inc.  Prior to 2017, CODA was being traded OTC and had not filed with the SEC since 2010 after voluntarily delisting under Section 12(g). 

CODA’s business is simple to understand.  The Marine Technology Business sells geophysical systems, motion and positioning systems, and Real Time Volumetric Imaging Sonar to various commercial entities operating in the subsea space.  The Marine Engineering Business offers similar solutions but to defense contractors and to the US and UK defense departments directly.  Over the past four years, the company has generated approximately 55% of revenue from the former.

Investment Thesis
A. Unique Technology

Real Time Volumetric Sonar (RTVS) is CODA’s proprietary technology and flagship product, developed inhouse over 25 years and currently the only such product on the market.  The advanced nature of this tech gives it a relatively wide moat and it is the company’s sole competitive advantage in the subsea imaging industry.  RTVS is sold as a hardware+software bundle.

The hardware, CODA’s proprietary Echoscope sonars, is sold, leased, or rented into every marine sector from offshore energy and renewables to commercial fisheries.  The company completed launch on its 4th generation sonars in late 2019 and expect to begin launch on its 5th gen sonars in 2020.  Among other advancements such as smaller frames and less power consumption, the iterative generations of sonar hardware relate to their compatibility with CODA’s 3D sonar software.

Native to this hardware is the company’s Real-Time 3D (4D) volumetric imaging sonar system.  While competitors offer basic sonar imaging on XYZ axes, CODA’s Underwater Survey Explorer (USE) software has the following unique capabilities:
  • Live 3D imaging of any moving objects within the sonar field of view including construction assets, divers, subsea vehicles and tools and machinery executing tasks underwater.
  • Accurate three-dimensional data unaffected by motion or water visibility.
  • Mapping of complex structures with a volumetric ping as opposed to individual angular slices of data. The more complex the structure, the greater the benefit of real-time volumetric sonar imaging over a traditional survey.
  • Live situational awareness of static and moving objects for safe terrain navigation or target tracking.
  • First Person Perspective imaging allowing the operator to point the real-time volumetric imaging sonar towards any target, regardless of where in the water column the target is located and generate a true image first person perspective image.
  • Imaging or visualizing subsea environments in low or zero visibility conditions and in situations of high waterflow and active noise pollution (dredging and rock dumping).
  • 3D Range gating of the live image to focus on specific targets or features at specified ranges – regardless of signal strength. This specifically allows for weak targets close to the sonar to be discarded from the image (e.g. bubbles or fish) or detected as threats (e.g. fishing nets).
  • Coherent single sensor delivery for multiple applications.
  • Unique rendering and viewing software techniques that simplifies data interpretation.
  • Direct integration with a range of compatible sensors (e.g. GPS, attitude sensors), actuators (pan, tilt) and custom, task-specific software that provides task or mission solutions for key markets such as the underwater construction market and offshore wind energy sector.
That list is taken directly from the company’s 10-k and, unless you have extensive experience in the demands of the subsea imaging space, its contents mean close to nothing to you.  After a few too many hours researching this industry and CODA’s competitors, I’m still forced to take much of this jargon at face value.  However, after talking to some people in the industry, it is clear that the Echoscope+USE is both necessary and a cost-saving product in the deep-sea construction business.  Furthermore, the rollout of the smaller and lighter 4th gen Echoscope Surface in 2019 paved the way for CODA to consolidate a greater market share in subsea operations as it was specifically designed for small autonomous surface vehicles.  The planned rollout in 2020 and 2021 of 5D and 6D abilities to USE, backward compatible with previous gen Echoscopes, give CODA the clear upper hand in technology over any other product on the market while its absolute pricing power in the deep-sea business afford the opportunity to set subsea offerings at competitive prices. 

CODA’s geophysical systems and motion and positioning systems make up the other 10% of the Marine Technology Business and operate in a fragmented industry where it controls maybe 5% of world-wide sales.  The only room for growth in this industry is by packaging these products with RTVS, which the company is currently doing with its motion and positioning systems.

B. Profitability

CODA’s aforementioned pricing power has translated to an outstanding 79% gross margin in its Marine Technology Business over the last four years.  This has been accompanied by a steady 4% CAGR in revenue from 2016-2018.  Revenue from this segment increased 13% in 2019 on the back of the rollout of the 4th gen Echoscope+USE.  If not for COVID-19, revenues from this segment would have been expected to grow ~10% on the back of the 4th gen and future software develops plus a sharper focus on marketing. 

The company’s Marine Engineering Business is the wildcard.  Offering services and solutions to defense departments and contractors, the segment generated $12M in revenue last year – a 79% increase from the 2017-2018 average and 49% of total revenue.  This revenue stream has been cyclical for the past decade; any delay in passing of the federal defense budget will affect the contracts and deliverables won by CODA, compounded by its odd fiscal year end of October 31.  Even though the dramatic growth in FY2019 revenue can be attributed to the company catching up on backlog, the engineering business stands to increase annual revenue for two reasons:
  1. Besides the rollout of its 4th and 5th gen products in the coming year, CODA has two new products coming to market in 2020: Thermite Octal and Diver Augmented Vision Display (DAVD).  Thermite Octal is the next generation of Thermite Rugged Visual Computers currently used by the US Army for, among other things, dismounted soldier training, robotic control, and weapon system control.  The new Thermite Octal, designed for military helicopters and tilt-rotor aircraft, has completed the first article inspection approval phase and is now in the production phase.  CODA expects this product line to add $3-$7M to annual revenue.  The DAVD looks like it is straight out of a David Cameron 20,000 Leagues Under the Sea passion project – it provides a real time 3d image to the diver that is also shared with a surface supervisor.  The company is introducing DAVD into the Navy fleet this year and has used its collaboration with the Navy to get a number of its sonars on the Authorized for Navy Use list. 
  2. Captain J. Charles Plumb was added to the board of directors in September 2019.  Cpt. Plumb has an inspiring story as a POW and chaplain in Vietnam – I recommend searching for one of his talks on YouTube – and has served on the BoD of the Lightspeed Aviation Foundation.  CODA flat out states that he was added “because of his close ties to the U.S. Defense establishment” which clearly signals its increased focus on growing revenue from its servicing business. 
Despite the cyclical nature of the marine engineering segment, the recurring revenue streams from defense contracting work and promise of growth from new products provide a foundation of sales that should make up at least 40% of total revenue going forward.  While the higher cost of sales (~50%) will never match the gross margin from the products segment, the revenue streams are less likely to be as heavily impacted by the economic downturn from COVID-19.

The decline in oil and gas prices in 2014 had severe adverse effects on CODA’s products segments which at the time generated the vast majority of its revenues from the O&G sector.  As a result, CODA had to shift its sales to other sectors and only 7% of Marine Technology Business revenues emanate from O&G.  Unfortunately, the company’s insulation from the O&G sector does not extend to the rest of its customers: most of sales generation for the products business requires international and offshore travel.  Historically, only 20% of products sales come from the Americas – contrasted with 90% of services sales – with the majority coming from Europe and Australia/Asia.  Q2 results should shed light on the extent of the downturn and provide a baseline for what to expect for the next few quarters going forward.  This constitutes the biggest risk to this investment in the short term.

The company’s only debt is a secured note to HSBC which expires in early 2022, the balance of which is approximately $940k as of Q1.  CODA has credit lines with HSBC of $4.5M which has not yet been drawn on and should not be needed as the company has sufficient cash reserves and working capital to fund its operations.  Even if it does make use of its credit lines, the company’s current ratio of 6.8 and debt to equity ratio of 0.03 are more than healthy enough to stomach some debt.  The accumulated deficit of $25M is not concerning as it has been steadily decreasing since 2011. 

If you annualize CODA’s Q1 earnings, you get an EPS of $0.52 before accounting for any of its $3.4M in NOL carryforwards.  It has just started producing consistent cash flow and was on pace to match last year’s EBITDA of $7.1M.  The economic downturn will erase sales from the products business, without a doubt, but if revenues grow at a 5% CAGR over the next five years you’re looking at a company that is being valued by the market at a 50% discount.

C. Potential Acquisition

In the realm of 3D underwater imaging, CODA has no real competitors.  However, in recent years, Teledyne Technologies has been rapidly expanding its Marine Group.  Teledyne’s most profitable business segment, Instrumentation, can trace $450M in revenue, 35% of total segment sales, to its marine business.  According to Teledyne:
Our strategy continues to emphasize growth in our core markets of instrumentation, digital imaging, aerospace and defense electronics and engineered systems. Our core markets are characterized by high barriers to entry and include specialized products and services not likely to be commoditized. We intend to strengthen and expand our core businesses with targeted acquisitions and through product development.
Since 2012, Teledyne has acquired eleven companies in the marine and subsea industry.  Four of these were direct competitors to CODA.  Out of the eleven, the only public company acquired was Bolt Technology, a marine seismic data business which Teledyne acquired for a $22/share, a 37% premium.  Revenue from the Marine Group has decreased over the last few years, and while Teledyne is holding a considerable amount of debt at the moment, acquiring CODA is very plausible given its synergies and advanced technology.  CODA’s public float is only 40% so its beneficial owners would stand to make a pretty penny.

If you’re a longer term investor, the only risk with this investment is an extended economic downturn and the ever present foreign currency exchange adjustment – close to 50% of CODA revenue is made in UKP.  Your margin of safety will be highest if you wait until Q2 earnings release: historically, the only major moves in the stock comes after a earnings are released.  With Q2 earnings expected to be depressed, I'm betting the price to drop close to $5.  Look for CODA to reach $12 by the end of 2022, if not sooner.  

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