Rare opportunity in a serial outperformer

When I last wrote a wire on electronic solutions company Codan (ASX: CDA) in May 2018, the stock had been in an earnings upgrade cycle for the preceding two years. This was due to the release of the company’s new flagship metal detector, the GPZ7000, which is used by artisanal miners to prospect for gold, predominantly in Africa. The share price had tripled as a result to $3/s. The new model retailed for up to US$9,999 and replaced the GPX5000, of which many tens of thousands of units had been sold over several years. My expectation was that the stock would remain in an upgrade cycle, as it was still early in the replacement cycle and given the cheap valuation, the stock would continue to perform well.

Fortunately, that remained the case, with the company delivering multiple earnings upgrades, and earnings per share (EPS) growth of 35% CAGR between FY18 and FY21. The stock more than quadrupled in value again, to the $13/s today, meaning a marketcap of ~$2.3bn currently. Importantly, Codan is a far better business today, being more diversified across multiple products as well as geographically. This has been achieved without any equity raisings or dilution to shareholders. From a valuation perspective, the market has rewarded the stock with the PE re-rating from 13x to 19x over the last three years.

So, it seems like a good story for investors who have been in the stock. However, the above belies the fact that the stock has underperformed the market considerably since the company released their 2021 earnings in August, with the share price de-rating from over $19/s to $13/s today. Why has this happened, and is there an opportunity in the stock currently?

Firstly, for those unfamiliar with the company, it has two divisions:

1. Metal Detection (under the brand Minelab). The company essentially sells the best metal detectors in the world – think detectors that scan the deepest, and most effectively across various soil types etc. These detectors are sold to two distinct markets: artisanal miners prospecting for gold (typically in developing countries), and recreational users looking for gold, coin and treasure (typically in developed countries).
2. Communications (under the brand Codan, as well as recently acquired acquisitions DTC and Zetron. More on this below.). Communication solutions are sold into various markets globally including emergency responders, NGOs, governments, and military.

Strong Fundamentals

Financially, you would be hard pressed to find a stock trading with Codan’s metrics with such a reasonable multiple. The company has delivered strong EPS growth (35% CAGR in the last three years), excellent cash generation, high returns (ROE of 35% in FY21), high margins (EBIT margin of 32% in FY21), a rock-solid balance sheet still in a net cash position despite deploying $174m into two earnings accretive acquisitions. The company has even paid special dividends along the way.

And, despite again delivering results above market expectations in 2021, the stock now trades at a discount to market at 19x. Two main reasons seem to explain the move:

1. The Managing Director Donald McGurk announced that he would be retiring; and
2. Speculation that the company’s best days are behind it.

Retirement of the Managing Director

McGurk has been the MD of Codan for 11 years, and with the company for over 20 years. There are plenty of studies on the impact of a long-term CEO/MD retiring. It certainly should give pause for thought. Will there be a huge cultural shift with the new appointment? Does he or she believe the best days of the company are behind it? The appointment of a CEO/MD is arguably one of the most important things that the Board of a company does; only the passage of time can show whether this has been successfully executed on. There’s never an ideal time for a well-respected MD retiring, but 11 years in the role is certainly a good stint. What we do know is that McGurk has provided the Board with plenty of notice, intending to stay on for 9-12 months to allow ample time for an appropriate successor to be appointed and ensure a smooth transition. Furthermore, there is bench strength in the divisional CEOs at Codan, who are themselves long tenured and highly experienced. The IP and capability in the business does not disappear with the MD.

Best Days Behind It?

The key driver of Codan’s earnings over the last few years has been its Metal Detection division, Minelab. Its earnings have grown from $30m in FY16 to $142m in the FY21, a CAGR of 37%. The law of large numbers certainly comes into the equation, so I’d expect a lower growth rate over the following few years. Yet, I’d still expect double-digit growth as the company continues to innovate and release new products, capture further market share from competitors, and penetrate new geographies. It’s important to note that the company has invested heavily in R&D over the years (to the tune of ~$30m p.a.), which supports the growth above. It’s also important to recognise that the company has had a history of over-achieving conservative outlooks over many years.

In my view, the two factors above do not justify the aggressive 30% de-rate in the stock in recent months. The financial metrics and historical track record of the company suggest that the company should trade at a premium to the market, and not at a discount to the Small Industrials PE of 23x.

Transformational Development

Aside from doing more of the same going forward, there has been an important and transformational development in the Communications division. The company acquired two businesses early in 2021, DTC and Zetron, both of which are EPS accretive. While the R&D investment and product development is ongoing, the two acquisitions complement their existing capability and expands Codan's customer base. Essentially, the total addressable market has increased meaningfully for the company, into the billions of dollars.

Segments of their addressable market are expected to grow 10-15% p.a. over the coming years, supported by substantial US government funding. For example, the Next Generation 911 program (abbreviated to NG911, the upgrade of emergency 911 systems in the US from analogue to digital) is expected to have $15bn in funding, and Zetron together with competitor Motorola are the only two companies offering a full suite of applications. There’s also the Integrated Visual Augmentation System program (IVAS – the development of mixed reality headsets for US infantry) by the US Army worth billions of dollars, which DTC is expected to provide its mesh radio product into. There are genuine growth opportunities in front of Codan over the next few years at good margin.

A Rare Opportunity

This seems to be one of those rare opportunities to buy a quality business that has been mispriced by the market. The dramatic de-rate appears unwarranted given the company’s financial metrics and track record. I’m comfortable that there will be an orderly handover in the MD role, and the outlook for the company continues to look bright, with high growth and returns continuing over the coming years.

Near-term, Codan is due to hold its AGM on 27 October; the company has historically provided a high-level view of near-term earnings guidance and may do so again this year. At the time of the FY21 result announcement in August, the company commented that it had a strong start to the FY22 year, which bodes well. Furthermore, any updates on the acquisitions made, contract wins etc may provide insights as to the large growth opportunity still in front of the business.