Codan: Prospecting for stability

Codan (ASX:CDA) has been on a wild ride over the last three years. Just before the COVID crunch the share price hit $8.50. It quickly fell to a low of $3.90 but then began a remarkable rebound topping out at $19.36 in June 2021.

It then gently tumbled all the way back, bottoming out at $3.64 in December last year before beginning a steady climb back to the current level of $5.60. Clearly the market is having trouble settling on a valuation, and large sums of money have been made and lost along the journey.

A lot of this has been driven by the unusual impacts caused by the pandemic, along with a tendency to extrapolate short term results well into the future. But the company has also been on its own transformative path during this period.

Codan derives its revenue from metal detectors and communications equipment. The biggest market for metal detectors is prospectors in Africa, but they are also sold for recreational and professional purposes throughout the world.

Communications consists of high-tech radio equipment. These products are sold through large contracts mainly to government agencies, law enforcement and military customers. During 2021 Codan made two large acquisitions in the communications space. Domo Tactical Communications for $US88 million and Zetron for $US45 million. This has increased the contribution to revenue from the communications segment from about 30% to 65% at the most recent half year result.

Source: H1 FY2023 Codan Limited Half Year Results, 16/2/23

The tracking solutions business, Minetec was also divested during 2021. This business had never managed to gain much traction.

These structural changes to the business place it in a good position moving forward. Whereas the revenue from metal detectors can be quite volatile and is based on many small sales, the revenue from communications comes from large contracts with blue chip customers. The geographic breakdown of sales has also shifted. Previously sales were about 50:50 between the developing world and developed world, whereas now developed world sales have increased to about 85%.

Codan is a global business headquartered in Adelaide. Only about 10% of revenue comes from Australia. They also have engineering and manufacturing centres located throughout the world.

Source: H1 FY2023 Codan Limited Half Year Results, 16/2/23

All of these changes should help to smooth the revenue profile of the business. Whilst there were times that selling metal detectors provided strong revenues at high margins, there is a high degree of risk in these markets given geopolitical and other cyclical factors. It makes sense to capitalise on them when the going is good, but not to depend on them for bread and butter.

The other big change in 2021 was the retirement of long-term CEO Donald McGurk. McGurk was highly regarded and had built the business into a very successful operation. The new CEO Alf Ianniello has big shoes to fill, but he appears to have a solid resume with both technical and leadership experience.

The financial performance of Codan up until 2022 was difficult to fault. Revenue grew at a compound annual growth rate of 24%p.a. over the prior three years, and EPS by 33%p.a. over the same period.

However FY2023 has been a much tougher year. The communications business has continued to grow, but metal detector revenue fell by 46% in the first half resulting in an overall revenue decline of 18%. Profit fell even further with underlying NPAT down 39% for the half, again driven by the high margin metal detector business as well as continued cost pressure.

Despite this, analysts see cause for optimism, and predict that for FY23 total revenue will decline about 10% and EPS falling about 30%, which implies a bit of an improvement in the second half.

These results initially led to the StockRank falling from 77 to 67 shortly after the interim results were released, however it has now moved up a bit to 70. The biggest contributor to this has been a decline in the Momentum rank from 63 to 50 (as at 28/2/23) as analysts have shifted their recommendations more towards sell. The value score also declined as most of the components contributing to it shifted towards being a bit more expensive as shown in the table below.

As at: 21Feb 2023

Returning to the opening comment about the market struggling to settle on a valuation, Codan is now trading on a forecast PE of 12.7. This compares with a long-term average of 13.3 so it is fairly close to a normal situation. Of course that valuation also depends on the accuracy of the EPS forecasts. As the business shifts more towards a steadier revenue profile, these should be a bit easier to predict, but there will always be room for surprises, both to the upside and the downside. That’s what makes it interesting.

Codan has been around for a long time, and has been very well run. Long-term faithful investors have been duly rewarded with growing dividends and an appreciation of the share price. There have also been opportunities to make some outsized profits for those who realised when the market had become dislocated from the business reality. The brave were buying in March 2020 and the sensible were selling in June 2021.

There have been some significant shifts in the business over the last year, but those willing to dig beneath the surface may find there is still some treasure to be found.

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