Why I Bought Codan (ASX: CDA) Shares

I am writing a quick note on why I bought Codan (ASX: CDA) shares, because even though I have followed the company for many years, I haven’t covered it on these pages.

As a quick primer, Codan is a historically well run engineering company that excels in manufacturing gold detectors through its Minelab business. It has had a long term interest in secure communications, but never really excelled there. It also has a mining focussed business I won’t go into, since it has been divested. It has grown its net profit from around $45m in 2013, to about $90m in 2021, all while paying out a dividend. This is not a recurring revenue business, so profits can go up and down. Still, the longer term trend is for profits to grow.

2021 was a big year for the company, since Domo Tactical Communications and Zetron were acquired in May and it sold Minetec to long-standing partner Caterpillar. As a result of these changes the segment results in H1 FY 2022 were EBITDA of about $62m from detection and $25m from communications.

Managing Director Donald McGurk Bails Out

However, just as the company was in the midst of these transactions, having just settled both Domo and Zetron, and announced the sale of Minetec, long-serving CEO Donald McGurk sold 136,000 shares for over $18, netting about $2.5m, and retaining around 600,000 shares. 

Then, McGurk announced he would resign from the company, with no reason given. The share price peaked in June 2021, not long after the stock was added to the ASX S&P 200. The new CEO Alf Ianniello took over in January 2021, so I suppose McGurk may have sold more shares since, but I just don’t know.

Of course, when a CEO sells shares and quits, that is always a sell signal for me. But, I have purchased shares after the price has already fallen from over $17 to $7, more than 60% from the peak. Put simply, the thesis is that the bad news is now priced in.

What is probably clearer is that the sale and then resignation of Mr McGurk has lent momentum to the share price collapse. After all, he had lead the company for 10 years and is slated to have built it “from relative obscurity into a global group with manufacturing operations in Adelaide, Canada, the United States and Malaysia”. On top of that, acquisitions always bring integration risk, so to see the architect of the acquisitions leave before integrating them, is a very crimson flag indeed.

Not only that, but in the most recent half year results, the company saw Metal Detection sales down 11% vs H1 FY21, and a steep inventory build of $20m, leading to cash burn of $13m for the half. That, along with a reduction in payables, left the company with a whopping $34m increase in debt, to around $58.5m.

Psychopaths Ruin Sudan

One of the main reasons for the reduction in metal detection sales was the coup in Sudan.

For many years, Sudan has been an unstable military dictatorship. It enjoyed a couple of years of unstable quasi-civilian rule after its long time psychopath dictator, al Bashir, was deposed in response to a popular uprising.

Just ahead of the full handover to civilian control, the military has done another coup, making it clear that the corrupt authoritarian psychopaths remain firmly in control of the country, despite the rosebud of civil society having begun to flourish, in the last couple of years.

According to Reuters, “The rehabilitation of the Islamist National Congress Party (NCP), which ruled Sudan under Bashir before he was ousted by a popular uprising in 2019, comes amid a worsening economic crisis and ongoing street protests demanding a return to civilian rule.” 

Earlier this month, the psychopath army killed hundreds of protests. Currently, it presides over a dumpster fire economy, with hyperinflation hitting 250% annually. The facts on the ground seem at odds with hopes for stabilisation, but you never know when these kinds of righteous struggles will calm down.

Samahir El Mubarak, spokesperson for the Sudanese Professionals Association said in December 2021 that, “To put a civilian face on a military coup will not change the fact that this is a coup… We will continue to fight, our journey is long, we are mid-way and we are not going to go back.” On the other hand, the military aims to destroy these hopes of freedom and democracy, through murderous repression=.

This all impacts Codan because it makes large amounts of gold detector sales into Sudan. In my view, the Sudan coup is the most likely reason Codan is no longer being priced for profit growth. This is sensible, because on the conference call the company said that it makes sales of about $40m to $50m in revenue selling just to Sudan (in the absence of civil unrest). 

This could mean that the actual profit of the company declines significantly throughout this civil unrest period, and it would be sensible to assume a reduction of around 20% from metal detection profits, at the very least.

Codan Priced For Decline

Today, Codan is basically priced for decline. In the most recent half, it generated a profit of about 27 cents per share. On the conference call, the company said that it is not expecting much of a skew to the second half, implying that it would be a surprise to make more than about $100m profit, for the full year. More likely, we’ll see something like $90m profit for the full year, with the run rate closer to $40m per half. In that case, we might forecast $80m profit for FY 2023, assuming no growth. That would be at about 44c per share.

This is massively at odds with the 62c per share in FY 2023 consensus analyst estimates. I do not know why the analysts are all so bullish, but the lowest estimate is 59c per share. Either way, the market is not on the same wavelength because the share price is about $7, or just 11.8x the lowest analyst estimate for FY 2023.

Using a more conservative 44c per share, and penalsing Codan a bit for its debt riddled balance sheet, I think Codan is trading on about 16 to 17 times conservative earnings per share, or an earnings yield of about 5.8%. Since “the board expects to continue its policy of paying shareholders in the order of 50% of our full year profits as dividends”, I can expect a dividend of around 2.9% based on my conservative estimated earnings.

Looking longer term, inflation is both good and bad for Codan. First, it is bad, because it means it costs more to build up inventory. We’ve seen some of that impact this half. But second, it is good, because inflation tends to push up the price of gold. Ultimately, Minelab is strongly impacted by the price of gold. Happily, the company says that it increased its prices by around 4% and that had the impact of improving gross margins. This suggests that it retains pricing power, and may be able to increase prices faster than its own expenses increase.

It doesn’t seem likely that the forces of good will win in Sudan, any time soon, so I would expect that market to remain unstable. That said, even the triumph of the forces of evil could result in sufficient stability to resume gold detector sales. My support is of course with the outgunned civilian population, but Codan probably wins with peace, either way.

Unfortunately, we have first hand evidence recently of how important secure communications are, both from Russia knocking satellite communications offline, and the near constant interception of Russian communications by Ukraine. Therefore, there is also some possibility for growth in the communications segment, as a result of these issues coming to front of mind for planners. Additionally, the company’s remote broadcast businesses should benefit (they say) from the relaxation of covid restrictions allowing more sporting events.

Overall, Codan might not be the most attractive business, but it is probably well placed in the current macro environment, so I sold some of my inflation hedge ASX:FOOD ETF to buy shares in Codan as a more risky, but potentially more rewarding gold-price-linked inflation hedge.

Please remember that these are personal reflections about stocks by an author. I own Codan shares and will not sell any for at least 2 days after publication of this article. This article should not form the basis of an investment decision. It is an investment diary valuable only for the cognitive process it demonstrates. We do not provide financial advice, and any commentary is general in nature. Please read our disclaimer.