Under the radar: Codan (CDA)

PORTFOLIO POINT: Codan is trading at a discount of more than 20% to Lincoln’s valuation, but all the metrics point to a strong future.

At the height of the global financial crisis, Bloomberg published a chart to show how equities exposed to guns, gold and Spam (the canned meat, not the email pest) rose in inverse proportion to a tanking stockmarket. Expect to see a return of the infamous Spam indicator, with gold hitting record highs and the papers awash with prophecies of doom.

Obviously a lot of the soothsaying is just noise, but sentiment can count for a lot in the market. So even if you don’t like Spam it’s never imprudent to stock up on defensive shares just in case everything goes south.

Codan Limited (CDA) is an Adelaide-based manufacturer of military communications devices and gold detectors. It might not be exposed to canned meat but it certainly covers the guns and gold thematic brilliantly.

What’s more, you don’t need to be a bear to like it. This is an excellent small company that, ironically for a business involved with satellite transmissions, has been under the market’s radar since listing in 2003.

Indeed, it’s not every day that you find a financially healthy $238 million company that’s a world leader in anything, but Codan leads in several niche markets. It’s a leading manufacturer of metal detectors, with a new range focused on landmine detection launching this year, and it’s a leader in high frequency radio applications. It also sells satellite communication systems across the globe and is a niche producer of electronic circuit boards. As the customers for these products are typically in the fields of defence, development aid and resources, Codan enjoys a balance of cyclical and non-cyclical revenue drivers.

Its subsequent appeal in good times and bad can be witnessed in its share price, with its performance in relation to gold and the ASX All Ordinaries index suggesting attractiveness for both defensive and growth investors.

Codan began operations in the 1950s, selling HF radios in outback South Australia, but now it counts some of the world’s biggest mining corporations, militaries, non-government organisations and telcos among its clients. With sales offices in Beijing, New Delhi, Britain, the US and Germany, Codan products are now sold in more than 150 countries.

Although it is not unique in being an Australian export success story, Codan is unique in being a high-tech company that’s mainly focused on frontier markets. Whereas Cochlear Limited (COH), ResMed Inc (RMD) and CSL Limited (CSL) sell their wares mainly to the more developed world, Codan’s products are used in such places as Afghanistan, Angola and Tanzania, adding to the counter-cyclical nature of the company’s sales book.

Codan’s HF radio systems are vital in places with a lack of transmission infrastructure, such as war zones, mining sites and remote border outposts. Over the past few years, Codan has filled large orders for the US Army in Afghanistan and Iraq, as well as the Chinese Border Police and the Indian Police for mobile receivers, manpacks and base stations.

Its satellite communications devices are also used by defence and aid organisations in a variety of remote locations, and the company’s 2009 acquisition of Locus Microwave, based in Boalsburg, Pennsylvania, has opened up contracts with the US government. Codan also manufactures narrowband digital microwave radio links and its circuit board business is a leader in Australasia.

Codan’s metal detectors, meanwhile, are not only used by those odd people you see prospecting along the beach, but by artisanal miners throughout the developing world. Artisanal gold mining has boomed over the last year, as gold prices reach new highs, yet penetration of metal detectors is still quite low. Although the 156% increase in metal detector sales between the 2009 and 2010 financial years is unlikely to be repeated next year, the long-term fundamentals for Codan’s Minelab metal detector division nevertheless remain compelling.

We are happy that there’s a short-term market among gun and gold bears, but it is for Codan’s long-term fundamentals that we like the stock. Codan has met our requirements for strong financial health like no other.

Following Codan’s latest annual financial results, we have maintained our share price valuation at $1.75. (Codan closed on Wednesday 20.7% below that, at $1.45.) Our valuation is based on the company’s conservative guidance of $160 million in annual revenues and $20 million in net profit after tax, a drop of 15.9% and 35.7% from 2008-09’s figures respectively, and also offers a clue to why Codan is trading so cheaply to value.

In the market’s infinite wisdom, the success of 2010 is punished due to the inevitability of 2010-11 being a hard act to follow. But on an enterprise value of $1.77 and a single-growth discount dividend model that assumes a mere 3% growth rate, such a discount looks ridiculous.

If we wanted to base our valuation on Codan’s simple price/earnings (P/E) history, the company looks even cheaper. Trading at a forward P/E of just 10.28 times for 2010-11, and 8.63 times for 2011-12, Codan looks inexpensive compared to a three-year P/E average of 22.32 times or a five-year average of 19.02 times. Based on its three-year average, Codan could hypothetically be worth $2.95 per share, twice its current level.

There is indeed a good reason why Codan has traded at high P/E multiples in the past. Unlike other high-tech stocks, it has a consistently high return on assets (24.65% on the basis of its latest results), and consistently high return on equity, the latest being 61.86%.

Earnings per share growth is yet another plus, averaging 36.65% over the past three years and the company's dividend is very consistent for a small-cap stock. Codan's yield sits at 5.52%, and for a company that exports 90% of its products, its dividends are also, very pleasingly, fully franked.

It is difficult to perform a peer analysis of Codan, simply because it operates in such a niche space, but among the other listed stocks in Australia’s tiny communications equipment sector, it is easily the standout in terms of size, return and financial health.

Simply put, this company exports a range of complex products, but its compelling value proposition is easy to understand. We try to stay away from technology companies whose niche products are only used by a handful of customers and are thus exposed to fluctuations in demand and very lumpy cash flows. Codan is a completely different story, as its financials demonstrate.

This is one stock that can be fairly described as high-tech without the high risk.

Michael Feller is an equities analyst at Lincoln Indicators. Lincoln develops Stock Doctor, Australia’s premier fundamental analysis research service. The author or the Lincoln Australian Share Fund may have interests in any of the companies mentioned.