We initiate coverage on Codan (ASX: CDA) with a fair value estimate of $19.50 per share. We assign Codan a narrow moat rating, Medium Morningstar Uncertainty Rating, and Exemplary Capital Allocation Rating.

The shares screen approximately 17% undervalued, and we think the market has not fully factored in the considerable growth trajectory for its Zetron command center software.

How does Codan make money?

Codan is an Australian company designing and selling communication products and metal detection devices. Its global customer base includes military, security, emergency responders, broadcasters, government, humanitarian organizations, utilities, and mining.

Codan’s communication products business provides command center technology mostly used to coordinate emergency services, such as 911 call centers for its US customers. It also designs and sells lightweight radios, suitable for attaching to drones, mostly for a military customer base.

In the metal detection business, Codan produces hand-held metal detection devices.

A moat from switching costs

We assign Codan a Narrow Moat based on switching costs. We estimate return on invested capital averaging 18% over our explicit 10-year forecast period, to fiscal 2034, comfortably above the weighted average cost of capital of 9%.

Zetron, the emergency services business, is moaty, due to the expected low propensity for customers to switch providers given the importance of the technology, which is used in life-and-death situations. Comprising about 45% of midcycle EBIT, this the fastest-growing of Codan’s businesses as 911 command center operators upgrade their technology. Here, we think the growth opportunity is substantial. We estimate low-double-digit sales growth as Codan sells more modules to existing customers, gains new customers, enters new segments, and introduces new products from acquisitions and internal development. The company is targeting near-term operating margin growth to 30% and we expect it to reach this by fiscal 2027, with higher margins expected in the Zetron business than tactical communications.

Tactical communications, 30% of midcycle EBIT, is Codan’s other communication business. The company’s wavelength communication devices are used by global militaries, including that of the US, Europe, South Korea, and Australia, and broadcasters in large venues such as the Olympics. Their ultra-lightweight and small size mean that their main use-case is attached to drones or commercial camera equipment. Our revenue and margin growth forecasts are similar to Zetron, but with slightly lower margins. Zetron’s higher margins are underpinned by subscription revenue, which we think is virtually cost-free.

Minelab metal detection, 25% of midcycle EBIT, is Codan’s flagship product, with strong market share. We estimate its Minelab product has an equal share of about 30% of the US hobbyist market with large player Garrett. In Africa, it is the largest hand-held metal detection company, with almost 100% market share. Here, individual customers buy metal detectors and independently scout for gold as a source of income. This differs from all other regions where these machines are either used by individuals for a hobby, such as seeking coins on the beach, or a corporation, such as in security. We expect high-single-digit percentage sales growth in the segment, underpinned by new product development, continued demand from African customers, market share growth as it enters new regions, new distribution channels, and acquisitions. We anticipate higher sales volumes to improve operating leverage, leading to our midcycle operating margin estimate of about 40% from 35% in fiscal 2024.

Capital allocation looks sound

We assign an Exemplary Capital Allocation Rating based on our assessment of a sound balance sheet, exceptional investment efficacy, and appropriate shareholder distributions.

Codan’s balance sheet is in good shape. At the end of December 2024, net debt/trailing 12-month EBITDA was 0.8, well below the 3.0 times covenant. Interest cover of 18 times was far above the 3 times covenant. Codan is a regular acquirer of complementary businesses, with six acquisitions between 2021 and 2024 totaling about AUD 370 million. We view the acquisition in Zetron and similar bolt-on businesses as sound strategic decisions to increase the company’s earnings stream and expand into new customer segments. Shareholder distributions of approximately half of adjusted net income are fair.

Cyclicality and geopolitical issues among downside risks

We assign a Medium Morningstar Uncertainty Rating. We consider its hardware sales to be more exposed to cyclicality than communication products, particularly its metal detection product, Minelab, which has some sales to discretionary hobbyist buyers.

Tactical communications and some of Minelab sales are to the military, but these are irregular, placed as one-off sales orders. Additionally, specialized customers like the military are discerning and seeking the latest in technology, which is not conducive to repeat buying.

Other risks are geopolitical, such as the supply to global military customers, who could instead turn to domestic producers for security or political reasons. Additionally, Codan’s Southeast-Asian production facilities could be viewed unfavorably in the instance of global trade wars, particularly with major customer, the US. But we think this unlikely, with most production in Malaysia, and no production in China. We think these risks are remote and exclude them from our base case.

Codan (CDA)

  • Moat rating: Narrow
  • Fair Value estimate: $19.50
  • Share price March 25: $15.92
  • Star Rating: Four stars

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.