In early February, I bought shares of Coda Octopus Group (OTCPK:CDOC) at 15.1 cents each. They were selling for less than 3X earnings, and had produced robust earnings for two years in a row! I determined that this was no "fluke" turnaround.
I discovered that Coda was the owner of a very defensible technology: the Echoscope, a real-time 3D underwater imaging device. Companies with more money had come in and tried to make their own version of the Echoscope, but all had failed. I was elated, having found a super cheap company surrounded by a moat. I figured Mr. Market was just being an idiot by offering me such a deal.
Initially, I had noticed that there were two main issues with the company, and that these were what was holding the valuation down. There was a lawsuit by a past investor, Iroquois Master Fund, charging that Coda had violated an anti-dilution agreement in recent years. And there was another looming issue: $16M in debt due in February 2015. This debt load is roughly equal to Coda's market cap.
Still, I brushed these worries off and bought some CDOC. I had become sold on their technology and their turnaround. I figured that the lawsuit and the debt would kind of "work themselves out." Every company gets sued, right? Plus, the online commenters I read said that Iroquois was a "litigious" hedge fund, so I figured there might not be that much merit to the suit. I decided it wasn't worth my time to read the lawsuit; I am not a lawyer, anyway, so I probably couldn't make heads or tails of it.
A BRIEF SUMMARY OF CDOC'S BUSINESS
Coda Octopus Group's business centers on their Echoscope underwater imaging technology. The Echoscope is a real-time, 3-dimensional sonar device, which is significantly superior to any other device of its kind. It is a great technology; built over the past 20 years with an expertise, which has proved impossible to duplicate, even by much more moneyed interests:
"We are aware of a number of research and development programs by large players to develop real time 3D sonar which have failed." (CDOC 2013 Annual Report, p. 20)
The Echoscope has many applications:
- port security
- harbor defense
- vessel inspection
- examining oil and gas installations
- underwater construction
Whenever one needs to see underwater, the Echoscope is the world's best tool.
Coda also owns two engineering subsidiaries: Colmek in Utah, and Martech in the UK. Through these businesses, the company has extended "tentacles" into the government contract and defense arena.
A BRIEF HISTORY
The chief event in Coda Octopus's history is the 2002 acquisition of Omnitech AS, a Norwegian company which developed the Echoscope. This is the gem of CDOC's business now, as I've described above.
Coda suffered around the time of the recession. Losses mounted upon losses as they continued to develop the Echoscope and other related technologies. Finally, new management was put in place. SG&A expenses were slashed, yet revenues grew. This leads us up to the present situation in which CDOC earned $4.9M in 2012 and $5.3M in 2013.
So, having earned a cumulative $10.2M in the past two years, it does seem a bit odd that the company would only be valued at $16M, right?
AFTER I BOUGHT, I READ THE LAWSUIT
The lawsuit, which Iroquois Master Fund and Plaintiffs have brought against Coda Octopus Group, is quite damning. When I finally read it, I started to see that maybe CDOC is not such a bargain.
Iroquois and other investors bought common stock and warrants from Coda in 2007. Part of that deal was an agreement that CDOC would not issue securities valued at less than the price the investors had paid. If Coda did "dilute" them in this manner, the investors were entitled to a further issuance of shares and a re-pricing of their warrants to counter the effects of the dilutive issuances.
Well, guess what happened? Coda got in a pinch and needed money, and they did indeed issue stock at prices much lower than the $1.00 level that was supposed to trigger the anti-dilution provision in Iroquois's agreement.
However, according to the lawsuit, Coda's management tricked Iroquois and the other Plaintiffs into believing that an 85% threshold of original investors in the deal had agreed to amend the prior agreement. From reading the lawsuit myself, it appears that Iroquois truly did get screwed.
Sometime after the amendment, a former Coda insider came to one of the Plaintiffs and alerted him to the fact that, indeed, the 85% threshold needed to amend had never been met:
"In the Spring of 2013, Plaintiff Cohen was advised by a former corporate insider that he and the other… Plaintiffs… were due many millions of shares and significant adjustments to their Warrants as a result of the Company's dilutive issuances since September 2010. This same insider further advised Plaintiffs that the Company knew that [it] had improperly circumvented Plaintiffs' rights and that Plaintiffs were owed many millions of shares." (Iroquois lawsuit, p. 19, emphasis mine)
Coda's only response has been to say that they "intend to vigorously defend these claims." (2013 Annual Report, p. 69)
The Plaintiffs want 97M shares. There are currently 93M shares of CDOC outstanding, so that is greater than a 50% dilution.
Remember that 3X earnings metric that seemed so juicy? Well, if 97M shares are issued, present shareholders lose half their ownership of those earnings. Now it is a 6X earnings valuation - well, that still sounds cheap...
There is another aspect to the Iroquois lawsuit about which I have seen no commentary online: the warrants. The Plaintiffs received as many warrants as they did shares of common stock when they invested in CDOC in 2007. Since then, Coda issued stock for as little as under a penny, according to the lawsuit. This leads me to believe that the Plaintiffs could actually end up getting closer to 200M shares for essentially nothing. The warrants should be re-priced to reflect the miniscule value Coda received for issuing stock in the interim. In other words, I believe Iroquois and Plaintiffs are entitled to another roughly 100M warrants exercisable for as low as 2/10th of a penny. The current stock price is 17.5 cents.
All told, I see a possibility of a 67% dilution to present shareholders coming. Iroquois has a strong case and probably wouldn't be willing to compromise much in a settlement.
Now we're looking at a valuation of 9X earnings. And on top of that, management has acted questionably if the allegations are true.
DEBT ISSUE COMPOUNDED BY LAWSUIT
On top of the lawsuit, Coda Octopus has convertible debt of roughly $16M due a year from now. It is highly unlikely they will have that much cash by then, so they will need to refinance or renegotiate somehow. The $1.05 conversion price on the debt is too high to make it likely that the debt holder will convert into shares.
From CDOC's 2013 Annual Report:
"The Company does not currently have the cash to repay all of the Debentures. Moreover, in the absence of a significant increase in the Company's cash flow from operations, it cannot provide assurance that it will have the cash when due. If we are unable to pay off the Debentures in a timely manner or renegotiate their repayment terms, the holder of the Debentures has the right to, amongst other things, foreclose on all of the Company's assets.
In addition, to the extent that we are successful in renegotiating the Debentures, this will likely require the issuance of large numbers of stock that may result in significant dilution of our existing shareholders. Renegotiation of the terms of the Debentures will likely be difficult by the current litigation reported in Item 9 (Subsequent Events) of this Report." (pp. 24-5, emphasis mine)
The "current litigation" that could make it difficult to renegotiate the terms of the Debentures is, of course, the Iroquois lawsuit. Coda might not be able to issue shares or drop the debenture holder's conversion price, because they could be in further violation of the anti-dilution agreement with Iroquois & Plaintiffs.
Yet Coda's only solution to the debenture issue (by their own word) seems to be "the issuance of large numbers of stock that may result in significant dilution of our existing shareholders." It's either that or a mini-miracle of new cash flow over the next 11 months.
Coda Octopus has made no public statement of a realistic solution to the Great Pinch they are under. This management has proved adept at turning around the operations of the company, but one is left to wonder if they will be able to navigate this very tough structural position they now find themselves in.
WHY CAN'T CODA JUST BORROW SOME CASH?
One thing that puzzled me was why Coda couldn't just borrow the extra $5M or so they will need to pay off the debenture holder? They had $8.2M in cash as of October 31, 2013. At current cash flow rates, they would have $11M-$12M by the time the $16M is due in February 2015.
A traditional loan would be non-dilutive, of course. Yet the only option Coda talks about is issuing new shares or renegotiating the conversion price with the debenture holder/s. I am led to believe that the company knows that it cannot borrow any money, for whatever reason. I know that banks and regulations are tight these days, but you would think that a company, which has earned $5M each of the past two years, would be able to negotiate a $5M loan.
IT PAINED ME, BUT I HAD TO SELL
In the end, I had to sell my shares of Coda Octopus. The future is too murky and I don't like the allegations, which Iroquois has brought forth.
I love Coda's product and recent operational turnaround, but it seems that there are some big fish higher up on the totem pole right now. I have been disappointed with the lack of vision, which Coda has enunciated in dealing with the lawsuit and debt. And the fact that the lawsuit may compound the debt problem was the final straw, which led me to abandon this company, which I had fallen in love with only a month earlier.
Unfortunately, I have no metaphorical Echoscope to enable me to "see" how Coda will navigate the lawsuit and debt maturity.
PRESENT SHAREHOLDERS, PRAY FOR A BUYER
Now, it seems like the best way out for shareholders is for the company to be acquired. This white knight would probably have to negotiate with Iroquois, as well as Coda.
Despite the fact that I have no doubt that Coda's technology is very valuable, I just don't know if I hear anyone galloping towards Coda's Florida headquarters.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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