paragon — Growing pains at Voltabox

paragon’s trading performance was below management’s expectations primarily as a result of issues that affected the Electromobility segment (Voltabox). There were also some higher than expected new product development costs and site integration costs incurred by the Automotive segments, Electronics and Mechanics (paragon movasys). As the issues continue to have an impact in H219, management significantly reduced guidance for FY19, and we have reduced our estimates for FY19 and FY20 to reflect the slower than anticipated growth.

The highlights of H119 are:

The Automotive facing segments of paragon, Electronics and Mechanics, continued to face challenging market conditions but nevertheless delivered revenue growth of 6%. However, the top-line growth of the two segments was markedly different, with the Electronics segment seeing almost little change and the Mechanics segment continuing to grow strongly (+22%). Gross profit from the Automotive segments was broadly maintained at €36.7m (H118: €36.6m) albeit gross margin fell to 54.3% (H119: 57.2%).

While the revenue performance of the Electronics segment was flat, the segment incurred additional costs as the acquisitions from 2018 (SemVox and LPG) are integrated into the existing paragon activities including the establishment of the new Digital Assistance subsegment. These costs noted by paragon in H119 will total c €3.5m for the full year and will be incurred largely by the Electronics segment. The challenging automotive market conditions also continued to increasingly affect one major German customer as Q219 progressed, which led to lower demand for the Sensors subsegment and the Acoustics division in the Interior subsegment. However, the Cockpit division of Interior and the initial €1.8m revenue contribution from Digital Assistance helped to mitigate the negative impact.

Overall, after the one-off integration costs, the Electronics segment generated an H119 EBIT loss of €1.4m (H118 positive EBIT of €4.1m).

The Mechanics segment, paragon movasys, continued to show strong revenue growth as series production of software controlled rear spoiler drive technology grew. However, the segment incurred considerably higher labour and material costs relating to new product launches from the former HS Genion activity acquired in late FY17. As a result, Mechanics generated an H119 EBIT loss of €3.4m (H118 positive EBIT of €0.4m).

In H119 Electromobility (Voltabox) grew revenues 77% to €32.1m (H118: €18.1m), with gross profit improving 45% to €15.4m from €10.6m despite disruptions, but nevertheless below management expectations largely due to slower development of US intralogistics sales than targeted. However, the emergence in H119 of a new incremental potential market segment for mobile phone mast backup power systems had appeared to underpin FY19 prospects.

Electromobility incurred an EBIT loss of €3.6m in H119. However, the European operations made a loss of just €0.1m with the US subsidiary (Voltabox of Texas) making a negative contribution of €3.5m. The loss in the US was largely due to additional personnel costs and procured materials incurred in anticipation of higher planned production.

The higher procurement costs arose from a change in planned mix during the period. While the US sales network and regional plan for intralogistics had been initiated and improved, the sales development in the segment had been disappointing. However, the emergence and rapid development of a new opportunity in backup power systems for 5G mobile transmission masts required additional investment in inventory and resources in anticipation of the expected commencement of deliveries in August.

In Europe the contracted sales for intralogistics to Triathlon for FY19 had been completed by the end of H119. In addition, there was a full contribution in H119 from ACCURATE that was acquired in 2018, and is supplying the growing market for e-bikes and pedelecs.

The group 60-month order backlog remains largely unchanged at €2.1bn suggesting solid prospects for all of the group activities, However, after the disappointing H119 performance and with the issues faced by Voltabox in H219, from an investment perspective the main focus for the managements of both listed companies should be to rebuild investor confidence. A major element of this must come in executing the Voltabox growth strategy, and returning both sides of the group to profitable growth with an accompanying improvement in cash flow performance. The company is going to place additional focus on development returns, allocating investment capital to products with stronger potential revenues.

Global automotive market conditions remain challenging, and paragon appears to be performing reasonably well against the market backdrop. In part this seems to be due to the somewhat niche, proactive development and specialist nature of many of the products that target the premium end of the car market.

Electronics has been undergoing a period of transition of products to new more sophisticated generations as well as developing and introducing new technologies that should start to contribute to additional growth in the future. In the meantime, margins should start recovering towards historical levels as the one-off costs taken in FY20 should not recur, and should provide greater operational efficiency for the segment.

In Mechanics, management expects a combination of operational leverage as new product volumes ramp up at paragon movasys to combine with already implemented targeted cost reduction measures that will complete by the middle of FY20 to return the segment to profitability, with EBIT margins of 3–4%.

While Voltabox has had to pull back its guidance for growth this year, it is still expected to show strong progression.

The two issues that have adversely affected FY19 performance are:

The reengineering for the mast supply contract is in hand and should lead to commencement of volume supply by 2020. Having supplied six verification systems to the Austin, Texas-based customer in 2019, the initial regional supply contract is for 2,200 units. However, in August the customer requested increased durability to 44 hours from 33 hours but with a reduced cycle life from 3,600 to 1,500 cycles. Voltabox indicates the higher specification is not technically challenging but requires a bigger battery with simpler management systems, as well as further validation tests.

The deferral of $22m of H219 revenue from the mast contract to FY20 is in itself significant, but the potential opportunity being opened up for transitioning mobile mast backup power systems from traditional lead acid solutions to lithium-ion technologies dwarfs this, and is likely to be global. In a large city, 5G networks are likely to require 3,000 to 5,000 transmission masts. Studies indicate Germany alone would require 0.75–1.20m masts, so if Voltabox can gets its offering right, it appears to be positioned in a strongly growing segment. Management expects strong double-digit margins on the initial revenues.

A battery cell supplier was unable to fulfil H219 supply requirements as it changed its production process to manufacture the latest generation of cell technologies, which in time should enhance the performance of Voltabox’s power packs. There will be a loss of supply of two to three months, with no ability to source from alternative manufacturers, with existing old technology cells in stock being manufactured into modules held in inventory. As a result, some product lines at Voltabox, including the most efficient from Aumann producing prismatic cells (as well as the similar line in Austin), are likely to be inactive for three to four months, with an estimated €12m of revenues deferred to FY20. In addition, Voltabox is the process of validating three other cell suppliers to ensure that in the future it has more options to guard against such a supply chain disruption.

For Electromobility as a whole, the €1.1bn order backlog remains broadly stable, providing support to longer-term expectations, and growth should accelerate as production returns to normal in FY20, and new applications and customers are introduced.

The newly developed mobile mast systems opportunity joins the currently growing intralogistics (fork lift trucks and automatically guided vehicles), electric bus, mining vehicle, agricultural and construction equipment and two wheeler segments. There could be some reduction in growth in intralogistics if economic conditions depress the market, and if the Triathlon supply agreement generates no further sales in H219 as all planned FY19 volumes had been delivered in H119. Overall lower input costs combined strong revenue growth and improved profitability is expected in FY20, assisted by an overhead and cost reduction programme currently being implemented at Voltabox.

The extended payment terms to Triathlon under the 2018 supply agreement were not due to unwind until H219 with around €45m of receivables still to be collected at H119. An agreed payment schedule for H219 should see around €40m of the outstanding cash flow back to Voltabox, which appears to be the main reason for management’s relative confidence in its liquidity levels. For example, on the H119 results call, Voltabox management stated that new credit lines that had been secured for unforeseen circumstances were not expected to be required in H219.

In addition, paragon, and especially Voltabox, had been building inventory levels in anticipation of higher H219 demand levels. While some of the excess inventory level is expected to be worked off to alternative customers in H219, the committed supply agreements at Voltabox for the now deferred mast system contract are likely to add to inventory by the year end. We expect the major inventory reduction will occur in FY20 as the deferred contract is delivered and stocks of standardised battery systems are worked off.

The resulting H219 movement in working capital combined with still high levels of tangible and intangible asset investment at paragon and Voltabox, together with the reduced profitability, are expected by paragon to result in a modest inflow in H219 at both Voltabox and the Automotive activities. Assuming a more successful delivery of growth in FY20, we expect a better cash performance aided by further significant inventory reduction.

Revised FY19 guidance provided by management in August is as follows:

Voltabox is set to announce Q319 results on 13 November 2019 and paragon a day later on 14 November 2019.

We are somewhat belatedly lowering our estimates in response to the revised guidance in August, and with Q319 results due in a mid November we will look for any additional guidance update then. The reduction reflects lower sales from the Voltabox range combined with a lower level of profitability within the new guidance. As discussed, sales for the Automotive segments (Electronics and Mechanics) are now expected to be towards the top end of the previously guided range at around €130m. However, profit expectations have also been reduced due to the €7m of one-off consolidation and integration costs, some excess material costs, as well as higher than expected new product development costs in Mechanics.

The reduced guidance for Voltabox has clearly affected the market value of paragon’s 60% majority stake. However, when we disaggregate the stake from paragon in order to value the Automotive segments, the implication is that they have a negative equity value. While it would appear concerns over liquidity are the primary cause of this perspective, the managements of both Voltabox and paragon appear to be comfortable that there is sufficient financial resource to recover cash flow performance to a more positive position. Management must clearly deliver the recovery of Voltabox and improved profitability at the Automotive segments in FY20, alongside a major reduction in the working capital burden starting from H219 as the Triathlon receivables are secured.

Assuming the company can achieve the recovery in financial performance towards EBIT margins around 9% or better, then the capped DCF valuation could provide a longer-term indication of potential. At present this stands at €32.4 per share, significantly below our previous value of €85 due to an increased risk assumption in WACC with a cost of equity of 15%, higher than expected current debt levels, and reduced near-term and terminal cash flows. The calculated WACC of 8.1% is also higher than previously but is constrained by the higher proportion of relatively lower-cost debt funding. The sensitivity of the DCF value to WACC and terminal growth rates are summarised in the table below.