paragon — Radically improving the investment case

paragon continued to display positive momentum in Q123, with semvox treated as discontinued ahead of its c €40m disposal, which was completed in May subject to final account adjustments. The proceeds facilitated the final redemption of the CHF bond and prepare the company for the remainder of the accelerated €25m repayments of the Eurobond that now fall due. The progress in the trading performance is confirmed by management’s unchanged guidance for revenue growth in FY23 to c €170m with EBITDA of between €20m and €25m. When combined with the continuing deleveraging, the investment proposition is being progressively de-risked. We expect the recent re-rating to receive further impetus as the growth plan is executed.

Once again, the continuing operations of both the Electronics and Mechanics divisions recorded growth in Q123. Both divisions grew revenues as the automotive market bounced back from the global shortage of semiconductors and the automotive supply chain disruption, caused by the war in Ukraine, that characterised Q122. Car registrations were up 17% in Europe and 8% in the United States, although China declined 7%. paragon’s operations continued to outperform the market. The key highlights of the Q123 results are:

There was an operating cash outflow from the continuing operations of €2.3m (Q122: €6.0m inflow) largely driven by the drop in profits as well as the switch to twice-a-year payments of Eurobond interest.

Adjusted net debt (excluding leases) increased modestly by 2.4% during the quarter to €88.1m (FY22: €86.0m, Q122: €98.8m), as the €9.7m accelerated bond redemptions were initially paid for from cash balances. Cash and cash equivalents declined to €4.6m (FY22: €18.1m) and lease liabilities totalled €15.2m.

In Q123, the continuing Electronics segment activities’ third-party revenues grew by 4.6% to €28.2m (Q122: €26.9m), accounting for 63% of group sales. The increase reflected a 3.5% decline in Sensors revenues to €12.2m (Q122: €12.6m), more than offset by a 4.2% increase in Interior revenues to €14.5m (Q122: €14.0m). The still-nascent new Power business unit made excellent progress, increasing sales to €1.5m (Q122: €0.5m). The divisional EBITDA contribution increased to €3.8m (Q122: €2.8m), a margin of 13.6% (Q122: 10.6%).

The Mechanics division (Body Kinematics) increased sales by 36.6% to €16.6m (Q122: €12.1m), while the EBITDA contribution fell to just above break-even (Q122: €1.0m) as paragon movasys ramped up volumes on newer products, including seat adjusters, rear tables and adaptive spoilers, in China.

In terms of business development during the period, paragon’s Sensors business unit won a third order for its Sensoric anti-virus filter (DUSTDETECT) with an anticipated lifetime contract value of over €10m. In addition, Power won a contract to supply lithium-ion starter batteries to a premium segment car OEM. Production starts in Delbrück this summer, with an expected lifetime value of more than €40m.

Management has maintained guidance for FY23, indicating sales of c €170m with an EBITDA of between €20m and €25m. paragon does not present an order backlog but does monitor booked business for the next five years, or the anticipated value of sales from contracts secured. It measures this at the year end. From the end of FY21 to FY22, the value of the five-year anticipated sales revenue had increased by 22% to €761m from €624m a year earlier. The expansion reflects the anticipated growth in China, where sales are expected to almost double to c €16m in FY23.

We have adjusted our earnings estimates to reflect the benefit of the continuing bond redemptions. While our revenues and profits before financing charges are essentially unchanged, the decrease in interest payable has a significant effect at the PBT and EPS levels. As a result, our EPS estimates increase by around 50% in both FY23 and FY24.

The disposal of semvox to CARIAD, a subsidiary of Volkswagen, was completed on 12 May 2023. The sale value of €43m was on a cash and debt-free basis so after deduction of a €3m loan the proceeds due to paragon are €40m, although this is subject to closing account adjustments, which should be finalised by early July.

paragon’s management believes €40m is a conservative assumption for total proceeds and received €34.5m on completion, which was initially used to repay interim financing used to facilitate the €21m CHF bond final redemption and the first scheduled partial payment for €5m nominal of the Eurobond in April 2023. The payment of the balance of the proceeds should be made in July at the latest.

The company continues to progress with net debt reduction (Exhibit 3), with the current level of €51.1m (excluding leases) following the April bond redemptions showing a substantial decline compared to €117.4m in FY19. Consequently, we forecast FY23 net debt of €49m, implying a healthier leverage ratio of 2.1x.

Having successfully redeemed the CHF bond, the immediate priority for paragon is to complete the accelerated repayment of the additional €25m nominal of the Eurobond that fell due as a result of the disposal.

Management has already redeemed a further €4.8m of nominal through a public buyback offer in April 2023 at 60% of nominal costing €2.9m. That leaves an outstanding €20.2m nominal (market value at 15 June 2023: €15.0m) to be redeemed by 5 January 2024.

We expect management to secure the balancing repayment using the remaining proceeds from the semvox deal together with a possible modest new line of debt (<€10m). We expect the cash redemption cost to be between the current market value and par (€20.2m).

After this transaction the Eurobond debt will be reduced by 50%, significantly further reducing the interest payable by paragon. We estimate net debt should be less than €50m at the end of the current year. We expect net debt to EBITDA would fall to less than 2x for FY23, a far more manageable and appropriate level for an industrial company such as paragon. This alone should significantly advance sentiment and de-risk the investment proposition. As free cash flow improves with trading, the future bond redemption and debt servicing should be more readily covered.

With such good progress being made in trading and ongoing debt reduction, it is frustrating to have the ownership and management of the company subject to a great deal of uncertainty.

External investor ElectricBrands AG of Germany exercised an option during 2022 to assume control of just under 30% of the listed entity. The stake came from the Frers family holding of 50% plus one share, leaving Mr Frers holding just over 20%. However, our understanding is that the remaining holding may also be subject to the option, but as ElectricBrands clearly did not want to make a full mandatory offer initially, it is unclear as to the precise agenda, control or cooperation. In either event, group management has to date regarded the move as hostile.

However, the KGaA structure of paragon means that even if ElectricBrands exercised the remainder of the option, it would not gain control over the company but just own the majority of the economic value. It would also be forced to make a mandatory bid for the remaining share capital of the listed company. However, in order to gain control of the operations, ElectricBrands could make a bid for the management company, which is 100% owned by the Frers family. In such a case ElectricBrands would need to be seen to treat listed shareholders fairly, so any bid for the listed entity would need to reflect a fair value.

It is unclear to us what the ultimate outcome might be: a bid, buyout or status quo. In any event, given the debt reduction programme and positive trading, we think investors should await further developments.

As the equity value has risen since our last Update note, our calculated WACC has also increased a shade to just over 8%. The result is a decline in our capped DCF value to €23.8/share (€26.6/share previously), although we have not yet reduced the equity risk premium from 10% to reflect the substantial deleveraging of the company. The table below provides visibility of how that adjustment may affect the value.

While the shares and Eurobond are now trading at recent highs, the low single-digit FY24 P/E multiple of just 3.2x fails to reflect the operational outlook. Our capped DCF valuation of €23.8 per share implies a multiple of 13.1x our revised post disposal FY24 EPS estimates. While this might look ambitious, we feel that such a multiple could increasingly be supported by fundamental metrics as the growth strategy is executed, with strong earnings improvements and rising operational cash flow facilitating further future reductions in the debt burden.