Paragon — Automation to drive enhanced returns

paragon was founded in1988, originally as an industrial electronics subcontract manufacturer, but subsequently concentrating on the automotive market. Its strategy is to develop products and systems ahead of OEM demand to capture market-leading positions in niche applications. This has been consistently demonstrated and the group is currently commencing a significant growth phase based on: 1) a strong underlying automotive core with increasing systems content and revenue per vehicle, worth several times product sales, offsetting potential cyclicality; and 2) new market segments such as electromobility and body kinematics.

We believe that paragon should be rated as a high growth, technology-rich automotive supplier. While the group is trading on a significant premium to its nearest peers, we believe this premium is justified by the company’s substantial above average market growth profile. To gain a true appreciation of the intrinsic value within paragon, we feel that a DCF valuation provides a more complete view of both its growth and margin potential. Our updated DCF fair value, reflecting our improved medium-term growth and margin forecasts yields an increased fair value of €82.1/share (from €40.1/share in October 2016).

With significant growth drivers across the business, we forecast a three-year CAGR in revenues of some 26% driven by the €1.2bn lifetime order backlog, over half of which is in the fast growth electromobility division. With highly automated production lines in place, margin expansion is anticipated, supporting a three-year CAGR in EPS of 63%. An elevated investment phase, which has seen €56m invested over the past two years is beginning to ease, and we forecast the group to transition to a cash generative delivery phase with improving free cash flow from FY18.

With the majority of sales direct to the automotive market, paragon is sensitive to economic conditions and automotive trends; however, it is less correlated to mass market cyclicality.

paragon was established by founder and major shareholder, Klaus Dieter Frers in March 1988, originally as an industrial electronics subcontract manufacturer, but subsequently concentrating primarily on the automotive market. Exhibit 1 below highlights the group’s timeline:

The group has undergone six key phases: 1988-1995: start-up in industrial electronics; 1996-2000: entry into automotive electronics; 2001-2008: emergence as a systems supplier; 2009-2011: concentration on automotive; 2012-2015: expansion to higher-quality systems and adjacent markets; and 2016 on: optimisation of the operation. The approach has been to identify emerging trends and develop products ahead of OEMs. Acquisitions have also played a part, such as SphereDesign in February 2015, which expanded the group’s capability into digital cockpit displays.

The group is organised by product divisions and following a reorganisation at the start of 2017, the divisional structure is as shown in Exhibit 2, supported by a central manufacturing organisation, productronic, which provides efficiencies of scale in manufacturing and is charged to divisions based on utilisation rates.

paragon operates a centralised, highly-automated manufacturing approach with products designed for ease of production from the outset, giving the company a competitive edge over many of its peers. While there appear to be many competitors, in reality very few participate in more than one or two specific product lines. Exhibit 3 shows the locations of paragon’s operations.

As the graphic shows, the group has expanded beyond its traditional German roots with the Voltabox of Texas facility opened in July 2015 complying with the Buy American Act and providing some protection against US administrative changes. Likewise, the paragon Automotive Kunshan production facility was opened in autumn 2015 and has provided the group with local capability that has seen significant indigenous OEM wins.

In June 2017, the group reorganised its corporate structure at its German Voltabox subsidiary from a GmbH into a stock corporation (AG) and transferred the shares in the American subsidiary to the German subsidiary to provide greater strategic flexibility. Exhibit 4 highlights the new structure:

Paragon has followed a strategy of evolution built upon strong principles of technology and innovation supporting megatrends with the purpose of enhancing the driving experience for passengers of modern cars.

Key to paragon’s approach is the management philosophy that has been instilled by the founder and CEO Klaus Dieter Frers since the group’s creation in 1988, whereby product development is guided through analysis of what the end user will require in the future. As the group has grown, the same approach to creativity has been fostered and enhanced, maintaining the family-owned agile and entrepreneurial culture, while benefitting from the larger corporate integration capability. In April 2014, the management board was expanded with the appointment of Dr Stefan Schwehr to the post of chief technology officer (CTO), responsible for development, sales, and customer management. The appointment allowed Mr Frers to concentrate on new growth segments and internationalisation.

The business invests in product innovation using a push principle, only taking products to the OEMs once working prototypes are available and patents filed. This keeps IP with paragon and allows it to maintain an advantage over competitors who tend to be more reactive. It also allows paragon to occupy lucrative market niches in the premium segment at an early stage. The group’s growth strategy can be summarised as follows:

This growth strategy is built upon both the strong historic foundation and an inherent focus on cost efficiency with a design for manufacture approach undertaken from the start. This focus is shown in the rapid uptake in automation across the group, a key feature that will ensure bottom line growth also follows the top line.

paragon’s innovative approach has allowed it to build a position as a leading tier one partner of premium OEMs, originally focused in Germany, but now expanded across the globe as shown in Exhibit 5 below:

While c 70% of the group’s revenues are derived from the German automakers VW Group, Daimler and BMW due to the historic uptake of enhanced features in the premium segment, the group has seen demand extend further through the OEM customer base as such features become more common across further model segments. For example, following the opening of the group’s Chinese production operation in 2015, there are several indigenous Chinese OEMs within the “other” segment such as GAC Motor, Changan and Sanden. In addition, the US auto manufacturers are responding to European quality by increasing their own comfort features increasing the opportunity with the likes of GM and Ford.

As a result of the rapid growth of the electromobility division, two of the strategic partners that paragon is supplying, Triathlon and Kiepe Electric now respectively account for 9% and 4% of group revenues from a standing start less than three years ago, showing the significant growth in this division, which now accounts for 14.5% of revenue in total in H117.

With innovation a key component of paragon’s strategy, the group spends an above-average level on R&D, averaging c 10% of revenue pa over the past five years and reaching 14.8% in FY16. This compares to an average spend of mid-single percentages for other automotive electronics firms such as Hella, which intends to spend about 8% of sales on R&D. The group has a unique combination of capabilities across systems engineering, electronics, software, sensor chemistry and physics, as well as electromechanics, which positions it to develop products with unique selling points that OEMs demand. In return, paragon maintains significant IP and superior margin performance compared to typical peers in the automotive equipment supply chain.

paragon has also moved from a provider of simply components and products to a developer of entire systems, increasing the content per vehicle to many times that of a single product and becoming increasingly involved with development with OEMs as a strategic partner.

Following the decision to directly enter the electromobility market through creation of its Voltabox subsidiary in 2013, the group has followed a clear strategy to expand into several niches of the electromobility market, focused on the capital goods segments with key strategic partners who already have established distribution networks and clients. This has seen the group deliver over >21MWh of energy capacity installed since 2013:

With each strategic submarket opened up by paragon, there is a clear economic driver for participants to convert to lithium ion batteries from existing lead-acid battery sources and hence it tends to be a substitution process rather than new development. This significantly de-risks the uptake of the technology and hence provides greater visibility for the group than in mass market automotive areas. Where there are niche opportunities however, the group will participate such as the July 2015 €72m, six-year contract from a well-known German automotive OEM for battery packs to be used as starter motors within conventionally powered vehicles. Likewise, a development team of experienced experts has been established at the newly created facility in Aachen focused on drivetrain components including power electronics providing paragon with the full range of capabilities. The 48V lithium-ion mild hybrid technology developed by paragon holds additional potential for specific mass market applications.

We recently visited the group’s Delbrück operations to witness first-hand the change since we first visited the site in 2015. There are several key observations we made that will ensure that paragon both has the necessary capacity to support the substantial growth requirements from its clients and to drive further margin accretion through increased efficiency:

Doubling of site footprint and increased workforce in place

Following the group’s 2016 capital raise, the group invested in expanding the footprint of the Delbrück site taking the total footprint of the group to c 25,000 square meters of production and storage facilities. At the same time the structure of the production line was improved along increasingly lean operational principles with a total of 21 production robots across the group by the end of 2016. This has enabled the throughput and capacity utilising existing workforce practices to increase substantially and has contributed to the group’s ability to rapidly scale up the business in-line with demand.

Automation the next stage of efficiency

While the group has utilised the concept of design for manufacture and cost from the outset, the introduction of the new automated production line for intralogistics at Delbrück provides the group with substantial future efficiency gains. Exhibit 6 below highlights management’s guidance on the key operational improvements that the line will provide:

The introduction of increased automation in the electromobility division will provide paragon with greater flexibility as volumes ramp up and allow margins to significantly increase from the largely fixed cost base. The benefit of this can be seen in the electronics division, where the high degree of automation allows paragon to achieve divisional margins of c 15% vs group margins of 9% in 2016.

A scalable architecture at home and abroad

Importantly the group has designed the automated intralogistics line with growth and scalability in mind through a modular approach. The machines were provided by Aumann, with the first line commissioned in June and room for a second line already available as demand ramps up. Each line costs c €1.5m to install and commission.

With the knowledge gained at the Delbrück site, paragon could replicate the line in its Voltabox, Texas, facility as demand ramps up. Likewise, while the line currently supplies cylindrical and prismatic batteries, developments are in place to allow production of pouch cells, which would open up further market opportunities for the group. These developments highlight that the evaluation of the division is likely to continue.

paragon’s FY16 and Q217 results clearly showed that the company is on a firm growth trajectory, having met management’s guidance despite some timing issues as old programmes ended ahead of new product introductions. With the confidence that this provided, management has reaffirmed its guidance for FY17 revenues of between €120-125m at an EBIT margin of 9.0-9.5%.

FY16 results demonstrated the positive developments at the group, reaching management’s guidance and in line with our forecasts. The group delivered revenue up 8.2%, EBITDA up 13.2% and EBIT up 14.4% at an EBIT margin of 8.7%. Electromobility remained the key growth driver, up c 93% to €14.3m or 14% of group revenue from a standing start barely two years ago and despite some project delays into 2017. With other areas of the group also contributing strongly (Cockpit and Acoustics, in particular), the group achieved our revenue and profit forecasts.

This was followed up by H117 results, which demonstrated a continuation of the strong growth, with revenues up 13.3% to €55.3m, driven largely by Electromobility (up 78.1%) and now accounting for c 14% group share of revenue. EBITDA increased by 17.7% to €8.0m despite a step-up in personnel and EBIT was up 5.3% at €3.7m following the increase in D&A. H117 also saw the construction of the new automated production line for Voltabox in Q1, which we subsequently visited.

Given the investment phase that paragon has been undertaking over the past three years, free cash flow has been negative following the substantial investment in new business ventures, production facilities and R&D. Over the past two years, the group has invested c €56m across the business with a further €27m planned in 2017 to accelerate the delivery capability of the group. We subsequently see this progressively dropping to a run rate of c €8m pa. With the group moving into a delivery ramp up phase, we expect this cash outflow to ease and turn positive, albeit the group will continue to identify and use funds to drive further top-line growth where new opportunities present themselves.

In June 2017, paragon announced that it was pursuing a bond issue to support accelerated growth in 2017. Following an extremely successful marketing period, the group closed the issue early in an accelerated fashion. This allowed paragon to close the bond issue at an elevated level of €50m versus the original target of €40m at an interest rate margin of 4.5%, the bottom end of the indicated range of 4.5-5.0%. This compares to the 2013 bond, which c €13m of the proceeds will be used to repay, and which had an interest rate of 7.25%, highlighting how the funding structure is being optimised.

The remaining proceeds from the issue will be utilised to provide further flexibility for growth projects. This includes: investment on working capital for orders under contract; further expansion of the Chinese business; potential acquisition activity in support of electromobility; further R&D with a particular focus on autonomous systems; potential further geographic expansion; and new capital expenditure of plant and production facilities as necessary. In total, investment is expected to increase to some €27m in 2017.

The most significant driver of our short-term forecasts is the ramp up of the electromobility division, as the automated production lines come on stream and the significant order backlog is delivered. With over half the lifetime order book of some €1.4bn related to the electromobility division, this is set to become the largest contributor to growth over the next five years. There will also be a further kicker to growth from 2018 as the new production programmes ramp up in both Mechanics and Electronics. Detailed divisional forecast drivers are as follows:

The electronics division has several effects on the growth profile across the different units, driven by the combination of increasing take rates and model transitions as new products transition into serial production:

The Electromobility division has demonstrated its ability to ramp up significantly as new contracts have come on stream even before the fully optimised automated production line was on stream. Exhibit 7 below shows the growth in installed energy capacity, which highlights this step up.

We forecast that the significant ramp up in electromobility is set to continue as the new contracts across the subsectors come on stream, supported by the newly installed automated production line. We assume the following key inflection points for each contract:

The Body Kinematics unit of Mechanics revenue was up 23% in H1, as the unit moves from development phase into serial production of new product generations of adaptive rear spoilers. Serial production of the first programme began in Q2, with another four series planned for production by the end of the fiscal year. As a result, we forecast that FY17 will start to see some year-on-year growth, arresting the decline of the last couple of years due to programme phasing, and is set to ramp up over FY18 and FY19 as the serial production runs begin in earnest. We saw on our visit to Delbrück the initial production runs commencing, and the lean manufacturing setup of the new expanded facility. With longer-term drivers for adaptive aerodynamic surfaces, the Body Kinematics unit is supported by the megatrend of fuel efficiency, which will be equally important in electric cars as in traditional fuel burning variants.

Exhibit 8 below highlights the key divisional and group-wide assumptions. As can be seen, there is a significant step up in our forecasts in our introduced FY19 numbers, which reflect the fact that each of the strategic markets currently being addressed in electromobility will have ramped up and be running in parallel. With a lifetime order backlog of over €600m in electromobility already, our forecast simply reflects delivery of the order book and easily supports our forecasts without any further orders being received.

As a supplier into the automotive and related markets, paragon’s development is linked to an extent to global economic growth and automotive market drivers. The group is also influenced by evolving corporate development, as it grows to address adjacent markets:

Since our initiation of coverage of paragon in September 2015, the shares have rallied by 343% as the potential of the group has been recognised and significant newsflow has validated the demand for the electromobility division. While this leaves short-term relative ratings appearing stretched, we believe that as the group continues to deliver the growth and demonstrates the benefits of the investment in automation and efficiency, a further re-rating may be possible. With the combination of strong FY16 and Q117 results and the operational improvements we witnessed on our visit to Delbrück, we have reassessed our medium-term prospects for the group and raised our assumptions. This has resulted in an increase in our fair value to €82.3/share.

As can be seen in Exhibit 9 below, paragon trades at a substantial premium to its nearest listed peers in the automotive electronics & interior sector. We believe, however, that the premium is justified by the superior above-market growth rates, with a c 26% 2014-17 CAGR in revenues many times the peer group average, which we expect to continue as the company is entering the next growth phase. As a result, we believe that paragon should be viewed as a high-growth, technology-rich, automotive supplier, which reflects the business model rather than the traditional electronics and interiors peers. This is also highlighted by a PEG ratio of 0.8x (2017e EPS divided by 2014-17e EPS CAGR) compared to the group average of only 1.3x.

To gain a true appreciation of the value potential of the group, we instead prefer to utilise a longer-term DCF valuation approach.

Following our visit to Delbrück and reflecting recent results and the June bond issue, we have updated our long-term financial assumptions for an increased EBIT margin potential (long-term target of 12% versus 10.5% before and 8.7% in 2016), driven by investment in automation and efficiency, and reduced our WACC to 7% (from 8%) to reflect the stronger balance sheet and cheaper debt. We use a terminal growth rate of 2%. As a result, our updated DCF fair value has increased to €82.1/share, as shown in Exhibit 10. With a strong backlog and order visibility supported by a transition from investment to production, we believe that execution is now the major focus and value driver for the group. As the ramp occurs, we forecast that free cash flow will improve, debt will further reduce and the fair value will respond accordingly.

A 2% reduction in our long-range revenue forecasts would reduce the DCF fair value by 11% to €74.1/share, while a 2% reduction in our margin assumption would result in a 17% decrease in fair value to €70.3/share.