paragon — It’s electrifying

paragon is a tier 1 automotive component and electronics supplier founded in 1988 by the CEO Klaus Dieter Frers. However, unlike traditional automotive suppliers paragon employs a team of engineers to develop innovative solutions that lead customers to adoption. It is based in Delbruck, Germany but also has subsidiary operations located in the US and China. In FY17 Germany accounted for 72% of revenues primarily to automotive OEMs, with 23% sold in the rest of Europe and 4% from other regions. Following a reorganisation in 2017 it operates through three divisions; Electronics (73% of FY17 revenues), Electromobility (20%) and Mechanics (8%). On 13 October 2017 the company successfully floated 39.97% of the rapidly growing Electromobility segment, named Voltabox, on the Frankfurt Stock Exchange (in the Prime Standard segment) in a €475m IPO. In Q218 the company changed its legal structure to maintain the current growth strategy and strengthen access to capital markets.

The change of legal structure to that of a KGaA, a partnership limited by shares, ensures the continued involvement of the founder with the development, strategy and management of the group. In addition, it should provide greater flexibility in raising funds through the capital markets especially if it leads to the inclusion of paragon in DAX Indices in the future. While the structure may appear somewhat retrograde in UK corporate governance terms, it is a common structure in Germany with Hella and Fresenius examples of KGaA corporate structures. It should remove the potential financial constraints under the previous structure, enabling investment for growth.

The flotation of Voltabox adds a new dimension to the valuation of paragon. With a market value attributable to a large, rapidly growing and identifiable part of its business, consideration of the nature of paragon’s strategy to grow and develop innovative businesses within the Electronics and Mechanics segments comes to the fore. We continue to believe that these parts of paragon should also be rated as high growth, technology-rich automotive suppliers. We expect EPS to double between 2018 and 2020. While the initial euphoria of the floatation has dissipated, our DCF valuation for the group highlights its potential and currently stands at €98 per share. Taking an average of this and our composite peer group value of €66, provides a fair value of €82 per share.

The rate of growth at the company continues to be dynamic, despite the transition of the sensors business in electronics to a new generation of products as more mature, higher-margin product lines come to the end of their lifecycle. Guidance from the company for 40% top-line growth is driven primarily by growth of Electromobility and Mechanics, with the latter benefiting from the addition of HS Genion for a full year. Electromobility (Voltabox) is expected to more than double revenues to €60m, generating a 10% EBIT margin, while Mechanics (movasys) is at a slightly below group average EBIT margin. Overall, the group guidance for FY18 is for €175m of revenues with a c 9% EBIT margin and investment of around €35m. Looking further ahead, the Electronics segment is expected to see renewed growth in 2019 as the lifecycle transition effects a move to a more favourable phase. As the benefits of the highly automated production support the increased volumes, we expect EBIT margins to progressively expand towards 12%, which we were previously anticipating. Sales are likely to be some 15-20% higher than we expected a year ago, largely due to the rapid expansion of Voltabox volumes as it executes its substantial order backlog.

paragon was established by founder and major shareholder, Klaus Dieter Frers in March 1988. It was originally an industrial electronics subcontract manufacturer, but subsequently focused on automotive electronics and systems supply and moved into adjacent markets. It has consistently used its engineering capabilities to identify trends ahead of the OEMs and provide innovative solutions to address them. The organic growth strategy has been supplemented by acquisitions. The addition of HS Genion in December 2017 is another example, providing a path to it becoming the clear leader in body kinematics systems. The purchase of Concurrent Design in April 2018 adds technical expertise to enhance Voltabox’s development capacities, while the Navitas acquisition should profitably extend the value chain towards highly customised battery cell production.

The company has changed its legal structure to that of a KGaA, a partnership limited by shares. In this structure the company is composed of a general partner and limited liability shareholders. It is a fairly common structure in Germany with companies such as Hella and Fresenius examples of listed entities operating under KGaA structures.

The KGaA structure consists of a general partner to manage the business, which would be paragon GmbH, 100%-owned by the Frers family with managing directors appointed by them. The limited liability shareholders would elect the supervisory board of paragon Gmbh & Co. KGaA at annual general meetings, who would also provide oversight of paragon Gmbh. It is a popular corporate structure with family-controlled entities in Germany, such as paragon, as it maintains effective control while increasing access to capital markets.

Essentially it should mean that paragon can raise funds to pursue its growth strategy without the family necessarily taking up its full pre-emption rights in future capital raisings. To maintain control under the previous structure, pre-emption fulfilment by the Frers family would have been required, meaning it was a potential constraint to investment decisions being progressed. In turn, the ability to raise additional funds without full subscription by the Frers family could increase the free float of paragon shares and allow them to be included in DAX indices in the future, further increasing the attractiveness of the stock to certain funds.

The advantages of the change in structure include:

Disadvantages are:

On balance the company believes the positives outweigh the negatives for shareholders, as the ability to grow the company is enhanced for the benefit of the family and shareholders alike.

Following ratification at the AGM on 5 May 2018, the conversion to the new KGaA structure was completed on 5 July 2018. The founder, Klaus Dieter Frers is chairman of the board of the general partner company, paragon GmbH. Other board members are Dr Stefan Schwehr the chief technology officer (CTO) and the new head of automotive operations Dr Matthias Schöllmann, who has been appointed from 1 September 2018. He was previously at Hella, another family KGaA. Mr Christian Johansson joined from Webasto as the new head of finance on 1 July 2018.

Since a reorganisation at the start of 2017, the group has been operating under three divisions Electronics (sensors, cockpits and acoustic), Electromobility (Voltabox; battery modules and management systems) and Mechanics (body kinematics; now renamed movasys following the HS Genion integration). These are supported by the central manufacturing organisation, productronic, which provides economies of scale in manufacturing and is charged to the divisions depending on utilisation. The Electromobility division, which consists of Voltabox, was part floated in October 2017 via the listing of 39.97% of its shares on the Frankfurt Stock Exchange.

paragon’s philosophy of highly automated, centralised manufacturing of products designed for ease of production provides a competitive advantage over many of its peers. The competitive landscape is fragmented, with few peers operating across more than a couple of paragon’s product lines.

As a result of the recent corporate adjustments the current group structure is shown in Exhibit 3.

paragon is evolving its strategy under an initiative known as PUSH 2018:

It is a natural development of the strategy of utilising paragon’s core competences in technological innovation and engineering resource to identify global megatrends affecting the automotive market, and provide solutions to improve the driving experience of passenger cars. Using the push principle, products are only presented to OEM customers once prototypes are developed and patents filed, providing significant IP protection. It also differentiates paragon from many of its automotive supply peers who tend to be reactive to OEM requirements. It enables paragon to dominate key product niches in the premium segments, with competitiveness maintained through the investment in cost-efficiency and increasing M&A integration scale.

The approach maintains the philosophy instilled by the founder and CEO since the company was formed in 1988. The agility and entrepreneurial nature of the business has allowed it to grow through product development, increased market penetration, development of new markets and diversification into new submarkets. The resultant emergence of Electromobility and Mechanics as high-growth segments are clear outcomes from the strategy.

In addition, the development of increasingly sophisticated products is enabling improved sales prices per product, with an average increase in 2017 of 16%, or 25% since 2015. The trend is important as the electronics product portfolio transitions from one generation to the next.

The global megatrends that paragon considers relevant to its strategic development remain consistent. These are

paragon’s strategy has enabled it to remain a leading Tier 1 partner of its Electronics segment’s historic customer base of premium automotive OEMs in Germany. Since opening the Chinese production facility of paragon Automotive Zunshan in 2015, several Chinese automotive OEMs have been added to the customer roster, and provide an opportunity for increased sales of certain products in the future. Similarly, products are expected to be adopted by US manufacturers as they respond to European quality. The growth of Electromobility also extends paragon’s international footprint, as it develops new end-market subsegments such as intralogistics (forklift trucks and automated guided vehicles), trolley buses, mining equipment, agricultural vehicles and motorcycles.

The proportion of sales derived from the top premium German automakers (VW Group, Daimler and BMW) continues to decline, and we expect it to reduce from c 70% in FY17 to around 55% in FY18 largely due to the strong growth of Voltabox, which is forecast by management to account for more than a third of revenues this year.

At the end of Q118 the group had a lifetime order backlog of €1.96bn, weighted for the expected contract lifetime and the probability of occurrence, which is equivalent to more than 10x anticipated FY18 revenues. Of this, over 68% is subject to signed contract or framework agreements.

The Electromobility operations of paragon consist of Voltabox’s operations based in Germany with a US subsidiary operation in Texas. The businesses supply advanced, modular, rechargeable, lithium ion battery systems. These consist of stacked lithium ion cells providing system voltages ranging from 12V to 1000V, with an energy content ranging from 120Wh to 1.6MWh.

The expected market dynamics for Voltabox are very encouraging. As the world electrifies, Voltabox expects the global battery market to increase in value from $59bn in 2018 to $160bn in 2025. Current end-market segments addressed by Voltabox of around $2bn are expected to grow at around 11% per year over the period but direct adjacent markets that are to be entered increase the 2018 addressable market by c $20bn. Together with potential new market segments, this increases the overall addressable market to around $25bn this year. The total addressable market is expected to be around 50% of the global battery market by 2025, or c $80bn.

Voltabox’s operations are divided into three business segments:

Electromobility has been and is expected to remain the largest contributor to paragon’s profits growth over the forecast period.

Voltabox’s success is reflected in its burgeoning lifetime order backlog and the rapid growth of its revenues as it continues to build advanced manufacturing capacity to fulfil these orders. Its major customers are Kiepe Electric (trolleybuses), Triathlon Batterien (intralogistics – forklift batteries) Komatsu (formerly Joy Global mining vehicles), KUKA (intralogistics – robotic AGVs) and BMW Motorrad (motorcycles). The backlog by end-market at 31 March 2018 is shown in Exhibit 8.

The IPO left Voltabox with a strong balance sheet, raising net proceeds of c €140m for the company. A total of €16m was earmarked for repayment of a loan to the parent and €25m was intended for a ramp up in R&D capabilities and investment in associated facilities, including in China. The balance was available for strategic M&A and Voltabox has already started to execute this element of its strategy. At the end of Q118, net cash stood at €91m on its balance sheet.

In April 2018 Voltabox announced the extension of its engineering capability in the US through the acquisition of Concurrent Design Inc based in Austin, Texas, for €2.6m. With more than 20 design and software engineering specialists, the purchase will bolster Voltapower’s R&D capability, extending the ability to develop platform solutions to more than one at a time and potentially further accelerating growth from 2019.

On 29 June 2018 Voltabox announced an agreement to acquire Navitas Systems of Woodridge, Illinois, for $43m (€37m) subject to regulatory approvals. The company has around 80 employees and has an R&D and manufacturing facility at Ann Arbor, Michigan. Mainly supplying US customers, Navitas Systems also manufactures lithium-ion battery systems for intralogistics and transportation applications, but adds renewable energy and other applications to the end markets served by Voltabox. It also brings some additional capabilities in highly specialised battery cell development and fabrication, the first exposure of Voltabox to battery cell production. Navitas has revenues of around c $25m and is expanding its annual production capacity for highly customised cells from 600k units to 1.5m. The US market is increasingly adopting lithium ion batteries in areas such as intralogistics as products become increasingly cost-effective due to the total cost of ownership advantage they afford.

Electromobility’s trading performance in Q118 showed strong third-party revenue growth with a 97.5% increase to €5.1m (Q117 €2.6m). Losses for the period were reduced at all levels, including EBITDA close to break even (Q117 EBITDA loss €0.7m), an EBIT loss of €0.8m (Q117 loss €1.0m) and a net loss of €0.9m (Q117 net loss €1.3m).

In FY18 paragon indicated that the Electromobility segment is expected to increase revenues to €60m, generating an EBIT margin of around 10%. In addition the Voltabox prospectus indicated that revenues would be expected to grow to €100m in FY19. This was based on an order backlog at June 2017 of €805m extending forward five years, which subsequently grew organically to c €1.0bn at the end of Q118. Of the current backlog, 77% is underpinned by signed framework contracts.

Despite the strong growth in Electromobility, the Electronics division continues to be the largest segment of paragon, accounting for 73% of group external sales. It offers a broad portfolio of sensors, microphones and cockpit instruments to its customer base, which is comprised primarily of the premium German automotive manufacturers. The top customers include Audi, BMW, Mercedes Benz, Porsche and Volkswagen, but paragon expects to be able to grow its presence in Asia and the US as manufacturers adapt to the comfort and quality megatrends driving the European manufacturers.

In FY17, Electronics achieved healthy overall revenue growth of 6.5% and generated an EBIT contribution of €9.7m, down from €12.7m in 2016. The performance was achieved despite a transition from the supply of older products to a newer generation of product offerings, with inevitable dilutive effects on revenue growth.

The division operates through three subsegments.

In Q118 Electronics third-party revenues fell by 3.9% to €21.7m (Q117 €22.5m), which accounted for 63% of group sales. The decline reflected a modest 1.7% rise in Sensors revenues to €8.7m (Q117 €8.5m), which failed to offset falls of 8.5% in Cockpit to €7.6m (Q117 €8.4m) and 5.1% in Acoustic to €5.3m (Q117 €5.6m). The divisional EBIT fell to €2.1m compared to €2.6m in Q117.

Management expects the transitional phase in Electronics to continue in FY18, remaining around 9%, with margins by implication from the overall group guidance. We expect an update with the H118 results release as the Navitas deal is expected to complete in Q318.

The Mechanics segment develops, manufactures and supplies adjustable aerodynamic body components such as adaptively extended spoilers, products for convertible car roof deployment and interior systems such as seat cushion adjusters. Lightweight movable body parts help to reduce weight and the drag coefficient of vehicles, in turn lowering fuel consumption and thus CO2 emissions. Growth for the segment is expected to be stimulated by the environmental megatrend, as applications for adjustable body components driven by motorised controls extend from high performance sports cars to other vehicles types. The trend of vehicle fuel efficiency will remain relevant as the vehicle markets transitions from combustion engines to electric cars. The leading customers for paragon movasys are Audi, Bentley, Mercedes Benz and Porsche.

While the division is paragon’s smallest, it was the fastest growing in FY17, increasing sales by 188% to €9.3m (FY16 €3.2m). The operation moved into profit, generating an adjusted EBIT of €1.2m compared to a loss of €0.1m in 2016. This excludes €1.4m of start-up costs and increased material costs of prototypes as well as €2.2m of expenses, not yet passed on to customers.

Growth is expected to be substantial in FY18. The improvement is a combination of strong organic development as new generations of spoilers were introduced from Q217 and should ramp up through FY18 and FY19, with profit performance improving as a result. The addition of HS Genion should also contribute significantly. In its one month of consolidation from the beginning of December 2017, it added sales of €1.7m with a net income contribution of €0.7m.

On 24 November 2017, paragon announced the €15m acquisition of HS Genion based in Landsbech am Lech in Germany. The company was paragon’s largest competitor in adaptive vehicle aerodynamic systems. Following the integration with paragon’s existing body kinematics activity, the combined operation now operates as paragon movasys. It is the global market leader in adaptive body components, and furthers paragon’s strategic aim to become a leading system provider in vehicle aerodynamics. The business has been operating since 1994 and has around 100 employees.

In Q118 third-party revenues for Mechanics increased substantially to €7.5m (Q117: €0.8m), accounting for 22% of group sales. It reflected both a full contribution from HS Genion as well the ramp-up to series production of several new rear spoiler products during 2017. Divisional EBIT improved to €1.0m (Q117 EBIT loss €0.2m) after charging a €0.4m (Q117: €0.0m) one-off cost for similar items on start-ups and prototyping to those experienced in FY17.

The Mechanics division is expected to increase both revenues and adjusted EBIT contributions in FY18, excluding one-off costs incurred in FY17. As seen in Q118, the one-off costs may continue in the rest of the first half but we assume guidance excludes these. In addition, HS Genion will make a full year contribution compared to only one month of consolidation in FY17. As a result, management expects the division to grow revenues to around €25–30m in FY18.

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

The sharp decline in paragon’s share price since highs around the Voltabox IPO in October 2017 appears unwarranted. While the change in corporate structure may have caused some technical selling by shareholders, the value proposition and guidance has remained unchanged since the preliminary results. The decline in the value of Voltabox can only partly explain the reaction.

As a result it would appear that stripping out Voltabox from the group valuation, the market is attributing an extremely low valuation to the remaining businesses of paragon of just 1.6x EV/EBITDA and 2.9x EV/EBIT for FY18e.

While some of this may relate to technical factors surrounding the change of legal entity, we would anticipate these to improve towards the multiples of peers, if not higher, given the growth potential. For FY18 the peers are trading on EV/sales of 0.8x, EV/EBITDA of 6.3x and EV/EBIT of 9.2x. Were the remainder of paragon excluding Voltabox trading on the peer group EV/EBITDA of 6.3x then the overall paragon market cap would be €300m or €66 per share.

As can be seen in Exhibit 13 below, paragon group trades at a significant FY19e EV/EBITDA discount to its nearest listed peers in the automotive electronics and interior sector despite its superior growth dynamics. We continue to believe that the strong growth metrics of paragon relative to its peers warrant a premium in ratings, with the development of Voltabox and Mechanics more than compensating for the transition to a new generation of sensors in Electronics. paragon thus remains a high-growth technology-based company and the view is supported by its PEG (P/E and EPS growth) ratio of just 0.3x compared to its peers at 0.9x.

We use a capped DCF methodology to value the cash flow of paragon. We use a six-year forecast period and cap growth in the terminal value at 0%. To reflect that terminal state, we set working capital to zero and normalise capex to depreciation. For a growth company such as paragon we feel is more conservative as it curtails longer term growth expectations in the tail cash flows. We use a calculated WACC of 8.2%. Currently, the capped DCF returns a value of €98 per share.

In terms of sensitivity to terminal growth rates and WACC, the following table displays a range of value outcomes compared to our assumed parameters. We have highlighted the closest assumptions to our own. Despite the WACC being higher than assumed last year in our Outlook’s DCF valuation, the value returned has still increased as the sales expectations have accelerated by around 15–20% in the forecast period following FY17 results and management guidance and the longer-term EBIT contribution is thus much higher, with a terminal EBIT margin in 2023 now forecast at 12.5% and EBIT CAGR of 27% in 2018-23e (from €17m to €69m). The €101 value highlighted is the closest to our calculated WACC assumption.

As the acquisition has yet to complete, we have not included Navitas in our modelling, although clearly the €43m acquisition price would leave paragon in a near-neutral net debt situation as Voltabox continues to invest its IPO cash proceeds. At the end of Q118 paragon had a net cash position of €63.3m, including Voltabox’s net cash of €91.1m.

Guidance for strong growth in FY18 is driven primarily by Voltabox, although the Mechanics division is also growing rapidly from a smaller revenue base and is boosted by the acquisition of HS Genion late last year, creating paragon movasys. This should add significant revenues and profitability. Following Q118 results, management reaffirmed its guidance for FY18 revenues of between c €175m with an EBIT margin of c 9.0%. It will report half-year results on 21 August 2018.

We expect the rapid growth of revenues to continue in FY19 with continued strong growth at Electromobility and Mechanics and a resumption of growth at Electronics. We also expect overall EBIT margins to start rising towards our long-term expected range of 12–13%, largely thanks to volume effects.

The high and growing level of organic investment by the group is also expected to be maintained with management indicating a volume of €35m for 2018 compared to €22m in FY17 before €15m spent on acquisitions. This is expected to be capex of €16.8m and capitalised intangible development of €18.2m. We would still expect this level to moderate in the medium term as required capabilities and capacities are attained, which should enhance free cash flow generation. However, we should expect paragon to continue to identify and use funds to drive further top-line growth as and when new opportunities present themselves.

The two tranches of the 2013 bond matured on 2 July 2018, with a combined value of €13m. Given the successful €50m bond issue in June 2017 carries a coupon of 4.5% compared to the 7.25% on the 2013 issue, we would expect to see net interest charges decline in both FY18 and FY19.