paragon — Update 24 January 2016

paragon’s Q3 update and FY16 guidance have demonstrated that the group expects to achieve sustained growth over the short, mid- and long term, driven primarily by new growth areas as highlighted in our September 2015 initiation note. With FY15 signalled as the peak investment year, which has seen new product launches, increased capacity and new international production facilities opened in the US and China, margins are set to improve over the next two years towards our medium-term 10% forecast. With sales to non-automotive customers set to ramp up in electrification and average content per vehicle increasing, growth is increasingly decoupled from automotive volumes. The company has not witnessed any indications of an impact from the VW diesel scandal at this stage, although management is prepared if leading indicators warrant action.

The Q3 update in November 2015 highlighted the continued strong growth in FY15 driven by momentum across all divisions. At the same time, new international facilities have commenced operation and new product introductions have continued apace, investments that continue to support long-term growth objectives:

The group also reconfirmed its revenue guidance for FY15 to achieve consolidated revenue of up to €100m, in line with our forecast. With substantial investment in the year, including the incremental cost of the November opening of the new plant in Kunshan, China, management has guided for unadjusted EBIT margins in line with the previous year, below our previous forecast as a result of this additional investment.

paragon provided more precise guidance for FY16 as usual on 3 December 2015, which suggested management expectations for sustained revenue growth of at least 8% and unadjusted EBIT margins of around 9%. While it is below our previous forecasts, we believe this guidance is very conservative and reflects management’s caution on the pace of ramp-up on new contracts and some caution on any future potential impact of the VW difficulties.

Our view remains that paragon has the opportunity to grow at a faster rate and as investment normalises, new contract ramp-ups progress and any impact from VW (67% of FY14 revenue, forecast to drop to 60% in FY15) is offset as non-VW OEM contributions expand and non-automotive contracts accelerate. As a result, we believe there is scope for further outperformance, both in terms of revenue and EBIT margins above the indicated 9% level.

Management has also guided for a further acceleration in revenues again in FY17, with guidance for an increase of 15-20%. With the majority of this uplift driven by new product introductions derived from this investment phase, we believe it will also further benefit the margin mix.

As we highlighted in our September 2015 initiation note, one of paragon’s key strengths is its ability to identify key market trends ahead of its competitors and develop solutions that are both technically advanced and cost-competitive. In recent weeks there have been a number of pieces of newsflow that are supportive of paragon’s product development strategy and highlight this thesis:

While these are but three examples of current trends that are gaining significant headlines, we highlight that paragon has been actively developing solutions in each of these areas for at least a decade. With the combination of strong OEM relationships and an innovative mindset, we believe paragon is well placed to continue its pursuit of the current strategy.

Given the relative importance of the VW Group to paragon’s current business, we believe it is important to understand the potential consequences of the dieselgate scandal.

To put the exposure into context, the group accounted for some 67% of paragon’s 2014 revenue. With strong growth in non-VW revenues in 2015, management forecasts that this will reduce as a proportion to some 60% in FY15 and likely further to 56% in 2016. With no fall in orders received having been witnessed either when the Q3 report or FY16 outlook was released, we believe the impact is unlikely to be significant for FY15. In addition, the main product lines delivered to the VW Group are microphones and air quality sensors, both of which are generally options, the uptake of which is increasing as a proportion of volumes sold as increases in passenger comfort and communication demands offset any macro-level volume reductions. This provides a further buffer to any impact from the VW scandal.

Our key forecast drivers over the next three years are predominantly from new products and markets. Of our forecast €56m increment in revenues to 2017, 55% (€31m) is derived from growth in Electromobility (Voltabox) and 25% (€14m) comes from Body Kinematics. The remainder of the growth is generated from increasing use of air quality sensors and Cockpit products. We forecast lower growth in the Acoustics division, which is where the largest proportional exposure to VW resides. Exhibits 1 and 2 below highlight the 2014 divisional split compared to our FY17 forecast split.

Given the increasing range of products that paragon is delivering to OEMs, growth is less determined by pure automotive volumes, but more by the increasing fitment of products such as microphones, air quality sensors and connectivity platforms. In addition, the penetration of such products into lower-value, higher-volume models is also supporting the decoupling from overall volumes. As a result, there is a decoupling effect from pure automotive volumes and we expect that this will only increase over the coming years as the new divisions generate increased growth.

Given guidance issued by management, we have updated out FY15 forecasts to reflect the indication that post-investment EBIT margins will be in line with FY14. We highlight that this reflects the opening of facilities in both the US in July and more recently China in November. Excluding such one-offs, the unadjusted margin would show significant improvement, as witnessed in Q3, and we highlight the margin potential as the current heavy investment phase tails off to a more normalised level. Exhibit 3 below highlights our adjusted forecasts for FY15, FY16 and FY17.

We point out that we believe these forecasts could prove very conservative, particularly in FY16, but they reflect a more conservative view of the pace of ramp-up in FY16 in Voltabox and increased investment levels to get to full production. This is followed by a near catch-up by FY17. Exhibit 4 below highlights our new detailed forecast assumptions.

We highlight that 2015 is set to be the peak investment year with significant investment undertaken across the group, the acquisition of SphereDesign, opening of new facilities in two new countries (the US and China), as well as significant R&D to support product launches. Each of these investments will contribute to the long-term growth of the group and we forecast that total investments will progressively decrease from the elevated level of c €28m in 2015 to €14m in 2016 and a more normal maintenance level of €3m from 2017 with the associated cash flow benefits. The combination of reducing capex and growing operating cash flows leads to our expectation that net debt should, by end 2017, fall to below €38m from our estimated end 2016 peak of c €42m.

Despite the near-term easing of our forecasts, we are maintaining our positive view of the prospects out to 2017 and beyond. In particular, we highlight that the indicated adjusted EBIT margins of 11.7% for the nine months to September 2015 exceed our previous long-term projection of 10.0% in our DCF valuation and we have therefore increased our long-term EBIT margin target to 10.5% as shown in Exhibit 5 below.

Given the significant backlog already present, with a total lifetime value of some €1bn, and with key trends supporting the long-term growth outlook and indicative underlying adjusted margin improvement, we have adjusted our WACC from 10% to 9.0% to better reflect risk. Our DCF fair value is therefore supported at €29.7/share. Further catalysts to drive increased value would include additional contract wins and further progress towards our long-term margin target as peak investment passes.