paragon — Risk reduction should relieve the equity rating

On 1 December 2022, paragon announced an agreement to sell its paragon semvox subsidiary (Semvox) to CARIAD, a software subsidiary of the Volkswagen Group, for c €40m. Semvox formed the digital assistance business unit of paragon. The deal is expected to complete by the end of April 2023, but there is a risk it could be delayed as it is contingent on several antitrust approvals. However, these are not considered by management to be likely to lead to delays given the scale of the business.

Following the agreement, Semvox will be treated as a discontinued business from FY22. As a result, on 5 December 2022 paragon’s management updated guidance for FY22 and FY23 as well as providing a new five-year outlook to 2027.

In a release on 6 February 2023, management indicated that Semvox generated €12.8m in 2022. As a result of its disaggregation, paragon’s FY22 revenue from its continuing business was €160.1m, an increase of 18.2%, beating December 2022 guidance of €156.5m. While not explicitly disclosed to date, we expect the FY22 EBITDA margin for the continuing business to be reduced to less than 15% as Semvox appears to have been achieving higher than average EBITDA margins. In 2021 it achieved net income of €2.6m.

For FY23, revenue guidance was maintained at €170m and while implying slower growth than the c 10% previously indicated, this may be conservative. Management highlighted January 2023 revenues of €14.6m for the ongoing activities being 29% ahead of January 2022. We assume Semvox’s revenue growth was expected to be above the group rate. We think the new EBITDA margin guidance for the continuing paragon activities of 12–15% reflects an element of adverse business mix as new lower-margin contracts ramp up.

We have reduced our FY22 and FY23 earnings estimates to reflect the revised guidance and introduce our FY24 estimates.

Management also updated its five-year outlook to FY27 (FY26 previously), again reflecting the agreed disposal of Semvox. It nevertheless expects revenues to almost double to more than €300m, a compound annual growth rate of around 14% over the five-year period. The previous longer-term guidance was for FY26 revenues of €250–300m with EBITDA margins of 20%. The revision in part reflects the elimination of growth at Semvox, but nevertheless represents a strong progression by the continuing businesses, especially in the recently created power business unit.

In our model, our FY27 revenue estimate is significantly below €300m.

The numbers above are adjusted to reflect the performance of the continuing paragon automotive activities, but do not reflect the actual impact of completing the disposal of Semvox. As is normal practice, we only adjust for M&A transactions when deals are completed. Therefore, Semvox’s assets are still consolidated as held for sale current assets, net debt does not reflect the receipt of the disposal cash proceeds, with earnings and cash flows still consolidated as discontinued items.

On completion, the company should receive the c €40m cash proceeds and, as discussed below, these should be applied to substantial bond redemptions, with a major benefit to the net interest charge in FY23 and the future. Net debt should fall to around €42m (€89.6m at end-September 2022), of which only around $25m would be the outstanding 2027 6.75% Eurobond issue.

The result is that while continuing revenues and operating profits remain the same, PBT, net income and thus EPS should be significantly enhanced by the lower interest charges. We estimate the disposal should generate an exceptional profit on disposal of around €15m. We assume completion around the end of April 2023.

The financial benefits should notionally benefit our current estimates approximately as follows:

With notional FY23 EPS of €0.93 per share, the P/E multiple of 5.0x is not demanding, and falls sharply to just 2.7x in FY24. In addition, net debt to EBITDA should fall to 1.83x in FY23 and 1.35x in FY24, confirming the alleviation of the debt burden.

On 10 January 2023 paragon launched a tender offer up to CHF10m nominal value of its CHF21m 4% bonds due for redemption in April 2023 (ticker: PAR19) issued in 2019. The offer was at 92.5% of the bonds’ par value. The offer period ended at midday (CET) on 27 January 2023, at which time paragon had bought back a total nominal amount of CHF8.433m of the PAR19 bonds, leaving CHF12.567m outstanding. With the Swiss franc/euro exchange rate at parity (CHF1:€1) settlement on 31 January 2023 (including 278 days accrued interest) should cost paragon around €8.1m.

Final redemption at par of the outstanding nominal is due on 23 April 2023.

In the 6 February 2023 announcement, management indicated it has launched a tender offer scheme for up to €5m nominal of the Eurobond that would run until 3 March 2023.

The agreed disposal of Semvox should trigger the accelerated repayment of all €25m of the interim redemption tranches of the €50m 6.75% 2027 Eurobond agreed on the extension last year. As a reminder, the early redemption schedule for half the outstanding bonds was in three tranches: €5m in 2023, €10m in 2025 and a further €10m in 2026. All become due on completion of the potential M&A project, which is Semvox. We assume the announced buyback scheme should offset the 2023 commitment. With the bonds currently trading at around 65% of the nominal value, the total early redemption might be achieved for a total cash cost of c €16m.

The outstanding €25m repayable on final maturity in 2027 would then be the only major financial liability carried by paragon, and the annual interest payable would reduce by c €3.1m (including CHF bond interest and 2.5% PIK1 interest on the Eurobond). Together with bank borrowings, the net debt to EBITDA ratio (the net leverage ratio) in FY23 would be just 1.83x, which would be in line with acceptable levels for similar industrial companies for the first time in many years. It should in turn lead to lower interest rates on the outstanding Eurobond as a reduction in the leverage ratio is a key factor in its adjustment. The cash interest payable would reduce as the net leverage ratio declines as follows: 6.50% if it falls below 4.0x at the last balance sheet date, 6.25% if it falls below 3.5x, 5.50% below 3.0x and 5.00% below 2.5x. With an expected improvement in net cash flow as the ongoing business grows revenues and margin, the leverage ratio should reduce further in subsequent years.

As a result of the proposed Semvox disposal, management has secured bridge finance that should cover both the early redemption payments and the final redemption of the PAR19 CHF bonds. The bridging facility will be paid down when the c €40m proceeds for the sale are received in Q223.

The deleveraging of paragon should have a positive impact on the risk assessment for the group, and thus on the cost of capital. In turn that boosts discounted cash flow (DCF) valuations for the group, underlining our previous view that paragon’s equity is adversely affected by the historical debt burden and more specifically the bond maturities. More normal industrial and automotive ratings metrics should then also be applied to the group.

The only significant outstanding issues that need clarification would appear to be the unanticipated circumstances surrounding the founders’ shareholding in the listed entity and the timing of a return to dividend payments in the future, which are currently restricted by the terms on the Eurobond until fully redeemed in 2027.

Our capped DCF has been rolled forward on an FY23 basis and now stands at €26.6 per share (previously €19.8 per share in August 2022 on an FY22 basis), adjusting for the discontinuation of Semvox by eliminating its cash flow and as an equivalence reducing net debt used for the calculation by the anticipated €40m proceeds. The calculation is still based on a 15% cost of equity but that should reduce as the bonds are redeemed and risk is alleviated. The resultant current WACC of 8.0% will benefit from lower risk levels, but as the debt funding reduces as a proportion of the EV there will be an offsetting upwards tendency towards the still higher cost of equity.

While the jump in valuation may seem surprising, it should be noted that we have slightly increased our forecasts for the ongoing businesses following the better-than-expected trading in FY23 and we also start with a reduced level of net debt in the calculation, following FY22 estimated debt reduction that adds around €3.3 per share.

The €26.6 per share DCF value would be a multiple of 15.6x our notional post disposal FY24 EPS estimates (Exhibit 2). While this might look ambitious today, we feel that such a multiple could increasingly be supported by fundamental metrics, as ongoing debt reduction reduces risk.

It is worth noting that the agreed disposal of Semvox will crystallise an EV of around €40m for a small part of the group (around 8% of sales and 20% of EBITDA). That compares to the current group EV of just over €110m.

As the debt reduction should substantially de-risk paragon, we would expect a further re-rating to be plausible as the growth strategy for the ongoing activities is executed over the next five years.