Paragon Entertainment - Creating Sustainable Growth

http://paragonent.com/


Paragon Entertainment (LSE:PEL) is a great example of a share that has been overlooked by the market, due to a lack of stock liquidity and, in the past, a valuation that has not been tantalising for investors amidst a bull market. However, that looks to have changed with the lack of liquidity having driven the share price lower towards all-time lows, around where the share price now rests. Paragon is now valued by the market at £3.99m, and trades at 2.13p mid price - this looks particularly low when factoring in past progress made by the company, and future potential. Paragon, which describes itself as a 'diversified visitor attraction operator', looks set to enjoy a much brighter future as an AIM listed company over the coming years.


As shown in the share price graph, the company's share price has dropped sharply in recent weeks, on light volumes - that is as a result of the poor liquidity that Paragon has historically suffered from. There are a couple of potential reasons for the selling, which led to the drop. The first potential reasoning relates to the fact that the July 2013 placing was completed at 3p. Even though the institutional money invested was relatively low, it would have been enough to cause downward pressure on the share price should the shares have been sold at a profit (given the sizeable discount to the share price at the time). The second potential reasoning would revolve around institutions cutting back their holding if they need to meet certain investing criteria - many companies with market caps of similar sizes simply do not attract institutional holdings because of market capitalisation requirements. In Paragon's case, I would expect that to be the less likely scenario given the very low volumes.

The spread on Paragon can be volatile at times, having ranged from 2p-2.25p in previous sessions. It currently stands at a narrowed 2p-2.15/20p, which is more attractive. Even though the wide spread acts as a deterrent, the stock is sufficiently undervalued (as will become clear later), to accept paying the higher price. As noted in the bottom left hand box within the chart, it is important to recognise that there are plenty of cases of highly successful stocks that have had very poor liquidity near the early stages of their development. Investing at those times would have yielded superior profits compared to investing at levels where liquidity was higher. Of course, in any case, the lack of liquidity is a risk, but for medium-term or long-term investors this can be accepted in the case of Paragon.

The shareholder structure of  the company is particularly surprising given the market cap, albeit when these institutions invested, the market cap would have been substantially higher. Private equity company ISIS LLP hold 18.5% of the shares in issue, Marwyn Value Investors hold 10.7%, Amati Global Partners hold 9.5%, Vesuvius Ltd hold 6.7% and Killik & Co. hold 5.3%. That is strong backing for the company moving forward, even though these institutions are almost certainly holding their stakes at a loss presently. Paragon also enjoys strong director backing, with CEO Mark Pyrah, Production Director Peter Holdsworth and supportive Ex-Chairman Robert Hersov collectively owning over 25% of the shares in issue. Four members of the board acquired material proportions of their current holdings in the 3p/share placing, contributing £285,000 between them - this demonstrates strong backing by the management. Pyrah also purchased shares (albeit an immaterial amount) recently at 2.375p for a further contribution of £2,375.

As mentioned earlier, Paragon Entertainment evolved from Paragon Creative, which was acquired in 2011 by Marwyn Capital II, which was effectively a special purpose vehicle looking to complete a reverse acquisition. Paragon Creative was an independent attraction design and production business located in the UK, and was bought for a maximum consideration of £4m in a mixture of cash and shares. The immediate point to note is that Paragon Entertainment is trading at the takeover value determined back in 2011 - in such circumstances you would predict that the business has not changed much. That is not the case, and the current business is significantly more developed compared to back in 2011. To make it clearer, Paragon Creative designed and produced attractions such as functioning models and exhibits for a wide range of clients, all over the world. These clients included theme parks, museums and science centres, all of which typically source creative work to third parties such as Paragon. The vision was "To create diversified attractions with the scope to service and extensive global entertainment industry".

Almost 3 years and one core acquisition on, and the company finds itself in a much firmer footing. The acquisition was of 'The Visitor Attraction Company' (TVAC) in 2012, with an acquisition price of £300,000 in shares. Based on this, the total acquisitive value of the company (£4.3m) actually exceeds the current market cap.

The operations of the group today, can be categorised into three areas:
- Creative ("Build and Design") = This is the main business segment of the group, accounting for the 95% of revenues in the 2013 financial year. 'Creative' designs and builds attractions for a variety of clients
- Attractions = This division creates, develops, builds and operates its own 'distinctively branded attractions'. This division accounted for 5% of revenues in the last financial year, and were derived from ticket sales
- Licensing = This division, which is the newest, licenses exclusive and third party attractions related IP from brand owners and sub-licences it on

Paragon operates from a recently expanded 60,000sqft site in York and now employs over 100 staff, up from around 30 in 2011. The company services an excellent blue-chip client base including the Disney, Merlin and Warner Bros, but also a range of other clients including the Natural History Museum and TFL. Unlike many rivals, Paragon manages projects from the start-up idea through to public opening, thus it covers the full cycle, and this has seen it been involved in (to various extents) prestigious projects around the world, such as Ski Dubai (UAE), Space Park Bremen (Germany), but most notably the £7m Olympic Museum in Lausanne. This has been the company's largest project to date and was won during a formal tender process for the International Olympic Committee - this has undoubtedly proved the market leading and highly regarded position that Paragon Entertainment enjoys within the industry. This contract should enable Paragon to win further large-scale contracts in the future.

To put into context what is involved with these attractions, Paragon's covers a wide variety of areas including model making, casting, electronic, sculpting, engineering and metal work. As the industry is highly creative, the company can enjoy strong margins, which tend to gravitate around 30%. As an industry example, very few theme park operators have in-house design and production capabilities, with Merlin Entertainments being one of the few, thus most outsource their work to independents such as Paragon, and that is where the market opportunity lies. With the UK tourism industry enjoying record spend in 2013 of £21bn and strong growth year-on-year, there is plenty of scope for such attractions to continue to be popular, as clients try to boost visitor numbers or dwell time. The strong revenue growth that the company has achieved over the last couple of years demonstrates Paragon's ability to both take market share, and exploit a market that is not all that cyclical. Typical projects for the Creative division last between 6 and 18 months. The size of the Lausanne project meant that the project took 23 months to complete. Other group projects include the design and build of Belfast's Titanic exhibition and the build of the Wallace & Gromit rise at Blackpool Pleasure Beach.

In the 2013 final results, CEO Mark Pyrah commented, "Our Creative division, the foundation of the Group, has gone from strength to strength with historic growth and profits. The completion of our largest ever project, the Lausanne Olympic Museum, is testament to the strong reputation our Creative division holds within the industry, and illustrates our strong capabilities. Growth is anticipated to continue throughout the year thanks to our excellent pipeline of opportunities."

Attractions and Licensing are the two more recent additions to the group, with the underlying reasoning behind these to help grow the business and diversify the revenue stream to help build a more rounded company. The attractions divisons flagship project is Quest Merry Hill, located in the Intu Merry Hill mall, Dudley. It was opened in November 2012 The attraction includes an indoor ropes course, Nerf combat arena and 9-hole mini golf course amongst other attractions. Unfortunately, Merry Hill hasn't met expectations to date as it is not yet at operating profitability, and that led to impairment during 2013. However, the management is seeking profitability during the 2014 financial year, and has taken various steps to ensure this. They have forecasts £60,000 in profits from the site during 2014. This effort will perhaps be enhanced by a recently announced overhaul for the Merry Hill mall earlier in the year. Intu Properties has acquired a 50% stake of the site from Westfield, and will inject cash to completely re-develop the site. In Intu's acquisition RNS, they commented:

"The Board believes that, although it is a prime regional centre, Merry Hill's relative position has declined in recent years. The centre presents significant opportunities to re-engineer and update the tenant mix encouraging large flagship formats and reducing the number of smaller units to make the centre more relevant for retailers and customers. On a square foot basis for a super-regional centre, Merry Hill currently has a relatively low valuation and rental levels. Current headline ITZA rents of £150 per square foot are below the PMA average for a comparable regional shopping centre of £317 per square foot as well as for intu Trafford Centre of £405 per square foot and for intu Lakeside of £345 per square foot. The Board is of the view that Merry Hill has the potential to be repositioned over the medium term as a family day out destination with an integrated shopping, dining and leisure experience, extending dwell time, trading hours and catchment."

In time, it is consequently very possible that Quest Merry Hill site will become far more profitable. Currently, the site remains immaterial relative to total group gross profitability. That is the same case with Licensing although it is expected to contribute positively to EBITDA in the latter part of 2014. Importantly, Paragon has sale rights to a number of valuable brands such as Hasbro's Nerf brand, and this should prove valuable. Commenting on the new divisions, Paragon noted, "We are proud of the solid Design and Build business which has led the Group to scale significantly. However, as the Group scales we recognise the strategic need to diversify our revenue stream, and we have made steps to accomplish this goal through the formation of new Licensing and Attractions divisions, which were announced at the beginning of 2014. These divisions, whilst still early in development, have been created to maximise the considerable opportunities for IP-Rights commercialisation in the attractions industry and attractions proprietary branding."

Turning to the financials, there is appreciable progress in the top-line figures that arguably justifies a higher market cap on this basis alone:


As the table above shows, revenues since 2010 have almost tripled to £10m last year, with gross profit also tracking higher to £2.60m. Gross margins have fluctuated over the period between circa 25% and 33%, albeit the best measure moving forward would be to take a gross margin of 30% - the 2013 gross margin was slightly depressed by the large-scale Olympic contract. Importantly, cash flows from operations were positive in 2013, and are forecast by broker Cenkos Securities to rise again in 2014 to £0.4m.

Looking in more detail at the results:
- Revenues were up 64%, meaning a trailing 2-year average growth rate of 52%
- EBITDA up by 97% to circa £0.6m
- Modest net cash pile relative to the market cap of £0.565m
- Gross margins of 25.9% were down from 31.9%, but depressed by the large Olympic project
- Administrative expenses of £2m and £3.6m of operating expenses
- Loss per share of 0.53p, but when adjusted for depreciation, amortisation, share-based payments, impairment and exceptionals, earnings totalled 0.15p

There are a few interesting points to draw from this. The company is currently trading on an EV/EBITDA of just 5.70, which, given the rate of revenue growth, looks particularly undemanding. Although a loss after tax of £0.92m was booked in 2013, that does not tell the whole story. The operating expenses for the group were inflated by certain items, notably a £603k impairment charge against Quest Merry Hill and £908k in depreciation and amortisation (vs. £2.03m in D&A in 2012), and various other items which totalled just over £0.1m. Considering that there was circa £0.5m in investment during 2012 compared to £1.32m in 2012, amortisation should be lower going forward. Indeed, Cenkos are forecasting a reduction in D&A to £0.5m in 2014. Aside from this, they forecast adjusted profit-after-tax of £0.5m, which filters through into 0.32p in earnings per share. They also anticipate a recovery in margins back to around 30% and forecast £1m in EBITDA for 2014.

Based on the above numbers, Paragon is currently trading on a very modest adjusted price-earnings ratio of 6.64, and even lower if you strip out net cash. However, given the pace of expansion, I would not be willing to strip out the cash on this occasion. The forecast EV/EBITDA falls to around 3.50. Although there are no expectations for years further ahead, it would be reasonable to expect additional organic growth, and potentially even acquisitive growth should Paragon look to add bolt-on companies to the current group. In the long-run, if the company is able to grow annual revenues to £15m, then at a 30% margin, there would be an additional £1.5m in profit filtering through to the bottom line since the cost base is relatively fixed - it is relatively easy to see where potential rewards could come from in terms of a long term hold. Both geographical scale and operational expansion should be expected, and the company has already started to pursue this through the signing of an agreement with Incorp Group to open up the business to the Middle East.

"I am delighted to announce this deal, which follows a period of significant progress and interest in Paragon throughout the Middle East. As most projects in the region require representation on the ground, this agreement is an important strategic step to drive sales and growth.  We chose to work with Incorp Group due to its in-depth knowledge of the region and we look forward to accelerating opportunities through this synergistic partnership."

The balance sheet is very reasonable for the current market cap. There is £1.65m in property, plant and equipment, and £2.2m in intangibles. Current assets are 1.1x current liabilities, so this combined with the positive cash generation and an unused £0.8m in term loans and overdrafts should be sufficient for the foreseeable future (unless acquisitions are planned). That is a comfortable position to be in, as it essentially means that Paragon is in good health, and there is not a material solvency risk despite the low market cap - that is an attribute that should be looked for in micro-cap stocks. Tangible assets are also 1.4x total liabilities, which is a good backstop, and there are just over £1m in tax losses.

The one point that is extremely important to raise, is about revenue predictability. There is a tendency to believe that, because the contracts are particularly large, revenue can be unpredictable hence gaps could open up in Paragon's order book, which would lead to a profit warning risk. Although the company has 'excellen' visibility in its creative division, it is a risk. The division has enjoyed an increase in order scale, and they now cover a number of contracts between £1m and £7m in size. Indeed, in RNS', the company has stated that they have a pipeline of opportunities in excess of £70m and confirmed order for 2014/15 of over £10m already. With a historic 50% conversion rate, the group now has an order book of £16m, is tendering on over £20m of work for the next 18 months, and has project visibility of £102m. These are very significant figures in that they underpin long-run growth potential, and exclude the likelihood of growth in the group's other divisions.

The final point to touch upon is that Paragon is currently being valued amongst a group of sub £5m companies, which are quite rightly being valued at very little. Very few of the market cap peer group, of which there are over 100 companies, are generating any sort of positive cashflows, very few have comfortable cash balances (many have a high risk of insolvency) and those that do have the above, certainly do not enjoy the same rate of organic growth that Paragon is currently experiencing, nor do they operate in a niche industry. That is what differentiates Paragon from the rest of those companies, and in my opinion, means that Paragon justifies a considerably higher market cap. That will likely materialise in the long run when the company demonstrates its ability to grow and create sustainable profitable growth.

Therefore, despite the liquidity factor, there is significant long run growth potential for investors willing to take a medium-long term approach. The company has only been listed on AIM since late 2011, but has already demonstrated its ability to generate rapid revenue growth and positive cashflows. The share price has headed in the other direction due to the liquidity factor, but that should change as the company continues to up its growth momentum. A valuation of around £4m is far too low for a niche market leader, especially since it represents a lower price than that which was paid for Paragon Creative and TVAC combined. To underline that point, any base (low) case takeover price for Paragon, would probably be closer to £8m-£10m at the current point in time, based on current financials and forward growth. Taking advantage of low prices during periods of low liquidity has the potential to reward significantly in the long run. Paragon is a case where this could occur. I have therefore put a Buy tag on Paragon Entertainment at 2.125p.

Article Updates (Click to view)
UPDATE (23/12/14) - In light of the share price declining to 1.4p (on the ask), I have increased the portfolio stake in Paragon Entertainment back to one full slot (£5k). The share price has declined as a result of a couple of profit warnings (related to contract delays), plus a lack of liquidity. The liquidity situation remains a key risk to the investment case, and that cannot be understated, but an improvement in the operational performance in 2015 could leave the market cap looking particularly modest. Although the liquidity means this is increasingly high risk, there remains an attractive investment case in my view. The portfolio average price drops to 1.7625p

UPDATE (20/02/15) - I have moved Paragon Entertainment from Buy to No Rating at 2.25p for a 27.66% profit, in line with the cessation of company reviews

6 comments:

  1. As ever, a fabulous review. I actually work in a similar industry to Paragon but in a much smaller company. We do small scale model making for shopping malls but more commonly for shops. We get paid either up front or at stages so cash requirements are not too bad at all. Without a shadow of a doubt this company is worth more than £4m.

    CraigJ

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  2. Really interesting write up El1te. I've had PEL on my watchlist for the last 12 months and have been surprised by the downwards spiral in the SP whilst the fundamentals continue to improve.

    Board seem on the ball and have the right experience, alongside decent holdings as you pointed out. My one criticism is the lack of contract announcements (which they are clearly winning!) and the lack of engagement with shareholders. I don't think this is purposefully done, the board seemingly just want to crack on.

    Few questions if you don't mind?

    * Current cash balance - you have this down as £565k, FY 2013 results state this is £930k? Have I missed something?

    * £16M order book, tendering for £20M of works over the next 18 months and project visibility of £102M. Is this from a Cenkos broker note?

    Thanks again for a most informative write up.

    OD

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    1. Hi OD,

      Thanks for your comment - regarding the questions:
      - The definition of net cash used in the results is slightly odd as they have stated net cash as being the £930k you mention. However, I have knocked off the current and non-current borrowings figures from that to get the £565k number
      - The set of numbers were provided by the company over the past couple of days

      Hope that helps,
      El1te

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  3. El1te - Thanks for the clarification.

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  4. Great article great little company.!

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  5. Very neat little company and there was plenty of time to buy at 2.25p today until the ask moved up in the afternoon. These are the sort of plays that the market tends to miss and having done due diligence this afternoon i think these shares could be trading at 6p - 10p over the next 18 months which would be a stunning return
    Thanks for your hard work and research. Brilliant

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