Paragon Technologies: Two Activist-driven Turnarounds For The Price Of One

| About: Paragon Technologies, (PGNT)
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With major stock market indices near all-time highs, I continue to fish in smaller and smaller ponds in order to uncover deeply undervalued companies. With just a $5 million market cap, I believe Paragon Technologies (OTCPK:PGNT) to be a deeply undervalued company. Paragon offers investors the opportunity to own:

1) $1.90/share in net cash

2) A material handling solutions business which is in the late stages of an operational turnaround. The business had been losing money and recently turned profitable.

3) Exposure to a potential cyclical upturn in the material handling business. Current year revenues are 35% below what Paragon did during the last peak. In particular, Paragon has meaningful exposure to automakers which are seeing a resurgent demand. While the business is on track to do $0.50/share in EPS this year, with its new cost structure, we could see earnings of $1/share if revenue returned to the past peak.

4) A 20.9% interest in a small electronics distribution business, SED International (NYSEMKT:SED). Last month, Paragon took control of SED's board of directors. SED has struggled in recent years but drastic action is being taken to turn the business around.

Importantly, Paragon is 28% owned by Chairman Hersham 'Sham' Gad. Gad is an activist value investor who gained a Board seat in late 2010 and became Chairman in early 2012. Shortly after Gad became Chairman, Paragon brought in a new management team. Since Gad became involved, Paragon has significantly reduced operating expenses. While the company had lost money for 5 of the 6 years through 2012, the turnaround has now taken hold - Paragon's core business reported a solidly profitable first half and appears set to generate $0.50/share in EPS. Looking to repeat this success, Paragon's board (led by Gad) invested some of Paragon's cash into troubled electronics distribution company SED. Last month, Paragon succeeded in gaining control of SED's Board of Directors. SED's new board has wasted no time - it ousted incumbent management and appointed an interim team and a Chief Restructuring Officer. If this effort is successful, SED looks to have considerable upside potential for both SED and Paragon shareholders. Should Paragon succeed in turning around SED, I estimate Paragon shares to be worth $9+/share or 200% upside from today's level. Even if the SED turnaround fails and SED shares end up being worth zero, I believe Paragon's cash rich balance sheet and now-profitable logistics business are worth $7+/share (+130% upside - see below). With nearly $2/share in net cash on the balance sheet and selling at ~1x book value, Paragon shares have limited downside making this a highly asymmetric investment opportunity. Note that Paragon is a tiny company ($5 million market cap) and shares are illiquid - as such investors should use limit orders and exercise patience if they decide to purchase shares.

Background - Paragon Technologies is a Pennsylvania-based provider of automated material handling solutions. The company provides both hardware (in-floor conveyors, sorting systems) as well as an accompanying software suite (8 modules) used for order processing & distribution. These productivity tools help customers to increase the order picking accuracy of their warehouse/distribution facilities and reduce labor expenses. While the company had been profitable in 2005 and 2006, it generated losses from 2007-2010. After accumulating ~7% of outstanding shares, in October of 2010 Hersham Gad joined Paragon's board of directors. Throughout 2011-2012, Gad continued to accumulate shares and took greater control of the board - slashing it from 5 to 3 members and becoming Chairman in 2012. Shortly thereafter, he replaced Paragon's aging 'Acting' CEO with a new management team (discussed below).

Turnaround - Paragon has struggled over the past six years:

USD million

2007

2008

2009

2010

2011

2012

Revenue

21.4

16.7

9.2

8.0

8.5

8.9

Revenue growth

-22.1%

-44.7%

-13.1%

6.1%

3.9%

Gross Profit

5.2

4.9

2.5

1.8

2.6

2.1

Gross margin

24.3%

29.4%

26.9%

23.0%

30.8%

23.6%

SG&A

5.781

5.480

3.628

3.089

2.487

2.439

% of sales

27.0%

32.8%

39.3%

38.4%

29.2%

27.5%

Operating Profit

-0.56

-0.57

-1.14

-1.24

0.14

-0.35

While there is clearly a cyclical element here as the materials handling capital equipment industry was decimated by the global financial crisis, it is important to note that even when times were good in 2007, Paragon was unable to generate a profit (the company was very marginally profitable in 2005-06). Up until 2007, the Paragon had a bloated cost structure. The former Acting CEO (served as 'Acting CEO' from 2007-early 2012), did a good job of cutting costs. SG&A expenses were significantly reduced during his tenure, falling 59% between 2007 and 2011. However, as Acting CEO he was solely focused on cost-cutting and didn't do enough to develop the business. Edward Strayhorn, 53, joined Paragon as CEO in the second half of 2012; he has a strong background in the material handling industry with 34 years of experience in the field. Importantly, he is the Chairman of the Materials Handling Industry Association which gives him valuable contacts and will enable Paragon to leverage its products and customer base to grow revenue. Paragon has a marquee customer base including: General Motors, Harley Davidson, Honda, Deere & Co., and various bodies of the US government. While Strayhorn has only been with the business for a short time, we have seen a nice upturn in sales during the first half of 2013 (+45% YoY). Importantly, the company continues to keep a tight lid on costs; SG&A has barely budged. Coupled with an improvement in gross margins, Paragon is on its way to achieving record profitability:

1H12

1H13

Revenue

4.4

6.5

Gross Profit

1.03

1.92

Gross margin

23.3%

29.6%

SG&A

1.24

1.26

% of sales

28.0%

19.5%

Operating Profit

-0.21

0.65

Operating Margin

-4.7%

10.1%

While gross margins have historically been volatile (ranging from 23-30.8%) due to mainly to product mix, I expect them to be toward the higher end of the range going forward for the following reasons:

  1. Increased focus on software which tends to have higher margins. In the second quarter Paragon acquired software maker Innovative Automation for $500,000.
  2. New management is taking further initiatives to reduce sourcing & manufacturing costs.
  3. As revenue increases, both from management initiatives as well as a continued upturn in the cycle, we are likely to see scale benefits appear in gross margins.

SED opportunity - During 2013, Paragon accumulated a 20.9% interest in struggling electronics distributor SED. Last month, Paragon succeeded in taking control of SED's board of directors; it appointed Gad (along with Sam Weiser and Jack Jacobs who are the other two members of Paragon's BOD). The following week, the BOD fired management and brought in a new interim team. While SED had a history of profitable growth, it has recently fallen on hard times, necessitating the changes in the BOD and management. SED has seen revenue decline from $606 million in 2011 to $517 million in 2013 (June year end). Similarly, the business went from earning an adjusted operating profit of $4.6 million in 2011 to an operating loss of $8.1 million in 2013. While the new BOD has yet to articulate its targets and how it will achieve them, here is a look at SED shares could be worth if is successfully restructured:

Revenue

500

Assume -3% decline

Operating Profit

4.5

0.9%

Assumed operating margin

-Interest Expense

-2.1

30

Debt @ 7% interest rate

-Taxes

0

Won't pay taxes for foreseeable future

Net income

2.4

Shares o/s

5.165

EPS

0.46

P/E multiple

6

2.79

7

3.25

Per Share value of SED

8

3.72

I assume we see a further decline in SED's revenue before seeing a resumption in growth. It seems reasonable that SED could generate an operating margin of 0.9% which is a well below larger competitors like Ingram Micro (NYSE:IM), Tech Data (NASDAQ:TECD), and Synnex (NYSE:SNX) which earn 1.2-2% operating margins. Being a significantly smaller company, SED lacks the scale of these larger players and is likely to earn lower margins. As a positive, I think there will be considerable cost savings achieved by the new BOD and management. Secondly, SED's customer base is comprised of smaller customers; business with SMEs tends to be higher margin than selling to larger customers. 0.9% seems to be a reasonable estimate if this business is turned around. If SED were able to achieve a 1.2% operating margin, shares could be worth $5.30/share. That said, given SED's considerable debt load (nearly $30 million in debt vs. a market capitalization of just $6 million), it is possible SED is worth 0 if management is unsuccessful in executing a swift turnaround. Even if this were the case, Paragon shares have considerable upside (see below).

So what are Paragon shares worth?

Paragon Operating business - In $ millions

Revenue

14.4

+5% vs. Pro-Forma 2013e revenue

Operating Profit

1.3

9.0%

Operating Margin

-Interest Expense

0.0

Debt Free

Pre-tax Income

1.3

-Taxes

-0.5

33.0%

Tax rate will be lower 2013-2016 due to

Net Income

0.8

Net Operating Loss carry-forwards

Shares outstanding

1.67

million shares

EPS

0.50

Multiple

8

4.02

9

4.53

10

5.03

A

11

5.53

12

6.03

I assume that $0.50/ share is the new cross-cycle normalized EPS run-rate which gives us a value of $5/share for Paragon's operating business (not including cash on the balance sheet or its stake in SED). This gives the company the benefit of the lower cost structure and uses a mid-cycle revenue figure (the business did $21 million at the top of the last cycle and $8 million at a trough, implying $14.5 million is a reasonable mid-point). There is further upside potential if management is able to expand their customer base or increase cross-selling to existing customers. Similarly, given that the market has been in a down-cycle for so long, I wouldn't be surprised to see a prolonged up-cycle which could result in $21+ million of revenue at an 11-12% operating margin (leveraging of fixed costs should expand margins from the 1H2013's 10%), which could translate to $1/share of earnings. I apply a 10x P/E multiple which is a significant discount to broader market indices reflecting: 1) cyclicality (2) customer concentration - biggest customer is 15% of sales and there are four other customers which are 10%+ of sales and (3) tiny market cap/illiquidity. This discount could be somewhat onerous as A) aftermarket sales/software represent ~50% of revenue -revenues from software/aftermarket tend to be stable and generally receive high multiples from investors and b) the company is overseen by an activist focused on creating value for shareholders.

We then need to account for Paragon's cash & investments as well as its stake in SED:

Cash & Inv

3.192

Cash at 6/30 + investments less $790k spent on SED shares

Cash/share

1.91

B

and adding in an estimated $500k in FCF generated in 2H13

SED shares

1.05

million

SED shares owned by Paragon

SED value

3.54

million

= SED shares owed by Paragon *

Estimated Value per SED share (3.25)

SED value per share

2.12

C

Value of 20.9% stake in SED / Paragon shares o/s

Value of Paragon

Operating business

5.03

A

Cash

1.91

B

SED

2.12

C

Total Paragon Value

9.06

per share

Paragon gives investors multiple ways to win big but its large cash balance provides significant downside protection. Even if the SED turnaround is a complete flop (and SED turns out to be worthless), I believe Paragon still have a value of $7/share (+130%). This is a very favorable risk-reward profile and I think that Paragon is an exciting investment opportunity.

Disclosure: I am long OTCPK:PGNT, SED. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.