Paragon - It’s not that bad (PAG)

Funding situation could be worse but I’m still dithering

Given the 38 per cent fall in the share price it may seem perverse to say that Paragon’s results were alright. The market focused on this:

“…the group will not pay a final dividend”

this

“If we are unable to secure new warehouse facilities or alternative sources of access to the securitisation market, we will have to scale back new lending activities significantly and manage costs accordingly.”

and this:

“…gives rise to a material uncertainty related to events or conditions which may cast significant doubt on the group’s ability to continue as a going concern…”

They paid less attention to this:

“The strength of profits in 2007 reflects the quality of income generated from match-funded assets within existing securitisation vehicles, largely insulated, as they are, from the sharp rise in the cost of credit.”

or this

“…the embedded value of our existing portfolio of assets remains strong and we expect it to continue to generate sound profits and cashflow in the future.”

The funding problems were entirely predictable and the message I take is that while Paragon’s lending franchise may be doomed, there is value in the existing mortgage book. Net asset value, minus whatever it would cost to put the business into run-off, should be a floor for the shares.

What is the funding situation?

Of Paragon’s £11bn mortgage book:

  1. £9.9bn is securitised
  2. New lending of £932m is funded by a ‘warehousing’ facility from a syndicate of banks that expires at the end of February. Paragon has said it cannot renew the facility on attractive terms, but that the existing facility will fund mortgages already written to maturity, at a small but positive margin.

Paragon funds working capital through:

  1. A £115.8m corporate bond due in 2017.
  2. A £280m banking facility that expires at the end of February. Paragon has announced that it cannot refinance this at an attractive rate and has paid UBS to underwrite an equity issue to replace it. The underwriting is subject to a ‘material adverse change’ clause but these are usually hard to trigger.
  3. £313.8m of shareholder’s funds

The underwriting means that Paragon is unlikely to run out of working capital. That the warehouse facility does not have to be repaid means it is not going to get stuck with too many mortgages. All it will not be able to do, from February, is write any meaningful volume of new business.

How might that affect the income statement? Net interest income would only fall a little in year one because of the higher cost of the warehouse facility; it would decline steadily thereafter as the existing loan book matured. Other operating income - arrangement fees and the like - would fall more sharply. Assume 50 percent, or £15m.

I assume that most of the £48m cost base is fixed unless Paragon chooses to restructure (in which case it will take exceptional losses). Without cost cuts, however, and even if Paragon does no new lending next year, it might still make a £50m operating profit.

My problem with Paragon is what happens if the UK housing market goes sour and the quality of its assets deteriorates. Unless that happens, however, I don’t think the funding situation is fatal.

Valuation

Tangible, diluted book value is £312.7m or£2.73 per share; at £1.25, Paragon trades at only 0.46x that. To pick a number out of thin air, suppose that it cost £75m to lay off Paragon’s sales staff, write off its systems and websites, and put the company into run-off. PAG would still be worth more than £2 per share.

Looking at it a different way, if Paragon could make £36m after tax next year then it would be on a P/E of only 4x, and though the profit stream would decline if it shuts to new business, it should easily be worth more than the current share price.

The possible £280m rights issue would dilute the value but not eliminate it.

Conclusion

If it was only a matter of the liquidity squeeze I’d say that Paragon is a buy: I think any concerns are now fully expressed in the price. I have my doubts about the UK housing market, however, which really could bankrupt the company.

I will ponder whether I want to make a short-term, special situation investment, which may mean stumping up extra capital in the rights issue.

November 20, 2007 | Filed Under Companies

 

Comments

4 Responses to “Paragon - It’s not that bad (PAG)”

  1. r williams on November 21st, 2007 7:46 pm

    I find PAG an interesting, well run company with stringent lending parameters. I bought 3000 for my daughter a few years back at circa 270p and believe is being targeted by the short sell vultures and hedge funds in general for no legitimate reason. I would be interested to read any other comments you may raise in the future on PAG.

  2. Dr A J Martin on November 23rd, 2007 10:33 am

    Paragon, currently capitalised at just over £100m are hoping to saise £280m via a rights issue before February 27th 2008. That seems to me to be extremely unlikely.
    If the rights issue fails, and credit markets remain shut the Company and all its shareholders have a big problem.

    Or am I missing a trick?

  3. The Analyst on November 23rd, 2007 11:13 am

    Hi,

    The rights issue is fully underwritten by UBS and a group of Paragon shareholders - they have been paid a fee and are contractually obliged to stump up the £280m if Paragon asks for it, and the rest of its shareholders refuse to oblige.

    There is a “material adverse change” clause that would allow UBS to weasel out of the agreement. To trigger it, though, there would have to be an important piece of new information about Paragon. The simple fact that the credit markets are in difficulty wouldn’t be enough.

    The real question is whether an equity fundraising will do any good given that what they really need is debt.

  4. Paragon rights issue (PAG) : The Rogue Analyst on January 11th, 2008 5:38 pm

    […] outcome was pretty much inevitable given the continuing credit squeeze and I’d expect shareholders to support it. There is residual value in the company and this […]

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