Paragon Care : Equity Report by Shaw and Partners – 4 July 2017

Paragon Care (PGC)

Rating: Buy | Risk: Medium | Price Target: $0.95

Initiation of Coverage: A Successful Evolution Yet to be Matched by its Multiple

Key Information Event Current Price ($ps) 0.78 We see an evolution in PGC's earnings quality, acquisition strategy and growth prospects 12m Target Price ($ps) 0.95 52Week Range ($ps) 0.69 - 0.91 yet to be fully recognized or matched by the multiple at which it trades. Shaw and Partners Target Price Upside (%) 22.6% initiates coverage of Paragon Care (PGC) with a BUY rating and $0.95 TP. TSR (%) 26.1% Reporting Currency AUD Highlights Market Cap ($m) 127.9  An obvious evolution in earnings quality - PGC's earnings profile has evolved Sector Health Care significantly over the last 18 months: it was always a defensive play on government Avg Daily Volume (m) 0.1 ASX 200 Weight (%) 0.01% funded hospital and aged care, but its acquisition program has made it considerably larger and more diversified. The lumpiness of the past has gone - with an increased Fundamentals level of long term consumables contracts delivering recurring earnings - and it now has YE 30 Jun (AUD) FY16A FY17E FY18E FY19E Sales ($m) 93.4 115.1 125.0 134.0 a number of significant unrecognised growth opportunities. NPAT ($m) 7.6 9.3 10.9 11.8  An unrecognised evolution in growth prospects - PGC has primarily grown through EPS (cps) 5.6 5.8 6.8 7.4 acquisition over the last few years acquiring $92m of revenue which now accounts for EPS Growth (%) 77.9% 3.6% 16.9% 8.6% DPS (cps) (AUD) 2.2 2.7 3.2 3.5 80% of its sales. Subsequent growth from these businesses as a result of PGC Franking (%) 100% 100% 100% 100% successfully leveraging its client base has been masked by its original capital equipment Ratios business which surrendered agency agreements. We estimate excluding capital YE 30 Jun FY16A FY17E FY18E FY19E equipment, PGC's organic growth from its consumable and service offerings was 13% P/E (x) 12.5 13.4 11.4 10.5 over the last three years and believe this rate of growth is indicative of ongoing growth EV/EBITDA (x) 7.8 7.9 6.7 6.0 (see page 5). We also expect PGC's capital equipment initiatives will rebuild lost sales at Div Yield (%) 3.1% 3.5%4.2% 4.5% higher margins (see page 7) and that its Ehealth product has very exciting potential. Payout Ratio (%) 39.3% 46.7% 47.7% 47.7% Price Performance  A subtle evolution in acquisition strategy - Acquisitions are expected to continue going YE 30 Jun 1 Mth 2 Mth 3 Mth 1 Yr forward enabled by the capacity to comfortably raise both debt and equity. However, Relative (%) 14.1% 14.8% 1.6% 3.1% PGC's acquisition rationale has shifted from needing to smooth its earnings profile with Absolute (%) 12.3% 11.5% (1.3%) 10.7% the addition of more reliable sales (ie consumables that provided recurrent monthly Benchmark (%) (1.8%) (3.3%) (2.9%) 7.6% sales) to a focus on leveraging its existing business (ie acquiring more service and 0.95 Ehealth businesses) in order to drive longer term sales growth and achieve the 0.90 company's aspirational targets - sales $250m, 5-6 x stock turns and 15% EBITDA 0.85 margins. PGC has been acquiring businesses at EV/EBITDA multiples of up to 5x and is trading on an EV/EBITDA multiple of 6.8x which equates to immediate value accretion 0.80 for shareholders, but we also see significant EPS accretion, improved liquidity and a 0.75 subsequent re rating of the multiple at which PGC trades over the next couple of years 0.70 as outlined in detail on page 10. 0.65  Risks are being managed out of the business - PGC's original product offering of Jul Sep Nov Jan Mar May branded capital equipment is no longer as significant to it and the acquired consumable S&P/ASX 200 Index PGC Price performance indexed to 100 Source: FactSet ranges, which now dominate its sales profile, are non-discretionary, not subject to online encroachment and relatively defensive. However, there is an increased level of Major Shareholders agency product, but this will decline from 80% of sales in FY17 to First Samuel Ltd. 7.6% couple of years. Barriers to entry are higher in its newer product and services categories Jmt Investment Group Vic Pty Ltd. 5.9% and PGC's balance sheet is conservatively geared at 13%. Peter Diamond 4.3% Posse Investment Holdings Pty Ltd. 2.8% Recommendation PGC's recent acquisitions (predominantly consumables and service businesses) have been performing better than recognised (see page 5), which has significant implications for the growth it is likely to deliver in the future both from its current businesses and the acquisitions that are clearly going to be made. The long term growth we expect sets it apart from comparative companies with similar health related product offerings and makes us think more about the way in which GUD has recently been re-rated in response Darren Vincent | Senior Analyst to its acquisition/divestment program. We believe, based on PGC's register and limited [phone] broker coverage that mainstream investors are yet to consider this and that PGC is [e-mail] undiscovered. Our 12 month TP is $0.95, however with acquisitions we will look to reassess our TP again. BUY.

Matthew Johnston | Analyst‌‌‌‌

[phone]

[e-mail]

Paragon Care Health Care

Financial Year End: 30 June

Investment Summary (AUD) EPS (Reported) (cps)	FY15A 3.2	FY16A 5.6	FY17E 5.8	FY18E 6.8	FY19E 7.4
EPS (Underlying) (cps)	3.2	5.6	5.8	6.8	7.4
EPS (Underlying) Growth (%)	77.9%	3.6%	16.9%	8.6%
PE (Underlying) (x)	18.0	12.5	13.4	11.4	10.5
EV / EBIT (x)	11.2	8.3	8.4	7.5	7.0
EV / EBITDA (x)	10.2	7.8	7.9	6.7	6.0
DPS (cps) (AUD)	130.0	2.2	2.7	3.2	3.5
Dividend Yield (%)	229.8%	3.1%	3.5%	4.2%	4.5%
Franking (%)	100%	100%	100%	100%
Payout Ratio (%)	nm	39.3%	46.7%	47.7%	47.7%
Free Cash Flow Yield (%)	(1.4%)	6.6%	10.7%	7.2%	8.7%
Profit and Loss (AUD) (m)	FY15A	FY16A	FY17E	FY18E	FY19E
Sales	32.2	93.4	115.1	125.0	134.0
Sales Growth (%)	65.6%	190.0%	23.3%	8.6%	7.2%
Other Operating Income	0.0	0.0	0.0	0.0	0.0
EBITDA	3.7	12.1	15.8	18.4	20.5
EBITDA Margin (%)	11.5%	12.9%	13.7%	14.7%	15.3%
Depreciation & Amortisation	(0.3)	(0.8)	(1.1)	(1.9)	(2.7)
EBIT	3.4	11.3	14.7	16.5	17.8
EBIT Margin (%)	10.4%	12.1%	12.8%	13.2%	13.3%
Net Interest	(0.7)	(1.4)	(1.4)	(1.0)	(0.9)
Pretax Profit	2.7	9.9	13.3	15.5	16.8
Tax	(0.6)	(2.3)	(4.0)	(4.7)	(5.1)
Tax Rate (%)	(22.0%)	(23.6%)	(30.0%)	(30.0%)	(30.0%)
Minorities	0.0	0.0	0.0	0.0	0.0
NPAT Underlying	2.1	7.6	9.3	10.9	11.8
Significant Items	0.0	0.0	0.0	0.0	0.0
NPAT Reported	2.1	7.6	9.3	10.9	11.8
Cashflow (AUD) (m)	FY15A	FY16A	FY17E	FY18E	FY19E
EBIT	3.4	11.3	14.7	16.5	17.8
Tax Paid	0.0	(3.4)	(4.7)	(4.7)	(5.1)
Net Interest	0.0	0.0	0.0	0.0	0.0
Change in Working Capital	0.0	0.0	10.7	0.6	0.7
Depreciation & Amortisation	(0.3)	(0.6)	(1.1)	(1.9)	(2.7)
Other	0.7	11.8	12.8	19.4	22.3
Operating Cashflow	0.4	7.8	17.7	13.3	15.2
Capex	(0.9)	(1.5)	(4.4)	(4.4)	(4.4)
Acquisitions and Investments	(5.9)	(55.2)	(2.9)	0.0	0.0
Disposal of Fixed Assets/Investments	0.1	0.2	0.0	0.0	0.0
Other	(0.4)	(0.7)	(0.5)	0.0	0.0
Investing Cashflow	(7.1)	(57.2)	(7.8)	(4.4)	(4.4)
Free Cashflow	(0.5)	6.2	13.3	8.9	10.8
Equity Raised / Bought Back	0.2	42.1	0.0	0.0	0.0
Dividends Paid	(0.9)	(1.6)	(3.8)	(5.3)	(5.4)
Change in Debt	7.9	27.1	0.6	0.0	0.0
Other	0.0	0.0	0.0	0.0	0.0
Financing Cashflow	7.2	67.6	(3.2)	(5.3)	(5.4)
Exchange Rate Effect	0.0	0.0	0.0	0.0	0.0
Net Change in Cash	0.1	10.4	(11.0)	(9.7)	(9.8)
Balance Sheet (AUD) (m)	FY15A	FY16A	FY17E	FY18E	FY19E
Cash	3.8	19.1	24.4	28.1	33.5
Accounts Receivable	7.1	19.4	10.6	11.0	11.8
Inventory	8.4	22.6	21.9	21.9	21.9
Other Current Assets	1.2	3.0	5.0	7.5	9.2
PPE	1.2	3.0	5.0	7.5	9.2
Total Assets	41.5	150.8	162.3	171.4	181.1
Accounts Payable	6.3	22.7	22.4	23.4	24.9
Short Term Debt	5.5	7.6	7.2	7.2	7.2
Long Term Debt	6.7	30.6	30.1	30.1	30.1
Income Taxes Payable	0.6	0.6	0.0	0.0	0.0
Other	0.0	11.0	3.7	3.7	3.7
Total Liabilities	19.1	72.4	63.4	64.4	65.9
Total Shareholder Equity	20.6	72.8	81.7	87.3	93.7
Ratios	FY15A	FY16A	FY17E	FY18E	FY19E
ROE (%)	20.4%	16.2%	12.0%	12.8%	13.0%
Net Debt / Book Equity (x)	0.4	0.3	0.2	0.1	0.0
Net Debt / EBITDA (x)	2.3	1.6	0.8	0.5	0.2

FactSet: PGC-AU / Bloomberg: PGC AU

Key Items Data

Recommendation	BUY
Risk	MEDIUM
Price ($ps)	0.78
Target Price ($ps)	0.95
52 Week Range ($ps)	0.69 - 0.91
Shares on Issue (m)	165.0
Market Cap ($m)	127.9
Enterprise Value ($m)	123.9
TSR (%)	26.1%

Company Description Paragon Care Ltd. engages in supplying medical equipment to the health and aged care markets. Its product categories include balance and mobility, beds, mattresses and furniture, carts and trolleys, consulting room equipment, dermatology and cosmetic medicine, general medical products, consumables, infection control, lighting, materials management, newborn care, operating theatre, and ophthalmic. The company was founded in 1994 and is headquartered in Scoresby, Australia.

Price to Earnings (x) - NTM

14

13

12

11

10

9

8

7

Jun14 Dec14 Jun15 Dec15 Jun16 Dec16 Jun17

Paragon Care

600

500

400

300

200

100

0

Dividend Yield (%) - NTM

Source: Shaw Research

Jun13 Jun14 Jun15 Jun16 Jun17

Paragon Care

Source: Shaw Research

Numerous positive factors draw us to Paragon Care

PGC operates in industries underpinned by strong demographic drivers, favorable market characteristics and over the last three years it has worked towards positioning itself to take greater advantage of those factors, re-engineering its earnings profile to initially deliver more stable revenues and more recently, to drive reliable growth.

Demographics underpin demand for Paragon's product and services

The Australian market for PGC's products and services is estimated to be worth >$10bn and to be growing at 4.5% p.a. underpinned by:

• An ageing population is driving increased demand for acute and aged care, and

• Governments are primarily footing the bill with investment into the sector growing in proportion to population growth across the age groups.

Combined these factors give PGC both defensive qualities and long term growth potential.

Fig 1: An ageing population driving demand for acute and aged care	Fig 2: Govt investment into the $161b sector was $108b in 2014/15
Source: AIHW health expenditure data base, Shaw and Partners‌‌‌	Source: AIHW health expenditure database, Shaw and Partners

Favorable market characteristics

The industry structure is also favorable to a relatively large participant, such as PGC, which can exercise its balance sheet and economies of scale. The industry is:

• Fragmented with lots of small participants not realising economies. Economies are significant to servicing hospitals as they generate a heavy administrative burden and they are looking to limit the number of suppliers they deal with,

• There's a large number of hospitals /aged care facilities across ANZ, most are PGC's clients (see p 7) which it's leveraging with additional products and services, and,

• Online encroachment into medical products has been low in Australia and the US.

  PGC's growth prospects have also been significantly improved

  Over the last two years PGC will have grown sales 2.6x to a guided $115-120m for FY17, EBITDA will have grown 4.4x to a guided $15.7-16.7m and EPS will have grown 2.5x from 2013 to 2016 despite a 150% increase in the number of shares on issue. The growth reflects acquisition (~35%) and organic growth (10-12%). Organic growth from acquisitions has been masked by PGC's original capital equipment business which surrendered agency agreements. Excluding this we estimate PGC's organic growth from consumables acquired over the last three years was 13% which is indicative of ongoing growth (see page 5).

• Growth opportunity 1: Servicing & Preventative maintenance. PGC has recently grown its service business into a national service operation which is leveraging its existing client base and forecast to more than double sales by FY19.
• Growth opportunity 2: EHealth. PGC acquired Midas (imaging workflow solution) for

  $2m in 2016 which has delivered some exciting upside (see page 9) not factored into our forecasts but which could underpin another evolution in PGC's earnings profile.

• Growth opportunity 3: Proprietary product. ~ $12m of PGC's revenue is from proprietary PGC branded capital equipment sales. PGC has initiatives in place to grow this substantially over the next few years (see page 7).
• Growth opportunity 4: Acquisition growth. PGC has grown through acquisition with thirteen acquisitions since listing at an average multiple of ~ 5x EBITDA. Essentially it is acquiring businesses with product (not key people that can walk). All have been integrated and stock has come out of escrow with little selling which reflects on PGC culture. With the capacity to raise both equity and debt, further acquisitions will be a

  key part of PGC realising its stated target of $250m of sales in the next few years.

  Management initiatives have also delivered an improved business profile

• PGC now has a wider product range making it more relevant to clients and allows it to have: lead products for developing new clients, higher margin products for sustainable earnings and improved economies which is driving organic growth.
• Client concentration is reduced. No one client represents more than 9% of earnings, but more importantly where PGC was previously making limited and one off sales, it is now selling a wider range of products to a broader group generating monthly sales.
• More contracted, recurring earnings across a range of Consumables and services which now account for 70% of revenues.

Risks are being managed out of the business

Hospital ordering patterns for capital equipment sales are now far less significant to PGC's earnings, only accounting for 28% of EBITDA down from 90% largely replaced by branded consumables that are non-discretionary, not subject to online encroachment and relatively defensive (see p8 - WBM has not been affected by WA weakness). PGC is an agent for over 100 different international brands which represent 80% of sales; loss of agency is a risk, however the largest agency is only 6% of sales and with forecast growth this will be reduced. Currency risk exists as PGC sources most of its product offshore, but its buyers (government funded hospitals account for 80% of sales) don't have significant buying power, although reform of the funding mechanism could impact sales. Integration of the key larger acquisitions made two years ago has occurred and PGC's balance sheet is conservatively geared with only $38m of debt.

PGC's valuation is undemanding and we rate it BUY

PGC's valuation is undemanding on both a compco basis and DCF, especially once its growth prospects from Ehealth acquisitions which are not in our forecasts are considered. There is no exact compco, the closest by product type is LifeHealthcare, but it doesn't have equivalent growth prospects. GUD has a significantly larger market capitalization, but is an interesting thought provoker from the perspective of what effective acquisition/divestment can deliver; its multiple has doubled in 12 months.

Figure 3: Compco analysis suggests PGC should trade at $0.95 to $1.10 per share

Compco Mkt Cap PE EPS growth Simillarities and differences relevant to valuation

Healthcare distributors $m FY17 FY18 FY17 FY18 BWX Limited 552 32.7 25.1 nm 27.8 Proprie ta ry bra nde d he a lthca re products s old into pha rma cy (~85%) & da igou (~15%) LifeHealthcare Group 95 12.4 11.0 95.6 1.5 Dis tribution a nd s a le of me dica l de vice s , cons uma ble s a nd biologics McPhersons 136 10.7 9.2 20.7 9.8 Proprietary branded (65%) & agency (15%) health, wellness 7 beauty products sold into pha rma cy & groce ry which a re price compe titive a nd s ubje ct to online compe tition Paragon Care 127 12.8 11.1 82.4 7.1 Be s t compcos : Life He a lthca re for product type a nd GUD for impa ct of re building profile Sigma 860 14.7 14.3 8.0 10.6 Pharmaceutical manufacture and distribution into pharmacy and grocery which based on consensus has lower growth potential than PGC - average 16.6 14.1 A more interesting comparison, to make you think! Proprietary branded aftermarket auto parts (100%) sold into trade buyers has had a GUD Holdings 1091 20.9 18.6 nm nm significant PE rerating as a result of changes to its sales profile associated with acquisition/divestments. Like PGC it is not subject to online threat.

Source: EPS and PE are Factset consensus estimates, Shaw and Partners

We conclude PGC should trade well above LHC and below GUD on a FY18 multiple of 13- 15x FY18 eps which at the mid-point implies a price of $0.95. Our DCF valuation based on a 12.5% WACC and 2% terminal growth rate, values PGC at $1.27 per share and implies a FY18 PE of 16x. Our 12 month TP is the lower of our two valuation methods, $0.95 and our rating is BUY.

Figure 4: DCF analysis suggests a PGC valuation of $1.27

Key va l ua ti on i nputs A$m A$ per s ha re Tax Rate 30% Shares on issue - dil 159.9 NPV - years 1 to 10 135.9 $0.85 Risk Free Rate 5.0% Share price A$0.71 NPV - terminal 79.4 $0.50 Debt Premium 2.00% Market Value of Equity A$114m Surpl us/assoc assets 0.0 $0.00 After-tax Market Ri 6.0% Fai r Value of Net Debt A$12m Enterprise value 215.3 $1.35 Equity Beta 1.25 Required Equity Return 12.50% Debt and prefs (l ess options) (12.1) ($0.08) Adj. Terminal Nomi 2.00% Net Debt/Enterpri se Valu 0.0% Equity valuation - current DCF 203.2 $1.27 Franki ng Percentag 100% WACC 12.50%

Source: Factset, Shaw and Partners