BNGO - Inotiv: High Expenses Likely To Impair Long-Term Profitability

Summary

• Inotiv's recently acquired companies cause its revenue to spike tremendously.
• However, the company's expenses are just as great, and not all of the largest cost items are one-time costs, meaning the company could remain unprofitable for a long time.
• Specifically, the Goodwill Impairment cost raises some concerns about the capability of the management to make good investment decisions.

Investment Thesis

Inotiv, Inc. ( NOTV ) experienced extraordinary growth in top-line revenue for the financial year 2022 that caught the attention of investors, causing a visible spike in the stock price.

Drilling down to its bottom line, it is still not profitable. Looking at the detailed cost items and long-term profitability trend, we contend that the company may not turn profitable even in the long run.

While NOTV made notable acquisitions that bumped up its revenue many folds, the huge Goodwill Impairment cost cast doubts on the management's capability to make astute investment decisions for the benefit of the company in the long run.

Even without the non-cash accounting loss of Goodwill Impairment, the company is still unprofitable due to 'other' operating and revenue costs, which are likely to be persistent in the long run.

Due to the long-term uncertainty in the future profitability of the company, in spite of the recent huge revenue gains, my rating for NOTV is a 'hold'.

Company Overview

Inotiv is a pharmaceutical development company that focuses on nonclinical and analytical drug discovery and development services for the pharmaceutical, chemical, and medical device industries. It also sells analytical instruments to the pharmaceutical development and contract research industries.

The company used to be providing mostly pharmaceutical 'services'. However, recently, we observe that it has pivoted away from services and provided mostly pharmaceutical 'products' instead.

As of 2022, the revenue share of the Service and Product segments is roughly split between 40% and 60%.

According to the company's latest annual report , the company's products and services are mostly contributed by 2 major business segments:

• Discovery and Safety Assessment ("DSA")
• Research Models and Services ("RMS").

We can observe that the DSA segment is responsible for most of the company's 'service' offerings while most of the company's 'products' are provided by the RMS segment.

Company's Trend Of Profitability And Loss

To understand the company's profitability since 2013, we will make use of Seeking Alpha's compilation of key income statement figures.

Here are some observations:

1. The company's top-line revenue has experienced extraordinary growth in the last financial year of 2022, after being relatively stagnant since 2013.
2. Unfortunately, this high growth also comes with equally extraordinary growth in the cost of revenue.
3. In spite of this growth in top time, the company is still unprofitable in bottom-line profits. The last financial year of 2022 saw the company incurring 27.4M in operating loss.
4. And this operating loss is not a one-off occurrence. It has been a consistent trend since 2019.

Right now, it is unclear whether NOTV is able to achieve profitability in the long run.

Extraordinary Revenue Growth

The company's revenue grew from $89.6M in 2021 to $547.7M in 2022. This is a whopping 600% ($547.7M/$89.6M) increase from the previous year. From the latest annual report, we can understand the source of this growth:

Revenue grew to $547.7 million during the fiscal year ended September 30, 2022 ("FY 2022") from $89.6 million during the fiscal year ended September 30, 2021 ("FY 2021"), driven by a $75.7 million rise in DSA revenue and $382.4 million of incremental revenue from our RMS business . Growth resulted primarily from acquisitions and growing customer demands along with favorable pricing.

The lion's share of the 600% revenue growth comes from the RMS segment . But before we conclude that NOTV has finally found the 'cash cow' to grow its business to stratospheric heights, remember that as discussed in the earlier section, in spite of the 6x increase in revenue, NOTV is still unprofitable in bottom-line operating profits.

Extraordinary Cost Incurred

We discussed earlier that NOTV incurred $27.4M in 'operating loss'.

If we drill down further to the 'net income', the loss at this bottom line further widened tremendously to $337M. Most of this loss is due to one item of 'EBT, Incl. Unusual Items. '

From the company's latest annual report, we can get a more detailed breakdown of the different cost items:

The company also incurred a substantial loss in Goodwill Impairment (part of operating cost), which is about 43% (236/547.7) of the total revenue:

RMS operating loss was $189.3 million in fiscal year 2022. The loss includes non-cash charges for goodwill impairment of $236.0 million

It can be observed that the bulk of the greatest cost can be categorized into 3 broad categories:

1. Cost of revenue (from both products and services) - 76%
2. Operating Expenses (excluding goodwill impairment) - 33.8%
3. goodwill impairment - 43%

Generally, in my opinion, points 1 and 2 are more likely to be persistent and recurring. The goodwill impairment loss, on the other hand, is 'subjective' and might be a one-time cost. We will discuss more on this in subsequent sections.

If I give NOTV the benefit of the doubt that 'goodwill impairment' is on-time and adjust it back to the overall net loss, it will only significantly reduce the overall bottom-line loss to roughly (18.6)%.

It does not reverse the loss-making financial status of the company.

Goodwill Impairment Cost

As noted from the annual report, the goodwill impairment loss sustained by the RMS segment is significantly high (about 43% of total revenue). From the annual report, we understand it is due to recent acquisitions:

RMS operating loss was $189.3 million in the fiscal year 2022. The loss includes non-cash charges for goodwill impairment of $236.0 million , $24.7 million intangible amortization related to intangible assets acquired through the acquisitions of Envigo, RSI, and OBRC, $11.1 million of depreciation expense and $10.2 million amortization of inventory step-up related to inventory acquired through the acquisitions of Envigo and OBRC.

According to Investopedia :

Goodwill impairment occurs when a company decides to pay more than book value for the acquisition of an asset, and then the value of that asset declines. The difference between the amount that the company paid for the asset and the book value of the asset is known as goodwill.

Goodwill is the intangible asset associated with the companies purchased by NOTV, specifically Envigo, RSI, and OBRC. In the same article, it was described that a high goodwill impairment cost might be a sign that the company is not astute enough in its choice of acquisitions.

Alternatively , a sharp decline in Goodwill can also be explained by the sharp and sustained decline in stock price:

stock price declines can trigger the need for an impairment test of goodwill. This is mainly because in goodwill testing for impairment, the market capitalization of the company is relevant and decreases with a fall in share prices.

This is what the management has to say about this accounting loss during the latest earnings call :

And as part of our impairment assessment, we determined that the carrying amount of goodwill attributed to our RMS segment was in excess of its fair value, primarily driven by the sustained decrease in our share price as compared to our share price at the time of the Envigo acquisition.

Generally, the value of Goodwill can be hard to quantify because it is intangible, like 'brand recognition' and 'customer loyalty'. In this discussion, NOTV's management attributes it to the sustained decrease in the company's share price. If that is the case, this impairment loss should be short-lived if the stock price can recover in the long run.

Investors should observe if this impairment cost is persistent in the long run.

Competition

The company has competition. Unfortunately, from the annual report, the company chose not to reveal the exact identity of its most significant competitors:

• "For DSA, we have many competitors, including three public companies in the U.S. and one public company in China."
• "For RMS, there are five main competitors, including one public company in the U.S., two privately-held companies in the U.S., one government-funded, not-for-profit entity in the U.S., and one privately-held company in Europe."

From Finviz , we can get a list of competitors by sorting the companies with similar market capitalization from the "Diagnostics & Research" industry:

We will compare the margins of NOTV with its competitors to understand whether the company enjoys any significant competitive advantage.

These margin figures are inferred from Morningstar. Note that for some of the competitors, the latest financial figures for 2022 were not reported yet, so we will compare the general trends from the last few years since 2017.

From the table, we understand that:

• Although the margin profiles of NOTV and Surmodics Inc. ( SRDX ) are significantly more favorable than the other 2 competitors in the comparison list, the bottom line operating and net margins since 2017 are usually in the low-tens range.
• Compared to SRDX alone, NOTV also does not seem to enjoy a significant competitive advantage.

In my opinion, the competitive advantage of NOTV over its competitors is either 'low' or 'non-existent'.

Risk

Recently there is a spike in stock price that pushed it up to around $8, from a low of about $4. The spike is due to the reported revenue surge in Q4 2022, leading to an overall 600% revenue increase in the financial year of 2022, as discussed earlier.

While this sudden rise in revenue is a good sign for the company's financial outlook, investors should question the sustainability in terms of the profitability of the company's recent acquisitions. As acknowledged in the risk section of the company's latest annual report:

we may experience unexpected adverse impacts on the acquired businesses, or we may otherwise not realize the expected return on our investments, any of which could adversely affect our business or operating results and potentially cause impairment to assets that we record as a part of the acquisitions, including intangible assets and goodwill.

We discussed earlier that the NOTV sustained a huge amount of Goodwill impairment loss and this is an intangible asset that is hard to quantify. Typically, a company needs to check its goodwill for impairment on a yearly basis.

If the impairment cost is persistent, it is generally a sign that the management has poor judgment in making investment decisions.

If investors are not confident in the management's capability in realizing the returns from the recently acquired companies, they should refrain from investing in NOTV.

Valuation

NOTV is not profitable in net income. Neither is it cash flow positive. As such, we cannot value the intrinsic value meaningfully using discounted cash flow or discounted net income. We shall compare the valuation of NOTV using its Price / Sales ratio and compare it with its competitors with comparable market capitalization:

• Bionano Genomics ( BNGO ) - $537.43M
• Senseonics Holdings ( SENS ) - $540.43M
• Surmodics ( SRDX ) - $508.67M

From the value of 'Price/Sales', NOTV is clearly the most undervalued among its competitors. The current price may look relatively cheaper compared to its competitors but without a proven record of being consistently profitable in bottom lines, cheap can get even cheaper and so I will not regard this undervalued status as a buy signal.

Conclusion

NOTV made notable acquisitions in several companies which results in an extraordinary increase in its revenue. However, it has a lot more to do in terms of convincing investors that these acquisitions will reap the expected rewards in the long run.

Specifically, it needs to drastically bring down its operating cost. Right now it is undergoing a phase of restructuring and mergers, according to what was mentioned in the earnings call:

During the fourth quarter, we did experience unexpectedly higher operating costs related to company-wide recruiting and the validation of new DSA services, as well as certain non-recurring costs related to restructuring charges, legal fees for closures of facilities, and consolidation expenses to move operations from Dublin, Virginia to other facilities; we also began the preparation for moves from Haslett and Boyertown; we had acquisitions integration costs, including expenses from terminated M&A deals, which we will not close, and financing transactions and the discontinuation of a capital project.

The company needs to show investors that most of the costs associated with these restructuring and mergers are short-lived.

The high Goodwill Impairment costs also cast doubts on the management's capability in making good investment decisions. NOTV needs to ensure the impairment costs will come down eventually to justify its huge investment in the recent acquisitions.

Until these issues are addressed, my rating for NOTV shall maintain as 'hold'.

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