2023-04-13 14:22:19 ET
Summary
- Neogen continues to rely on its acquisition strategy to grow, and create value for shareholders.
- To date, this has been largely unsuccessful, with the stock giving away 50% of its value over the last 5-years.
- The capital charge for Neogen to continue its existing and growth operations is now much higher, hurting its ability to throw cash off to shareholders.
- The stock is also overvalued compared to my 15x FY'23 EBITDA number.
- Reaffirm hold.
Investment Summary
Following my previous publication on Neogen Corporation ( NEOG ) things have turned more constructive, although not at enough magnitude to change my rating on the company. After a mixed set of numbers in its Q3 FY'23 results end of March, the price response by the market has been underwhelming, and NEOG has lost relative strength versus the benchmark, itself catching a strong bid in Q1 (Figure 1). Despite a breakout after my last report, this hadn't caught strength beyond January and is being sold off to the present day. Net-net, I am reiterating my rating of NEOG as a hold, outlining the case below.
Fig. 1
No bang for the buck, just yet
Allocating capital in the most efficient manner requires managers to pick the most selective opportunities that offer the highest upside potential in the risk/reward calculus. For the spectrum of companies in question, this involves exceptional returns on capital, differentiated offerings, low capital intensity, economic profitability, and profit growth to throw off large amounts of cash to equity holders. Within the current macro milieu, NEOG doesn't present with this kind of value in my opinion, and here are the three reasons why.
One, even with the selloff, NEOG still trades at 134x forward EBIT and 36x forward earnings (non-GAAP). It is highly unlikely the stock is worth paying this multiple for. Granted, quarterly revenue came in strong with 70% YoY growth to $218mm. Food Safety was the major driver with 141% YoY growth to $152mm and Animal Safety up 2% to $67mm. Further, gross margin decompressed by 470bps to 49.5% and this carried through to a doubling in quarterly adjusted EBITDA to $51mm.
But NEOG lacks operating leverage. Note the phenomenon in Figure 2. Revenue delta is associated with sporadic changes in operating income, mostly leading to a <1x leverage to operating income on average since FY'20. Alas, each turn in revenue could potentially drawdown on operating margin, meaning revenue growth could be dilutive to profitability. Top-line growth into the coming quarters will generate <1x operating leverage on average, according to my growth assumptions (Figure 2).
Fig. 2
Note: Rolling TTM periods are used. (Data: Author, NEOG 10-Q's)
Two, related to the above, NEOG relies on a bolt-on acquisition strategy to grow. As a reminder, company valuation is an equation that sums the contribution of current operations plus the contribution from growth. Firms can grow by 1) increasing current capacity, 2) launching new products/services, 3) making acquisitions, 4) increasing efficiency/margins, or 5) a combination.
However, acquisitions create the least value for shareholders, versus launching new products and services for example. In addition, acquisitions are expensive to shareholders, and require enormous sums of capital to be diverted from other opportunities. As equity investors, we want to buy companies where huge amounts of capital aren't required to fuel growth. A higher capital charge leaves less profit on the table for investors, and needs more reinvestment to maintain.
For example, NEOG ended Q3 with $819mm in net debt after its 3M acquisition that it made on a $1Bn transaction. This has taken $100mm in TTM cash flow with $38mm interest expense from shareholder earnings last quarter.
Added to that:
- The CapEx leveraging associated with acquisitions has seen CapEx requirements lift sequentially to $53mm last quarter.
- NWC intensity increased by $50mm sequentially to hit the Q3 revenue growth numbers.
- That makes an additional $100mm in capital required to grow, plus the $40mm quarterly debt pay down.
- NEOG completed another bolt-on acquisition, Corvium, in February to " accelerate its Neogen Analytics Platform ".
- With net debt at $819mm the firm is now at net leverage of 6.6x trailing EBITDA.
- These aren't attractive numbers in my estimation, as we're yet to see the pull-through to owner earnings.
Fig. 3
Data: Author, NEOG 10-Q's
Three, when looking beneath the hood of the growth engine, only 4% of top-line growth was organic last quarter. The remaining ~66% was from acquisitions. Further, the 106% YoY gain in EBITDA arose from the 3M acquisition.
Therefore, collectively, acquisitions drove $143mm in turnover in Q3, and therefore probably ~$10mm of operating income. As mentioned, the additional capital investment was $140mm to hit this mark. This was a 7.1% return on new capital. The problem with these numbers is this:
- The firm's trailing return on invested capital ("ROIC") has slipped majorly since its last 2x acquisitions, from highs of 14% in May FY'22, to 1.4% and 1.6% in the last 2 periods, respectively.
- If the firm can get 14% return it's not unwise to invest more capital to try and maintain this ROIC and create substantial value. But this relies heavily on where, and how much cash is invested - and remember, acquisitions typically create the least value in that regard.
- Most importantly, the ROIC must outpace the cost of capital to create value for shareholders via economic profit. As said, 14% at a cost of capital of 5% is attractive, for instance. For NEOG however, it's turned into 1.6% at a 9% hurdle rate, creating an economic loss of 7.4%.
- Hence, whilst only early days still, the enormous capital that's been diverted from owner earnings has yet to generate economic profit, nor create value for shareholders. Meaning, the company's strong revenue and EBITDA growth from acquisitions have likely been destructive to value for now.
My estimate is these facts have been a major compressor for the NEOG share price since Q4 2022. Moreover, my numbers estimate a widening economic loss with the cost of capital increasing for the firm and ROIC remaining flat at the 2-2.5% range. I am calling for the firm to grow quarterly revenues ~10% sequentially for the firm to clip $274mm at the top line by Q3. Without the supporting economics of its operating model, NEOG won't be able to throw off any additional cash to its equity holders, making valuation upside difficult.
Fig. 4
Valuation and conclusion
NEOG attracts a substantial premium to peers. It is priced at 22x forward EBITDA and 36x forward (non-GAAP) earnings. These are also substantial premiums to its 5-year averages.
However, the stock has given away 50% of its value over the last 5-years of trade. I believe it should trade more in-line with the sector at around 16x forward EBITDA, and ~19-20x forward earnings. My numbers call for $235mm in FY'23 pre-tax earnings on top-line revenues of ~$840mm, pricing the stock at 15x forward EBITDA, below the sector. I am happy with this number, as there's nothing here to command a premium in my opinion. I also forecast the company requires an additional $100-$150mm in CapEx and $50mm in NWC to maintain and grow current operations for the next 12 months. At a 15x multiple, the stock looks fairly priced at $16, a nick off the current market price at the time of writing.
In order for NEOG to catch a re-rating off this low base, it needs to reduce capital intensity, and drive its acquisition revenue to the bottom line, to throw off high amounts of cash to shareholders. That's the key upside risk in my opinion, that could see it trade at higher multiples. My estimates suggest the pattern of low returns on capital on a higher capital intensity may prevail for the time being.
In short, it's best summarized with the following points:
- NEOG is growing reported revenue and operating income, but the bulk of this is derived from acquisition revenues. In fact, this is NEOG's preferred growth strategy. This is very expensive, and doesn't say much for the core business.
- Also, this hasn't pulled through to owner earnings, as the growth requires a substantially higher capital charge (including external financing, CapEx, and NWC), leaving far less on the table for shareholders at the end of the year.
- Leverage has crept up to 6.6x EBITDA after notes issued in November last year.
- Related to (2), more capital is now required to produce profits which eats into owner earnings even further.
- The returns on capital are slim and fail to offset this, instead are below the cost of capital, and not creating value.
- Until these points are resolved, it is difficult to see NEOG priced fairly at 22x forward EBITDA. Nor generate valuation upside. It is more appropriately valued at 15x, in my estimate.
As such, I reiterate that NEOG is a hold for the time being. Until the issues around profitability are satisfied, I believe it will be difficult to attract investment at levels required to drive its stock price higher. Reaffirm hold.
For further details see:
Neogen: Capital Charge To Drive Growth A New Headwind