2023-07-19 01:21:02 ET
Summary
- Neogen Corporation's shares have risen 36% since my last report.
- Despite strong Q3 figures and a 70% YoY revenue increase, I'm still cautious on returns on capital and profitability downstream.
- Investor sentiment for Neogen is currently low, with no upward revisions to earnings or revenue estimates made by Wall Street in the last 3 months.
- Net-net, reiterate hold.
Investment briefing
There have been multiple updates in the investment debate for Neogen Corporation (NEOG) since my last publication on the company in April. As a reminder, I had identified numerous tension points that NEOG would have to overcome in order to be considered investment grade, including:
- Unattractive market multiples, trading at 134x forward EBIT and 36x forward earnings at the time of publication.
- Potential risks with the 3M acquisition, where the capital commitment may not pull through to earnings accretion, or growth in owner earnings.
- Sub-par returns on capital after the new additions to its portfolio.
Collectively, these formed a large hurdle NEOG needed to overcome in order to attract investment and see it rate back to FY'21 highs.
Turning to the present day, and the equity line governing NEOG's stock price has turned north once more, with shares up 36% since the last report. There are obvious drivers for this, and not so obvious ones. For instance, it's no secret NEOG's purchase of the former 3M food safety business brings a pure play avenue to enter the food security market. Its portfolio is now >95% led by consumables, thereby expanding NEOG's offering immensely.
The question is, though, what cost or value does this come at/produce for shareholders, and, is it worth paying 48x forward earnings to get a piece of the action? This report will run through all the critical changes to the NEOG investment debate, and link this back to the fundamental principles that we, as equity investors, must know in full— 1) what are the prospects for NEOG rating higher, 2) what is the true profitability of the business, and 3) is it fairly priced. Net-net, I continue to rate NEOG a hold for reasons discussed in this report.
Figure 1.
Changes to critical facts
Within the changes I'm about to discuss, it's equally as important to talk about what hasn't changed in the debate. There have been fundamental improvements based on the company's latest numbers, for one, and these signify a new artery of growth pumping income to the heart of the business. The "veins" of the company—those factors returning/recycling the blood [capital] back to the business' heart—are also a standout, with incremental profitability a potential talking point. What hasn't necessarily changed? Investor sentiment, and the economic characteristics of the business.
1. Financials—key driver of capital appreciation
NEOG's Q3 FY'23 numbers were absolutely critical in gauging "where to next" for the company, after its mammoth 3M purchase. It was made on a $1Bn consideration, financed through a combination of cash and debt. However, and admittedly, much to my surprise, NEOG's Q3 figures were undeniably strong.
Herein lies the major standout for me. Revenues were up 70% YoY, reaching $218mm for the quarter. If you strip out FX and the acquisition effect, core growth was 4%. As a reminder, it uses a bolt-on acquisition strategy to grow and create investment value. A breakdown on the strategy in Q3:
- Acquisitions accounted for 68% of Q3 revenue growth
- Meanwhile, the increase from non-acquired growth was $69.7mm.
As to what's changed with NEOG's acquisition strategy—this is best shown via the language used by management on the latest call:
We are a serial bolt-on acquirer. We've changed that focus now to deleveraging."
This is interesting. It's no secret rates have shot up in perhaps the most aggressive hiking cycles in history. Perhaps this is one reason. Perhaps it is that NEOG is also satisfied with its current positioning. After all, if you strip out the former 3M business as part of the whole earnings profile, NEOG's core growth, on a pro forma basis, would have been in the low single digits. Hardly attractive.
To this point:
- Food Safety revenues amounted to $152mm, a major YoY increase of 141%.
- That brings pro forma revenues to $377.5mm for NEOG's YTD; otherwise, the 9 months Q3 fiscal '23.
- The major growth drivers were the culture media and bacterial & general sanitation segments of the business.
- Animal safety revenues were up just 1.8% YoY in Q3, 4.4% for the YTD. A stark contrast.
Figure 2.
In that vein, could it be argued the 3M acquisition is a short-term success? It did, after all, contribute the bulk of pro forma income for the business, and by the looks of it, will continue doing so moving forward. Hence, this is something to factor in heavily to the investment debate.
2. Economic Characteristics
FY'25 is the big year for NEOG in terms of its post-3M life. An honest appraisal is required of the profitability levels today and moving into the FY'25 period. To demonstrate the business economics you'd be buying in NEOG today, I've decided to include all the firm's acquired goodwill as an asset and treated it as a capital commitment. You may or may not agree, as goodwill is not operating capital. But the point is it represents a transfer of wealth from the acquiring firm's shareholders, to the target firm's shareholders. So I've opted to 'penalize' NEOG in this regard:
- You'll see below the mountain NEOG has to overcome in order to meaningfully justify the acquisition. Figure 3 shows the rolling TTM gross productivity, calculated as TTM gross profit scaled by total assets each period.
- Note the asset base increased from $977mm in August '22 and jumped to over $4.5Bn by the following period. The bulk of this was in goodwill tied to the purchase.
- Prior to this, it had been averaging ~$0.25 in gross for every $1 in assets off the leaner asset base. Now, however, you're looking at more like 16% gross profitability moving forward, at the current prints for gross profit. My numbers have NEOG pushing ~$805mm in gross by FY'25, up from TTM $347mm last period. That gets me to ~16% in gross productivity as mentioned, not the most attractive figures to bite into.
Figure 3.
Perhaps more important to my own investment tenets, is what this means for growth in post-tax earnings—the complete measure of value-add to investors—downstream. You can see my estimates below. Critically, there are two major observations:
- That returns on existing capital commitments (ex-goodwill) have been hammered by the inclusion of 3M in the near-term. This is to be expected, and thus not surprising.
- Over time, however, even with aggressive growth projections, there doesn't appear to be a recover in NEOG's returns on capital above the long-term market return on capital (around 10-12%).
- Instead, my estimates have the company hitting 6-7% ROIC by FY'25, a full 500-600bps behind the hurdle rate.
Unless it comes out with some spectacular figures over the coming 2-3 years, surprising my internal assumptions, then I wouldn't say NEOG is undervalued at present. It would need to produce at least $700mm in post-tax earnings by FY'25 to align with a ROIC of 15% or more. That's a 657% growth on my FY'23 numbers.
Figure 4.
What then is responsible for the sudden rally in NEOG's equity stock? One possible explanation is the incremental returns of profitability the transaction could add. I analysed this while keeping the same convention as before, by including goodwill in the capital base.
Based on my FY'23—'25 growth assumptions, it's not unreasonable to see incremental profitability gains whilst we walk through the periods. My modelling spat out a range of 26–28% return on the new capital commitments going forward. Whilst this shouldn't be compared to the hurdle rate as evidence of value–add, it does speak to the potentially accretive nature of the deal. This is something to consider for sure, but still enough to get me over the line.
Figure 5.
3. Sentiment hasn't arrived
Positive sentiment is one of 3 requisites that are usually required to drive a stock price higher. Combined with fundamental and valuation factors, sentiment evidences the perspective of investors, and looks at actual investor positioning. In that vein, sentiment is low for NEOG right now. Why?
One, there's been no upward revisions to earnings or revenue estimates made by Wall Street in the last 3 months, suggesting no change to the financial outlook. Usually, I'd be looking for at least 3–4 revisions higher to indicate analysts are turning more bullish. We don't see that here. In fact, The Street's' analysts project 26% and 33.6% YoY declines in earnings this year and the next, despite a projected 50% growth in sales. Get used to that.
Two, there's a lack of bullish investor positioning in the stock evidenced by the lack of strike depth and open interest for call options expiring in July—September. Most of the demand is centered around the $23 strike, right where the stock currently sits as I write. In fact, a bulk of the calls for August expiry are stuck around $20–22.50 strike ranges, below the current mark. You'd expect to see bullish positioning if sentiment was in fact positive.
However, the balancing point on sentiment is momentum. The stock trades above all its moving averages, meaning it trades "above average" across those time frames. Further, as the quant system as identified, NOEG scores an "A" for momentum, pacing ahead of its peers in its latest rally. This is worthwhile noting, but doesn't change the above two points, or the fundamental findings either.
Figure 6.
Valuation and conclusion
The investment debate pulls to an abrupt stop when talking valuation for NEOG. Pay 48x forward, earnings, 243x forward EBIT, whilst being valued at just 1.5x book value? A big no thanks. There's no way I can urge any investor to pay those kinds of multiples, regardless of what deals a company just completed. It doesn't matter that investors may be expecting huge earnings growth, valuing NEOG this high. The opportunity cost for myself, and my readers, is even higher, when there's ample opportunities elsewhere at far, far more respectable valuations.
Say there's no earnings growth, you're paying $48 for every $1 in future earnings, and, said another way, it would take you 48 years for the payback period. Simply unacceptable economics; and it would require an Amazonian effort (quite literally, Amazon ( AMZN ) style) growth to make it justifiable. Just as the Quant System rated it an "A" for momentum, NEOG scores an "F" for valuation, and I agree with the objective data.
Figure 7.
In summary, therefore, I continue to rate NEOG a hold based on factors of valuation and returns on capital. A gargantuan effort is required to converge intrinsic value to market value, and for the time being, I've not uncovered evidence of this occurring in the mid-term. Net-net, I rate hold.
For further details see:
Neogen: Fundamentals Unmatched To Latest Market Rally, Reiterate Hold