2024-01-02 04:08:08 ET
Summary
- Neogen's merger with 3M's Food Safety business resulted in a significant drop in its share price and a disappointing operating performance.
- The combination is struggling to show organic growth, shows suboptimal earnings and operates with a rather leveraged balance sheet.
- Neogen's shares have recovered slightly but are still trading in a range, and the company's future operating performance remains uncertain, with appeal only seen if execution returns.
In the fall of 2022, I called Neogen ( NEOG ) a mess, although I recognized that it seemed to have been priced in already. The company announced a large deal with 3M ( MMM ) in 2021, a transaction which raised real questions as it seemed that two overvalued companies from the get go have combined their operations.
With many moving parts, including a massive debt overhang, further questions have arisen. While valuations started to look compelling, that was based on the assumption that no dilution or leverage risks would emerge. Fast forwarding to today, we can indeed see that the worst leverage concerns are a thing of the past, but execution has been lagging as well, which makes shares not necessarily cheap here.
Steady Operator Gone Rogue
In the 2010s, Neogen has proven to be a real steady value creator as the business grew its sales from a quarter of a billion in 2014 to nearly half a billion in 2020, accompanied by solid (although slightly lower) operating margins of around 15%.
Shares peaked around the $50 mark in 2021 as the company commanded a $4 billion and change valuation in the forties when it announced a tie-up with the food safety business of 3M. This valuation corresponded to about 9 times prevailing sales and 70 times earnings, both lofty multiples.
Neogen merged with 3M's Food Safety business in a $5.3 billion deal. In this transaction, Neogen was designated to be the remaining entity, with its former shareholders combined owning a 49.9% stake in the business, leaving 3M to hold the majority of the shares, while 3M fetched a billion dividend as well.
The 3M activities were to add $400 million in sales, as the $175 million EBITDA number of the activities surpassed the $125 million number on this metric reported by Neogen itself. With another $30 million in synergies projected as a result of the tie-up, investors initially liked the deal, as was evident in shares of Neogen moving up in response to the deal announcement.
Deal Turns Sour
A $40 stock in the fall of 2021 plunged to just $10 per share in the fall of 2022. In the meantime, Neogen posted a 13% increase in its full year sales to $527 million, with adjusted earnings down six cents to $0.63 per share, with the deal still set to close.
Based on the transaction structure, the share count would double to 216 million shares after the deal closed in September 2022. Pro forma net debt of around $653 million came in a touch higher, as Neogen furthermore saw its CFO resign at the time. All this bad news caused shares to fall to the $14 mark in the fall of 2022, as the enterprise valuation had fallen to $3.7 billion. This was the valuation for the combination, with each of these business fetching a higher valuation on a standalone basis just a year before!
Hence, it shows that the deal resulted in an extremely painful outcome for investors, as no quick avail was in sight, while no guidance was given for the upcoming year. With the core business posting earnings of sixty to seventy cents per share, the potential was there, but leverage pitfalls had to be avoided. While value was apparent, I also failed to have conviction given the troubled past, most certainly the questionable deal, making me extremely cautious here.
Range Bound
Since September, shares have recovered and have generally traded in a $15-$25 range, now trading at $20 per share, after they traded near the lower end of the range as recent as November.
Fast forwarding to July of this year, Neogen posted fiscal year 2023 results of $822 million, up from $527 million in the year before. This was for the year which ended in May of this year, including about nine months of the acquired 3M activities, with revenues trending near a billion based on the fourth quarter results. While full year GAAP operating profits of nearly $38 million for the year were dismal, the company posted a $23 million operating profit in the fourth quarter of the year.
The company posted a full year GAAP loss of $23 million, equal to $0.12 per share, with adjusted earnings reported at $106 million, equal to $0.56 per share. While I am happy to adjust for all the charges related to the deal, a $10 million stock-based compensation expense is not something I am happy to adjust for, with earnings otherwise seen around half a dollar.
With full year adjusted EBITDA reported at $205 million, that number comes in way short of the three hundred million number guided for at the time of the deal announcement. Net debt of $655 million has not come down, working down to a leverage ratio in excess of 3 times.
For 2024 the company guided for sales at a midpoint of $970 million, plus or minus fifteen million, with adjusted EBITDA seen between $235 and $255 million. That suggests a forty million improvement on a sequential basis on the EBITDA front, adding about twenty cents on a pre-tax basis. Worrisome is that capital spending of $130 million is elevated, driven by the need to integrate both businesses.
A Solid Start To 2024
Early in October, Neogen posted its first quarter results for the fiscal year 2024 with revenues reported up 73% to $229 million. This is the last quarter in which revenues are rising rapidly, as the deal with 3M closed a year before the end of the first quarter.
The company reiterated the full year guidance, even as the first quarter results felt a bit soft, all while net debt has been stable at $661 million.
Hence, this feels like a bit of a lost year in terms of cash flow generation, on the back of lack of organic growth and the business merely muddling through. With 217 million shares trading at $20, the $4.3 billion equity valuation translates into a $5 billion enterprise valuation. This values the operations at 5 times sales and a rather demanding EBITDA multiple, with adjusted earnings likely seen around $0.70 per share.
All of this shows that the worst leverage concerns are likely a thing of the past, as this is likely a big reason why shares have risen from $14 this time last year to $20 here. The operating performance is nowhere nearly impressive enough to get compelled to shares here in a greater fashion.
Given all this, I am deciding to keep shares on my watchlist from here, as a somewhat better operating performance might easily create a lot of value down the road, but few signs indicate that this is about to happen soon.
For further details see:
Neogen: Muddling Through After The 3M Food Safety Deal