2023-10-17 13:41:45 ET
Summary
- Neogen's weak first quarter results, including flat revenue on a pro forma basis, have seriously damaged its growth stock reputation, leading to a major decline in the shares.
- The integration of 3M's Food Safety business has faced multiple challenges, and it will take time to fully maximize the earnings power of this combined business.
- Getting all the acquired business operations under a Neogen-controlled roof should be a big help, but is still a year out.
- I believe high single-digit revenue growth and mid-to-high teens FCF margins are attainable over time, supporting a fair value in the high teens and a positive GARP investment thesis.
One way or another, large M&A is often transformative for a company. In the case of Neogen (NEOG), that transformation has not been a positive one, as the integration of 3M 's (MMM) Food Safety business has hit more than a couple of bumps, with the company also seeing some challenges here and there in the base business. Once a growth darling, investors have bailed on the name, sending the shares down about two-thirds since my last update on the company.
I do think that Neogen is battered and bruised, but not broken. At least some of the challenges that Neogen is experiencing confirm my larger concerns about 3M as a company, but they're not insurmountable challenges - it will just take a few years of R&D reinvestment and "white glove service" to operational matters. I believe management is up to the challenge and I think these shares can do better in the future, and it certainly doesn't help that there's a much more reasonable starting place now where valuation is concerned.
Looking Back At Earnings
Neogen had already warned that fiscal first-quarter sales weren't going to meet prior expectations, and the stock sold off sharply as a result. The actual earnings weren't great, but it's certainly debatable as to whether they should have driven such a large reset to the valuation.
Revenue declined about 1% in organic terms and was closer to flat by management's pro forma organic reckoning. Core Food Safety was up 4.5%, with respectable growth in businesses like Bacterial and General Sanitation, as well as Natural Toxin/Allergen testing. The Petrifilm business continues to have some supply challenges, and the business also saw a steep (high-20%'s) decline in its business in China. Management didn't really explain this particularly well; while China's economy is indeed struggling, I don't see evidence that the food sector is struggling to a degree that explains that sort of decline.
Taking a bit of a step back, management noted fundamental underlying pressures in the Food Safety business - namely, now that companies are no longer in a mad scramble to satisfy orders and rebuild channel inventories, production volumes are down and many of Neogen's product sales are "in process" sales that are directly tied to activity/volume. Management also noted that some customers were actually curtailing capacity at the moment.
On the Animal Safety side, the business declined about 7% with around half of that spurred by destocking in the veterinary channel. This absolutely makes sense to me; given the supply shortages seen after the pandemic, many customers would have over-ordered to make sure they didn't risk running out again. Now that fulfilment times are back to normal (generally speaking), there's no need to carry the unusually high inventories.
I do also note that the Genomics business saw an 8% decline, with management talking about losing two large customers in the poultry and swine businesses. Management characterized this as a response to pressures in those respective sectors. While I don't question management's honesty, I would find that a curious move to make as genomics testing is not a high incremental cost and is actually important to maintaining/improving long-term competitiveness.
Gross margin improved four points (to 51%), adjusted EBITDA rose 94%, with margin up 250bp to 22.9%, and operating income more than doubled, with operating margin up about three points to 20.9%. Neogen is clearly seeing a margin uplift from the more profitable 3M operations (3M's profit margins were about double Neogen's before the deal), but there remain ongoing integration and operational issues that are stretching out the process of fully realizing those benefits.
A Once In A Lifetime Opportunity, Or Buying Somebody Else's Problem? Maybe Both?
There's a saying that goes along the lines of when you buy a used car (or some other expensive piece of capital equipment), you're buying the former owner's problems. To some extent that seems to be the case with the 3M transaction, and I do think that Neogen's post-deal experience validates some of my concerns about the business.
One of the biggest challenges has been that the 3M operations have largely run out of a 3M-run facility that is shared with other products ( Dermacare , I believe), and 3M doesn't really care all that much about the Food Safety business beyond fulfilling the transition agreements. Neogen is building its own facility (for Petrifilm, among other things) that should be up and running in a year (validation in FQ1'25), and has been transitioning other products since then (about 50% of them), but the company is still having to deal with the challenges and limitations of this facility.
I also believe that Neogen is realizing that 3M is under-invested in the business. I have many acquaintances who've worked for 3M (including the Petrifilm business) and a common theme among them has been frustration with 3M's approach to margins and reinvestment. As they relate it, margins take precedence over almost everything and there's a reluctance to reinvest in R&D that goes beyond incremental product development (reiterated on existing products or technologies).
What's more, I think there's an argument that 3M has approached margin maximization the wrong way. There's a difference between stripping out costs to achieve a bottom-line target and using a continuous optimization process (like the system created by Danaher (DHR)) to optimize margins without compromising operations.
Think about it like this. If you are trying to win a car race, you have some choices. On one hand, you can take a car and strip literally everything off it that doesn't serve the purpose at hand (leaving you with something that looks like the result of a Top Gear challenge). On the other hand, you can take the approach that F1 engineers take and look at all of the systems/components involved and how to optimize them. That takes more time, money, and effort initially, and may not be the fastest approach immediately, but that stripped-out car won't get any better than it is (and may not be sustainable), but the "process improvement" car can get better and better.
This may be a tortured analogy, but I hope I'm getting across the central point that I think 3M ran its Food Safety business with a fairly blinkered focus on the bottom line and not nearly as much focus on optimizing the overall operations for maximal long-term success (revenue growth/market share and sustainable improved margins).
The Outlook
On balance, I think the 3M deal can still work for Neogen - it's just going to take more time and more effort. I still like the Petrifilm business, and I like what the deal does to enhance the company's business in core food safety testing (including increased share with larger enterprises). The problem is that Wall Street is not a patient place and Neogen used to be priced as a growth stock - growth stock investors aren't interested in why a company's growth has stumbled, they simply sell and move on.
Between the underlying growth potential of food safety (around 6% to 8%), animal safety (4% to 5%), and genomics (high single-digits), I think Neogen can still generate high single-digit long-term revenue growth through underlying market expansion, market share gains, and some additional M&A. With that, my estimates work out to around 8% to 9% long-term growth.
On the margin side, it's going to take time to work through the integration process and improve the 3M operations. I'd also note that Neogen's track record with margin improvement has not been great - the company prioritized growth and had a nearly two-decade run of missing its own operating margin targets. I believe there has been some change in philosophy (and the CFO has ties back to Danaher), but this is still a work in progress. I think free cash flow margins can get to the mid-teens in a few years (historically Neogen generated high single-digit to low double-digit FCF margin) and move on into the high teens over time.
Between discounted cash flow and a multiples-based approach, I think Neogen should trade at least in the high teens today. I get a near-term fair value of about $18 on discounted cash flow and a similar fair value with a growth and margin-driven EV/revenue approach. Using my standard model, I get a fair forward revenue multiple of 4.25x (which I use on FY'25 revenue and then discount back); if Neogen regains it's "growth credentials", a multiple of 6.5x is possible, which would support a fair value above $27.
The Bottom Line
I've long liked Neogen's business but thought that the multiple was much too high. At this point I see a business undergoing some serious operational transitions and a stock that is in transition - growth stock investors have moved on, it's not exactly "value" yet, and so GARP-type investors are starting to take another look. I realize it requires giving management the benefit of the doubt that they'll successfully get past these initial integration challenges, but I think Neogen could be worth a look at this price.
For further details see:
Neogen Struggling Through An Awkward Transition