Description

I think NEOG is worth a look for quality-oriented investors after the enormous sell-off in 2022. The stock has given back the entire past decade’s gain (lesson: entry multiple matters) and presents a compelling ‘pro-forma’ opportunity to own a juggernaut in the acyclical global food and animal safety industry with multiple structural tailwinds at a decent valuation. As the new Neogen executes on cost synergy, recaptures recently lost margins via re-pricing, and pays down debt, investors can make ~50% here over 2 years in a highly defensive stock underwritten with median ‘animal diagnostics/life science’ multiple, with robust upside optionality (could be north of 2x the base case price target) if the stock regains its lost halo and gets once again ‘cornered’ by the long-only mafia and index funds, like it once was.

Brief situation overview:

• NEOG announced to acquire 3M’s Food Safety business via a Reverse Morris Trust in December 2021 (details below), creating a global pureplay leader in food and animal safety.

• The deal didn’t close until September 2022, and by the time it closed, lackluster fundamental developments since transaction announcement (it became clear that the Proxy Projection wasn’t going to be hit) + technical selling by 3M shareholders (large cap LO / index holders puked the tiny NEOG) created a massive penalty box for PF NEOG shares

However, not all hope is lost…A fresh reset of expectation and a few quarters of steady execution from here could help the PF NEOG story get its mojo back, especially as…

1) 3M Food Safety starts converting its delayed orders in backlog into revenue in upcoming quarters, normalizing organic growth (which was disappointing between deal announcement and transaction close)

2) Combined company finds more cost synergy than expected ($15mm is overly modest on a ~$700mm combined cost structure, company is already finding areas of incremental efficiency gains in the early days of integration)

3) Recent margin pain eases away (3M Food Safety pulls its over-due pricing lever / COGS disinflation) and we get margin normalization in both assets

4) We may start to see more sellside coverage – especially by large banks (this is a surprisingly under-covered company for a ~$3.6bn market cap)

Overall, while $10bn combined EV at the time of deal announcement was quite rich, the current $4.4bn EV appears as a dislocation

Enterprise value on Dec 14, 2021 at deal announcement

Enterprise value (current)

Neogen Standalone business overview: serving 3 end markets (Food +  Animal Safety + Genomics) with ~95% of revenues being recurring consumables

1) Food Safety is 45% of revenue mix participating in a TAM with ~6% to 8% blended organic growth

• This segment sells diagnostic kits and related products that detect harmful toxins, foodborne pathogens, allergens, and levels of general sanitation in areas where food is produced 

• Customers: top 30 food producers (also beverage / feed)

• Resilient end market with structural growth: NEOG (standalone) put up +15% cumulative organic growth in 2008 and 2009

• Key growth driver is just global demand for greater volume and quality of food products, increased scrutiny on importers, and rising middle classes in EM. There is heightened regulatory environment in the US and abroad + US is demanding increased testing at facilities/ports that it can’t monitor 

• It focuses on the prevention and detection of food safety issues in domestically produced food and food imported from abroad 

2) Animal Safety is ~35% of revenue mix in a market with 4-6% blended organic growth 

• This segment has hundreds of various products that aid in the control of rodents and disease as well as assist animal protein producers and farmers in the multitude of daily tasks required 

• Examples: rodenticides, insecticides, disinfectants, pharmaceuticals, vaccines, and other veterinary products 

• Also resilient with structural growth: NEOG put up +4% organic growth in 2008 and 2009

3) Starting inn 2010, NEOG entered the Genetic Testing services business (now ~20% of revenue) through acquisition 

• Uses Illumina technology to improve the quality and yield of animal herds through genetic profiling and selection 

• Improves efficiency in farming operations by providing actionable genetic information to breeders. 

As John Hempton noted (per one of his funny tweets in the past), NEOG is tremendous diversified company with tons subcategories of products (no single SKU moves needle). But there is a unifying theme for the company: which is around improving global food/livestock security (food safety segment protects food supply, animal safety segment ensures wellbeing of livestock/pets, genomics segment improves food security by developing solutions that allow protein producers make educated breeding decisions)

Standalone NEOG Revenue Mix

I’ll give the audience here two examples of NEOG’s products that improve speed + accuracy of pathogen testing and sanitation monitoring

Soleris automated microbiology system 

• Looks for spoilage in high-throughput settings using up to four instruments connected to a single computer that can process up to 128 unique samples simultaneously

• Used in quality-assurance programs in CPG companies 

https://www.neogen.com/neocenter/videos/the-kraft-heinz-company-and-soleris/

AccuPoint sanitation monitoring system

• Handheld device used in food processing manufacturing processes that determines the cleanliness of a surface or purity of a liquid by measuring adenosine triphosphate (ATP) collected from liquids or food contact surfaces

• The ATP test is a simple way to detect the presence of living organisms and thus is a commonly used way to assess sanitary conditions

https://www.youtube.com/watch?v=iOjcHHAAWBc

Historical NEOG organic growth and recent profitability KPIs

The company historically  sees itself as a roll-up platform and has generated 22-yr revenue CAGR of ~15% with HSD % organic growth, partly thanks to ~35% int’l exposure

Per my calculation from Fiscal Q1 2016 (quarter ended August 2015) to latest quarter, over 30 quarters of positive organic growth, with average organic of 7.2%, and 7% over the last 12 quarters

Organic growth driver is focused on rapid new product development: ~60 successful product developed over last 2 years, and planning another ~60 in the next 2 years

NEOG’s EBITDA margin had been trending in the ~22% range over the past 5 years, with acquisitions (different margin mix) masking underlying operating leverage / margin expansion However, Adj. EBITDA margin has been weaker in the latest 2-3 quarters even before the deal close due to inflationary pressure across supply chain

FY ’23 EBITDA margin was run-rating at ~20% before the transaction close vs. NEOG’s goal of achieving ~22% EBITDA margin in the current fiscal year per its proxy projection. Culprits for the weak margin in latest quarter: “inflationary raw material cost increases, ongoing supply chain issues”.  

A couple of years ago, NEOG used to have a more aspirational LT goal of ~10% organic revenue growth with ~5% M&A sprinkle on top, while maintaining 20% EBIT margin. It’s M.O. was “double revenue every 5 years”, and NEOG had been able to do that a few times already before law of large number caught up to it.

Historically, NEOG had an R&D philosophy of only spending ~3% of revenues, as the business had been enhanced primarily through the improvement of existing products and acquisition of new products (rather than bottom-up research of novel products and technologies) 

Merger overview, industrial rationale, synergy benefits, and pro-forma capital structure

When the RMT merger was announced, merger rationale was articulated as 1) build scale, 2) bet bigger on Food Safety end market, 3) realize synergy. 

Scale: PF revenue close to $1bn+ with broader geographic footprint, bigger platform value to pursue future strategic investments with more advanced R&D/manuf/commercial capabilities (especially international); EBITDA margin optically increases given 3M Food Safety carries higher margin %

Bet bigger on Food Safety: PF company will have ~70% revenue exposure to Food Safety which has higher structural growth and lower volatility than Animal Safety segment

Merger structure: NEOG shareholders would own 49.9% while 3M shareholders to own 50.1% + receive $1bn dividends. NewCo will take on $1bn debt to fund the dividend, taking net leverage to close to ~3x at closing

Financial benefits: $30mm of total synergy within 3 years consisting of 1) run-rate growth synergy of $15mm from ~$40mm of revenue (4% one-time cross-sell bump) and 2) run-rate cost synergy of $15mm

Overview of 3M Food Safety asset

This is a pure play food safety asset that provides cost-effective solutions to detect food contamination in commercial food safety applications, with 90%+ being consumables

Customers are multinational food processors and contract labs in 45+ countries

Major products 

• Indicator testing: Petrifilm brand products help customers detect organisms of interest to food processors using culture film plates (consumables) that are inoculated w/ samples collected from the food product environment

• Hygiene monitoring: helps customers verify cleanliness of processing equipment and surfaces

• Sample handling: helps customers collect samples from environmental surfaces by selling devices like sponge sticks, sample bags

3M Food Safety revenue mix

~50%+ of revenues come from indicator testing tool Petrifilm – which determines the presence + amount of a given organism in a sample 

Review of 3M Food Safety historical organic growth

3M Food Safety’s organic growth averaged at ~5.6% over the last 4.5 years (since YE 2017). 

The steepest decline post COVID onset was no more than 5%.  It’s been a very resilient structural grower, but it did run into some likely short-term disruption in the latest quarter (calendar Q2 2022 = flat organic growth)

Below organic growth history is collected from scraping 3M’s call transcripts (where they would give some more qualitative color on the food safety segment), last time they talked about it was Q2 2022 / the quarter before the deal close, where organic growth fell to 0% as the business being divested wasn’t getting mgmt’s full attention with regard to commercial execution

At the time of the deal, mgmt wants to sell 3M Food Safety organic growth as closer to HSD % historically (by calling out the ~10% historical growth CAGR as ‘largely organic’). The reality is probably somewhere between MSD and HSD growth 

As a result, here is the Pro Forma NEOG Product & Geographic Mix

After transaction close, CapEx spend will double vs. historical pace as PF NEOG invests to build world-class manufacturing / IT footprint post close. The ambitious CapEx spend vs. historical pace gives investors more credence / support for revenue synergy materialization. NEOG will expand its Lansing, MI facility to be able to produce 3M PetriFilm there in the future.  Historically it’s been produced at scattered 3M manufacturing sites that aren’t “dedicated” to Food Safety business.  3M Food Safety was likely under-invested in its past as it was seen as a cash cow for 3M, there is potential to rejuvenate organic growth

What happened post transaction announcement?

Original proxy projection was overly rosy

At the time of deal announcement, the combined company was seen to generate $300mm of EBITDA in its first year post close – $125mm from Neogen and $175mm from 3M Food Safety before synergy. However, 3M Food Safety asset started tracking below proxy projection due to a combination of FX, supply chain driven shortage of parts, and cost pressures. Instead of ~40% EBITDA margin for 3M Food Safety, margin deteriorated to the low 30%s area. We knew from some proxy financials that GM % contracted another ~260bps in calendar Q1 2022 after shrinking ~120bps in calendar 2021 and 170bps in 2020. Major culprits to blame raw material, logistics and outsourced manufacturing cost inflation

Below exhibit sums up the “Proxy Case” (which is not happening) – which would result in $420mm+ combined EBITDA by Fiscal Year 2026 (ending ~mid-2026)

I think it’s reasonable to give recent quarters’ growth stagnation a pass given the ongoing transaction and supply chain mess:

Food Safety’s recent growth headwind was due to lack of supply chain priority within 3M, causing ~500-600bps headwind

“…Our operational teams are working diligently with 3M to fix their back-order situation, which has slowed their food safety sales over the last 2 quarters by 5% to 6%. Doing so will improve sales in the remainder of the fiscal year…

…when 3M Food Safety was a part of 3M, they were a very small part in a very big business. So they were at the end of the line for manufacturing, there at the end of the line for critical raw materials, there at the end the line for everything…

…As of September 1st, the role has changed where 3M is our contract toll manufacturer for these products. So we've been able to work with 3M to reprioritize those things under the new reality of the business. And so those are the things that we're seeing that are going to help us alleviate back orders much faster than what 3M that team would have traditionally been able to do, there no fault of their own. So we feel confident and 3M has been a really good partner to help us move that forward…”

Mgmt recognized by late 2022 that the original $300mm combined EBITDA goal for Year 1 was “off the table” at this point and admitted this to the public market

“…We've had numerous calls from analysts trying to model the company going forward, given some of the recent headwinds in the 3M business in particular. We're currently working with the commercial teams to review the forecast for the rest of this fiscal year, and our plan is to present our revised projections for the combined business for at least the rest of this fiscal year at our second-quarter earnings call, which is currently scheduled for the first week of January. We appreciate your patience and your support as we better understand and integrate the businesses.

…we've had the business for about 28, 27 days. So we're learning more about it. The positive is we're finding a lot more synergies than what we even thought we were there before. The negative was that the 3M business over the last couple of quarters has not performed to the way it was forecasted when we put out the initial $300 million…

My view on a more realistic PF NEOG financial projection

While NEOG is still working through 3M’s Petrifilm production constraints (limiting shipment to fully fulfill customer’s demand), it recently did a significant pricing increase on 3M’s product given its 2022 pricing increase was inadequate to cover inflation (Neogen did a 6% price increase in 2022 on its own product while 3M only did a 2% price increase last year)

Under my latest projection, the ~$125mm NEOG standalone EBITDA goal would be postponed by ~1 year and I don’t have 3M Food Safety’s EBITDA getting to $175mm by itself until post 2026 (given magnitude of disappointment thus far). I’m also using a tad more reasonable organic growth compared to the proxy.  Gradual margin-recovery initiative is baked into 3M Food Safety to bring its EBITDA margin back to high 30%s by FY 2026. I do have $5mm outperformance in cost synergy given some of the discussions with formers who suggested cost synergy upside is quite probable (NEOG is already finding efficiency improvement ideas early in integration that isn’t in the original cost synergy).  Overall, while FY 2023 to FY 2026 combined EBITDA is meaningfully below what Proxy case suggests, the past is the past and EBITDA could grow at mid-teen CAGR % for the following 3 years. Bottomline, I can still get ~$1.10 of adj EPS by FY 2026 (baking in full paydown of the term loan and a refinance of high-coupon bond).

Interest expense materially goes down in this projection period as FCF will be used to deleverage the company, pay off all the TL, and NEGO should be able to refinance its 8.625% bond once leverage normalizes

Source of upside to this projection could be more accretive cap allocation (bolt-on deals, share repurchase)

Valuation discussion

NEOG traded at rather rich forward earning multiples over the past decade, see the exhibit below for an analysis of multiples for the 7 years before COVID (multiple got even crazier post COVID onset given the ZIRP environment, so I will exclude that)

Historical avg P/E of ~49x, 25th/75th percentile are 45x/53x

Historical avg EV/EBITDA of ~26x, 25th/75th percentile are 23x/31x

Why did the business trade at such high multiple pre-COVID? Here were the reasons I gathered:

• It was one of these ‘cornered stocks’ with a decent amount of float held by strong-handed long only’s and index funds in the “never sell” camp

• Investor base ascribed a high magnitude of scarcity value in this asset, given its differentiated offerings with breadth in highly niche markets, the end market was “healthcare-esque” yet no reimbursement risk + very rational pricing environment for most of its products 

• Many of the product categories were niche enough that large industrial conglomerates don’t want bother breaking into, yet hard for smaller mom and pop to match from a technical/manufacturing capability standpoint

• High degree of SKU / product diversity that no one thing can blow it up

• Seen as a M&A platform

Comps suggest low-20x P/E at a minimum with multiple expansion potential to mid-20x before the ‘cult premium’ kicks in

There was once a strong cult around the old mgmt (who have fully retired) that traces back to Neogen’s humbling history/origin.

The business was founded in 1982 in Lansing, Michigan, by Ted Doan and James L. Herbert with the help of funding from Michigan State University. Herbert still served as chairman in recent years post his retirement from CEO role until stepping down from the Board in 2022,  while Doan served on the board from its inception until his death in 2006. 

The historical continuity of senior management (incl. 28-yr tenure of former President /COO who retired in 2013) formed a very unique and tight corporate cultures – “a Midwestern company with Midwestern values”

NEOG was known for its unique organizational intimacy: a distinct family-like feel that is easily observed through events like summer picnics that are held for employees and their families. The corporate headquarters sit in an early 1900s elementary school that the company purchased from the city of Lansing and renovated. The various business units fill classrooms, and for many years the gymnasium was used for regular face-to-face gatherings between management and employees 

Neogen makes routine purchases of older buildings and single-family homes in Lansing that are then returned to working shape and used by Neogen for business expansion

Given all of the above, there is immense cultural buy-in from employees and Neogen is what people look up to in Lansing, MI. The company is one of the few spots of growth left amid the city’s general decline

Overall, it’s not difficult to see this up ~50% over ~2.5 years without relying on the “old NEOG avg multiple”, which is more than double of our base case 22.5x P/E

Furthermore, legacy 3M shareholder who wanted to get out already did, given the high volumes of shares traded around the transaction close

Lastly, there have been quite a few insider buying transactions from Board and management after the material sell-off in the stock in 2022

Total of ~$750k purchased between July and October 2022, in contract against very sparing insider purchases over the last 10 years of history

Catalyst

Deal integration and synergy execution, organic growth inflection and margin recapture