Neogen - Great Business, Great Past Performance, Lousy Entrance Levels

| About: Neogen Corporation (NEOG)
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Neogen is a great business, operating in attractive niche markets.

The company has built up an impressive track record in terms of growth and dealmaking.

Investors have been attaching very premium valuation multiples to the business, a reason why I urge for caution at current levels.

Neogen (NASDAQ:NEOG) is a food safety company which is little known to the wider investment community. Its products and solutions are crucial for the health of consumers all over the world, as still some 3,000 Americans die each year from food poisoning. The company operates in attractive niche markets which show consistent growth as the company has built up a great track record in growing its sales in a profitable way.

Last week, Neogen posted solid second quarter results which indicated that momentum in terms of operational performance continued. While these results and the past performance has been great, the multi-year momentum ride has left shares too expensive to my taste, even as they have been trading flat over the past year.

The Business

Neogen earns its money by providing food safety to both human and animals. In terms of real tangible products or processes to think of, this includes vet instruments, life sciences, animal care, DNA testing, bacterial & sanitation as well as toxins and allergens.

The company focuses on niche markets, in what generally are already niche industries. Within the $21 billion intervention production markets, the company has identified a nearly $1 billion niche market for vaccines, veterinary instruments, diagnostic tests and genomics analysis. This market is stable and grows by 5-7% per annum, with Neogen holding a comfortable market share of 12%.

In the smaller $2 billion diagnostics product market, the company focuses on toxins, pathogens, allergens and genomics, among others. The targeted subsegment of this business is $900 million in terms of size, while growing by 8-10% per year, with Neogen holding a 12% market share.

Second Quarter Highlights

Neogen reported sales of $68.5 million for the past quarter, up 15% compared to the year before with growth being partially aided by acquisitions. Food safety sales rose by 16% to $33.0 million as animal safety revenues were up 14% to $35.5 million. Analysts anticipated that overall revenues would come in at $69.8 million.

Gross margins for the business came in at 50.0% of sales, a 50 basis point improvement versus last year as a result of a favorable shift in the product mix. Lower legal expenses and tight operating cost control further aided operating margins which improved by 250 basis points to 18.8% of sales.

Net earnings rose by nearly 26% to $7.8 million, as earnings improved by four cents to $0.21 per share. Analysts who cover the business anticipated earnings of $0.22 per share for the quarter.

Premium Valuation, Solid Balance Sheet

Neogen ended the quarter with a rock solid balance sheet which contained $94 million in cash and equivalents, while not having any debt outstanding on its balance sheet.

Shares currently exchange hands at $48 per share which combined with 37 million shares outstanding results in the business being valued at close to $1.8 billion. Subtracting the net cash holdings results in the fact that operating assets are valued at $1.7 billion.

On a trailing basis, Neogen has now posted sales of $256 million on which it net earned $29 million. This values the business at very premium multiples. Operating assets exchange hands at 6.6 times sales and close to 60 times earnings.

Long Term Growth Story

Neogen has shown remarkable steady and impressive growth since 2000, essentially ten-folding the business in terms of sales from roughly $25 million to $250 million, with growth approaching 20% per year on average.

This growth has been driven by overall market growth, but also from market share gains, synergistic acquisitions and a focus on the customer, combined with great focus on the development of new products. Acquisitions have been a key focus for the business, with Neogen having bought 27 businesses since 2000 for a total price of $146 million, thereby adding $116 million in sales.

This growth has paid off big time for investors, especially as the company managed to grow the business without creating severe dilution of the shareholder base. Shares traded below $2 in 2000 as they have risen to levels around $50 at the end of 2013. Shares have increased by a factor of 25 times over this fourteen year time period, which has resulted in roughly 25% returns per year on average for investors.

The returns in the shares has however outpaced growth of the sales, resulting in higher valuation multiples over time. Arguably valuation multiples have become a bit stretched despite the great track record in terms of organic sales and acquisitions, with shares trading at close to 60 times earnings.

Final Thoughts

Neogen is a business to love, with the company having shown significant and continued growth for decades now, thanks to both organic growth as well as accretive dealmaking.

That said the valuation has become too expensive, even as the company has the capacity to make many more deals to fuel growth going forwards. A 30 times earnings multiple seems warranted based on the past performance, the growth prospects and excellent dealmaking capabilities, which already represents a steep premium versus the rest of the market. I furthermore note that Neogen has built up quite some assets in China, further adding to the long term growth profile. Adding back the net cash holdings and a valuation close to a billion seems warranted.

This translates into a valuation of roughly $27 per share based on 37 million shares outstanding. You get the point, I am not interested in the shares at current levels despite the great business behind it, with the current risk-reward not offering much appeal in my eyes.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.