Neogen Has To Rebuild Investor Trust, Battered By M&A Integration Issues

Growth through acquisitions has long been key to the Neogen (NASDAQ:NEOG) growth story, but the key to such a strategy is efficiently integrating those deals and the bigger the deal, the more crucial execution becomes. So far, the integration process of Neogen’s acquisition of 3M‘s (MMM) food safety operations can best be described in language that isn’t really printable here, and that is having a major negative impact on both the company’s financial performance and its credibility with the Street.

I don’t think the 3M operations are unfixable, and the integration process will eventually be finished over the next couple of years. Going forward, Neogen will have considerably more scale in food safety and the opportunity to generate more attractive profits and cash flows, but I’m reminded of an old racing cliché – “in order to finish first, first you must finish” – and there’s a lot of work left to be done.

If Neogen can generate long-term revenue growth in the mid-to-high single-digits (not unreasonable given underlying market growth), get adjusted EBITDA margin to 30% in around four to five years and get free cash flow margins to the mid-teens, there’s still a case to be made that the shares are undervalued. While I think this terrible FY’24 is setting a lower bar for execution and obscuring some of the long-term potential, I also think Neogen management bet a lot of their credibility on the execution of this major deal and that bet has not been paying off.

Another Disappointing Quarter Since The Merger

Disappointments have become all too common since the close of the 3M deal, and the fiscal third quarter was no exception, as lackluster revenue growth and ongoing operating inefficiencies drove another miss-and-reduce quarter for the company.

Revenue rose a little more than 6% on a core basis, which was basically in line with expectations, but it’s worth remembering that Neogen is sparsely followed at this point. Food Safety grew a little less than 6%, with stronger results in Petrifilm and sample handling (both up double digits), with weaker pathogen and toxin testing due to supply and shipping issues.

Animal Safety grew about 7%, or 15% excluding the genomics business, with broad growth, including strong performance in biosecurity, vet products, and vitamins and biologics (part of Animal Care). Genomics sales were down mid-single-digits as the company continues to transition away from small production animals (poultry in particular) in favor of cattle (beef and dairy) and companion animals.

Gross margin was a relative bright spot, improving 160bp from the prior year and 20bp from the prior quarter. Stronger sales of Petrifilm appears to be the main driver here.

While gross margin was a bit better than expected, opex was not, and the company’s 3% growth in adjusted EBITDA (margin down 50bp to 23%) and 1% decline in adjusted operating income (margin down 50bp to 8%) were disappointing.

Some of the problem here can be tied to the ongoing issues with producing and shipping to demand, as these revenue shortfalls are leading to inefficiencies as the company scaled up for a larger revenue base than they’re achieving. Cost overages tied to inefficiencies and friction in the transition process, logistics in particular, are also an ongoing issue.

Another Cut To Guidance, And It’s Fair To Wonder When This Gets Better

With the disappointing results from this quarter and the ongoing issues producing and shipping to demand, management cut guidance once again. The company is now looking for revenue of $910M to $920M versus the prior guide of $935M-$955M and the EBITDA guidance has dropped to $210M-$215M from $230M-$240M.

Not surprisingly, management isn’t willing to say much about FY’25 at this point, other than to talk about ongoing progress in the integration and transition process with 3M. The companies have exited their transition services and distribution agreements and completed the relocation of the pathogen detection manufacturing operations.

The relocation of sample handling is next on the schedule, with Neogen-controlled production likely to start in two quarters (FQ1’25), but the transition for Petrifilm as longer to go; Neogen is “nearing” the completion of facility construction and while management hopes to exit the transition agreement early, this could take until August 2026. Given the higher profitability of Petrifilm (gross margins above 70% and likely 70% incremental EBITDA margin), this is a must-have and a key item on management’s to-do list.

If there’s anything good about this year for Neogen, it’s that it’s setting easier comps for the coming year. I do believe the full integration of the pathogen detection and sample handling businesses will improve the company’s ability to meet customer orders, driving more revenue growth and margin leverage than may otherwise appear to be in the business. I also expect the implementation of the new ERP…