Neogen Stock: A Mess, Appears Priced In (NASDAQ:NEOG)

In August, I still had many questions on Neogen (NASDAQ:NEOG), even if shares were cut in half. The company announced a massive and complicated merger with the 3M Food Safety business late in 2021, a deal complicated by the fact that valuations of both businesses were high to start with.

High valuations, leverage and softer organic performance made the situation complicated, as I failed to see appeal in August.

A Recap

For years, Neogen has been a steady value creator, typically demanding steep valuations. The company has grown revenues from about a quarter of a billion in 2014 to nearly half a billion in 2020, as operating margins of around 15% have actually been trending lower a bit.

The core operations posted fiscal 2021 revenues of $468 million and operating earnings of $74 million. At $43 per share, a $4.2 billion enterprise valuation worked down to 9 times sales and 70 times earnings, both steep multiples.

To complicate matters, Neogen announced a $5.3 billion merger with the Food Safety business from 3M (MMM) towards the end of last year. The deal called for investors in Neogen to hold 49.9% of the shares of the combined company, with 3M (or its shareholders) holding the remainder of the shares. On top of that, a billion dividend would be paid out to 3M as well.

With $400 million in sales contributed by 3M’s activities, its operations are smaller in terms of sales, yet a $175 million EBITDA number of the acquired activities are vastly superior compared to the $125 million contribution of Neogen on that front.

With $30 million synergies seen, or about $0.15 per share on a pre-tax basis, investors liked the deal, with shares rising from $40 to $43 per share, as the standalone valuations were far too high for me to get involved.

What Happened?

Since the announcement of the deal, investors in Neogen have seen a huge pullback, trading at $22 by mid-August. In July, Neogen posted a 13% increase in full year sales to $527 million, with adjusted earnings down six cents to $0.63 per share, still resulting in high valuations even as shares are down 50%. The issue is that this still results in a 35 times earnings multiple, moreover, based on adjusted earnings.

While the deal had not closed yet, I believed that a 108 million share count would double to 216 million shares upon closing of the deal. This works down to a $4.7 billion valuation at $22. A $380 million net cash position of Neogen would translate into $620 million net debt load after the billion dividend payout to 3M.

With combined EBITDA seen at $300 million, leverage ratios are seen just over 2 times which looks manageable. The pro forma picture is a bit complicated as 3M posted flattish revenue growth of the unit in the meantime, as Neogen will assume some higher coupon notes from the acquired activities as well.

With many uncertainties, high valuations from the get-go, modest leverage and general uncertainty seen, I was cautious, being mindful as many 3M divestments have not made their new owners happy in recent times, leaving me to hold a neutral stance.

An Update

While my last take on Neogen is only about one and a half month old, many events have taken place ever since, warranting a short update. Neogen’s investors approved the deal with 3M in mid-August. Finally, the deal closed on September 1, and towards the end of the month the company posted its first quarter results, that is for the quarter ending on August 31, so the day ahead of the 3M deal closing.

Fourth quarter organic revenue growth came in at just 4%, with growth slowing down in recent quarters. GAAP earnings were largely decimated on the back of transaction costs, yet margins took a beating with adjusted EBITDA down 6% to $27 million. With net cash down to $347 million, the pro forma net debt load would increase to $653 million. More bad news was seen alongside the earnings release as the company announced the resignation of its CFO which is never a great sign, and certainly not so soon after the closing of a massive deal.

With 216 million shares now down to $14, the equity value has fallen to $3.0 billion, for a $3.7 billion enterprise valuation. This includes both businesses as this value (for the combination) surpasses the valuation of each of these businesses in December of last year. With shares down two-thirds, for a name which once was a predictable value creator, shares have lost all the ground which they gained over the past decade, an extremely painful outcome for investors.

Unfortunately, the company was not able to provide a guidance for the coming year, as the situation is quite dicey in terms of how earnings per share will evolve. The key for now remains integration of both businesses and avoiding leverage concerns, but this should be quite easily doable I guess, certainly if the business is stable and posts organic growth.

The real question is how long term margins will evolve, and with core operating earnings seen around sixty to seventy cents on a standalone basis, synergies have the potential to add quite some pennies to that, but in the near term, leverage has the potential to detract some from earnings.

Hence, it is still too early to see convincing value, but if we believe the long term business should be doing alright, while the company can avoid dilution and leverage concerns, this is the time to gradually start dipping into the shares here, as I fail to have great conviction yet.