Searching For Wonderful Businesses: Neogen Corporation (NASDAQ:NEOG)
In Times of Uncertainty: Look for Pure Quality
When times are uncertain, investors with cash to allocate in the equity markets often search for quality businesses to add to their portfolio for the long term. Identifying and following high-quality businesses (and their equity securities) over the long term can allow a diligent investor the luxury of being able to show up to a fire-sale with a well-curated “shopping list” already in hand.
While the features that successful businesses exhibit such as high growth, stable cash flows and a strong balance sheet are widely known and can be found in many investing textbooks, there are other qualities common to a winning investment which are more qualitative and intangible in nature.
These qualities (and the ability to detect and appreciate them) can separate decent investment outcomes from those which are truly great. Known to Warren Buffett as “Wonderful Businesses,” these types of exceptional investments exhibit a durable competitive advantage that Buffett conceptualized through the terms “Consumer Monopoly” or “Toll Bridge.” A company that enjoyed a Consumer Monopoly was able to command consumer loyalty through strong brand recognition such as Coca-Cola (NYSE:KO), Tiffany (NYSE:TIF), or WD-40 (NASDAQ:WDFC) while a “Toll Bridge” business was one that provided services that were essential for use, thus requiring use by consumers in order to get where they were going, with examples being a Moody’s credit rating, a FICO score or even a literal toll bridge.
One such name to add to the list of “Wonderful Businesses” might be Neogen Corporation (NASDAQ:NEOG), a world leader in the fields of Food and Animal Safety. In this article, I argue that Neogen benefits from both “Consumer Monopoly” and “Toll Bridge” characteristics. Founded in 1982 and headquartered in Lansing, Michigan, Neogen has been a publicly-traded company since 1989 and operates in numerous profitable niche markets within two broad business segments: Food Safety and Animal Safety.
What Neogen Does
Neogen offers hundreds of products, tests and equipment designed to keep crops safe, animals healthy and the food supply chain free of toxins like aflatoxin and pathogens like salmonella, e. coli, and listeria. Due to the large amount of proprietary products and brands in the company’s portfolio as well as the critical applications of its products, Neogen enjoys a leading position in the Food Safety and Animal Safety industry. Neogen is an essential business, with products of critical importance to the integrity of the domestic and global food supply, with management mentioning that its operations have continued in the midst of Coronavirus mandated work stoppages by governments in the countries in which it operates. Examples of Food Safety products consist of diagnostic tests for food and feed producers and processors while products in the Animal Safety Category includes veterinary instruments, animal care products, cleaners and disinfectants, insecticides, rodenticides, diagnostic tests for drug detection in livestock and racing animals, vaccines, and genomics analysis.
Over the past several decades, Neogen has grown steadily through acquisitions into new business lines including Genomic Testing, Foodborne Pathogen Testing and Biosecurity (disinfectants and cleaners) and the company is effective at applying new technologies that have been recently developed, often for use in humans, to the veterinary market, with this combination of application and innovation being utilized to great effect over the past several decades as the company has built out its product offerings. The company is global in scope, doing business over 100 countries.
The Numbers on Neogen
With a market capitalization of $3.5 billion, Neogen is a company of moderate size. The company has a book value standing at $13.15 per share, of which $5.87 is in cash and zero long-term debt. EPS was $1.15 for the fiscal year of 2019. The company currently trades at a P/E of approximately 56, and with a current stock price of approximately $63, shares trade around five times book value, indicating that investors are paying a substantial premium for the company and its assets currently, though this should be no surprise given the high-quality earning power of the company’s asset base. When subtracting the company’s $5.87 per share cash holdings from the last reported book value of $13.15, one may calculate that the business generated approximately $1.12 per share on $7.28 of working capital, an adjusted return on equity of approximately 15.38%, an attractive return that has been growing on a consistent basis year after year. The company pays no dividend, instead retaining all its earnings in the business.
Perhaps even more remarkable than the company’s high return on equity (when adjusted for its sizeable cash balance) is the long-term growth highlighted in the investor presentation, with the business having a record of 15% growth in net income for the past 10 years, enjoying 102 quarters of sustained profitability and having grown revenues at a rate of 17% since the year 2000. Globally, Neogen has approximately a 12% share of the Animal Safety market and a 12% share of the Food Safety Market, making it one of the major players in the world. For 2019, 52% of the company’s revenues were derived from the Food Safety category while 48% of the revenues came from the Animal Safety segment. International sales made up 40.1% of revenues in 2019, with the remaining 59.9% in the United States.
Enjoying the Best of Both Worlds: Consumer Monopoly and Toll Bridge Characteristics
One of the most attractive features of Neogen is the fact that the earning power of the company benefits from both Consumer Monopoly and Toll Bridge effects. The safety of both the food supply chain as well as animal health are vitally important industries that are only growing more essential over time, both domestically and internationally. Often, testing needs to be repeatedly performed by law in order to guarantee consumer safety, representing a repeat consumable “Toll Bridge” opportunity for the company. With over 400 products, the widest offering in the industry is ideally situated to benefit from these longer-term tailwinds as the importance of food and animal safety increases.
In addition to serving a vital function, many of these tests and equipment that Neogen produces are for niche product lines that have patent protection and limited competition, creating a de-facto consumer monopoly. To illustrate the point, one such example of this niche dominance is Neogen’s monopoly on vaccines for equine botulism (BotVax®), the only vaccine approved by the FDA for this deadly disease. Horse owners simply have no choice but to purchase this product, as they need to inoculate all their animals with this life-saving vaccine. For this product and many others in its portfolio, Neogen is the only game in town. All the company needs to do to increase its competitive moat is to continue acquiring and developing niche technologies like this, a strategy which can be employed to great effect given a methodical acquisition strategy.
For investors who are familiar with the exceptional strategy and performance of a company known as Roper Technologies (ROP), this pattern of acquiring or developing numerous niche products will sound familiar, as it is a proven recipe for long-term value creation across numerous industries. Just as Roper methodically acquires niche software companies that enjoy a strong competitive position in their categories, Neogen has been able to gradually execute on this strategy over the past several decades to great effect.
Achieving Growth Through R&D and Bolt-On Acquisitions
With an exceptional product lineup and serving an essential function in the marketplace, Neogen has had no trouble growing over the years, something that can be made obvious with little more than a cursory glance at the company’s stock price over the past several decades: an initial investment made on April 1 in the year 2000 generated a total return of slightly over 5,000% against approximately 132% on the S&P 500 during the same period.
What drives this two decade pattern of exceptional growth has been the gradual expansion of Neogen’s business into more and more specialty niches. That has been accomplished by both developing new products internally and acquiring 40 companies since the year 2000 in order to be able to gradually and opportunistically expand into more specialized niches in the Food and Animal Safety sector, with revenues having grown at a rate of 17% since 2000. Once established in a product niche, Neogen benefits from previously discussed Consumer Monopoly and Toll Bridge effects – as those that purchase Neogen’s products typically require them for regulatory reasons such as disease, pathogen and allergen testing and will continue to use them for the foreseeable future.
Another lever of growth available to the company is to strategically acquire distributors of its products in international territories, which both increases its geographic footprint and increases the profit margins on existing products sold in the region. The company has completed five international acquisitions since January of 2020 in Argentina, Uruguay, Italy and Australia and most recently a distributor in Chile. Acquisitions of distributors cut out a layer of cost while increasing margins for Neogen and can represent a very effective use of capital (in contrast to potential risks involved in R&D expenditure).
Tailwinds: Continued International Growth and Coronavirus-Related Demand
The recently announced distributor acquisitions in South America is of particular strategic importance. In addition to potential margin expansion from internalizing its distribution in these markets, Neogen has aggressively increased its corporate presence across the agricultural region of South America known as the Southern Cone. The Southern Cone is one of the major areas of agricultural productivity in the world, and Neogen’s aggressive expansion into the region represents a significant investment in future growth. The focus of management towards international market development and expansion is a significant market opportunity as global standards of living increase along with food and animal safety requirements.
One of the most interesting aspects of Neogen in this environment is the fact that some business lines within which it operates may experience significant future demand growth due to the outbreak of the Sars-CoV-2 Novel Coronavirus (COVID-19). Due to the outbreak of the virus, food safety has become even more important for a vast majority of the public. Neogen already produces products that disinfect other types of Coronavirus and has been working on producing disinfectants and other equipment to fight the virus in the near term; however, the longer-term opportunities may be even more significant.
Over the longer term, it is likely that there will be significantly increased demand for products that can detect potentially dangerous viruses in the food supply, where livestock act as vectors, before human transmission occurs. This type of disease transmission, known as zoonotic transmission, will likely be the target of increased testing and regulatory activity in the future in order to prevent the risk of another pandemic disaster. This type of increased testing demand represents a potential future line of business squarely within Neogen’s core competency set and it is likely that the company will be at the forefront of adapting technological advances made in testing during the Coronavirus epidemic to its markets.
Despite the high-quality balance sheet and large cash position of the company, investment in Neogen does not come without risks. One major risk to investors is over-payment risk given the fact that shares have historically commanded a high multiple in the marketplace due to their exceptional performance over the past several decades, making it difficult for investors to purchase shares of this company at a “fair price” due to its high-quality, competitive position and excellent earnings power. Therefore, investors in periods of significant economic uncertainty might be afforded a considerable opportunity should broader equity markets continue to decline.
Another risk is the significant amount of cash on the balance sheet not being allocated correctly, as that could impact the long-term earnings power of the company in the future. Though I believe that the possibility of malinvestment occurring is low, it is important for investors to be aware that capital allocation is difficult – though it is undeniable that management has proven itself to be more than capable capital allocators in the past.
Product defectiveness or the inadequacy of R&D efforts represents another area of risk to Neogen, with any product failures potentially damaging the company’s reputation and causing litigation due to damages caused by non functionality in a critical environment. Though this author believes the risk of this to be remote, it is something to be aware of. Theft of IP, or competing innovations that are superior to Neogen’s products are also of significant risk to the company, though this is mitigated by the diverse product lines within the company’s portfolio.
Due to the company’s lack of debt, strong cash position and essential function I believe that there is very little if any risk of bankruptcy or insolvency on the horizon.
Notes on Corporate Culture
Appreciating The Strength of the Owner Operator Business
Throughout his career Warren Buffett was praised for his ability to assess the character of management; something that set his investment style apart from his mentor Ben Graham who was steadfastly devoted to rigorous balance sheet analysis. In contrast, Warren knew the value that could be produced by a superior manager, particularly a manager who both owned and operated the business he was acquiring all or part of. In his letters Buffett devoted time to discussing the managers of the businesses he was involved with. One he would refer to time and again was Eugene Abegg, the founder of The Illinois National Bank and Trust Co. of Rockford, Illinois. Abegg had operated the bank for 30 years before it was acquired by Berkshire (NYSE:BRK.A) (NYSE:BRK.B) and he was praised by Buffett as being able to consistently generate superior returns regardless of the prevailing macroeconomic environment. Abegg was an exceptional manager who was focused on cost control and high levels of service to customers of the bank. As the largest bank in Rockford, he also benefited from a consumer monopoly. The consistent earnings inherent to a community bank, an exceptional manager and a consumer monopoly all converged to make Rockford a business Buffett wanted to own.
In the same vein, Neogen has a strong corporate culture instilled by the founder and former CEO of the company, Jim Herbert, who led the company from its founding in 1982 until 2016 and remains chairman of the board. The effects of Herbert’s prudent management are readily apparent, with the company enjoying outsized growth with low risk as well as the drive to consistently explore new opportunities and apply newly developed technologies to the markets in which it operates. Herbert also was averse to debt and took a pragmatic and measured approach to profitable growth, simply trying to “add good people and good products.” I believe that the presence of an extremely capable owner operator who is still involved with the business and selected the current CEO makes Neogen especially attractive as a long-term investment, and that the winning approach instilled by the company’s founder endures under the new CEO John Adent.
Try to Buy This Wonderful Business at a Fair Price
I believe that Neogen represents an excellent, long-term investment given its exceptional track record of continuous sales growth, product innovation, opportunistic bolt-on acquisitions and a growing global interest in the importance of Food and Animal Safety. Though shares are by no means cheap, the company’s pristine balance sheet, lack of long-term debt, substantial cash reserves, niche market dominance, essential products and strong management culture all make Neogen an equity worth owning for the long term and certainly deserves a spot on the watchlist of any investor in search of a “Wonderful Business”
When it comes to purchasing shares, I believe that investors will be well served by dollar cost averaging over time. Shares currently trade approximately in the middle of the 52-week range, with a 52-week high of $79.83 and a 52-week low of $48.91, and I would be a buyer of shares should they trade under $56 in the near term, or approximately a P/E ratio of 50 using $1.12 of earnings. Assuming net income continues to grow at 15% over the next 10 years, Neogen could generate approximately $4.50 in earnings which at a P/E of 50 would equate to $225 per share long-term price target.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Client accounts managed by the author are long Neogen (NEOG).