Neogen Corporation (NEOG) Earnings Call Transcript & Summary

Welcome, everybody. Wells Fargo Healthcare Conference 2023 day 2. My name is Tim Daley. I'm life science tools, diagnostics and pharma services analyst. We are pleased to have here Neogen with Dave Naemura, CFO. And again, thanks for coming. We're going to, I guess, kick things off. This morning, you guys filed an 8-K, laid out some, I guess, more refined expectations around the first quarter. Just if you could kind of run us through what the update was, how that compares to, I guess, how you kind of previously talked about the first quarter. That will be great.

Yes. Sure, Tim. Thanks. I'm happy to be here. Obviously, we just ended the quarter. So our timing being a [ May ] year-end is a little bit tricky. So we ended the quarter last Friday before the holiday weekend, but got a view of the top line, which came in a little bit lighter than we had thought, but directionally I would say, in the same shape that we had talked about, we'd always talked about Q1 being the lowest growth quarter of the year, and it's seasonally a smaller quarter anyway to begin with. So we see a slight decline, less than [ 1 point], but generally, the same market backdrop that we talked about coming out of the fourth. I think if you go back to our year-end, we talked about some food volume production headwinds that we're seeing, particularly in the developed markets and people still growing on price, but maybe testing a little less as production volumes come down. We continue to see that in the first from what we saw in the fourth. We also saw large distributors rebalancing inventory on the Animal Safety side. And that, again, continued in the first from what we saw in the fourth, maybe a little bit worse than we had thought. I think on the good news side, 3M, some of the -- some of the continuity of supply, manufacturing improvements that we saw in the fourth quarter continued to be sustained in the first quarter. So that was very encouraging. And we talked about 3M being a little bit flat on a pro forma basis globally, but that was really pulled down by Asia Pacific where we saw bigger headwinds in China. And I would say, regionally, probably more broadly softer in Asia Pacific due to some of the hangover effects, maybe some of the supply constraints. But outside of Asia Pacific growing more in line with our expectations. So not a big delta from what we were thinking, but we knew we'd be here. So we wanted to get that out there, so we can talk about it.

Yes. No, it's always fun when I got some live numbers to toy around with. So just again, I think just detailing the update, so Legacy Food, mid-single up animal, high single down 3M flat year-over-year, as you said. So I think you guys were up on our expectations on food, both on a: Legacy and the Pro Forma basis as well as, I guess, down on animals. So we guess we mis-modeled on animal here. But I just wanted to, I guess, start off on that front. So you guys have detailed the kind of more macro sensitive side of the business and just want to make sure we understand these dynamics in animal as it relates to macro headwinds specifically did things get worse, did things get better over the last, say, 3 months or so?

Yes. I think if we look at kind of end user consumption, we probably saw that soften a little bit. We know there's some more cyclicality, we kind of herd sizes and things like that, that tend to drive that side of our business. I'd say directionally, it was what we were anticipating, maybe a little bit softer. These things are pretty tough to call. We did and I think we noted this morning, we did see a little more softness on the genomics side as well. We see that more in kind of poultry and swine, which some business that, frankly, we've walked away from historically and you see a little bit of a bias towards cattle from us. And so some of that reading through as well. So I think those things compounded to make it maybe a little bit worse than we had anticipated on that side. And I think, clearly, Asia Pacific and China, in particular, came in a little softer than we had anticipated.

Okay. All right. And China is relatively small percent of total revenues. Where is that today?

Yes, China is small, 3%, maybe a little under at the consolidated level, but still came in soft enough that had an impacted consolidated level that was a little more than we had anticipated.

Okay. All right. Got it. And just granted, I know it's early, just closed the books, a lot of moving parts, but just did notice, didn't call out margins. Should we still be kind of thinking about -- I think the margin rough guide was 100 basis points on a pro forma basis of accretion from 1Q to 1Q. Animal thinking about that softness, how should we digest all that?

I'd love to give you that answer. I think we're kind of 2 days into it, so it's too early to put a stake in the ground there. I -- we got to just wait and get the books closed.

Yes. That makes sense. All right. So it's interesting, again, as I said, I think the Food -- the 3M business being flat year-over-year was I think, $5 million, $10 million above our expectations. I think we were modeling a bit of a pullback on the pent-up demand or the backlog burn that you benefited from in the fourth quarter. But if we were to think about food within 3M going forward, like what's a good quarterly run rate for the near term until we bring on additional capacity, I think $80-ish million, I think a little bit above was implications this quarter. That's good place to start?

Well, look, we know historically, and I think you've seen us publish a chart that shows the long-term, I think, 20-year CAGR of that business in the high single digits. So we think through the cycle, this is a high single-digit growing business. But of course, that's not linear. I think what we're experiencing here is a little bit of this uncertainty of a couple of factors. One, what's happening in production volumes. And I think we've generally tracked that pretty well, but it's a little difficult to predict with 40-year high inflation and interest rates doing what they've done and how does that read through to consumption. So I think that makes it a little tricky to predict as well as we kind of come back from some of the supply constraints, a couple of good quarters in a row, as you point out, we think we're through some of the big challenges. But there's a little bit of trust we need to earn back with some folks, particularly, I would say, in some of the international markets. We're in the process of doing that. So I'd say more to come. I don't want to guide where the right run rate is. We'll get more into that here as we get into the year. But I would just say that I think we're pleased with getting another more stable quarter under our belt.

No, that's helpful. And on the 3M business you did in the press release call out, the improvements within the transaction manufacturing agreement, where sustained or continue. How is that progressing? I know you guys provided a good update last time, maybe some reshuffling of your direct line of sight to senior management at 3M. Is all the same there, more or less kind of consistent with the state of the union that you provided on the earnings call.

Yes. Tim, I think it's kind of continuing to see that work as we had anticipated. I mean the path of escalation some great things that our manufacturing partner has done to insert some more oversight to help make some calls here to get things processed through their organization more rapidly has been helpful. We have more people embedded now over that manufacturing facility, which is very helpful. So all of those things that we saw benefits from in Q1, we've continued to do and they've continued to work. There's always going to be some challenges, right? I mean -- but what we want is kind of normal challenges. And I think that's what we've kind of seen experience on a little more of a sustained basis here.

Okay. And any update, again, 2 quarters in a row of good volumes. I know there's still some backlog to burn out here. But can you update us on the supply of the sterilization of raw materials, I guess, kind of held up some of the volumes last year as, again, not everybody is struggling with it, medtech, no environmental protection groups, what have you, are approving new facilities. Is that still weighing on you guys? Or has that alleviated a bit?

Well, it wasn't a constraint for us this quarter. And I think we found ourselves not manufacturing constraint. But as you know, I mean, we're a big believer here that our focus on this business and this incredible franchise it's going to give us the opportunity to drive incremental demand. So as we prosecute that over the coming quarters and frankly, years, hopefully, we do have to continue to address that bottleneck. So I'd say more to come as we continue to drive demand.

Okay. Perfect. Stepping back from 3M a bit on to the Legacy side of the business. So I guess thinking about the longer-term thesis around growth. I know you guys talked about taking to double-digit, high single-digit companies and wanting that to be the go-forward growth rate. But I guess, in the kind of near term as we progress to 2025, if we were to think of what's maybe a good CAGR over the next few years for Food versus Animal on a Legacy basis, obviously, with ebbs and flows, just kind of if we were to think about normal market environment, if you will.

Yes. Look, we think kind of -- I don't know if it's [ written but ] kind of through the cycle that the food safety backdrop is a little higher end growth market than the animal safety market exposures that we have. So maybe that kind of mid-plus on the Food safety side with maybe a kind of low to mid on the Animal Safety side, neither one of which is really, really linear, but that's why you see some of the strategic focus for us in some of the steadier growth businesses like like Genomics, some specific areas within Animal, but obviously a bias towards food with the big transaction with 3M. We like our exposures. Now again, right now, we see for a period of time, production volumes lower than we had seen in previous years. And that's okay, that too shall change. But as we continue to work through the integration, accelerate our strategy, opportunities to go out there and take share in what's a good end market backdrop with, as you know, great growth drivers we like our end market exposures and how that positions us for growth.

Okay. Great. And again, kind of a similar question, but if we were to just bifurcate a bit on price. What is the, I guess, price assumption embedded in the next few years, differences on food versus Animal, just staying with Legacy here?

Yes. Look, I think pricing is always a bit dependent on the market backdrop, right? So what we want to do is be dynamic and really focus on price cost. And we want to be price cost positive at the gross margin level. So we need to look at what material inputs are doing. Some '21 and '22 provided a backdrop for pricing that was far favorable to what we'll see in '24 and '25. But we're going to respond to what's appropriate in the market. And we don't take a cost-plus mentality, particularly with a lot of our real value-add products, rather we value pricing. So we'll continue to lean in and really focus on maintaining positive margin at the price cost level and see how the backdrop develops.

Okay. That makes a lot of sense. And I know you guys were focused on price here given from the legacy dynamics that were going on recently. But -- so that's helpful. And then I guess stepping back into 3M here. So this is something that I get asked a lot by investors is the road map to new capacity, right? Could you kind of just walk us through when -- I guess, how the construction is going of the new facility? I know that there is a bit of a lag between the equipment getting installed, given its specialized and bulky nature, obviously. But yes, could you just kind of give us an update on timing, roughly when we should see, number one, kind of doors open, fully installed capacity and then obviously, you ramp up utilization over time, but just kind of rough time line?

Yes, I think roughly speaking. So when we look at all the integration activities, the one kind of long pole in the tent is Petrifilm Manufacturing. And we need to bring that in-house. It's on the dual shared line with some other products within 3M and that manufacturing facility. So we're standing up the new facility, if you were there 6 months ago and what you see today, and I was just telling Bill, we need to put some pictures or something on the website because it's amazing. So that's really coming together. I would say we're well on track with the new facility. The equipment has been designed. It's on order. I know we had a team over in Asia checking on production. I don't have a real-time update on that. But I think we're tracking to our expectations. When we look back, I mean, our goal is to move as fast as possible. So we had a 4-year agreement with a potential 1-year extension beyond that with the folks at 3M, and we want to be well within that. That would say that we should look to be producing after that third year, which means of which we're a year into. So I think we're well on track for that. There are some big milestones. To your point, we got to see some equipment hit the ground and get stuff in the building. And this is big stuff and close up the side of the building and get going. But we'll bring people along for the progress I think it will really -- progress will really ramp up notably with a lot of parallel activity starting to happen here over the coming couple of years. And we're going to look forward to kind of sharing the progress here.

Okay. that's all. And just kind of, I guess, a similar vein of question the cost, the operating dollars, if you will, operating expense dollars, you were kind of running parallel capacity as you're standing it up, you are hiring people without revenues coming through. So could you help us think of even broad strokes, dollars, percent of revenues that you might have kind of in that overlap period of staffing a facility that's not yet running revenues through?

Yes. If you think of it from a people standpoint, this isn't a labor-intensive production. It's highly automated. So I don't think people will be the big part. And then, of course, we won't start depreciation of some of the stuff until we really get it get it online. So it's hard to predict, and I'm not kind of trying to bail on it. I just don't want to give anyone a wrong number here. I think what we need to do is really dimensionalize that for folks as we start to see some of that. I think right now, more of the noise is on the operating expense side. The business came over and it leaves a significant amount of cost behind. So we saw an immediate pop in EBITDA margin by consolidating this business in at the time we were then adding in cost. So we had a partial year of the cost we needed to have last year and then we get a full year of that this year, plus we need to add more, which creates kind of an interesting year-over-year operating expense dynamic. But what it equates to is the synergies that we had anticipated. We're still going to do a significantly cheaper synergy target to what the business was burdened with at the operating expense level. level previously. So we're on track, but there is, to your point, a lot of noise, and I think, incumbent upon us to help dimensionalize that for folks.

Okay. And then just on the agreement. Are you paying -- like what is the fee, what's the middle man getting, if you will, for the CMO relationship is if we think about current state of 3M stand-alone margins, are they 5 points below because you're paying an extra fee to the third-party manufacturer?

We pay a fee, right? We have 3 types of transition services, 1 for the back office, 1 for distribution and 1 for manufacturing at various rates. And so yes, of course, we pay a fee, but we're adding the cost to get those off. So I think at least on the operating expense side for distribution in the back office, it gets into how much of that's duplicate. And we do get some of that feedback, where it will fall off. '25, we won't be burdened with the fee where we'll be burdened with it for, call it, 3 quarters of '24. And then as manufacturing comes in, yes, we're bringing that expense on, but we're paying a markup to folks to do that. How much savings that equates to? TBD, I think, on a net basis, once we see how our cost structure exactly equates to not just what we're paying, but the cost is the base that's being marked up. So I want to -- I want to be careful not to put an expectation around that. But we think once we get through the integration and we get up and running that we can do this pretty darn efficiently.

Okay. On that front, again, before your time, but the initial kind of Pro Forma of 4Q '24 target was for 40% EBITDA margins on a Pro Forma basis. You guys obviously took a nice conservative view here. You've rolled that back to 4Q '25 at squishy, 30%. Again, I know you're using dollars, but is there a governor or anything structurally different than when those numbers were looked at in the initial model that will hold you back from achieving a 40% margin. It's like is the governor below that. Was that too optimistic? Just kind of just helping folks think about beyond the milestone of 4Q '24, Obviously, there's a lot of other stuff operationally. I want to dig into this, but...

Well, look, I think from the time the deal was announced and initial projections were put out, to your point, I wasn't there, but familiar -- very familiar with it. The December of '21, to the time the deal was closed, it's a pretty different environment. I think the inflationary environment, the interest rate environment, that had a compression, that had an impact on the margins of the acquired business. And it is what it is. And I think that read through the Pro Forma and that doesn't come back overnight. So I think what you saw us adjust for was just that. That was a significant amount of it. And so we need to see. And I think part of it goes to the market backdrop as well, the relevant growth rate. These are really high fall-through products. So the demand environment is going to be really important to the margin profile.

Okay. No, that's great. And so again, just thinking about what you bring to the table here. So given your background previously, the Legacy, specifically on the Animal side as lot of acquisitions really focused on growth, much less so on efficiency, if you will. Just curious if you could kind of lay out for us some of the self-help, if you will, on the legacy side of things that you see both from a kind of low-hanging fruit perspective as well as more longer term after we get through all the fund transition period? And should we be expecting a fund 3-letter acronym for the Neogen?

Well, you always have to [indiscernible]. So look, growth is growth is hard and sometimes not eloquent, right? Neogen is a great business, and it's got a tremendous track record of growth. And I think we're I think everyone in Neogen, no matter how long you've been there, is really respectful and honors that has put us in this position we're in. And I think it's now kind of an evolution to a bit of a next stage. And I think not just me but many others in the organization are focused around, okay, what's the right move from here? I think that is taking a look at as we always are taking a look at the portfolio. And saying what is the exact right stuff for us given the strategy we're trying to accelerate today versus maybe years prior when you grow, you do it however you can. And so we have a lot of sites around certain places, particularly in Lansing, where you're seeing a lot of those sites now integrated into our new manufacturing facility. So I think those are opportunities to kind of address this idea of, well, if you had it -- if you had done it ideally, you would have done it differently, and now we get to drive some of that. And there really are a lot of opportunities, not because we did things wrong because we did things relative to the times we were in. And now we got to go back and look at some of that stuff. And I think part of that is taking some functions. An example might be procurement. We have a great global procurement leader that we'll be taking over something that happened in many different places around the world and bring in a lot of different lens and expertise to that function, which is a real opportunity for us. So I think that's one example of many looking at how we contribute from how R&D is engineering cost out of the products. to our manufacturing efficiency to how much capital we have tied up in working capital. All of those things are opportunities now that we've really kind of graduated to this to this next stage. And I do think some of the opportunity to drive some efficiencies out of Legacy business is a bit underappreciated.

Yes, that's one of the, I think, the most compelling pieces of the Neogen story [indiscernible] models, just really looking at the ROIC on a legacy basis. And then as we pro forma out and get to kind of the -- even the new reset, if you will, expectation or pretty significant ROIC accretion. So just is it -- is the majority of that? Is it obviously the margins significant. But if we were to think about other factors behind that, I know you talked about balance sheet optimization, talked about site managements. Just kind of if you guys have a target, if you will, I know you've got some in-house targets that you guys like to use back the envelope mass. Anything to help people out in their own modeling?

I think generally speaking, when we look at the P&L, we look to grow faster than the market, right? And that's not the same every year. It's not linear, but we look at the environment and try to build an algorithm that says we're going to do better. We're going to take some amount of share every year, we're going to -- and at the margin level, we need to drive gross margin improvement. Some years, the opportunity is greater than others, depending on volume, but we need underlying operational improvement, which implies that we're appropriately pricing for raw material inflation. We've got favorable price material economics at the margin level that we're contributing to things like procurement and those activities and productivity on an annual basis. And I think you'll see a very much an increased focus on those things. Is that there's got to be some minimal threshold there that, I don't know, probably 50 basis points is something we'll always be shooting for. Although years, particularly years of good volume growth, should afford us an opportunity above that. And then operating expenses has been a lot of noise. But look, if we're going to grow faster than the market, we got to expand margins on that growth appropriately. And so we look at that relationship, and we look to grow -- we look to grow, obviously, earnings faster than revenues. And then we'll look at free cash conversion, which we think is an opportunity in the near term given some of the Legacy working capital opportunities. That will fund some of this integration capital, and then we look to reinvest it. And I think doing that in a little more focused manner, maybe a little more disciplined manner, which I think is, again, the right evolution for us. I think you've heard John talk about kind of the same focus in a way that really accelerates strategy. And if we get that going in that kind of -- that cycle going, it creates nice momentum.

Yes. Yes. The flywheel is really compelling, especially from kind of starting point for sure. So like we were talking about reinvestments on that theme. You guys recently launched a few new product lines. I think a new insecticide line. I think you introduced a batch of 100 new genomic tests. Like how much incremental growth comes from these launches? And is this kind of the thought going forward of new organic investments via R&D internally? Or is there any kind of white space or adjacencies within the portfolio once you digested 3M?

Yes. Well, look, I think in parallel with 3M, and I don't want to give a number where I don't know the exact number, but I think what you'll see from us is a focus to continue to get more drop-through from R&D investment. That is a primary focus. And we've got complicated products. We spend a lot of time in what some people may think of as sustaining, but we spend a lot of time on making sure our products meet the high-quality specs would be demand. But we also believe we have an opportunity to continue to get more return on the R&D investment dollars spent. And as a bigger company, we need to do probably fewer more impactful things, and I think you'll see that as a focus in the coming years.

Okay. And I guess on the flip side of the coin, like you said, there was a lot of investments, a lot of not things that were done wrong, but maybe things that in hindsight maybe would have been done differently. Are there any businesses as you look at the portfolio that maybe might have a better fit elsewhere, maybe some capital to be reallocated to higher growth adjacencies or higher growth businesses. Any thoughts?

Look, I wouldn't want to call somebody out here. But I think at the end of the day, what we need to be in is a mode of continuing to look kind of proactively in our portfolio. And I think it includes kind of putting on that lens that you just described, and we're doing that. And having said that, one of the strengths of this business is the breadth of the offering. And so we need to really be thoughtful about that. But I think we've definitely got a renewed focus on making sure we step back and look at the portfolio, again, not because we think we did something wrong, but it's more about just what is the kind of the course we're charging going forward and making sure we are trying to accelerate this focused strategy around some of these attractive end markets that we have.

Okay. And then taking, I guess, one step forward there. Capital allocation. How should we be thinking about -- obviously, I think you guys have laid out a pretty good framework around the new facility. But in terms of like maintenance CapEx as a percent of revenues, and then thinking about debt pay down, like how should we kind of rank order and organize these moving pieces in our mind?

So generally speaking, first of all, capital allocation priority in the near term is going to be the integration. Building the new plant is no small task. Some of the systems work and kind of the enterprise platform that we're building here is clearly the near-term priority. Not to say we wouldn't do any M&A. Sometimes you can't choose small deal timing and some of those things. But integration capital is a near-term priority. But we operate in a very attractive fragmented End markets. Aand we have a history of effective growth through M&A, and I think we'll continue to look through M&A will be a big delever and accelerating strategy. But I think you'll see us get to that more once we work through the integration. And it becomes a balance from a returns perspective, with debt pay down. You saw us pay down $100 million, the initial $1 billion of debt. We wouldn't anticipate in the near term reducing gross debt. We think we'll delever obviously, as we continue to grow the business over time. You asked specifically about CapEx. CapEx tends to run 2.5%, 3% of sales, I think overall, that's kind of 50-50 growth in maintenance, maybe 60% growth, 40% maintenance. And then the other will put some cash into this year is bringing in the 3M finished goods as we stand up the distribution network on our side, we've got a load in the finished goods, so we'll do that. I think we said at year-end, that's kind of $40 million to $45 million. So we've got to work through all that stuff on the front end. And we also said we'll fund that stuff with free cash generation for the most part, which includes hopefully some working capital improvement in the underlying business.

Okay. Yes. And as we kind of get those chunking costs out of the way, is how should we think about like a long-term or even near-term leverage target? [Grants, you said gross], but thinking about like net...

Yes, net leverage, look, we kind of view a top end in the 3-ish range. We'd go above that with line of sight to coming back below it in a reasonable time frame. I think if we get down below 2% we should be asking ourselves if we should be more aggressive in deploying some capital. I think those are probably the goal post -- it goes -- it never works out perfectly.

Yes, yes, of course. And I guess just, again, back to the kind of quarterly update here, should we be anticipating animal in the second half of '23 returning to growth? Or is this kind of a full year type of headwinds from your various [indiscernible].

Well. We said at year-end. I'm going to go back to what we said at year-end. We said at year-end that we anticipated this inventory rebalancing continuing through the first half of our fiscal year, kind of the calendar year-end. I don't know why we'd see that any different now. Now as you pointed out, we're a couple of days into the new quarter. So we've got some digesting to do. We're going to see what September looks like and come back and talk to folks. But I take what we said this morning and kind of this conversation, it's pretty aligned with what we talked about, shape of the year, the shape of the quarter. A couple of points of growth isn't a lot from a dollar perspective. So I see things developing kind of as we had discussed. But more to come, we'll see another month, we'll get back together, talk about the quarter and at that time, share with you our best insights, but I kind of see things developing as we had anticipated.

Okay. That's helpful. And I just did want to touch on Genomic here. Again, it's I think faster growing above average, if you will. What's the ambition there in terms of total revenue mix is there enough -- like if you guys look at your TAM versus your actual market size, there's a lot of white space there. Is that a priority?

Yes. I would say Genomics has been and remains a strategic priority for us. I think you see us continuing to kind of shift that focus to some of the more -- what we see is some of the places that we play very well, particularly cattle, which is also a very profitable segment there. Obviously, we're very active in companion as well. So you'll see a continued focus on that end market. It's a little disrupted right now. I think from some of the poultry and swine impacts and reduced spending in those areas, some customer churn as we continue to work through our focus. But definitely will remain an area of focus for us in a place where we have a -- we've built a really nice business.

Okay. Great. I've got a couple more, but I know it will get us way past limit. So I think I'll end there with 1 minute left here. Appreciate it. Obviously, Dave, appreciate Bill, thanks for being here and everybody for attending and hope you all have a productive rest of the day.

Thanks, Tim.

Appreciate it.