Neogen Corp Q2 FY2020 Earnings Call

Welcome to Neogen's Second Quarter Earnings Results Conference Call. My name is Sylvia and I’ll be the operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. I will now turn it over to John Adent, CEO of Neogen. Mr. Adent, you may begin.

Thank you, Sylvia. Good morning and welcome to our regular quarterly conference call for investors and analysts. Today, we will be reporting on the second quarter of our 2020 fiscal year, which ended on November 30th. As usual, some of the statements made here today could be termed as forward-looking statements. These statements, of course, are subject to certain risks and uncertainties. The actual results may differ from those that we discuss today. The risks associated with our business are covered in part in the company's Form 10-K as filed with the Securities and Exchange Commission. In addition to those of you who are joining us by live telephone conference, we also welcome those of you joining us via the Internet. Following our prepared comments this morning, we will entertain questions from participants who have joined this live conference. I am joined this morning by our Chief Financial Officer, Steve Quinlan, who will provide more detail on our results for the quarter. Earlier today, Neogen issued a press release announcing the results of our second quarter. As stated in the release, our net income for the quarter was approximately $16.3 million or $0.31 a share, up slightly from the prior year quarter, when we reported $0.31 per share. Our year-to-date net income is approximately $31 million or $0.59 per share, down from the same period a year ago, when we reported $0.60 a share. Our revenues for the quarter were up 1% from our prior year to about $108 million. On a year-to-date basis, our revenues improved 1% to over $209 million. We had a number of strong performances in the quarter at our international locations, as our revenues from international sources grew to 41% of our total revenues, up from 39% in the prior year's second quarter. However, like most American companies with significant international sales, Neogen continues to be adversely affected by the recent strength of the dollar against most other currencies. In a neutral currency environment, sales would have been approximately $1 million higher in the second quarter. As we've previously stated, we believe that two-thirds of our growth potential exists outside of the U.S. We see significant opportunities throughout the more than 120 countries we have served in the past year. In some cases these opportunities come through meeting expanded regulatory requirements, as with the recent introduction of our test for ergot alkaloids to meet expected new regulations in the European Union. Other, even more significant opportunities exist in meeting the needs of the expanding middle classes in China and India, who are demanding the same high-quality food products available in other parts of the world. I just returned from visiting our teams in Australia. Despite the current difficult environment of extreme heat, fires, and floods, they're really excited about numerous growth opportunities we have. I also met with several customers and distributors to discuss new offerings that were developed specifically for the Australian market. In meeting after meeting, I saw our Neogen team is providing unique and viable solutions to help our customers meet their needs. At this point, I'm going to turn it over to Steve for more detail on the quarter. Steve?

Thanks, John, and welcome to everyone listening this morning. John has reported the overall sales and profit performance for the second quarter and first six months of our fiscal year. In the next few minutes I'll give you some color behind those results. As John mentioned, we continue to be negatively impacted by currency fluctuations in the countries in which we operate. Revenues would have been $1 million higher for the quarter in a neutral currency environment with the euro being 4% lower than this time last year and the pound 3% lower. On a positive note, the pound was 6% higher at the end of the second quarter than at the beginning of the quarter on optimism regarding a possible Brexit solution. The Brazilian real continues to hurt our comparative results as that currency was 6% lower than a year ago and the Aussie dollar was 5% lower. About $875,000 of that comparative revenue shortfall was in the Food Safety segment, as the majority of our international businesses report through this segment. Revenues for the Food Safety segment were $56.9 million in the second quarter of fiscal 2020, an increase of 6% compared to $53.7 million in last year’s second quarter. Our Brazilian food safety operations had a 15% increase in sales of diagnostic products, led by continued market share gains in aflatoxin sales during the country's corn harvest, and a 15% increase in dairy antibiotic test kit sales. Additionally, we recorded a $900,000 non-recurring sale of insecticides to the Nicaraguan government and two smaller sales of insecticides totaling about $300,000 to Brazilian government agencies. Now these sales are non-recurring in that they are tenders or bids that are won for a set period of time, with no assurance that the business will be put up for bid the next year. This business is somewhat opportunistic and is what we characterize as a lumpy business, resulting in tough year-over-year comparison, but it is good, profitable business. If you recall, we discussed at our first quarter call a $1 million sale in last year's first quarter, which did not repeat this year. Overall, our Brazilian business has achieved revenue growth of 20% in the quarter, even after considering a $700,000 sales shortfall from their loss of a forensic test kit customer we also talked about on the first quarter call. Our European operations had solid results for the quarter with revenues up 10% in local currency and growth across the entire product portfolio, with particular strength in the culture media line, which is up 15%, a 9% increase in cleaners, disinfectants and vet instruments, and a 48% increase in aflatoxin test kits due to increased business in an outbreak in Africa. This was a nice recovery off a fairly sluggish first quarter. Genomics revenues, which grew at a double-digit pace throughout 2019 and 30% in last year’s second quarter, rose 3% in the second quarter of this year in Europe. The 10% growth overall in Europe was reduced to 7% after currency conversion. Neogen Latinoamerica, our business based in Mexico City, had strong 20% growth in sales of our food safety products with sales up across all of the diagnostic product line. Sales of cleaners, disinfectants, and rodenticides declined 15% due primarily to continued sluggish demand from our largest distributor in Central America. This resulted in an overall increase in revenues of 5% for the quarter for this group. Our operations in China reported a revenue increase of 40%, aided by increased sales of cleaners and disinfectants driven by increased awareness of the importance of biosecurity products to counter the African swine fever outbreak in that country. Our domestic food safety diagnostic business grew by 6% for the quarter with nice areas of growth within the business. Revenues for our industry-leading product line to detect inadvertent allergen contamination, which includes diagnostic tests to determine the presence of milk, peanuts, and processed soy, among others, were up 17% domestically in the quarter. Our gliadin, egg, and milk test kit sales were particularly strong, up 27%, 21%, and 15% respectively for the period. We've continued to strengthen our allergen test kit portfolio and have seen commercial success with our recently introduced tests to detect coconut contamination, which grew nicely for the quarter. Our AccuPoint line, which is used to detect general sanitation and cleanliness in food processing environments, had a strong 21% increase in revenues during the quarter on strength in both equipment and disposable sampler sales. Year-to-date, this line is up 16%. Our domestic natural toxin product sales declined 7% compared to last year’s second quarter. This year's crop was planted late due to the severe spring weather and is not yet fully harvested and has been relatively clean with only small pockets of DON outbreaks. Revenues for our test to detect the presence of antibiotics in milk declined by 30% in the quarter and are down 18% for the year-to-date, due primarily to lower demand from a large European distributor. To address this loss in business, which has been steadily occurring over the past few years, we've modified our contract with the distributor to make them non-exclusive and will begin direct sales in these markets in the third quarter. Our domestic culture media business, which had declined 13% in the first quarter of this year, recovered somewhat to post a 2% gain for the quarter. However, there is still weakness in this market resulting from lower end-market demand from a number of our larger customers, particularly those in animal vaccine production, and orders have been pushed into the second half of the year. The Animal Safety segment continued to be adversely impacted by the trade impacts between the U.S. and China during the second quarter and reported revenues of $50.9 million for the quarter, down 4% from the $53.3 million achieved in last year's second quarter. There appears to be a truce called in the trade war near the end of the quarter, with an agreement signed to increase agricultural exports to China. As yet, it’s too soon to have seen a positive impact on our market. Animal care products sold out of our Lexington, Kentucky-based manufacturing and distribution center, such as small animal supplements, wound care, and antibiotics, decreased 13%, and vet instruments declined 10% for the quarter, primarily as a result of lower sales for our largest U.S. distributors due to lower end-market demand and related destocking efforts by these distributors. Rodenticides sales declined 8% in the quarter, and insecticide revenues were down 30% for the same period, due primarily to lower rodent and insect pressure in certain areas of the country. Domestic cleaner and disinfectant sales also declined 14% during the quarter due to reduced demand from our larger U.S. distributors as they worked to reduce their inventory levels. Partially offsetting the weak market conditions in the majority of our animal safety markets was a robust 18% increase in service revenue at our domestic genomic testing and bioinformatics business located in Lincoln, Nebraska; with market share gains in the companion animal parentage and wellness testing markets, which more than doubled during the quarter, a 21% increase in revenues to the porcine market, and continued strength in the commercial beef and dairy cattle market. Worldwide, genomics revenues rose 17% with strong growth in the U.S., Australia, and Canada offset by slower growth in Europe. Gross margins were 47.3% for the quarter compared to 46.7% in last year's second quarter. Improved margins are due to a shift in mix towards food safety products, which have higher gross margins, and margin improvements at our domestic genomics business resulting from a product mix shift toward higher margin companion animal services and efficiencies achieved with the higher volume. For the year-to-date, gross margins are at 47.4% versus 46.8% last year. Overall operating expenses were up 3% compared to last year's second quarter and 4% for the year-to-date. Sales and marketing expenses decreased 3% and are down 1% for the year-to-date from lower commissions, shipping, and other variable expenses tied to revenues and a reduction in bad debt expense due to the reversal of reserves for collected receivables. General and administrative expenses rose 9% for the quarter, due primarily to increased non-cash stock-based compensation, higher legal and professional fees, and increased depreciation expenses, resulting from our ongoing investments in information technology infrastructure. R&D expenses increased $615,000 or 19% over the prior year, as we continue development spending on a number of new products, which are scheduled to be launched in late fiscal 2020 or early 2021. The $3.8 million we spent this quarter is similar to the run rate for the past two quarters, and this run rate will continue to be elevated throughout fiscal 2020. Operating income for the second quarter was $18.3 million compared to $18.2 million in last year's second quarter. Expressed as a percent of revenues, operating income was 16.9%, compared to 17% last year. We recorded $1.3 million in interest income for the quarter compared to $1 million last year, reflecting our higher cash and marketable securities balances and higher interest rates on those balances. Yields on our investments had dropped this quarter compared to the first due to the impact on fixed income investments from the Fed lowering the prime rate three times this year. Foreign currency losses totaling $350,000 in the second quarter compared to $70,000 in the same period last year. Our pre-tax profit of $19.2 million compares to $19.7 million in last year's second quarter. Our effective tax rate for the second quarter was 15.3% compared to 18.5% in last year's second quarter, with a reduction in rate driven primarily by the recognition of tax benefits of $1.2 million from the exercise of stock options. In last year’s second quarter, those benefits totaled $484,000. As I've mentioned on previous calls and will continue to point out, the volume of action exercises, the strike price, and the stock price at the time of exercise all result in large fluctuations in the effective tax rate for these comparative periods. On the balance sheet, our inventory levels of $86.4 million are essentially flat with year-end levels, and we continue to work on improving our inventory turn. We generated $40.5 million in cash from operations during the first half of the year and have invested $12.8 million of that in property, plant, equipment, and other assets. Included in that total are investments in companies and technologies, which we believe will give us a competitive edge going forward. I'll stop here to say that although the numbers were sluggish, we were encouraged that we were able to get back to growth in the Food Safety segment and also capitalized on some significant growth opportunities in the genomic business. We know what we need to do to return to growth in the rest of the animal protein markets we serve. Our more than 1,700 employees worldwide believe in our mission, are excited about our future, and appreciate your support. At this point, I'll turn it back to John for further comments.

Thanks, Steve. While we didn't meet all of our performance expectations for the quarter, I'm really optimistic about where we are going from here. First and foremost, Neogen is in the right markets helping our customers improve the safety of the worldwide food supply, a dynamic and growing market. With our products and services that reach from behind the farm gate all the way to the dinner plate, we're uniquely positioned in that market. The demand for our products is only going to increase going forward. For example, I just read a report that stated more than 650 food products were recalled last year in the United States alone, and the leading causes might just be the easiest to prevent: food allergens. According to the report, undeclared allergens are the leading cause of U.S. food recalls, accounting for about 48% of the food recalls from the FDA and 63% of the food pounds recalled by the USDA. The next step becomes even more alarming when you consider that roughly 11% of adults in the U.S. have a food allergy. So we can do even more to help the global food industry protect its consumers. We've recently signed up our first major users for Neogen Analytics, a world-class safety and risk management system that will allow our customers to reduce their food safety risks. We believe combining Neogen Analytics with our leading food safety diagnostics provides a powerful combination that gives Neogen a distinctive competitive advantage. The success that we've had in developing and marketing food safety tests has led to an almost overwhelming amount of data that our customers will sort through to protect their consumers and businesses. Our new platform will help our food safety diagnostic customers efficiently aggregate, analyze, and act on all that data. We've also made recent advancements in the development of blockchain technology that will benefit our customers and their customers. As consumers are increasingly demanding transparency in the origin supply chain processes of the products they purchase, blockchain technology is being developed to deliver just that. For example, let's consider the production of premium beef products. Our customers, cattle ranchers, will start with DNA data produced by Neogen Analytics and then we will collect additional blocks of information on that animal, which could include its health, medical history, diet, ranch environment, and other production variables. This information can then be shared with processors, retailers, or even consumers who are seeking that level of transparency. Blockchain technology enables our customers to tell the story of their brand, mitigate risks in their supply chains, and enhance operational efficiencies. We believe our markets are moving quickly toward more informed, data-driven decisions, and we're working to be at the forefront of this movement. As we work to improve and expand what we can offer our customers, we're also looking to acquire additional technologies and capabilities. While I'm not ready to announce anything yet, we have an active acquisition program and a number of targets under investigation. As shown on our balance sheet, we are perfectly positioned; there’s plenty of dry powder, as Jim Herbert used to say, to pursue any of our growth strategies going forward. All I can do is encourage you today to stay tuned for upcoming announcements from us. I'm excited about our future and I look forward to stronger performances going forward. Let me stop at this point and entertain any questions from those of you who joined us on the call.

Thank you. We'll now begin the question-and-answer session. And the first question comes from Paul Knight from Janney Montgomery.

Hi, John. Could you give us some granularity on these distributors? Specifically, you mentioned on vet instruments and animal care within the animal safety market. Your distributors are destocking. Can you tell us what's going on with those distributors for them to take these kinds of actions?

Sure. Paul, I think when you look at some of the results, as you’ve seen move out. I saw Patterson's results for the livestock business were down 1%. MWI's livestock business was down, their companion animals are up, but what matters to us is their livestock business. What's happening is as their sales are slowing to their customers, distributor margins are very thin. They need to ensure they're controlling their operating working capital, and their management groups are looking at their businesses and tightening up their inventory days. That's something that we've seen happen before when markets are a little soft; distributors tighten up inventory. When markets grow, they loosen up inventory. So that's what's happening on the animal safety side in the U.S. Steve also mentioned, Paul, distributor issues with our food safety product in Europe. We've worked with them for a long time. They're a good company; they just have not had the growth that we've seen across all of our other businesses in that same line. We ultimately sat down and worked out a solution. They're going to continue to be a distributor, but it's going to be on a non-exclusive basis.

And this weak demand that they're facing, is it a commodity-driven event, or are they seeing trade restrictions due to China? What do you think are those key factors?

I believe it's about profitability for the producer. It’s important to analyze this by segmentation. I noticed that pork exports increased this quarter, although they remain lower than last year. There was a recent tweet suggesting significant news related to agricultural exports, which could assist customers in reopening the pork market. The dairy sector continues to present challenges. We see smaller dairy farms going out of business, while larger farms are expanding, keeping the overall number of cows stable. This situation affects how these businesses allocate their funds. The key point to monitor is understanding the profitability of the producers. If they are making money, they tend to expand; however, if they are losing money and facing cash flow issues, even if using our products makes economic sense, they may restrict their spending.

Okay. And then lastly, my final question would be regarding your cash and investments totaling $313 million. Is your pipeline getting richer due to this blockchain and IT outlook that you have, or what's your view on this building cash that isn’t being deployed of note?

Paul, you're speaking to a guy who's just as disappointed as you about deploying cash. I want to go and buy stuff. In the last six months, we've looked at 15 different businesses, and we said no on 13 of them. So we're shaking the trees, looking for opportunities, but we're still going to be judicious in what we want to buy. I think it goes back to what Jim has talked about all along: Do we understand it? Can we make it? Do we have a market for it? Those types of questions still resonate when we look at acquisition opportunities. So we are looking at some right now that are very exciting to us and that meet all three of those criteria, and we're working to execute those deals.

Just wondering with the African swine fever in China, you guys saw some pretty strong growth there. How much benefit do you see from increased sales of disinfectants and cleaners due to biosecurity measures?

We did see increased sales. I know Steve is looking right now to see what that number was. We are seeing that and I think that's going to continue as we can train the smaller customers to understand biosecurity. The larger swine producers in China understand biosecurity, and that’s what we do really well. The smaller backyard operations are harder because those pigs are one common fence, touching noses, and that’s how that disease spreads quickly in backyards in China. So reaching that group is highly fragmented. You have to do a lot of training; it's a lot of dealers. So there's opportunity for that. But most of our growth has been with the large swine producers.

While Steve looks that up, can you give us an update? Do you think the spread has slowed a little bit or are we still on pace like we’ve seen in the last six months?

Kevin, I don't know. I haven't heard anything one way or the other. I mean, we talked about this, I think it was last quarter or two quarters ago that we’ve seen some large producers repopulate and then get hit again, which is really devastating for them. But I haven't heard anything that indicates that the situation has changed. I think I would take that as a good thing; it doesn't seem like it’s continuing to escalate, but it's been such a dramatic impact on losing half of their animals. You would think that, losing half the animals, it would slow just from a numbers standpoint. Steve, do you have anything to add?

Sure, Kevin, that was about a $0.5 million increase. Now the only caveat there is that it may not all be directly related to African swine fever; it’s really about biosecurity and the importance of having a clean environment to raise your animals. It's not all directly going into the pork production market.

And then, Steve, while I have you, so sales and marketing expenses are actually down in terms of absolute dollars for the first time in a while. Just wondering what causes that — should we expect it to continue to decrease? And on the other hand, you talked about going direct in Europe. Wondering if you need to add any sales force or infrastructure and does that lead to a little bit of higher costs in the second half of the year?

I guess I would say, as long as our sales on the animal safety side are sluggish or, in this case, declining, you would see related sales expenses follow along with that. Our goal is to stay positive; we want our sales and marketing expenses to grow. That means our revenues are growing and all related commissions, shipping, and promotional expenses mean the markets are growing, and those are good signs for us. Regarding the distribution business in Europe, we have added staff to market those products there. I don't think it's going to have a material impact on our sales expenses in the second quarter because we're also using our existing sales force to pursue that business.

Kevin, we've got existing teams in many of those markets; they weren't allowed to sell previously due to an exclusive relationship, and now they're going to be able to sell.

Okay. And then lastly, John, your veterinary instruments and other business, both disposables and animal care, were pretty weak this quarter. I know you had a tough comp on the animal care side with vaccines. Just wondering what's going on there and do you think that will continue — should we expect a reversal in the second half?

I think we need to go back and look, but I believe we had pretty strong growth in those areas last quarter.

You did. Well, instruments were up 9% last quarter.

Yes. That’s the one that stuck out at me, Kevin. I’m wondering if there’s a little bit of timing at play. If you average the two, you’ll see it maybe normalized to what those market is. It appears to be a tough animal safety market, but I don’t think there’s anything fundamentally different going on.

And the next question comes from David Westenberg from Guggenheim Securities.

I'm glad to see that pick up in R&D. I think you guys can develop some good products. How should we expect these new products to hit the market? Is that in fiscal year '21? I guess you said that we expect the spending to continue. How big are these products that might be coming out in 2020? Should we expect a growth lift in our models to come then?

Sure, David. We're excited about the R&D; that's why we're doing it. You saw the ergot testing; that's the only one available for rapid testing today worldwide, and we are the only one that has it. We're trying to stay ahead of some of the regulations. We want to be in a strong position. That was driven by our European team, which did a fantastic job of taking that and driving it with the help of the group here in Lansing. We’re excited. We’ve got some new products coming in the second half of the year. Now, again, I’d love for all of them to be blockbusters, but we've got some new technology and product offerings coming in the second half of the year and into next year. I don't think we've ever talked about firm forecasts for those, but it's always been a key piece of our growth, and we know that it needs to be. That's why we invest in it, and it’s something we're focusing on to continue to drive growth this year and next year. Steve, do you want to ...?

So there's essentially some product growth there. Okay. In terms of the alternative meat, I know stock price-wise they’ve been hit. Are you seeing an increase in demand from these producers of alternative meat? How do you see that business playing out?

Yes. David, I think it's just like any other segmentation. If you remember when organics came on the market, everyone said that was niche, and it's grown into a nice market. I think that plant-based proteins are going to continue to be a nice market. As long as consumers want it, it’s going to continue to drive and grow. What's interesting to me is they have the same issues, whether they’re making plant-based hamburger patties or meat-based hamburger patties. You still have to check for allergens, E. coli, Listeria, and more. So whether it’s plant-based or meat-based, we sell the same products to those types of customers. It’s really about food production, and anything around food production is where we’re there to help those producers make the safest product possible for their consumers.

I know there's not much you can say in terms of M&A here, but can you talk about some of the priorities, whether it's a technology or maybe a product focused on IT? And perhaps talk about the relative interest between animal safety versus food safety, if that makes sense. Any generalities would be helpful here?

Yes, I mean, you've seen what we've done in terms of technology with Neogen Analytics and blockchain, right? This is something we heard loud and clear from our customers that they still keep paper records for FDA audits to provide paper record keeping. We felt we should be able to help, so we partnered with different groups to develop Neogen Analytics. The same applies to blockchain; I read recently that McDonald's stated that in the future, half of their beef will be antibiotic-free. That raises the question: how will they prove that without a blockchain solution? We’re leading that today to provide the needed transparency for customers. The IT side continues to be crucial; if you only conduct tests without giving customers ways to capture, analyze, and act on data, it's somewhat ineffective. We're really pushing that. We also look for technologies that have a hold in our portfolio. Where is the market going, and what are those types of technologies? We have a Scientific Advisory Council where we constantly vet new technologies and determine what's coming that we can either bring from a human market to our segmentation or that's brand new. We identify where we can make an impact. The final area we look at is geographic markets where we are underrepresented; that led to discussions about our growth with European distributors. They were helping, but we weren't achieving the growth we wanted. This solution should help both parties grow where we are currently underrepresented.

At this time, we have no further questions. I'd like to turn the call back over to Mr. Adent for closing remarks.

Thank you, Sylvia. I just want to thank all of you for your time today, and I wish everyone on the call and listening a happy holiday and a prosperous New Year. Thank you very much, everyone.

Thank you, ladies and gentlemen. This concludes the conference. Thank you for participating. You may now disconnect.