Neogen Corp (NEOG) Q3 2023 Earnings Call Transcript

Welcome to the Neogen Third Quarter Fiscal Year 2023 Earnings Conference Call. All participants will be in a listen-only mode. Please note today's event is being recorded. I'd now like to turn the conference over to Bill Waelke, Head of Investor Relations. Please go ahead.

Thank you for joining us this morning for the discussion of the results of the third quarter of our 2023 fiscal year. I'll briefly cover the non-GAAP and forward-looking language before passing the call over to our CEO, John Adent, who will be followed by our CFO, Dave Naemura. Before the market open today, we published our third quarter results as well as the presentation, with both documents available in the Investor Relations section of our website. On our call this morning, we will refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. Reconciliations of historical non-GAAP financial measures are included in our earnings release and the presentation, Slide 2 of which provides a reminder that our remarks will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed in or implied by such forward-looking statements. These risks include, among others, matters that we have described in our most recent annual report on Form 10-K and in other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. With that, I'll turn things over to John.

Good morning, everyone, and welcome to our earnings call covering the third quarter of our fiscal 2023 year. We're pleased to be with you today to provide an update on our performance and the ongoing integration of the Food Safety business we acquired from 3M last year. On our last earnings call, I mentioned the trend we're seeing in some of our macro-related softening in our end markets. This continued in the third quarter, with many feed producers seeing lower unit volumes, with inflationary pressure on consumers being a key driver. On the Animal Safety side of our business, the macro weakening was driven primarily by a difficult comparison against extremely strong market growth in Q3 of the last fiscal year and some destocking by our channel partners. Despite the macro headwinds, we delivered core growth in both legacy segments, aided by diversification across product categories. In the recently added Food Safety business, key product lines continue to be negatively impacted by the backlog situation at our transition manufacturing partner. After an unanticipated holiday shutdown in December, we've seen intermittent improvement, but not the sustained progress we expected. To resolve this, we've elevated it to the highest levels of our contract manufacturer, where we've seen meaningful engagement to address the root causes and alleviate certain process constraints. We're working with them to provide additional input into key production decisions and believe we have a path to successful resolution over the coming quarters. As we've discussed before, the former 3M business is a high-quality franchise with leading diagnostic technology for high replenishment environments that in many cases are specified into their quality control processes. We understand the critical roles our products play and are working closely with our customers to fulfill as much of their demand as possible while we work to return supply to its more normal levels. With respect to the ongoing combination of the businesses, we continue to make good progress on the integration activities. Commercially, our teams have been combined and cross-trained, and we are navigating the tighter market conditions, focused on a prioritized set of opportunities globally. We've seen significant growth in the sales pipeline over the last few months and are excited about the potential ahead. Additionally, we opened a new distribution center in Mount Sterling, Kentucky, which will be our primary point of distribution in the U.S. for the combined business, allowing us to serve our customers more efficiently from a single location. We're also continuing to make progress scaling up the infrastructure we need to fully accommodate the former 3M business within Neogen. The new facility we're building in Lansing ultimately will house the production currently handled by our transition manufacturing partner. Construction is progressing on track; the foundation is being poured, sections in the frame are starting to go up, and the customized equipment has already been ordered. Additionally, our ERP implementation for the combined business is well underway, with completion on schedule for the end of calendar 2023. Finally, we continue to add critical personnel in the quarter with additions to our back office and related support teams, which play a key role in enabling our exit from the transition services agreements currently in place. Clearly, there's more work to do, but we remain very excited by the opportunities, the addition of such a high-quality business, and the contributions we've seen from our new employees who are now part of our one Neogen team. With that, I'll turn the call over to Dave for some more insights into our results for the quarter.

Thank you, John, and welcome to everyone listening this morning. Jumping right into the results, our second quarter revenues were $218 million, an increase of 70% compared to the same quarter a year ago. Core growth, which excludes the impact of both foreign currency and acquisitions, was 4% for the quarter. Acquisitions added 68%, while foreign currency amounted to a 2% headwind compared to the prior year. At the segment level, revenues in our Food Safety segment were $152 million in the quarter, an increase of 141% compared to the prior year, including core growth of 6%. Sales in our Culture Media & Other category grew high teens on a core basis, benefiting from a large order from a vaccine manufacturer. Within Bacterial & General Sanitation, our microbial testing products had solid growth, partially offset by lower sales of general sanitation testing products, in part due to supply challenges. Rounding out our larger Food Safety product categories, Natural Toxins, Allergens, & Drug Residues had a slight core revenue decline, due largely to the discontinuation of our product line of drug testing kits for international dairy markets. Quarterly revenues in the Animal Safety segment were $67 million, up 2% over last year's third quarter on both a core and reported basis, as the foreign currency impact was modest. Sales of our biosecurity products had the strongest core growth, led by insect control share gains in the animal protein market. This growth was partially offset by a decline in vet instruments and disposables, which faced a difficult comparison against a new business win last year, and lower volumes of antibiotics and vitamin injectables in the animal care and other category. Worldwide genomics revenue was up high single digits on a core basis, with growth in the global beef markets offsetting weakness in China from COVID-related lab closures that continued in the quarter. As John mentioned earlier, the performance of the Food Safety business we acquired from 3M was impacted primarily by lower-than-expected production levels in our transition manufacturing partner. We had anticipated seeing some progress in reducing the backlog during the quarter, but the unexpected shutdown of production over the holiday prevented this from happening. This business is not included in our definition of core growth, but on a pro forma basis, it experienced a core revenue decline of 2% in the quarter. Including the former 3M business, core growth for Neogen as a whole would have been low single digits on a pro forma basis. Gross margin in the third quarter was 49.5%, representing an increase of 470 basis points from 44.8% in the same quarter a year ago, with the increase primarily driven by the addition of higher-margin business in the 3M Food Safety transaction. Adjusted EBITDA was $51 million, representing growth of 106% from the prior year quarter driven by the merger with the former 3M Food Safety business. Adjusted EBITDA margin was 23.5%, a year-over-year increase of 410 basis points. The increase was driven by the gross margin expansion, which more than offset costs added in the quarter to accommodate the larger scale of the combined business. Adjusted net income was $27 million for the quarter, with adjusted earnings per share of $0.12, compared to $16 million and $0.15 respectively in the prior year period. The increase in adjusted net income was driven by higher adjusted EBITDA, more than offsetting the increase in interest expense, while adjusted earnings per share was impacted by the increase in weighted average shares outstanding from the Food Safety transaction. In February, we completed the strategic bolt-on acquisition of Corvium, a SaaS provider behind our Neogen Analytics Platform, accelerating our organic data strategy. Although we can't always control the timing of when certain strategically attractive bolt-ons become available, our capital allocation priorities are funding integration CapEx and deleveraging. Following our debt paydown in December, we ended Q3 with gross debt of $900 million, 67% of which is at a fixed rate and a total cash position of $183 million. In addition to the Corvium acquisition, our cash position at the end of the quarter was impacted by integration CapEx and the timing of two interest payments in the quarter. As we look to the remainder of fiscal year '23, we believe our previously communicated view of second half core growth in the mid-single digit range, with an adjusted EBITDA margin in the mid-20s range, remains intact. We expect to see sequential margin improvement in the fourth quarter, but believe our second half results will be pushed towards the lower end of those ranges as a result of the production loss during the December shutdown at our transition manufacturing partner. With respect to adjusted net income, we continue to anticipate a full-year effective tax rate of around 20%. For the fourth quarter, interest expense is expected to be approximately $18 million. I'll now hand the call back to John for some closing thoughts.

Thanks, Dave. We're excited about the progress we've made to date combining Neogen and the former 3M Food Safety business into a clear pure-play leader in the food security market, with a product portfolio that's over 95% consumables. While our market is not immune to economic slowdowns, it has historically been resilient. And we believe there are a number of attractive long-term secular tailwinds, such as heightened pathogen awareness, the growing prevalence of food allergies, and increasingly health-conscious consumers who want to know what's in their food. It's also a market in which we believe the aggregation of structured data and use of analytics are of particular importance. The effective use of data can allow auditing bodies and food companies to identify risks and improve safety and testing processes to ultimately minimize outbreaks. We are implementing our data strategy through Neogen Analytics, a software platform that capitalizes on our many touchpoints across the food supply chain and provides users with actionable data. Neogen Analytics can provide insights from industry best practices, predictive modeling, trend analysis with real-time monitoring, and simplify compliance processes. The acquisition of Corvium last month will allow us to accelerate this strategy and further embed Neogen Analytics in the market, as customers are increasingly looking to leverage data. We've seen strong growth in the platform and are planning to build on this leading presence by launching additional software modules and digital mapping capabilities in the near future. We've also begun working with one of the leading providers of generative AI to search for potential opportunities to drive monetization for Neogen Analytics capabilities. I appreciate the efforts and commitment of our team members around the world. We have numerous integration work streams underway across the organization, and I couldn't be happier to have them working with us as we build the future of Neogen. I'll now turn things over to the operator to begin the Q&A.

Thank you. Today's first question comes from Brandon Vasquez with William Blair. Please go ahead.

Good morning, everyone. I appreciate you taking my question. I have a couple of short-term queries, and maybe one or two longer-term ones. First, I'm curious about the holiday shutdown at one of the manufacturing facilities. You issued guidance in January, so I assume you were past that by now. Can you discuss whether that was the reason for the weaker-than-expected results? Was there something that changed after the January guidance?

Brandon, it was a combination of factors. In January, we assessed the full impact of the December shutdown, which was unexpected because we believed our contract manufacturer had a plan to continue operations. We didn't fully understand the consequences until later in January. This was very disappointing as we were progressing, and it significantly hindered our plans. Currently, we are unable to meet customer demand for the 3M business we acquired because the manufacturer cannot produce enough for us. Over the past 30 days, we've held three meetings with their CEO, and we have established a new structure. I believe we now have their attention, and this business is no longer overlooked; they must concentrate on it. We are beginning to observe that focus, but it will take time to resolve the issues. I perceive that we are moving in a better direction, but I want to ensure it continues positively rather than reversing. We are hopeful this situation is temporary and will provide us with momentum heading into next year, but they also need to demonstrate their commitment to following through on their promises and completing the necessary tasks.

Okay, got it. Regarding the mid-single digits core growth, which may currently be on the lower end, what does that indicate? I understand that Neogen is a core legacy business. What should we expect from the 3M business in that context? It's a significant revenue figure, right? Can we anticipate sequential improvement as we approach the fiscal fourth quarter?

Yeah, hey, Brandon. I think I'd say we're not anticipating too much improvement, maybe a little bit better. Obviously, there's some more selling days. But from a growth perspective, we would anticipate it probably doing a little bit better, but more kind of that mid-single digits on an underlying legacy business and the acquired business, not showing significant improvement sequentially, I think, is what's contemplated there.

Okay, looking ahead to long-term guidance, it's encouraging that you still feel confident about the fiscal '25 expectations, even with the backlog this quarter being a bit worse than anticipated. As we start evaluating our fiscal '24 projections, I understand you won't provide a specific number now. However, how should we anticipate recovery in fiscal '24? Will it be a gradual improvement, or do we expect a significant surge in the latter half of '24 and into '25? Any insights you could share to help clarify would be appreciated.

I believe there will be more updates as we approach year-end. We are involved in food safety markets, and our legacy business saw solid mid-single-digit growth on a core basis in these sectors. We also see growth from our acquired businesses. Despite facing some near-term challenges and production volume headwinds with certain customers, we believe the underlying markets remain strong. This strength will help bridge our outlook from 2023 into 2025. The speed and shape of this transition is what John is referring to, emphasizing the need for momentum as we move from 2023 into 2024. This will provide us with better insight moving forward. More details will be available in the next quarter.

Hi, everyone. Thank you for the question. I'd like to discuss the debt and free cash flow for the quarter. You mentioned it might be due to the timing of interest payments and some increased capital expenditures. I noticed that net debt has increased during the quarter. Could you elaborate on that? Additionally, how should we view the debt to EBITDA ratio as we move forward this year, especially with rising interest rates?

That's okay. We know what you mean. Hey, Dave. So a couple of thoughts. Yes, leverage is a little bit elevated on a net basis here, where we would have typically expected to see it flat or come down a little bit. I would say that aside from funding our integration CapEx, deleveraging remains a top priority for us. But we can't always predict the timing of everything. We are a serial bolt-on acquirer. We've changed that focus now to deleveraging. The Corvium deal that we completed in the quarter, the timing was such that it needed to be transacted, and that's a very strategic deal for us for all the reasons that John outlined in his prepared remarks. So obviously, cash utilization of that of $24 million was a headwind to net debt in the quarter. In addition, you noted the timing of interest payments, which I think had about an extra $12 million kind of increase to what you would think of as a normal underlying quarterly cash outflows. And then our integration CapEx, which is elevated and will be elevated, not the same quarter-on-quarter, might be linear. But as we work through more of the factory side but also the system side over the next couple of years, and that's always been a known item. So we knew that would be a headwind to free cash conversion over time. But underlying all of that is a pretty strong historically free cash flow conversion business that we think we can make even more robust in the future with some opportunities on the working capital side of the balance sheet. So that's what's going on. And our priorities remain the same. Having said that, like in many cases, you might see that bounce around a little bit quarter to quarter, but our objective remains the same.

I appreciate your understanding of my phrasing. Regarding the Petrifilm and the manufacturing issues, specifically the challenges in receiving all your orders from suppliers, can you discuss how you prioritize products for your customers? I'm interested in how you ensure that your customers have access to this product so they don't look elsewhere or switch suppliers during this process. Could you share some insights into your conversations with customers to assure them that you're managing their needs effectively, even though some aspects may be beyond your control as the intermediary?

Yeah, so what we're doing, David, is to point that out on the SKUs, we're having issues because we don't have it on every issue. We don't have it on every SKU, in Petrifilm or even in sample handling. It's on the SKUs that are an issue. We end up allocating, and we end up working with customers to make sure that we're trying to do the best, but we're just not meeting their demand. We're not getting the manufacturing support we need. Because of that, we're losing that sale and that share of market at that moment, because they're having to go and do something else. By definition, we're losing that sale, and that share of market at that moment because they have to seek an alternative. We know it's a very resilient business, and we're confident that our solution is better. So we're very confident that we're going to be able to get those customers back. But that is a sale we lose, and we don't get back. It's not like they can just say, well, we'll wait until you're ready, and then that demand comes back later in future sales. That's why we're working so hard at it. That's why it's so frustrating to me and the team. And that's why we're so focused on communications with the customers to make sure that the products that we have, even though it's not enough, we're trying to work with them in a way on an allocation basis to make this the least painful, but we recognize this is extremely painful for our customers. I've talked to our customers almost every week about this. I know they're frustrated; they know we're frustrated. We're seeing some incremental progress, but we've got a lot more work to do.

Got it. Are there any other technical or invoicing issues with Petrifilm? Is the current situation primarily due to a stock-out, and is everything else from the transition going smoothly? Do you feel comfortable that the frustration is mainly related to the product?

Yeah. The biggest issue is manufacturing. It's not logistics; there's nothing in the order to cash cycle. We don't see any issues with billing or receiving or anything like that. It's purely a manufacturing issue. And Brandon kind of brought this up about what '24 looks like. During fiscal year '24, some of those lines will be coming over to us, just Petrifilm for now, but sample handling, portions of that will be coming over and even the pathogen side. So we'll feel a lot more comfortable. We're working very hard to continue to move some of those products into our manufacturing and into our hands even at an accelerated rate than we had anticipated because we believe we can get that fixed. So those are some of the things we're doing.

Can you discuss the integration and potential cost savings? Are you able to provide any estimates on the distribution integration and the quicker-than-expected manufacturing, particularly regarding timing and speed? I understand you reaffirmed the long-term guidance, so could you elaborate on the potential near-term cost savings related to this integration?

David, in the near term, I think what you've heard us talk about is having to build up some costs. So we'll have some duplicate costs, where we're paying our partners in various forms of transition services, where we're building up the cost to come off. One of the things we will do here at a point in the future, when we have a little better fidelity into the timing of that is to help characterize some of that a little bit and what it means over time. But I'm not prepared to do that now. We do think that we'll be able to gain efficiencies once we're through building up the cost of transition services to bring these products into our existing processes. We believe there's efficiency over time with that.

Sure. Can you discuss how the farm to table data strategy is evolving? Traditionally, it has been challenging to get these companies to recognize the significance of the entire food chain. What does this strategy entail to finally achieve the long-awaited goal of a complete farm to table system?

Sure, thanks, David. Yeah, I mean, the course of action is what we're doing now, right? Starting with our analytics platform. What that platform does is allow us to work with our key customers in food manufacturing to help them modernize and digitize our environmental plant mapping policies and procedures, right? So it's a suite of products around environmental plant mapping, benchmarking, and predictive analytics, and we continue to develop new suites for that offering to be able to show customers the things we can do to help them connect. The more we add in the ecosystem, the easier it is to connect the ecosystem. We already have our blockchain solution; we can take one of our customers, you buy their steak in a supermarket and send it to me, I can tell you every place that animal went, everything it ate, every time it was sick, every medicine that was given, all the way from birth to your dinner plate. Neogen tends to lead the industry. While we have that capability, we don't see a huge demand for that because right now the question is, who’s going to pay for it? The rancher says, well that should be the processor. The processor says, well that should be the grocer. The grocer says, well that should be the consumer. But at some point, we know that we have the ability to tie that all together, something nobody else has. We're continuing to drive the solutions forward because we know this will happen. This happened just like with our genomics business; over a decade ago, everybody said we don't need genomics. I can look at that animal and tell you how it's going to grow. And now you've seen the whole industry has changed in the decade. You're going to see that too on this side of the business. So we're really excited about our Corvium acquisition. It will allow us to not only stay in front but to be 10 times in front of our competitors around this part of the marketplace that really is just a big white space. We're excited. We have so much data within the organization; we're not even sure yet of the value streams to provide, which is why we're working with one of the largest generative AI companies to figure out what do we have and what can we make actionable. So those are things that are really exciting about what's coming.

Thank you guys. And thank you for putting up with my inability to ask a question this morning.

No problem. We know you got other things on your mind, so we hope that goes well.

Thank you. And our next question is a follow-up from Brandon Vasquez of William Blair. Please go ahead.

Hey, thanks for the follow-up. I have one last quick question about Petrifilm. Can you quantify the backlog of Petrifilm sales for the quarter? Also, you mentioned that things have improved in January and February regarding output. Now that March is nearly over, is that also true for March? I just want to understand the cadence moving forward. Thanks.

About $7 million, I think. We're just about flat, and Brandon, the challenge is a little bit less the absolute backlog number but the fact that we're still in this allocation situation. So as John pointed out, we don't lose a customer, but we lose some sales. I think production, absolute production was lower in December than January and February. We saw an uptick, which was good. I think we've again seen some improvement in the backlog number here in the March timeframe. But again, we've seen periods like that; we've seen periods like that before. I think John alluded to that. The key is to get the backlog down to a sub-million dollar type number on a sustained basis, which is a better sign that we're fulfilling at the rate we need to for the requirements of this product category.

Got it. Super helpful. Thanks a lot.

Thank you.

Thank you all. Really appreciate you joining us this morning. Again, as we work through this, we're really excited about the future of this business. So we look forward to speaking to you all again in our fourth quarter and at the end of the year this summer.

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.