Neogen Corp (NEOG) Q1 2024 Earnings Call Transcript

Welcome to the Neogen Corporation First Quarter 2024 Earnings Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I would now turn the conference over to Bill Waelke, Vice President of Investor Relations. Please go ahead, sir.

Thank you for joining us this morning for the discussion of the first quarter of our 2024 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 opened today, we published our first quarter results, as well as a 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.

Thanks, Bill. Good morning, everyone, and welcome to our earnings call covering the first quarter of our 2024 fiscal year. We've made significant progress across a number of fronts on the integration of the former 3M Food Safety business while continuing to navigate soft market conditions. Our results for the quarter were largely as anticipated with two primary exceptions: greater than expected weakness in Asia and in genomics, along with a couple of unanticipated cost items. For Neogen in total, we saw core revenue growth decline by 0.4% in the quarter on a pro forma basis, which includes a negative impact from China of approximately 1%. In our legacy Food Safety business, core revenue growth was in the mid-single digit range, including positive volume growth in an end market where food production volumes continue to be down on a year-over-year basis for many producers. Additionally, certain producers have taken capacity offline in order to right-size the output from higher levels last year to the current environment. On our Animal Safety segment, we continued to see the impact of destocking in the distribution channel. Sales out of the channel to our end customers remained positive compared to the prior year, with large veterinary distributors continuing to reduce their purchases. Based on the data we have from the larger distributors in North America, channel inventories are at a three to four year low. In the former 3M Food Safety Division, the progress made with production levels at our transition manufacturing partner in Q4 of last year was maintained. For the former 3M division in total, core revenue grew by approximately 1% in the first quarter on a pro forma basis. Backlog remains at reasonable levels following the progress in the prior quarter in catching up on past due orders, which helped drive a strong fourth quarter. We continue to work on rebuilding demand through targeted initiatives as we demonstrate reliable supply of Petrifilm, and progress has been notable. Although pro forma growth was lower in Q1, impacted by weakness in Asia, a tough comparison against some elevated activity last year and a strong Q4 where we caught up on fulfilling orders, we have seen good progress so far in Q2 and remain very optimistic about the opportunities ahead of us. As we operate through a rather dynamic market environment, we are encouraged by our performance. The destocking in Animal Safety will ease as inventories right-size and end-user sales out of the distribution channels continue to grow. On the Food Safety side, we are dealing with a few challenges unique to us in Asia Pacific and macro weakness in China specifically that is common across most companies. However, outside of Asia Pacific, our Food Safety core revenue grew over 4% with positive volume despite the lower production volumes we see across much of the food production landscape demonstrating the resiliency of our business. On the integration front, the relocation of the former 3M pathogen and sample handling product lines in the Neogen facilities remains on track for completion in the third quarter. Hiring and training of new employees and inventory builds are underway as our initial equipment transfers with site preparation expected to wrap up later this month. These two product lines account for nearly 30% of the revenue of the former 3M business and are a strong complement to the Neogen product portfolio that we're looking forward to having fully embedded within our operations. After these moves, we will have nearly 50% of the former 3M product lines fully integrated, all but Petrifilm. The plan to exit the two transition services agreements, those covering back-office functions and distribution, are also on track to be completed in the third quarter. A key step that enables the exit of these agreements is the implementation of our new ERP system, which will allow us to take over order fulfillment services currently provided for the former 3M products. Last month, we had the initial go-live with our Food Safety business in the U.S. and Canada, as well as corporate, making the cut-over to the new ERP on which we are now up and running. Implementation has generally gone well in that we are fully operational on the new system, processing orders and shipping products, but as is typical, we are not as efficient yet on the new system as we were on the old one. As a result, we've exited the month of September with an elevated level of open orders in our legacy Food Safety business that we expect will mostly ship in October and November. However, as we continue to work our way up the efficiency curve, it is possible that some level of revenue will shift from Q2 into Q3. What will be most important, however, is continuing to see end-user demand in line with our expectations and working diligently to satisfy it. The final phase of integration activities involves the construction of our new facility in Lansing, which will house the production of Petrifilm and other products from the legacy Neogen portfolio. The new facility continues to progress on track with construction of the exterior expected to be completed during Q3, at which point the focus will shift to the completion of the interior work and the installation of the custom manufacturing equipment. We’re pleased with the progress we've made on the integration to date and are focused on the execution of the upcoming key transition activities in the second and third quarters that will bring the former 3M business closer to full autonomy within the One Neogen we’re building. Now 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 on the call. Jumping into the results, our first quarter revenues were $229 million, an increase of 73% compared to the same quarter a year ago. Core revenue, which excludes the impact of foreign currency, acquisitions, and discontinued product lines declined just over 1% for the quarter. Acquisitions and discontinued product lines added a net 73%, while foreign currency was a 1% tailwind compared to the prior year. On a pro forma basis for the 3M transaction, core revenues declined modestly, down 40 basis points compared to the prior-year quarter or approximately $4 million to $5 million below our expectations, driven primarily by lower sales in Asia. In Asia-Pacific, customers were more impacted by the Petrifilm supply constraints we experienced last fiscal year, leading to what we believe will be a slightly longer path to demand recovery. Our China exposure is small, representing less than 3% of total company revenue, but worsening macro conditions there contributed to significantly lower sales in the quarter. Moving now to the segment level, revenues in our Food Safety segment were $166 million in the quarter, an increase of 157% compared to the prior year, including core growth of 4.5%. The core growth was led by the Bacterial and General Sanitation product category, which benefited from new microbiological testing business in the U.S. and U.K. Natural Toxins and Allergens also had solid core growth with a notable increase in sales of milk and gluten allergen test kits. Within the Indicator Testing, Culture Media and Other category, modest core growth in Culture Media was offset by a decline in food quality and nutritional analysis sales due in part to international distributor ordering patterns. Quarterly revenues in the Animal Safety segment were $63 million, a core decline of just under 7% compared to the prior-year quarter. While generally in line with our expectations, Animal Safety revenue was a bit lighter than anticipated, driven primarily by the continued destocking at large veterinary distributors. This destocking was the primary reason for the core revenue decline in veterinary instruments and disposables, while supply constraints played a role in the lower sales of small animal supplements and vitamin injectables in the Animal Care and Other category. These declines were partially offset by solid growth in our biosecurity products with higher volumes in insect control products and cleaners and disinfectants. Worldwide genomics revenue was down modestly on a core basis with growth in international beef markets offset by declines in poultry and porcine, driven primarily by the attrition of a couple of large customers in the U.S. In the former 3M Food Safety division, core revenue grew modestly on a pro forma basis, as John mentioned, which includes a compare headwind of a few points and also follows a very strong Q4. The Bacterial and General Sanitation product category saw the highest growth in this quarter with particularly strong sales of Clean-Trace Hygiene Monitoring products. This growth was partially offset by a modest core revenue decline in Petrifilm, with the largest driver being the aforementioned weakness in Asia and China, in particular. Importantly, we were pleased to see that the improvements made in transition manufacturing during Q4 were sustained into Q1, providing stability of supply and allowing us to focus on demand-generating activities. From a geographical perspective, results were mixed. Growth was led by EMEA, which grew in the high single digits, and LatAm in the mid-single digits. USAC was down low single digits due mainly to the destocking of large animal safety distributors, as well as lower sales in genomics, while the Food Safety business grew in the low single digits. Finally, APAC declined mid-single digits as a result of a slower-than-anticipated recovery in 3M demand following the Petrifilm supply constraints and also across-the-board softness in China. Recall that China represents less than 3% of our global revenues, but we experienced a decline in the high 20s, so the impact was measurable, particularly at the regional level. Gross margin in the first quarter was 51%, representing an increase of 400 basis points from 47% in the same quarter a year ago, with the increase primarily driven by the addition of higher margin business from the 3M Food Safety transaction, as well as positive price cost. On a pro forma basis, gross margin expansion was 180 basis points. Adjusted EBITDA was $52 million, representing growth of 94% from the prior-year quarter, driven by the merger with the former 3M Food Safety division. Adjusted EBITDA margin was 22.9%, a year-over-year increase of 250 basis points, including approximately 100 basis points of negative impact from a non-recurring billing adjustment from our transition manufacturing partner and transaction FX. On a pro forma basis, adjusted EBITDA margin expansion was 10 basis points, lower than we had anticipated due to the non-recurring items I mentioned and volume being a bit lighter than expected. Adjusted net income was $24 million for the quarter, with adjusted earnings per share of $0.11 compared to $18 million and $0.16 respectively in the prior year period. The increase in adjusted net income was driven by higher adjusted EBITDA, which more than offset the increase in interest expense, while adjusted earnings per share was negatively impacted by the increase in weighted average shares outstanding from the Food Safety transaction. We ended the fourth quarter with gross debt of $900 million, 67% of which remains at a fixed rate and a total cash position roughly unchanged from Q4 at $239 million, resulting in pro forma net leverage of 2.9 times and total liquidity of over $375 million. Although the first quarter is typically our lowest quarter seasonally, this year was a bit lower than we had anticipated, but generally aligned with how we anticipated the year developing. From what we have seen through the first month of Q2, the demand environment continues to appear consistent with what we had expected. As John noted, though, we are fully immersed in our ERP implementation, which will enable us to extract ourselves from the transition service arrangements we have with 3M. The inefficiencies he mentioned will make shipments more challenging in Q2, and we will likely have carryover of some Food Safety open orders into the initial weeks of Q3 as a result. Based on this dynamic, we could see a broader range of outcomes for the second quarter depending on how the backlog of open orders develops. Our current base case view is that we should see a modest sequential increase in revenue, which assumes we exit the quarter with an elevated level of open orders, as well as a modest sequential increase in adjusted EBITDA margin. If we do see some amount of revenue shift from Q2 to Q3, this would correspondingly affect the normal seasonality of our business, in which the second half of the year typically accounts for 52% of the year's revenue. Based on our first-quarter results and the normal seasonality of the business, as well as the expectation of an improved end-market environment in the second half, we are maintaining our full-year outlook. I'll now hand the call back to John for some closing thoughts.

Thanks, Dave. As you heard today, we believe we're making solid progress on the integration of the former 3M business and are on track to be completely independent from 3M in the third quarter outside of Petrifilm manufacturing, but we feel that arrangement is in a stable place. Our new ERP system is up and running after the Phase 1 launch, which is a significant step to have behind us. We will work diligently through the backlog of open orders as we continue to become more efficient in our new ERP system. We still have significant work ahead of us, though, with key activities taking place in the second and third quarters as we implement the final steps needed to relocate production and exit the transition services agreements. In addition to the important step of gaining full operational control of this part of the business, there are the associated savings we expect to see from exiting the agreements, and we fully anticipate ultimately achieving greater efficiency and utilization in our footprint. Having now crossed the one-year anniversary of the 3M transaction, we are excited about the opportunities we have to leverage our leading position in the Food Safety markets. Our sales and R&D teams are now approaching one year of working together on the combined product portfolio, building momentum that will result in new commercial opportunities, particularly as the market conditions improve. Our team members around the world have worked tirelessly on advancing the integration process, and I want to wrap up here today by thanking them for their hard work. We have a shared goal that we are ever mindful of: to remain the global leader in food safety and help protect the world's food supply. I'll now turn things over to the operator to begin the Q&A.

Yes. Thank you. At this time, we will begin the question-and-answer session. At this time, we will pause momentarily to assemble the roster. And the first question comes from Brandon Vazquez with William Blair.

Good morning, everyone, and thanks for taking the question. To start on guidance at a high level, I think some of the weakness in the quarter was coming from worsening macro conditions, especially in China, given updates seem to be negative out of there. Just curious, what gives you confidence around reiterating the guidance range? That was encouraging to see maybe an indication of the underlying momentum you’re seeing, but, again, in a worsening macro backdrop that seems to be out of your control. What are you seeing that's giving you guidance or comfort in that guidance range?

Yeah. Thanks, Brandon, and thanks for being here. Specifically to China, what we're seeing is that it's a relatively small piece of the business, only 3% of revenue. So, while China was a challenge, as we look forward it was a particularly tough quarter that had a tough comp. However, I don't think it’s going to repeat, so we don't see that big of a drag. For the overall markets, it's pretty similar to what we've been seeing: food production volumes are slow, the distributor channels destocking—that's kind of what we thought was going to happen for the year. While this quarter was about a $4 million miss on what we expected it to be, we feel pretty comfortable about where we are on end-user demand. The wild card is making sure that we're getting the product out the door with the SAP conversion. I'm really proud of the team on what we've been able to do under the SAP conversion. You hear all the horror stories, but you don't hear the good stories. This is one of the good stories, right? We’re 40 days in, we're immediately able to do order to cash, build customers, pick, pack, and ship, manufacture, but we're just not as efficient and it's going to take us a little while to get that efficiency up, so we're caught a little bit behind. We think we can catch up in October and November, but as Dave talked about, there may be a little bit of carryover going into the third quarter. So, I’ll let Dave talk a little bit more about guidance as we move ahead.

Hi, Brandon. I think John summarized it pretty well. I’d just highlight that we’ve talked about the first half being softer, and that’s what we're seeing. But outside of Asia Pacific, where I think we have some challenges that we noted in the prepared remarks, we saw, particularly, the Food Safety business grow pretty well outside of Asia on a global basis. So there is some strength there, but I think the environment is not too different than we had anticipated.

Okay. As a follow-up to that, you mentioned some unique challenges to Neogen in APAC. Can you talk about some of those challenges that are unique to you and what you're doing to address them?

When we say that, we mean that when 3M was struggling with their production of Petrifilm, APAC was asymmetrically hurt regarding supply. You had almost 24 months of supply disruption, which really challenged customers because they had to do other solutions and find ways to continue to run their businesses without the Petrifilm product. Our unique challenge is to earn back their trust. We have to show them we have supply. One quarter they might be okay, but we need to prove it over time. We’re now two quarters in where supply is at the levels it needs to be, but it's about going back to those customers and winning back their trust that we, under our regime, have fixed the supply issues that weren't able to be resolved for two years.

Do you have a sense of where those customers are going? When we talk to experts, they often mention backup plans—are they moving to competitors, or do you think this is temporary?

It’s a little bit of both. We did see some movement to competitors, but we're starting to see those customers come back. That’s why I said in my prepared remarks I was encouraged, because we're starting to see that move back. However, it takes two years to lose them, and it's going to take us a little while to get them back. I am confident that our solutions and overall product offerings are head and shoulders above our competitors, so I believe we will get that business back.

So, John, could you give us a bit more details on genomics? I think you mentioned the attrition of two U.S. customers. Did that impact the revenue for the quarter?

Yeah. We had two large customers in very challenging markets right now, specifically poultry and swine. They are putting extreme pressure on pricing and other solutions for us. For years these have been good volume customers but relatively low-margin customers. We’ve been moving to transition the genomics business to different species that are higher value, higher margin. When the pressure came and they wanted a significant price decrease, we declined. We made the decision that even though it's going to hurt us on volume, it wasn't as significant from a profitability standpoint. That drove that decision.

Hi, Tim. I would say the new news for us in the quarter wasn’t these customers. Things came in generally a little bit lighter because of some end-market pressures. This more describes the kind of the absolute growth rate. I’d say it’s contemplated in the guidance.

So, when you think about the destocking, can you talk about when you think this rebound might happen or how long these low levels of inventory might last before going back to normal?

Tim, I don't think we're at a new normal. I think this is abnormally low. Based on what we're seeing in end-user demand, we monitor what goes in and out on end-user demand. While we've often been bad at calling bottoms, to me, this doesn't seem sustainable. I feel pretty comfortable; as we discussed, in the second half of the year, it cannot drive inventories down that low while still providing the service levels that distributors want to give to their customers. We think that this will improve.

Could you walk us through the transition agreement on the pathogen and sample handling lines? You mentioned they account for about 30% of revenues. How much of the transition manufacturing agreement costs are attributed to those product lines? What should we expect in terms of day-one margin impact as those costs roll off?

We’re obviously standing up a considerable amount. There are costs involved from the move and one-time nature, but we’re also setting up recurring costs to accept those product lines in. When those happen, we won't be paying the manufacturing transition fee. I think net-net, that’s accretive to us; tough to quantify too sharply. Some of the costs are overlapping as well, but you had seen us put forward a schedule in the spring on where we expect to be from an integration standpoint at the end of our third quarter. I think the other thing to note is that on the OpEx line, we have some duplicate costs that we’ll see come out for the fourth when we reach that point of integration. We reported an adjusted EBITDA margin of just under 23% for the first quarter, and while I mentioned 100 basis points of some kind of unanticipated headwinds, there’s probably another 100 basis points of duplicate costs in there. We have to manage this well, but I think the fourth quarter and really the exit rate for the year is where we should see ourselves down to just manufacturing transition fees related to the manufacturing of Petrifilm, and then of course, that becomes an issue in the coming years. So, maybe not as precise an answer as you're looking for, but hopefully that contextualizes it.

Thanks for the information. I appreciate it.

Thanks, Tim.

Thanks, Tim.

Thank you. And the next question comes from Dave Westenberg with Piper Sandler.

Hi. This is John on for Dave. Thanks for taking the questions. Can you provide additional details on the ERP implementation? There was some revenue shifting between the different quarters. Can you walk us through what the implementation issues were, what the degree of the shift was, and the areas affected?

Thanks, John. As we discussed in the prepared remarks, when you build a new ERP system, you will not be as efficient day one as you were on the old system because you spent 20 years on the old one, and you knew it inside and out. The good news is the business was up and running, we were able to do all the functions—nothing stopped. It’s just that we are not as fast. We identify warehousing as the main area where we need improvement among other functions. We’re continuing to train the teams and see sequential daily improvement, but we had a period that wasn’t reflecting our average; that’s where we need to overperform to get back up to average. I don’t know if Dave has any comments.

Yes, to clarify, this didn't affect the end of the first quarter. We went live on the first day of the second quarter. What we’re looking at is at the first month of our second quarter. Our shipments were out the door, but we carried over open orders from September into October. That was low double-digit millions, while it usually would be much lower than that. The goal was to emphasize that the implementation went well; this is the headline. We are shipping a bit slower than we anticipated, and we indicated that there may be some carryover going into the third quarter as well. What we really want to emphasize is the demand backdrop; we feel supported so far.

We heard that Walmart suggested that consumers are reducing their buying because of GLP-1. Are you hearing food producers saying anything similar?

We're hearing similar comments that you're hearing. Most producers are watching and understanding that it may have an impact. While it may be a headwind going forward, it will be relatively small compared to the large tailwinds we have around this business, particularly increased regulatory environment, increased customer usage, and expanding into new geographies. So, while it may be a headwind, we believe it will be de minimis.

Do you think any customers stocked up on Petrifilm earlier in the year due to the supply-constrained environment?

I didn't get the question. Can you repeat that?

Sorry, I didn't catch it. Did you think any customers stocked up on Petrifilm earlier in the year during the supply-constrained environment?

I don't think we’ve seen that.

Thank you.

Thank you. This concludes the question-and-answer session. I would like to turn the floor to management for any closing comments.

Thank you. As we stated earlier, while the quarter was a little softer than anticipated, I think what we wanted to talk about was the success really of the integration and the transition out of our two transition services agreements, and standing up ERP. For those of you that have been involved in a lot of different companies, those were significant risk factors that could derail organizations. I’m really proud of the team and the work they’ve done to plan and execute seamlessly. We continue to move to the new Neogen and the One Neogen environment. We’re really excited about the future, and we look forward to talking to you in the second quarter. Thank you.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.