I'm not usually a fan of stocks that trade for 30x earnings and over 25x free cash flow. Such a scenario creates a huge reliance on growth. But one of the most valuable lessons an investor can learn is to look beyond the first layer of a company -- its valuation metrics -- and see what the story is all about.
I missed Chipotle Mexican Grill (CMG) when it was trading at $150 a share, because of a price-to-earnings ratio of 33 several years back, despite my deep familiarity with the company's story and how rapidly the business was growing. Owing Chipotle several years back at 30x earnings translates into owning the company today at less than 20x earnings, on the basis of that past price.
While it is certainly no Chipotle, Neogen (NEOG) is a business that appears to be sitting on the bottom half of its growth curve. Shares currently trade for $32, down from $48, implying a market cap of $750 million. For fiscal 2011, ended May 31, 2011, revenue was $172 million, of which $23 million hit the bottom line. For the first six months of fiscal 2012, revenue totaled $90 million, and net income was $11.2 million. For this small-cap, the fiscal 2012 quarterly numbers represent the 75th consecutive profitable quarter from operations and the 79th quarter out of 84 that Neogen has reported a revenue increase from a year earlier.
Despite this company's fancy tech-sounding like name, it is actually is a very simple business: the development and sale of food and animal safety products. The company makes and markets diagnostic tests for food processors, drug detection for livestock, vaccines and animal care products. From the farm to the dining room table, Neogen provides service to food producers and processors at every point of the food chain. Its two divisions, animal safety and food safety, each account for about half of the company's revenue.
For customers of Neogen, its products are non-discretionary expenses. The economic and legal costs of a food illness or animal contamination are far too high to risk not being protected. In most cases, law dictates that proper food and animal testing occur before it can be sold or consumed by the public. According to the U.S. Centers for Disease Control and Prevention, every year, 1 in 6 Americans gets food poisoning, or nearly 50 million people. Of that number, 128,000 are hospitalized, and 3,000 die.
Neogen operates in markets that offer significant room for growth. The intervention products market, which includes vaccines, diagnostic tests, pharmaceuticals and veterinarians' instruments, is a $21 billion market, and Neogen currently markets products in each of those segments. The company serves the world's largest food producers and processors, including Kraft (KFT), McDonald's (MCD) and Coca-Cola (KO). For these customers, the money they spend with Neogen is a minuscule fraction of their expense, but it is an essential expense. That gives Neogen a slight degree of pricing power, and its gross margins exceed 50%.
True comparable companies are hard to find, but Balchem (BCPC) seems like the lone standout. Balchem is valued at $1.2 billion and has an enterprise value of $1.1 billion, a trailing P/E of 31 and a multiple of 16x EV/EBITDA. Balchem has annual revenue of about $300 million, with operating margins of 19% and a return on equity of 19%. Those multiples are very close to those of Neogen, and Balchem has been a consistent performer for years.
Yet Neogen gets very little coverage, even though it is just the type of business one would like to own in any economy, especially this one. It's a very asset-light business, with only $22 million in property, plant and equipment and $31 million in inventory. The company has very low annual capital expenditure, as cash has grown from $14 million in fiscal 2009 to over $36 million in fiscal 2011. Since 2000, Neogen has made over $80 million in acquisitions, all of which were financed with cash on hand, which represent over $60 million in annual sales. As that trend continues, it will add another lever for growth.
Neogen is a fantastic business, and the market seems to get that. It's highly unlikely that you will ever get a chance to own this business at a dirt-cheap valuation multiple. Given the company's significant growth potential and the high probability that such growth will continue for many years, the valuation doesn't deserve to get that low in this low-growth economy. Growth will be the company's value-creating catalyst. While I am not pulling the trigger at these prices, this is a fantastic business run by a quality management team, and it is sitting at the top of my watch list.