Neogen Corporation (NEOG) has served its patient shareholders quite well over the long term. Over the past 10 years, since 2002, its share price has increased from around $7 to $35 currently, making the annual compounded rate of return 17.5%.



Is Neogen suitable for long-term value investment? Historically, it has proven so. How about the future? Let’s do some quick analysis of the fundamentals.

The company was founded in 1981 in Michigan. Its business is to develop, manufacture and market a diverse line of products dedicated to food and animal safety. The two segments of food safety and animal safety are divided nearly equally in terms of sales for the previous three years. During fiscal year 2011, it had around 6,000 customers for its products. And the majority of them are either distributors or retailers. No single customer or distributor accounted for 10% or more of the company’s revenue in 2011. Last year in 2010, only one food safety distributor customer was 10.3% of total revenue.

Operating Performance

Historically, Neogen has consistently performed quite well. The table of its operating performance is below:

USD million	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
Revenue	41	46	55	63	72	86	102	119	141	173
Operating Income	6	7	8	9	12	14	18	20	27	36
Net Income	4	5	5	6	8	9	12	14	18	23

The revenue, operating income and net income have been consistently on a rising trend, at a stable pace. The annual compounded growth for the revenue, operating income and net income are 15.5%, 19.6% and 19.1%, respectively. So over the past 10 years, it has had quite impressive performance in business growth, both for the top line and bottom line.

Profitability

Regarding the profitability of Neogen, we can see stability with gradual improvement in its margin.

%	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
Gross Margin	50.9	53.2	49.6	48.8	51.1	51.7	52	50.1	51.9	50.8
Operating Margin	13.4	14.6	13.6	14	16.6	15.7	17.6	17.3	19.1	20.8
Net Margin	9.6	10.3	9.19	9.43	11	10.6	11.8	11.7	12.5	13.2

The gross margin has been quite stable in the range of 49-52% in the past 10 years. The operating margin and the net margin have experienced some improvement over time, from 13% to nearly 21% for operating margin, and 9.6% to 13% for net margin. On average, the operating margin has stayed at 16.3% and the net margin stayed around 11%.

	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
Net Margin %	9.6	10.3	9.19	9.43	11	10.6	11.8	11.7	12.5	13.2
Asset Turnover	1.13	1.06	1.03	1.01	0.95	0.89	0.88	0.88	0.87	0.86
Financial Leverage	1.12	1.16	1.25	1.17	1.37	1.15	1.14	1.1	1.18	1.16
Return on Equity %	12.2	12.4	11.4	11.5	13.3	11.7	11.9	11.6	12.5	13.4

The return on equity historically has been quite stable in the range of 11.5 – 13.3%, with an average of 12%. Gradually the net margin has been offset by the decreasing trend of asset turnover, which has held the return on equity within that stable range. The fluctuation in financial leverage is not much over time.

Financial Health

The company is quite conservative in its level of capitalization. The debt/asset ratio at the end of fiscal 2011 was only 14%, with interest-bearing debt. The main items of its assets are cash and cash equivalents, which take 25.5% of total assets, and goodwill, 23.5% of the total assets. Its enterprise value after adjusting the level of cash and debt is around $760 million.

Cash flow

USD million	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
CFO	3	7	3	7	12	10	8	11	28	29
CAPEX	-2	-2	-5	-3	-3	-5	-2	-3	-5	-8
FCF	2	4	-2	4	10	5	5	8	23	21

With conservative financing and stable profitability, Neogen has been producing sustainable and growing cash flow for its shareholders as well. The CFO is fluctuating a little bit but is on a rising trend, and the same with free cash flow, especially in the last two years of 2010 and 2011. From $2 million in 2002 to $21 million in 2011, the free cash flow of Neogen has marked the impressive annual compounded growth rate of 26.5% for historical 10 years.

Discounted FCF valuation

With free cash flow historical growth of 26.5% over the last 10 years, if we conservatively assume over the next five years its FCF growth stays at only 8% per year, then grows to infinity at the rate of 2%, and the discount rate is at 10%, then the estimated value of Neogen would be around $988 million.

Historical valuation

The historical valuation of Neogen over the past 10 years has been staying at quite a high level, ranging from 21 – 45x earnings, and 17 – 40x cash flow. In the 10-year period, the growth in operating cash flow of Neogen averages 25.5% compounded annually, and the average valuation of 10 years is around 30 times its operating cash flow. If we assume that on the next five years, its operating cash flow grows at the rate of 15% only, the CFO would reach $58.3 million at the end of year five. With the multiples of 30x cash flow, its value at the end of year five would be $1.75 billion. Applying the discount rate of 10% to discount the value of year five back to the present, the present value of Neogen would be around $1.1 billion.

Management

The executives do not hold a significant amount of shares in the company. Reportedly, James Herbert, its chairman and CEO, currently owns around 3.6% of the total share outstanding, whereas all the insiders collectively hold 5.9% of the company. The plus is that both the CEO and the COO have been working for the company long-term: for 29 years and 26 years respectively.

Conclusion

Historically, Neogen has served its shareholders pretty well. With stable growth in revenue, operating income and net income, along with the stable return on equity and growth in both operating and free cash flow, Neogen can be considered a stock for very long-term investors. The assumption of discount rate of 10% and growth of 8% and 15% respectively regarding to its cash flow, has made its current value ranging from $988 million to $1.1 billion, so it is trading at 23% – 31% off its calculated intrinsic value. Although there might not be quick profit in the short run, the long run might accumulate benefits via the compounding magic.

What Worked in the Stock Market for Long-Term Investors?

Extensive research has found that the companies with predictable revenues and earnings outperform the market average; they also suffer lower probability of loss. As a matter of fact, this kind of companies are exactly what Warren Buffett wants to buy and hold forever. Please read the research about what worked in the stock market:

Part I: What worked in the market from 1998-2008? Part I: Predictability Rank
Part II: Role of Valuations
Part III: Intrinsic Value, Discounted Cash Flow and Margin of Safety

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