Tickers in this Article: NEOG, ILMN, BIO, LIFE, IDXX, WAT, SNY
Investors who want to play the really interesting stories in med-tech have to be ready to act fast or step up when times look uncommonly tough. That's about the only way to get a decent valuation on stocks like Intuitive Surgical (Nasdaq:ISRG), Cepheid (Nasdaq:CPHD) or Illumina (Nasdaq:ILMN), and that seems largely true for animal and food safety specialist Neogen (Nasdaq:NEOG). Although valuation and earnings quality are still problematic here, these shares also highlight the importance of being up-to-date on research and able to pull the trigger quickly.

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A Disappointing Second Quarter
Although Neogen doesn't generally step far out of line, this quarter was a notable exception. Revenue rose just 2% this quarter, not only missing the averaged estimate but missing the low-end estimate as well. Animal safety revenue was up just 1%, due at least in part to lower activity in the GeneSeek agricultural genomics business. Food safety was hardly stellar, though, as revenue was up just over 3% this quarter.

Profits were even more disappointing than growth. Gross margin slid almost a point, and management blamed it on a mix shift (which would be consistent with lower sales of more profitable genomics services). Operating income fell 16% and operating margin four points as the company put more money into its sales and marketing efforts in the hopes of driving better revenue growth. (For related reading, see A Primer On The Biotech Sector.)

Mostly Just a Pause
There could be plenty of explanations for this quarter's poor performance that don't ding the long-term story. The company is annualizing tough comps from myotoxin testing in corn and there are rumors that there's another poor quality crop out there that could boost sales later in this fiscal year.

At the same time, the company is seeing some momentum in other kinds of toxin testing and will soon be pushing the ANSR molecular diagnostics platform for foodborne pathogens. This ANSR could be an interesting platform and grab business from the likes of Bio-Rad (NYSE:BIO) as it offers a simple and quick testing methodology that's easy on equipment and labor.

There's also the question of the genomics business. Neogen is partnered with Illumina and seems to be seeing some of the same problems - including lower government spending and a tough European markets. Longer term, though, it's easy to be bullish on agrigenomics even with companies like Life Technologies (Nasdaq:LIFE) and Luminex (Nasdaq:LMNX) active in the space.

Still Some Issues to Resolve
Neogen's stock may have overreacted to one quarter's disappointment, but then a lot is baked into the price. Neogen generates good returns on capital, but a lot of its growth has long been dependent on serial acquisitions. For a company that needs to prove it can produce organic double-digit growth, this quarter was a definite setback.

Valuation is likewise an issue. Not unlike Meridian Bioscience (Nasdaq:VIVO) or IDEXX Labs (Nasdaq:IDXX), Neogen has a great business but a valuation that goes beyond "healthy" and a fairly sluggish free cash flow margin.

Be Ready, Move Fast
Quality and scarcity are two valid reasons for Neogen to be richly valued. There may also be acquisition expectations at work here as well. Unfortunately, there is only a limited number of likely potential suitors - companies with a presence in food safety like Waters (NYSE:WAT), Mettler Toledo (NYSE:MTD) or Bio-Rad arguably don't need or want the animal business, and companies with animal care businesses (including large pharmas like Sanofi (NYSE:SNY)) don't need the food safety.

In the immediate aftermath of the earnings release, Neogen shares traded as low as $26 before steadily recovering during the day on Thursday. Near the $26 level, it was an interesting play on a company that generates good returns from underserved markets. At $30, it's a harder sale given that it presupposes a lot of top-line growth and improvements in free cash flow production. For now, then, this is a good example of the virtues of being prepared and ready to move - bargains don't always hang around very long. (For related reading, see How To Do Quantitative Analysis On Biotech Companies.)

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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