In previous columns, I've written about some of the myriad ways that investments in small companies go bad and how investors can identify the symptoms. Today, I'd like to flip the coin and discuss some of the things I look for in small-cap companies. As our case study, I'll take Neogen (Nasdaq: NEOG), a company that I like quite a bit. 

Neogen specializes in food- and animal-safety products. In its food-safety business, the company sells diagnostic tests that detect the presence of foodborne bacteria and allergens in foods, and natural toxins in grains. This is a big opportunity -- the Centers for Disease Control and Prevention estimates that 76 million Americans suffer from foodborne illnesses each year, and 325,000 of those require hospitalization. 

Neogen has become a known leader in this area, producing some of the least expensive, fast, and accurate tests on the market. Most of the diagnostic products are single-use and disposable (meaning that the company has that great repeat-purchase dynamic that we like to see.) 

The U.S. Department of Agriculture's (USDA) grain inspection service uses a Neogen test to measure the nation's grain supply for aflatoxin, a known carcinogen. Seafood producers use Neogen's tests for histamine (which can cause poisoning and death) and sulfites (which can cause allergic reactions) in fish and seafood. Neogen also sells kits to detect E.Coli, Salmonella, Listeria, and Campylobacter, all dangerous foodborne bacteria. The USDA has used Neogen's E.Coli test to monitor the U.S. meat supply since 1994. 

Neogen's animal-safety business produces and markets products for animal health, including more than 250 different veterinary instruments used to administer antibiotics and vaccines in very precise amounts, which reduces drug residues in the meat and milk supply. The company also produces a line of products for the professional equine industry (that's horses to you and me), including grooming aids, vaccines, and health-care products.

The leader in a growing niche
One of the things I look for in small companies is leadership in their chosen niche. Neogen, now coming up on its 20th birthday, is clearly a respected leader in the food-safety business, and is moving aggressively in animal safety as well. The company has been adding to both businesses with acquisitions, which play a big part in the company's growth strategy. Small companies are often attracted to acquisitions as a way to grow their business -- and many of them screw it up badly, something I wrote about not long ago in an article on Koala Corp (Nasdaq: KARE)

Neogen has had a lot of success in buying other companies, largely because it concentrates on acquiring businesses that are complementary to its own. In addition, Neogen has traditionally taken small bites, and almost always pays very reasonable prices. One example is Neogen's 1997 purchase of Triple Crown, a company that specializes in products for the professional horseracing industry, for $1.9 million. Neogen has worked hard to integrate the business and market Triple Crown's products, and Triple Crown's sales have grown from $1.9 million in 1998 to $2.6 million in 2000.

Another successful 1997 acquisition was that of Vetoquinal, U.S.A., a company that makes a pharmaceutical that speeds the recovery from respiratory infections in horses. Neogen paid $2.2 million, and has grown sales of this unit from $570,000 in 1998 to $1.25 million in 2000. Additionally, in 1998 Neogen paid $600,000 to acquire the rights to a vaccine for botulism, a deadly disease in horses, and the company is now the world leader in this market. 

In 2000, Neogen made several more acquisitions: Acumedia, a company that makes dehydrated culture media used in diagnostic tests, for $900,000; AmVet, a fast-growing animal pharmaceutical maker, for $4.5 million; and Squire Laboratories, another veterinary medicines company, for $1 million. Squire is expected to add $1 million in revenues in the first year of the acquisition. 

So far in 2001, Neogen has made two more acquisitions -- both fairly small, and both for reasonable prices. It's taken on virtually no debt to do these deals, and its track record in integrating and growing its additions is excellent. These acquisitions have caused gross margins to drop slightly, but pre-tax operating margins have increased.

Another favorable quality is that Neogen isn't obsessed with top-line growth. A couple of years ago, it sold its Ampcor human product line because it wasn't in the company's core area of expertise. Neogen's management shines, too, at capital allocation -- when the stock's been undervalued, they've bought it back. When a good acquisition at a reasonable price comes along, they use their money for that.

How big can it get?
In writing about paintball equipment maker Brass Eagle (Nasdaq: XTRM) in a recent article, I noted the company's $180 million market cap and came to the conclusion that it was unreasonable to expect Brass Eagle to grow to a $500 million or $1 billion market cap; the opportunity just wasn't that big. 

Neogen is a different story. The company estimates the size of the total food-safety market at about $600 million, and the markets it specifically targets at about $300 million. The animal safety and health market is huge, about $3.8 billion, although Neogen only targets about $300 million of that market. That's a combined $600 million (and growing) market, for a company that has recorded about $25 million in trailing-nine-month sales. At a recent $17 per share, Neogen has a market cap of about $100 million. There's plenty of opportunity for Neogen to grow. 

What to watch for
As with all small growth companies, investors need to keep a wary eye out for danger. Watch for the smooth integration of acquisitions, for one. Then there's the Flow Ratio, which is often high for small companies -- Neogen's, at over 5, is way up there. Cash flow from operations has been good historically -- make sure that this number is close to or exceeds net income. 

The stock price, at 28 times earnings, is not excessive given the company's prospects and proven track record, but neither is it dirt-cheap. Neogen continues to come out with new and better products, so you'll want to look for product announcements and signs that the company is growing its core business. 

In short, get to know the company if you're thinking about investing in it. And if you find that it's got the right stuff, make sure you pay a reasonable price. It's not a complicated formula, and investors that have the discipline and patience to buy good companies at good prices will do well over time.

Zeke Ashton does not own shares in Neogen, but is suspected to have ingested large amounts of animal-health products and Flintstones vitamins. The Motley Fool has a full digestio... er, disclosure policy.