Sink Your Teeth Into This: Pet Stocks Are On The Rise

Includes: PETS, WOOF, ZTS
by: Cheryl Swanson

Just how deeply do most folks love their furry companions? According to a recent study cited by The Wall Street Journal's Robert Sapolsky, 40 percent of respondents voted to save their dog over a foreign tourist.

The puppy-love sentiment translates into big consumer spending and has powered the rise of several stocks that have some attractive characteristics. Since the pet industry as a whole is under-followed, recession-proof and has strong growth prospects, it's worth taking a closer look. In a market that has been on a tear so far this year, investing in a sector Wall Street has mostly overlooked gives you a chance to find some underappreciated picks.

Americans spend $61 billion a year on their pets annually-more than the gross domestic product of all but 64 countries in the world. It's also double the amount shelled out on pets a mere decade ago, making pet care the fastest growing retail segment after consumer electronics. Pet ownership of dogs and cats has tripled in the past thirty years, with almost 82.5 million households in the United States now owning at least one pet. About 30% of the spending came from veterinarian services, a category listed separately from the medications often prescribed because of those services.

Consistent growth, strong balance sheets and an ever-expanding market are all favorable tailwinds that should provide solid, continuing growth for pet stocks. There are only two caveats--one of which is obvious. The recent general stock market run up could be topping. The other is that each of these companies is facing more competition than they were even a scant year ago. Still, investors with a long-term horizon could take advantage of the any coming turbulence and find one of the following stocks well worth snapping up.

Pick of the Litter: VCA Antech

VCA Antech (NASDAQ:WOOF) has a market cap of $2.6 billion and contains two separate divisions, Animal Hospital and Laboratory. The company owns 600 small animal veterinary hospitals across the U.S. and Canada, boasts a nationwide clinical laboratory system and is a leader in animal diagnostic imaging.

Vet medicine is a traditionally fragmented space. VCA Antech is benefiting from both consolidating this space and increasing its geographic and segment footprint through strategic acquisition. VCA Antech acquired MediMedia Animal Health and Bright Heart Veterinary Centers in the last two years. In the first half of 2013, it acquired 40 million dollars in revenue through strategic acquisitions and plans to add enough animal hospitals to translate into 50-85 million more revenue every year.

The growing footprint has paid off. Shares were up 33 % over the past year. In its most recent quarter, VCA Antech posted record revenues and a 23% increase in operating income.

Is there reason to think that upward trend could continue? A vet friend who works at VCA Antech and brings his dog to the office tells me VCA Antech a good employer. While many doctors look down their noses at corporate medicine, VCA Antech gets favorable ratings in employer online surveys. A centralized payroll, good training and in-touch management are cited as pluses, as well as up-to-date technology.

The core of VCA Antech is the animal hospital business, which provides 78% of VCA Antech's revenue. This side of the business has the highest growth are, but it is also a relatively low margin business, which needs to be taken into account. The diagnostic testing and device market has much higher margins, but it also has powerful competitors, including IDEXX Laboratories (NASDAQ:IDXX) and Core Laboratories N.V. (NYSE:CLB)..

VCA Antech has shown year-over-year sales growth in every quarter since 2009. While the stock is near the top of its 52-week range, it has a good growth plan. Analysts' consensus price target is $34.11 in WOOF. Investors are noticing that WOOF's revenue growth has slightly outpaced the industry average (6.1% over the past quarter, compared to the industry average of 5.9%). The growth is helping the company's bottom line, improving the earnings per share.

Good Dividend, Clever Business Model, But Volatile: PetMed Express

PetMed Express (NASDAQ:PETS) is America's largest pet pharmacy, especially focusing on medicines for dogs, cats and horses. Established in 1996, PetMed is an example of how the Internet is in the process of radically altering the medication industry playing field. Founded by people physician Dr. Marc Puleo, PetMed was the first company to offer discounted pet prescription meds and OTC pet health products direct to consumers. The new business model gave pet owners the opportunity to buy their pet's medication online at a significant discount, after their vet provided a prescription. It should come as no surprise that there was great initial resistance from veterinarians. That resistance put PetMed so deep in the doghouse it was losing more than $50,000 a week by 2001.

Current CEO Menderes Akdag joined PetMeds that year and began transforming PetMeds from a foundering operation to a successful company. Akdag was formerly the CEO of Lens Express, the online retailer of contact lenses and supplies who undercut optometrists and ophthalmologists in the contact lens market. Akdag lacked experience with pet products, but he proved himself adept at building the brand image and establishing a defensible moat in customer service.

PetMed still faces lingering resentment from veterinarians (a group of veterinarians protested after the company signed up to be an exhibitor at the 2012 North American Veterinary Conference, calling it a slap in the face to the veterinary community). Probably a more significant threat is that some of PetMed's best selling products, such as the Frontline flea and tick treatments for dogs and cats, are now being carried by major retailers like Walmart, PetSmart and CostCo.

PetMed has gross margins over 25%, pays enviable dividends, and at the same time maintains zero debt as of the end of the 2013 fiscal year. In recent years, the online pet supply sector has increased dramatically, with outlets such as MWIV Veterinary Supply, VetDepot, PetCareRX and others now in the game. PetMed's edge is that they are generally a big hit with consumers, due to their consistently good prices and extremely creative marketing, which makes excellent use of the social media. Just one example: the company sends a "carepack" to any animal blogger who blogs about their products.

On October 22, 2013 PETS earnings per share (EPS) fell shy of the Zacks' Consensus Estimate, however the figure remained up on a year-over-year basis. Bottom line, the company still earned enough to pay its large dividend and have some left over to add to its pile of money, but the stock got punished almost 20% for it. Most analysts blamed the sales decline of 4.4% at the end of fiscal 2013on Novartis (NYSE:NVS) suspension of several key products.

PetMed is currently priced close to its price target, but the company throws patient investors another bone: a mouth-watering 4.5% dividend. The company began paying a 10-cent dividend in 2009, and has increased it by 70% since then to its current 17-cent payout. PetMed is currently focusing on improving new order sales. It is also shifting to higher margin items like generics, while also expanding its product offering. The consensus analyst price target is $15.60 for PETS.

While PetMed attracts considerable short interest so it could bite back, the dividend payment and solid earnings growth prospects make the stock attractive.

The Big Dog in the Game: Zoetis

Zoetis (NYSE:ZTS), formerly the Animal Health Unit of Pfizer, debuted on February 4 as the one of the biggest IPOs since Facebook. Zoetis is currently the biggest global animal health company; it added revenues of $4.3 billion to Pfizer's coffers in 2012 alone. In what most analysts consider a very smart move, Pfizer spun off Zoetis, divesting itself of its stake so it would have free rein to focus in on its core business.

On November 5 of this year, Zoetis said its net income fell 19 percent in the third quarter, from $162 million in Q3 2012 to $131 million, or $0.26 per diluted share. The drop was caused by costs associated with becoming a standalone company, an increase in cost of sales, as well as a double digit increase in the amount of money the company spent on research and development. But the company reported an 8 percent increase in overall sales, and brought in $1.1 billion in revenue, certainly an impressive performance for a company that has had to learn so recently how to stand on its own. Zoetis CEO Juan Ramon Alaix also lifted the outlook, raising guidance for the full year.

Big-cap Zoetis has a yield of .80%, but it attracts a sizeable short interest, and has several big pharma competitors in the space to contend with, like Merck, Merial, Bayer and Eli Lilly. Big pharma doesn't play nice against their competitors, but companies normally operate more efficiently once they are split into logical operating pieces, so Zoetis may have a key advantage.

While many expected big things from Zoetis, it turns out so far that supplying vets isn't as good of a business as supplying pet owners directly. Zoetis strongest growth has come not from the rapidly growing pet demographic, but from the livestock products side of the business, which account for 64% of total revenues. The company is diversified in 120 different countries, with manufacturing facilities in 11, and develops products specific to different geographic areas.

Zoetis tends to attract investors who like the big cap pharma segment and are not afraid to take a bite out of the animal kingdom. According to David Krempa, associate equity analyst for Morningstar investment research, "The animal health industry is a really attractive business to be in, more so than human pharma."

One key benefit of the animal health business is also a drawback for some investors. There are few (if any) block-buster drugs in the animal health business, so ZTS is not nearly as vulnerable to patent expirations as its big pharma competitors. But this also means there is less opportunity for explosive growth. Thirteen out of fifteen analysts surveyed covering ZTS rank it either an outperform or a buy, with an average target price of 36.79.

In the present era of QE-to-Infinity and the corresponding massive melt-up in stocks, attractive stocks have become as scarce as hen's teeth. It's certainly a time to exercise caution and perform due diligence. But with so many people treating critter companions as part of their family, the animal-health market shouldn't be discounted.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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