A company with leading share in almost every relevant segment of a $24 billion market, strong margins, and strong barriers to entry arguably should trade at healthy multiples, so I can't say that the valuation of Zoetis (NYSE:ZTS) comes as much of a surprise. What's more, the company isn't done growing and expanding, as the company can still target share growth in Europe, market growth in emerging markets like China, margin improvement, and expansion into adjacent markets/products. Even so, the valuation gives me pause, as I believe it already factors in strong growth and over $2.1 billion in free cash flow in 2026.
A Clear Leader...
Zoetis is a clear leader in the animal health space, holding top three share in virtually every relevant sub-market where it competes and overall market share leadership as well. Geographically diverse, the company generates about half of its revenue in the U.S., but Brazil is the next-largest market (at around 6.5% of sales), and the company's revenue mix includes meaningful contributions from Europe, Latin America, and Asia-Pacific.
Recent successful product introductions have skewed Zoetis's mix a little more toward companion animals (dogs, cats, and horses), but livestock still make up close to 60% of the sales mix, with cattle accounting for roughly a third of revenue. Cats and dogs collectively account for more than this (close to 40%), while the swine and poultry categories within livestock are also double-digit contributors. Zoetis is the overall leader in drugs, vaccines, and related products for cattle and swine (with over 20% share and high teens share, respectively) and the #2 provider to the poultry and companion animal markets.
Zoetis has long prided itself on a balanced model with no heavy reliance on any particular product. That said, antibiotics (or "anti-infectives") have long been a cornerstone of the business, contributing about a quarter of revenue (down from close a third a few years ago) and representing one of the company's strongest markets (over 40% share). Vaccines contribute about one-quarter of revenue, and anti-parasitics contribute another 15% or so. Medicated feeds make up about 10% of revenue, with the remainder going into the catch-all category of "other".
I would expect "other" to become more significant in the coming years. Zoetis has recently launched two meaningful products for the canine atopic dermatitis market, and I would expect the company to show more interest in markets like pain/inflammation, anesthesia, nephrology, cardiology, and maybe oncology in the companion space, while also expanding its capabilities in reproductive health in the livestock market.
Using the most commonly-cited numbers for the size of the market, Zoetis has close to 20% share of the animal drug/vaccine market, with Merck (NYSE:MRK) and Lilly (NYSE:LLY) both in the low teens. With Sanofi (NYSE:SNY) recently swapping its Merial animal health business to Boerhinger Ingelheim, that business now likely has a market share around the mid-teens, though future updates will likely be sparse given that BI is a private company.
… In Attractive Markets
There are a lot of attributes that make the animal health market an attractive one. For starters, it is quite a bit easier to get a drug to market, as it takes about half as long as for human drugs (around five to six years) and typically costs less than $20 million (sometimes less than $10 million). The flip-side is that while there is no pushback from insurance companies or government-run health systems, the market opportunities are generally more modest; a "blockbuster" in animal health is generally a drug with $100 million to $200 million in peak sales prospects.
Livestock remains a growth opportunity for Zoetis as people still continue to prefer to eat animal protein when they have the money to do so. The livestock market opportunity is worth upwards of $14 billion a year, growing at a mid single-digit rate as countries like China continue to increase their meat consumption. While cattle will likely remain the biggest market for Zoetis within livestock, the company has made a couple of acquisitions to expand into aquaculture - a fast-growing protein market currently worth about $400 million, but likely to continue to grow as wild stocks come under more and more pressure from over-fishing.
The market for companion animal healthcare is likewise attractive, but better-understood. Investors have been hearing for years about the attractiveness of the market, as people continue to spend on their pets through companies like VCA Antech, IDEXX (NASDAQ:IDXX), and so on. Zoetis has solid share here overall, and recently moved into the oral anti-parasite market with its Simparca flea and tick medication. In the coming years, I expect the company to broaden its focus in the companion animal market, as there are meaningful opportunities across the spectrum of diseases/conditions.
One other attractive aspect of the animal drug market is the relative lack of generic pressure. There are companies making generic drugs for this market (like the UK's Dechra (OTC:DCHPF)), but the capital requirements and small individual drug markets (remember, a "blockbuster" is $100 million) have kept generic penetration to less than a quarter of the market, and generics are often priced at only a modest (10% to 30%) discount to branded drugs.
Threats And Opportunities
There are some potential vulnerabilities that investors should consider in regard to Zoetis. First, while generics have not historically been a major factor, that could change in the future. What's more, it seems like the elevated level of market interest in the sector over the last decade has led to more start-ups in the space. While more competitive pressure is a potential risk factor for Zoetis, in practice, an increase in the number of start-ups may actually become an opportunity for future M&A, as the company's size makes large-scale M&A impractical now.
Changes to food production policies is another threat to consider. There is a cottage industry in trying to make people afraid of their food, and that has led to companies and consumers pushing back on things like the use of antibiotics in livestock. The medicated feed business is probably the most vulnerable segment (an area where Phibro (NASDAQ:PAHC) also competes), but greater pressure against the use of antibiotics is at least a plausible risk factor.
Last and not least is a non-quantitative issue - Zoetis seems to get batted around relatively frequently on the basis of its quarterly earnings, even though management has gone to some length to forewarn the Street that quarterly results can be volatile and not indicative of emerging trends. Nevertheless, there's a sizable institutional presence here, so it's likely not going to change.
On the positive side, I see multiple avenues for Zoetis to do better and to grow the business. The company's involvement in biologicals has thus far been limited, but it could be a meaningful growth opportunity in companion animals, as could expansion into other therapeutic classes like oncology. Further market expansion (like the move into aquaculture) can likewise bring in more revenue.
On a more controversial note, Zoetis could also look to expand into new adjacent lines of business. Diagnostics could be a logical extension of the company's platform, particularly in companion animals, and expanding further into animal breeding tools like genetics (in the livestock business) could likewise make sense.
Management is also looking to improve margins. The company culled a large number of low-margin SKUs in 2016 and has been restructuring its manufacturing footprint by closing plants. Over the next three to five years, that could drive gross margins into the high 60%'s and the SKU reduction should help a little on shrinking its working capital needs.
While currency can influence near-term reported results, I'm looking for Zoetis to generate underlying long-term revenue growth in the neighborhood of 5% to 6%. With improving gross margins and operating scale, I believe FCF margins in the mid-to-high 20%'s are possible, fueling roughly 7% FCF growth from 2017 onward. Unfortunately, that's already well-reflected in the stock price, as today's price seems to assume long-term annualized FCF growth of closer to 20%.
The Bottom Line
With Zoetis trading about 10% above my fair value estimate, it's certainly not an obvious buy but nor is it egregiously overpriced. Well-run animal health companies tend to get healthy valuations (such has long been the case for Neogen (NASDAQ:NEOG)) and Zoetis is well-placed to leverage ongoing growth in livestock herds and spending on companion animals. I'd much prefer to get the shares at a discount to fair value, but I also recognize that waiting for a pullback here could be a long wait.
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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.