- Zoetis is a leading player in the rapidly growing animal health segment.
- The company has been focusing on innovation in many high growth areas of the animal health business.
- The COVID-19 pandemic may have a short-term impact on the company's share prices, thereby opening up lucrative entry opportunities for retail investors.
Zoetis (NYSE:ZTS) has emerged as one of the less affected companies in the COVID-19 pandemic. Although this leading animal health player also got beaten with the broader market in March, the stock has recovered much of its losses. The company is now down by only 3.71% YTD (year-to-date).
A spin-off of Pfizer (PFE) from early 2013, the company has been fast to capitalize on the increasing global demand for pet care products and animal protein. The company manufactures and commercializes medicines, vaccines, and diagnostic products for companion animals as well as livestock animals. Although more resilient to COVID-19 than many others, the pandemic has exposed the company to certain short-term headwinds. While the impact was not felt as much in the first quarter, the company expects them to be more evident in the rest of 2020. I believe that this can result in some emotional selling for the stock and lead to attractive entry points for retail investors.
The fundamental story of Zoetis is largely intact
Zoetis reported $6.3 billion and an adjusted net income of $1.8 billion in 2019. Both top and bottom line exceeding the high end of the company's fiscal 2019 guidance. Revenues were up 7% YoY, despite a 3% negative impact due to FX. The company reported revenue of $1.5 billion in the first quarter of 2020, a YoY rise of 5%. Net income was $423 million, or $0.88 per diluted share, a YoY increase of 36% and 35%, respectively, on a reported basis.
The companion animal business has been the key growth driver as the expanding middle-class population chooses to spend increasingly on pet care. According to the American Pet Products Association, the total spending on pets in the U.S. was close to $95.7 billion in 2019. Of these, pet food and treats accounted for $36.9 billion while vet care made up almost $29.3 billion of the spending. Spending on Supplies, live animals, and OTC (over-the-counter) medicine was $19.2 billion. Spending on other services which include boarding, grooming, insurance, training, pet sitting and walking and all services outside of veterinary care was $10.3 billion.
Understandably, companion animal health products accounted for almost 47% of Zoetis' total revenues in 2019. Companion animal health products are also higher-margin products in the company's product portfolio. This segment reported 23% YoY rise in revenues in 2019, driven by rising demand for new products in parasiticides and dermatology segments and for medical and veterinary diagnostics tests. In the first quarter, companion animal health segment reported revenues of $797 million, a YoY jump of 9.3%.
Another positive aspect of Zoetis is the increasing number of pet adoptions from shelter houses. The expanding base of pet owners is definitely a strong growth driver for Zoetis in the long run.
Although the COVID-19 outbreak is definitely a major disruption, the basic dynamics for this segment will remain mostly unchanged. Zoetis enjoys significant pricing power due to a limited number of competitors. Hence, realistically, Zoetis can grow its companion animal health revenues by a high-single-digit percentage rate in post-COVID-19 times.
However, in 2019, the company's livestock business faced problems such as the outbreak of African swine fever in China and challenging beef and dairy cattle market conditions in the U.S. Despite this, rising demand for animal protein from a growing global population continues to support Zoetis' livestock business. In the first quarter, Zoetis reported revenues of $717 million for livestock business, a YoY jump of 1.4%.
Things may change somewhat in 2020, and the livestock segment may assume greater importance than the companion animal health business. Countries across the world continue to prioritize food production. Hence, these essential businesses have been permitted to function albeit with appropriate controls. Livestock and poultry fall in this essential services category. Also, in this time of heightened vigilance, livestock and poultry farmers would like to ensure that their animals are as healthy as possible. Hence, there is much less incentive to forego vaccinations and other essential practices for these animals. This trend may help Zoetis maintain its livestock revenue stream, which is significant considering that it accounted for 48% of the company's 2019 revenue.
At the end of 2019, Zoetis had cash worth $1.94 billion and long-term debt worth $5.95 billion on its balance sheet. The company also has access to $1 billion in senior unsecured revolving credit facility which can be extended up to $1.5 billion in certain circumstances. This coupled with the company's topline can sustain its operations even in dire circumstances.
The company is also committed to returning significant value to shareholders. In 2019, the company paid a quarterly dividend of $0.16 per share, an increase of 30% from the 2018 dividend rate. The company also completed approximately $625 million worth share repurchases. For 2020, the company has announced a 22% hike in quarterly dividend and has approximately $1.7 billion remaining under a multi-year share repurchase program after repurchasing approximately $625 million worth shares in 2019. Although the company's dividend yield is modest 0.63%, Zoetis has come a long way from a quarterly dividend of $0.065 in the second quarter of 2013.
The company continues to introduce new products on the market
Zoetis expects traditional market segments such as medicines, vaccines, parasiticides, and medicated feed additives to grow annually at 4% - 6%. On the other hand, the newer segments such as diagnostics, biodevices, genetics, and precision livestock farming are expected to grow annually by double-digit percentages. Zoetis sees a total addressable market opportunity worth $40 billion in the animal health segment. And to grab a larger pie of this ever-growing market, the company is going all out to strengthen its position in both traditional and expanding areas of the animal health business. In 2019, almost 90% of Zoetis' portfolio comprised of products for which the company holds a leadership position in the market.
Zoetis is now working to address areas where it does not hold a leading position. In 2019, the company ranked #4 by market share in the parasiticides product category. This, however, may soon change due to Simparica Trio, the first monthly chewable tablet to protect pets against heartworm disease, ricks, fleas, roundworms, and hookworms. Approved in the U.S., EU, and Canada, the company had estimated sales of around $150 million for this product in 2020. Besides the inline Simparica Trio, the company has also recently launched new parasiticides such as Revolution Plus and ProHeart 12.
Going beyond traditional areas, Zoetis is also focusing on delivering the next wave of high-value innovation, including monoclonal antibody therapies for osteoarthritis pain in cats and dogs and new vaccines for poultry. The company has already submitted applications for the monoclonal antibody products in both the U.S. and Europe and is anticipating approval in 2021. The company is mainly targeting pain segment in cats, an area with huge unmet demand and no approved products.
Zoetis expects to leverage its biologics expertise to develop immunotherapies for livestock. In case these biologic therapies can substitute antibiotics, it can prove to be a major breakthrough for the company. Increasingly, governments across the world are becoming more aware of the presence of antibiotics in the food supply. This has given rise to the emergence of many multi-drug resistant organisms, also called superbugs, which are now proving to be a major healthcare challenge across the world. As governments start restricting the use of antibiotics in livestock rearing, there will be a significant market opportunity for these biologic therapies.
Besides improved medicines, the company is also opting for digital solutions called precision livestock farming for livestock business. The company has already made its presence felt in this segment with its Smartbow dairy cow monitoring system. In April 2020, the company acquired a private company, Performance Livestock Analytics, to expand digital and data analytics offerings for livestock producers. Performance Livestock Analytics is a pioneer in the field of offering cloud-based data and analytic solutions for beef producers. The company's Performance Beef solution helps feedlot managers make financial, nutrition, and animal health decision. Cattle Krush, a complementary tool to Performance Beef, supports producers to take optimal financial decisions based on real-time market data.
Zoetis is also targeting the ever-growing opportunity in the animal diagnostics segment, a market it believes to be worth $4.0 billion. The company has been on a spree of acquisitions in this area. In 2018, Zoetis acquired Abaxis, a leader in the development, manufacture and marketing of diagnostic instruments for veterinary point-of-care services. In November 2019, the company acquired a full-service veterinary clinical reference laboratory company, ZNLabs. In February 2020, the company acquired a veterinary reference lab business, Ethos Diagnostic Science.
Finally, Zoetis has also entered the pet insurance market in April 2020.
Zoetis is seeing short-term headwinds due to the COVID-19 pandemic
The ongoing COVID-19 pandemic is affecting both business segments of Zoetis. A survey by JPMorgan analyst, Chris Schott, of 25 U.S. veterinarians living in different parts of the country, highlighted the month-over-month fall in total visits by around 32% in April 2020. Some veterinary practices reported dramatic declines in patients and revenues, while some others saw relatively modest declines. Patients are visiting most of the veterinary clinics only in case of emergency, and are cancelling elective procedures. Chris Schott expects second-quarter companion animal sales to be down 15% - 20% on YoY basis. He expects trends to normalize in the third quarter and recover only in 2021.
While some of the demand for animal health products will be captured in later quarters, a certain portion will be completely lost. Although patients may resume their veterinary visits after quarantines are lifted, they may not necessarily make up for doses of antiparasitics and such other vaccines. Hence, even if the American Pet Products Association expects spending on pet care in the U.S. to be around $99 billion in 2020, the actual spending may be significantly below this estimate.
Besides, the pandemic has also affected the demand for livestock health products. Restrictions on travelling and eating out have reduced demand for animal protein. Although now people have started buying it in grocery stores, the nature of preferred animal protein is different in home and restaurant setting. Serving sizes also tend to be larger in restaurants. This also affects overall volumes of animal protein. A more permanent shift in consumption trends can even have a long-lasting impact on Zoetis' business.
Zoetis may also face some issues related to API (active pharmaceutical ingredient) sourcing especially for its poultry product, Zoamix. The company is also seeing pricing pressures for its livestock products, which it attributes to limited innovation in the space.
What price is right here?
According to finviz, the 12-month consensus target price for Zoetis is $138.50. The company is currently trading at a P/E (price-to-earnings) multiple of 40.79x and a forward P/E multiple of 29.78x. Although not cheap, these levels are definitely lower than the company's historical valuations. However, I believe that the company can trade at even lower valuations in the coming months due to the short-term impact of the COVID-19 outbreak on the overall animal health industry.
On May 6, the company updated fiscal 2020 revenue guidance to $5.95 billion - $6.25 billion, down from $6.65 billion - 6.80 billion. Guidance for non-GAAP net income has been lowered from $1.865 billion - $1.915 billion to $1.52 billion - 1.64 billion. Further, the company has reduced fiscal 2020 guidance for GAAP EPS to $2.80 - 3.07 from $3.53 - 3.65 and for non-GAAP EPS to $3.17 - 3.42 from $3.90 - 4.00. I expect some emotional selling now, which can be a good opportunity for retail investors.
The majority of the analysts are upbeat about the stock, although few have reduced target prices to reflect the impact of COVID-19 on the company's 2020 financial performance. On April 27, JPMorgan analyst Chris Schott cut target price for Zoetis but maintained Overweight rating. On April 23, Cantor Fitzgerald analyst Louise Chen reiterated an Overweight rating and $159 price target on Zoetis shares. On March 23, SunTrust analyst Gregory Fraser lowered the price target for the company from $145 to $112.
There is no doubt that Zoetis is a well-managed company with robust business fundamentals. However, I believe that retail investors can benefit significantly from correctly timing their investment in the stock. Since there is a very high possibility of dampened performance in the second and third quarters of 2020, I believe that the retail investors should gradually build a position in the stock, starting with small positions now. Hence, retail investors with above-average risk appetite should be keeping an eye on this one in 2020.
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