Zoetis: Expensive But Precision Livestock Farming Division Could Be Game Changer

Oct. 26, 2021 1:11 PM ETZoetis Inc. (ZTS)5 Comments
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Summary

  • Zoetis is the leader in pharmaceutical drugs, nutrition, and diagnostics for companion animals and livestock.
  • Both its segments benefit from demographic tailwinds and rising affluence, which enable people to spend more on pets and consume more animal protein.
  • The pet segment was boosted by increased pet spending and the rollout of several blockbuster drugs. The livestock segment has grown less but has a strong pipeline of innovative drugs.
  • Zoetis stock is expensive, but its Performance Livestock Analytics division has potential to be a game-changing precision livestock farming platform, which could create significant long-term value for investors.
  • I intend to grow my position over time but will be closely watching the performance of the company’s precision livestock farming division as I add to my position.
Handsome caucasian farmer in overall crouching next to calf, using tablet and smiling. Stable interior.

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Thesis

Zoetis (NYSE:ZTS) is the leader in pharmaceutical drugs, nutrition, and diagnostics for companion animals and livestock. Both segments have benefited from demographic tailwinds and rising affluence, which enable people to spend more on their pets and consume more animal protein. Long term growth in the companion animal segment was boosted by increased pet spending, higher adoption during the COVID pandemic, and the rollout of several innovative blockbuster drugs. Zoetis' livestock segment has shown less growth, but the upcoming rollout of new drugs and vaccines should kickstart growth.

At a free cash flow yield of under 2%, the valuation is expensive, but Zoetis' Performance Livestock Analytics division has the potential to become the leader in precision livestock farming, which could boost earnings and create significant value for investors over the mid- to long-term.

Company Background

A leader in the animal health sector, Zoetis has the stated objective to predict, prevent, detect, and treat animal diseases. It discovers, develops, manufactures, and commercializes medicines, feed additives, vaccines, and diagnostic products for companion animals (i.e., dogs, cats, and horses, 51% of revenues) and livestock (i.e., cattle, swine, poultry, fish, 49% of revenues) (figure 1). Its broad and diversified portfolio covers 300 product lines across 8 animal species and includes 13 blockbuster drugs with annual revenue of over $100 million each.

Figure 1: Zoetis key facts

Zoetis key facts

Source: Company presentation (as of Dec 2019)

Zoetis' products and services enhance the quality of our lives by improving the health of animals that are important to us--it brings emotional happiness to the owners of healthy pets, and it raises the growth efficiency and quality of livestock that provide protein to humans.

The company has demonstrated the ability to grow its markets through innovation by bringing human health research knowhow to the animal market. With over $7 billion in annual revenues today, it is one of the largest animal health companies and has leading positions in its product lines and geographies around the world (figure 2).

Figure 2: Market leadership

Zoetis Market leadership

Source: Company presentation

Industry growth characteristics

According to management, Zoetis' target market has historically grown at an annual rate 4-6% (figure 3, grey bars). This growth rate is driven by several macroeconomic and demographic trends:

  • The world's population is increasing by 1.1% annually (source: World Bank). As a result, more livestock is needed to feed more people
  • The middle class is growing around the world. As people become more affluent, they consume more animal protein, and they begin to humanize and spend more lavishly on their pets
  • Pet ownership will continue to increase, particularly amongst millennials, Gen-Zers, and in countries with an aging population and where the elderly live alone
  • With the increased emphasis on sustainability, raising healthier and more thoughtfully bred livestock results in less waste of society's resources.

As the company's products constitute a relatively di minimus portion of the pet and livestock owners' overall expenses, demand is generally less elastic. Management notes that the company has been able to raise prices by ~2% annually over time. As such, the company’s revenues have consistently outgrown the market. (orange bars)

Figure 3: Comparison of market growth vs revenue growth

ZTS Comparison of market growth vs revenue growth

Source: Company presentation

The company was a division of Pfizer until 2013 when it was spun out into a separate animal health company. Since the spinout, the company’s revenues have grown from $4.5 billion to almost $7.5 billion (figure 4, green line). The gross margin has increased over time due to its pricing power (figure 5, green line), as has the EBITDA margin from operating leverage (figure 6, green line).

Figure 4: Zoetis trailing twelve month revenues

Zoetis trailing twelve month revenues

Source: Created by author using publicly available company financials

Figure 5: Zoetis gross margin expansion

Zoetis gross margin expansion

Source: Created by author using publicly available company financials

Figure 6: Zoetis EBITDA margin expansion

Zoetis EBITDA margin expansion

Sales by segment

The company’s companion animal segment has grown strongly and more than doubled since 2016 (figure 7, green line). In contrast, the livestock segment has been relatively flat over the same period (orange line).

Figure 7: Zoetis companion revenues: animal vs livestock segment

Zoetis companion revenues: animal vs livestock segment

Source: Created by author using publicly available company financials

Sales by geography

Zoetis’ US sales constitute ~55% of its total revenues and is more heavily weighted towards companion animals (figure 8, blue line for the US vs orange line for international markets). In comparison, the ~45% of international sales is more skewed towards livestock (green line for international markets vs red line for the US). The growth trends for each of the segments are relatively similar between the US and internationally.

Figure 8: US vs international growth

ZTS US vs international growth

Source: Created by author using publicly available company financials

Companion animal segment

Zoetis’ companion animal segment growth is driven by long term pet spending trends that accelerated during the COVID-19 pandemic, as well as new product innovation in both pharmaceuticals and diagnostics.

Increased pet spending

The American Pet Products Association estimates that 70%, or 90.5 million US households own at least one pet in 2020, up from 56% in 1988. Of these households, 50% have dogs, 35% have cats, and 3% have horses. Trackimo noted a 29% increase in dog ownership in the US over the last decade, with multiple-dog households growing at a faster rate.

In 2017, the American Pet Products Association estimated that spending on pets doubled from $36 billion in 2005 to $72 billion in 2018 (figure 9). It subsequently revised the numbers upwards to $90.5 billion for 2018, $97.1 billion in 2019, and $103.6 billion in 2020. Spending was further boosted by the increase in pet adoptions during the COVID-19 lockdowns around the world, with pet spending projected to further increase by 5.8% to $109.6 billion in 2021.

Pet spending is stable over the economic cycle. For example, even though overall consumer spending declined in the US during the 2008-10 recession, pet spending actually increased by 12% over that period (shaded recession box).

Figure 9: Estimates of the US pet industry size

ZTS Estimates of the US pet industry size

Source: American Pet Products Association, via Chewy’s S-1 filing

Spending on pet healthcare, which includes drug prescriptions and pet health insurance, has grown even more rapidly than the overall spending . According to the American Pet Products Association, approximately 25% of dog and cat owners surveyed said they would prioritize their pets over themselves when considering large medical expenses while another 25% were not sure who they would prioritize. In addition, approximately 75% of dog owners and more than 50% of cat owners administered medication or drugs to their pets in 2016. Of the projected $109.6 billion of pet spending for 2021, $32.4 billion or 30% will be spent on healthcare services and pharmaceutical sales (excluding OTC medicines, figure 10).

Figure 10: Pet medication market size

Pet medication market size

Source: Packaged Facts, via Chewy’s S-1 filing

New owners of pets are required to vaccinate their pet at the time adoption, and they enter into what is in effect is a long-term commitment to care for the pet for its 10+ year life. This includes annual wellness visits and booster shots, which creates a recurring revenue stream for veterinarians and the suppliers of diagnostic equipment, vaccines, and pharmaceuticals.

Through the pandemic, pet owners have spent more time at home with their pets and become more attuned to the health condition, needs, and ailments of their pets, driving more visits to the vet and thus additional demand for medication and vaccines. This will continue as many companies will likely allow employees to continue working remotely from home at least part of the time.

Revenues for Zoetis and its competitors have steadily increased over time (figure 12). Furthermore, pets’ healthcare needs increase as the animals age, which will create additional demand for Zoetis pharmaceuticals and diagnostic equipment over the next decade.

Figure 12: Revenues of ZTS, IDXX, Freshpet, and Chewy

Revenues of ZTS, IDXX, Freshpet, and Chewy

Source: Created by author using publicly available company financials

Companion animal product innovation

Pharmaceuticals

Zoetis has launched several innovative blockbuster companion animal drugs over the last few years and continued to invest large amounts of resources and money to adapt human immunology and vector vaccine research and development to animal health.

The success of Zoetis’ innovative pharmaceuticals pipeline has driven sales of its companion animal market considerably, which encompass several categories, including:

  • Dermatology: Apoquel and Cytopoint for dogs, which prevent skin itches and scratching, grew 22% year-over-year and have mushroomed into a billion-dollar drug (figure 13, olive line)
  • Parasiticides: Simparica Trio, a triple-combination parasiticide that protects dogs from ticks/fleas, heartworms, and roundworms/hookworms grew $200m year-over-year. The company's Proheart anti-worm treatment is also driving sales growth in the category (purple line)
  • Other pharmaceuticals: Zoetis developed Solensia for dogs and Librela for cats by adapting monoclonal antibody technology licensed from Regeneron (REGN) to treat pain from oesteo-arthritis that is common in older pets. They have received regulatory approval in Europe and Canada, and US approval is expected in 2022. (green line)
  • Vaccines: Versican Plus, which protects dogs against respiratory diseases, received approvals in Europe. Versican, together with Core EQ Innovator, which protects horses against a combination of five potentially fatal diseases, are driving growth in this category. (orange line)

Pharmaceutical sales will inevitably continue to grow as these drugs gain popularity amongst veterinarians and Zoetis receives regulatory approval in additional countries around the world.

Figure 13: Companion animal revenue by product category

Companion animal revenue by product category

Source: Created by author using publicly available company financials

Diagnostics

Zoetis’ diagnostics grew revenues 38% in 2Q 2021, outpacing the growth of the animal healthcare market. Zoetis’ 2019 acquisitions of Abaxis, Phoenix Lab, and ZNLabs gives it the ability to offer both onsite and reference lab diagnostics to help veterinarian clients prevent, diagnose, and treat animals. Even though Zoetis is playing catchup behind pet diagnostic leader IDEXX Laboratories (IDXX), the diagnostic segment has been among its big revenue growth drivers (figure 9 above, pink line), and will likely increase in importance as Zoetis leverages its salesforce to cross-sell diagnostic equipment and supplies to its base of existing veterinarian clients.

In 2020, Zoetis announced Vetscan Imagyst, the first cloud-based diagnostic platform that uses image recognition technology, algorithms and cloud AI capabilities to improve testing results. The software and connectivity should dovetail well with the company’s longer term efforts to create a comprehensive cloud-based animal health platform.

To summarize, the companion animal market’s growth was boosted by increased spending and adoption of pets through the COVID-19 pandemic. Furthermore, Zoetis’ sales should increase as animals age, the company receives regulatory approvals in more countries for its new pharmaceutical products, and its strategy to cross-sell diagnostic products to existing veterinarian clients gains momentum.

Livestock segment

In contrast to the companion animal segment, Livestock revenues have been flat over the last 5 years. However, there are new drugs in the pipeline that are expected to kick-start growth. More exciting is the company’s initiative to build a leading cloud-based digital precision livestock farming platform.

Flat livestock revenues

Livestock revenues have been flat over the last 5 years (figure 14, brown line) due to the following dynamics:

  • Swine: sales declined after the African swine fever outbreak in 2018 which necessitated the large-scale culling of herds throughout China and Asia, causing swine population to decline by 100 million in China alone (orange line). Sales are recovering as countries begin rebuilding their swine industries
  • Poultry: sales grew through 2020, but are beginning to decline due to Zoetis’ loss of exclusivity for the poultry vaccine Draxxin (green line)
  • Cattle: revenues declined in 2019 as the excess supply of cattle disincentivized herd owners from spending on vaccines (blue line), but according to management, the excess appears to be bottoming out
  • Fish: the company’s entry into this category through the acquisition of Norway-based Pharmaq in 4Q2015 drove significant growth (red line), but was insufficient to offset the revenue decline in the cattle category over the last 2 years

Figure 14: Change in revenues, by livestock species

Change in revenues, by livestock species

Source: Created by author using publicly available company financials

Livestock pharmaceutical pipeline

Zoetis is building upon its early success in vector vaccines, as Poulvac Procerta was the first poultry vector vaccine approved in the US. This is expected to be followed by Newcastle and IDB, which will expand the portfolio and partially offset revenue declines stemming from the loss of exclusivity for the Draxxin poultry vaccine, which saw sales decline by 19% year-over-year due to share gains by generics.

Zoetis received USDA approval for two additional products: (1) Fostera Procine for swine that protects against two genotypes of the Circovirus vaccine, and (2) Bovi-Shield for cattle that protects against deadly bovine viral diarrhea, respiratory diseases, and parainfluenza. These new products are expected to contribute to longer-term growth as they receive regulatory approval from more countries around the world.

Building a digital precision livestock farming platform

In April 2020, Zoetis Acquired Performance Livestock Analytics, a cloud-based data management digital platform for cattle consisting of two products: (1) Performance Beef, which allows users to analyze feed intake, monitor animal health, and track costs and performance, and (2) Cattle Krush, which enables users to track profitability by lots and integrate decisions with real-time pricing information from the Chicago Board of Trade.

Zoetis already has many of the requisite pieces needed to build a digital precision livestock farming platform for cattle, including the eartag tracking technology for cattle identification; diagnostic equipment for genomic tests and diagnostics; and feeding lot and weight sensors to measure feed conversion. In addition, the software's health monitoring capabilities can potentially be used to track the efficacy of Zoetis and competitors’ vaccines and pharmaceuticals as well as how animals with different genotypes might respond to different medications and feeds.

I expect the company to expand its APIs and develop partnerships to extend the capabilities of the software (as an example, it can potentially be connected with SoundTalks NV’s automated microphone systems designed to detect and analyze pig coughs for respiratory diseases). By applying AI and machine learning algorithms to data collected, the digital platform can drive and improve animal health, feed conversion, culling decisions, more efficient breeding, and potentially optimize vaccine and drug efficacy. At the right time, the technology can also be adapted for other animal species.

Management noted in its 4Q 2020 earnings call that precision livestock farming is an important area of focus for individual animal care and herd monitoring, but has not provided detailed updates. However, there is good information on the company’s website that gives those who are curious a glimpse of the many possibilities.

This is a large and complex data analytics project that is not part of Zoetis’ research and development DNA. However, in an interview given by Dane Kuper, the CEO of Performance Livestock Analytics, Dane cited access to the Zoetis’ resources and intellectual property as a factor that could help Performance Livestock achieve its objective more quickly. If Zoetis succeeds in building and transforming itself into a data-centric platform for livestock owners around the world, its SaaS (software as a service) characteristics will create wide moats, drive earnings, and create significant value for shareholders.

Future growth and valuation

Management guided investors to a low-teens revenue growth for 2021, reflecting the continuation of the strong 2Q 2021 operational revenue growth (36%) in companion animals and some moderate (3%) improvement in livestock. Operating margins should continue to expand over the long run due to operating leverage so earnings could continue to grow in the low to mid-teens.

Zoetis stock is currently priced at a free cash flow yield of 1.8% (figure 15, orange line), which is expensive if the company’s growth comes primarily from its pharmaceuticals and diagnostic segments. However, embedded in the company’s stock price is an option on the potentially transformative, game changing precision livestock farming platform, which can become very valuable if successful.

Figure 15: Zoetis valuation

Zoetis valuation

Source: Created by author using publicly available company financials and stock price data

Concern

My main concern is the high valuation discussed in the previous paragraph, which leaves little room for error, or revenue or earnings misses.

Summary

Zoetis is the leader in pharmaceutical drugs, nutrition, and diagnostics for companion animals and livestock, both of which should continue to benefit from demographic tailwinds and rising affluence which enable people to spend more on pets and consume more protein. Growth in the pet segment will likely continue due to increased pet spending, the growing recurring revenue from pets adopted during the COVID pandemic, and the growth in sales of its innovative blockbuster drugs. While the livestock segment has been relatively flat, growth should start picking up with the rollout of new drugs in its pipeline.

At a free cash flow yield of under 2%, the valuation is expensive, but Zoetis has potential to become the leader in precision livestock farming, which could boost earnings and create significant value for investors over the mid- to long-term.

I intend to grow my position in Zoetis over time but will be closely watching progress of the company’s precision livestock farming division as I add to my position.

This article was written by

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I strive to unearth less obvious, overlooked, or under-appreciated but intriguing and potentially profitable data-driven insights into companies of service to society.   I would be grateful if you call out blind spots, flaws, or gaps in my observations or reasoning. I hope you enjoy my contributions, but please do not take them as investment advice!

Disclosure: I/we have a beneficial long position in the shares of ZTS either through stock ownership, options, or other derivatives. 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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