Stock Analysis: Zoetis

The ‘Humanisation of Pets’ is a macro trend that I’ve been observing that I’ve not put any of funds towards in the past. Early this year, I decided to do a deep dive into the largest cap proxy for this trend – Zoetis.

Today, I’ll share my stock analysis and why I invested in the company early this month.

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The Humanisation of Pets

The Humanisation of Pets refers to the trend where pet lovers want more human-like products and services for their pets. It is the trend that drives the “premiumisation” of various traditional pet products and the emergence of indulgences like pet spas.

Some sub-sectors within this trend include:

Food
Toys
Fashion and accessories
Housewares
Healthcare and wellness

This list is certainly not exhaustive, with anything a human could possibly want for themselves potentially applying to pets.

Zoetis, of course, falls under the Healthcare and Wellness sub-sector.

Background and Business Model

History

Zoetis was the animal health division from pharmaceutical giant Pfizer prior to it’s IPO in 2013. The animal health division in Pfizer has been around since 1952.

Pfizer decided to spin off the division as its own separate company in order to unlock value for its shareholders. This also allowed the fast growing division to be free of having to compete with other Pfizer divisions for capital investment.

It has since grown from strength to strength on its own.

Business Divisions

Zoetis’ main business is in the R&D and sale of animal health products. It has 2 key business divisions – Livestock and Companion Animals.

As its name goes, the Livestock division focuses on farm animals while the Companion Animals division focuses on pets. Zoetis’ main business is the production of medications, vaccines and parasiticides for both divisions. There are other small businesses like diagnotics and genetics, but these are not the main drivers for Zoetis’ revenue as these are relatively small.

Division revenue contribution and growth

For the Livestock division, Cattle products contribute about half of the division’s revenue, with an even split between Swine and Poultry for the remaining revenue. Fish and Sheep have a negligible contribution at this time. The main growth driver for the Livestock division is the rising middle class driving demand for meat production.

As for the Companion animals division, Cat and Dog products drive the bulk of the revenue, with negligible contribution from Horses. The main growth driver for the Companion Animals division is the humanisation of pets driving demand for better pet healthcare.

The Company has an even split between US and International revenue. Its Livestock division contributes about 55% of revenue while its Companion Animals division contributes 45%.

Revenue contribution from the Livestock division has been relatively stagnant year on year. On the other hand, the Companion Animals division has been the star of the business, growing its revenue from US$1,455m in 2013 to being on track for US$3,154m in 2019. This represents a doubling of the division’s revenue in just 6 years.

This spectacular performance by the Companion Animal division is largely due to novel breakthroughs in the dermatology space for Dogs, among others. Apoquel and Cytopoint are blockbuster drugs for treating itching and dermatitis respectively which are on track to contribute US$700m to revenue in 2019.

Direct to consumer

Zoetis is unique in the pharmaceutical industry by not using distribution networks for its key markets, opting to sell direct to vets and farm owners through their own sales staff. This model saves cost by cutting out one layer of middlemen.

This is why Zoetis has some of the highest margins in the industry.

Competitors

Zoetis is the largest player in the animal health industry with a market cap of about US$64b. It lists its main competitors as various internal divisions within other big pharmaceutical companies like Merck and Boehringer Ingelheim.

The other 2 listed direct competitors are Elanco and IDEXX Laboratories.

Elanco was spun off from Eli Lilly in September 2018. The company has not performed well since IPO. On the other hand, IDEXX Laboratories focuses on diagnostics and not so much on vaccines and medications. As such, they are not exactly direct competitors.

All in all, animal health is a very competitive industry and heavily reliant on R&D to come up with better products.

Management

CEO Transition

The company saw the end of an era recently. Its CEO since IPO Juan Ramon Alaix retired at the end of 2019, handing over reins to Kristin Peck, who was EVP of US Operations, Business Development and Strategy.

Kristin Peck has been with Pfizer since 2004 and was integral in bringing Zoetis public in 2013. With the length of experience and familiarity with the company, I don’t expect much issue with the transition.

Share buyback history

One area typical of US stocks is that most companies have share buyback programmes. It is necessary to monitor these programmes to ensure that companies are investing in the business and not excessively doing share buybacks.

Zoetis commenced a US$1.5b share buyback programme in 2016 and authorised a US$2b programme in 2018. Here are the company’s buybacks so far:

The company has used up its initial buyback programme of US$1.5b, while using US$450m of its new US$2b programme so far. Free cash flows are still able to support these buybacks so far. However, continued observation of this is needed.

Financials and Ratios

Now, let’s take a look at my favourite part – Zoetis’ financials.

Profitability

Revenue, Gross Profit and Net Profit

Revenue, Gross Profit and Net Profit has been increasing over the years, with acceleration from 2016 due to the development of its blockbuster drugs.

Gross Profit Margin and Net Profit Margins have been growing over the years, maintaining GPM above 63% and NPM above 16% in recent years.

SG&A and R&D Expenses

Selling, General and Admin expense ratio has been compressing thanks to increased revenue over the years. Research and Development expenditure has not compressed as much, indicating continued investment in the business.

Financial Strength

Current Ratio

Current ratio is healthy with current assets well in excess of current liabilities.

Borrowings

Zoetis has levered up over the years taking advantage of low interest rates to make acquisitions and fund its growth. That said, Debt to Asset and Debt to Equity ratios have been stable / declining respectively. Looking at the debt maturity, Zoetis’ debt has relatively long debt maturities, as such risk of default is still remote for now.

Something to continue to observe.

Management Efficiency

Return on Assets (ROA) and Return on Equity (ROE)

The company’s RoE has been impressive, probably due to the leverage used. The company’s return on assets has been growing as well, which is good.

Free Cash Flow (FCF) and FCF to Equity

Free cash flow has seen explosive since 2017. 2019 sees a drop on annualised FCF, which may not be representative at the moment.

Valuation

Zoetis’ trading PE is 45.37, slightly above its 5 year historical median 42.31. As such, there is no margin of safety based on current valuation.

Key Risk Factors

Livestock division stagnant to declining

As you can see, the livestock division has had stagnant revenues for many years, with even potential declines in 2019.

This division is not my favourite part of the company due to its sensitivity to weather elements and diseases. This is because if diseases or weather wipe out livestock, there are less “patients” to sell your vaccines to.

There is also the plant based foods trend. While I can’t imagine a 100% vegan future arriving so soon, it is a small macro trend that will slowly erode the demand for meat.

That said, my bet is on the Companion Pets division more than making up for any declines in the Livestock division.

Highly Competitive Industry

As earlier mentioned, it is a highly competitive industry. It is also heavily reliant on being able to develop new products that are superior to whats available in the market.

Zoetis has done well in this regard in the past, which may not last forever.

Why I invested

Crystalizing my Avenue Therapeutics gain

As you know from my 2019 Performance Scorecard, I was sitting on some hefty gains from my position in Avenue Therapeutics. I wanted to rotate the profits into a growth stock that I can hold for the long term, instead of leaving it in a situation where I either double my money or lose it all.

As such, I’ve taken out my profits in Avenue Therapeutics and put it in Zoetis, while leaving the rest of my position to face the FDA drug approval roulette.

Best Proxy for the Humanisation of Pets theme

As presented earlier, there are many sub-sectors that can potentially play a role in this theme. However, I went with the healthcare sub-sector as I feel it is the sub-sector with the widest economic moat. I can’t imagine pet food, fashion accessories or housewares having a very defensible moat and will be prone to knock-offs.

Pet health is paramount for pet owners and they won’t want to mess around with that. At the very least Zoetis’ drugs will be protected by patents.

Within the healthcare sub-sector, there were a couple of other public entities as potential choices – Elanco and IDEXX Laboratories. I didn’t go with those options as Elanco is not doing well since IPO and IDEXX Laboratories is trading way above its median PE levels.

Thus arriving at Zoetis as the stock of choice.

Strong Financial Performance

The company’s financial performance has been very strong since IPO 7 years ago:

Consistent Revenue and Net profit growth
Strong Gross Profit Margins and Net Profit margins
Consistently high RoE and RoA
Highly cash generative business with FCF growth and high FCF to equity

The only potential issue being the company’s propensity to do share buybacks and increased debt levels over the years. For now, the company’s cash flows and strong balance sheet can afford the debt and share buybacks.

Fair valuation

Purists will view a PE of 45.37 as being very richly valued. I do agree to some extent.

However, it is only trading slightly above its median PE. Also, I’m only investing half my typical position with half an eye on the upcoming earnings result next week, which I expect to be decent. Should the company’s share price tank after earnings, I’m prepared to double up my position when there’s 20% margin of safety.

Final Thoughts

In my opinion, Zoetis is a great proxy for the Humanisation of Pets trend. While it is fairly valued at this time, it may be worth a small position in case the share price continues to run. The key next catalyst on the horizon is its earnings on 5th Feb.

If it drops from its price post earnings or thanks to the Wuhan coronavirus, I’ll be ready to add to my position at a lower price.

What do you think of my analysis of Zoetis? Do you agree with it?