Stocks to Watch in Animal Health: Zoetis and WOOF Lead the Pack

Courtesy of Flickr, Creative Commons

It's a dog's world. Forty-seven percent of American households own at least one dog. In addition to the horde of canines, an estimated 95.6 million felines have human owners (although who owns who is highly debatable with cats).

Money follows love. As a nation, we're expected to shell out a record $58.5 billion on our beloved furry companions this year. That's more than double what America spent a mere decade ago.

With other countries following the trend, companion animal spending is at an all-time high. Meanwhile, improving standards of living in emerging markets are driving up demand for meat protein. To meet the demand, the world's livestock sector is growing at an unprecedented rate, according to the World Health Organization.

These two trends are behind the powerful gains of animal health companies such as Zoetis (NYSE: ZTS), which was spun out of Pfizer (NYSE: PFE) two years ago. In the past year, Zoetis has consistently out-performed its Big Pharma Daddy, both in stock price and earnings gains.

Ready for the kicker? The potential of the animal health space often flies under the radar. Analysts tend to ignore these stocks, despite how minimal generic condition for animal meds gives the industry significant pricing power compared to human pharma. There are also no single payers around (such as government agencies or PBMS) to squash price increases, which can knock a gaping hole in a human health company's profitability almost overnight.

There's clear opportunity in the animal health space for investors not afraid to take a bite. Here are two stocks with solid growth prospects over the long term. The first also has a potential catalyst that could lead to big gains this year.

Bill Ackman snaps up Zoetis
Zoetis (NYSE: ZTS) is the largest global animal health company by revenue, and pays a small dividend of about 0.7%.

Scale is a big deal in the animal health, since it allows for higher margins and stronger growth. Zoetis' size and broad portfolio of drugs helps supports its own sales force, so it can bypass distributors.

Zoetis also has a potentially huge catalyst ahead. Last November, high-profile activist investor Bill Ackman acquired a $2 billion stake in Zoetis and started to work with management. Ackman's stake is roughly 10% of the company, and he now has one director on the board.

Ackman, at the very least, should be able to accelerate efficiencies at Zoetis. But the big question is whether he will engineer another deal, as is his tendency. You may recall Ackman's involvement in the highly-publicized failed takeover of Allergan by Valeant Pharmaceuticals. While Ackman didn't get the deal he wanted with Allergan, the company was bought at a premium after he acquired a 10% stake. Some estimate he made about $2.6 billion on the deal, and Allergan's small shareholders emerged as winners as well.

Ackman has long been allied with Valeant Pharmaceuticals, which has been mentioned as a potential buyer for Zoetis, as well as Novartis, and Bayer. None, however, have marched up to the plate yet. Still, since Zoetis has been fully independent from Pfizer for less than two years, rules governing the tax benefits of such separations could delay bids until sometime this year.

Of course, trying to ride Ackman's coattails is highly risky, as Motley Fool contributor Alexander MacLennan pointed out recently. In addition, Zoetis' stock already had a pop when Ackman bought in. Investors should understand the risk -- there is no guarantee of any buyout bid ever coming.

Long story short, Zoetis isn't a buy based on Ackman's involvement. But in my opinion, the company looks attractive on its own for long-term investors. Ackman's involvement suggests he sees the company as substantially undervalued, something he got right with Allergan.

One risk for Zoetis is worth noting. The FDA recently issued guidelines for the use of antibiotics in livestock. Since the guidelines are voluntary, they won't significantly affect Zoetis sales. That situation could change, however, if they become more restrictive. What Ackman may be seeing is how the pet market and surging demand for animal protein is driving an impressive earnings track record for Zoetis. The company beat estimates in three of the last four quarters (average surprise 3.45%), including the last one.

WOOF's straining at its leash
California-based VCA (NASDAQ: WOOF) reported fabulous earnings last quarter. Revenue jumped 11% to almost $500 million from a year ago, and net income rose 12%. The core of WOOF  is its animal hospital business, which provides 78% of the revenue. The company also boasts a nationwide clinical laboratory system, and is a leader in the highly lucrative field of animal diagnostic imaging.

The animal hospital side of WOOF has the fastest growth, but it is typically a relatively low margin business. The diagnostic testing and device market has much higher operating margins. In fact, these margins hover around 40%, far higher than those of human laboratories such as Quest Diagnostics, for instance, which run around 15%. But WOOF also has competitors in this space, including IDEXX Laboratories and Core Laboratories. 

WOOF has a lower profit margin at 7.38%, than Zoetis' 12.46%, reflecting its lower pricing power. But the company also seems more attractively valued, with stats from Capital IQ showing a lower P/E and P/S of 32 and 2.2, respectively, compared to Zoetis' 41.6 and 5.1.  

Vet medicine and labs are a traditionally fragmented space, but WOOF is aggressively increasing its size through strategic acquisitions. In April, the company bought Abaxis for $21 million, adding to its purchase of MediMedia Animal Health and BrightHeart Veterinary Centers in previous years.

The growing footprint (or should I saw paw-print) has paid off for WOOF, and same-hospital volume is up as well. The company's quarterly same-hospital volume grew every quarter for the past year, with the volume growing almost 2% last quarter.

Should you take a bite out of animal health?
Unlike human health, animal health operates on a cash-and-carry basis, meaning bad debt expense is kept below 1% of sales, much better than the 4-5% historically seen in human hospitals -- and just one more reason to keep a close watch on these stocks. Consistent growth, strong balance sheets, an ever-expanding market -- come to think of it, there's so much to love here, maybe it's even time to take a bite.