Wall Street is often willing to pay extra to sleep better at night, and Zoetis (ZTS 2.25%) is the sort of business that won't often lead investors to lose much sleep. The largest player in animal health, Zoetis is in the top three in every relevant sub-market it addresses and is often #1 or #2, but its leading product is less than 10% of sales and the top 10 list of products is less than 40% of revenue. Helping Zoetis' valuation even further is the relative lack of alternatives – companies like Neogen, Virbac, and Dechra are much, much smaller (and harder to own for larger funds), while the big comparables remain locked within large pharmaceutical companies like Merck (MRK 0.05%), Sanofi (SNY 1.29%), and Lilly (LLY 1.87%).
The biggest name in a large space
At its largest possible definition, the animal health space is probably somewhere around a $100 billion global market, with antibiotics, medicinal feed additives, vaccines, parasiticides, and other medicines making up a still-significant market worth around $22 billion to $23 billion and growing 5% to 6% a year. The majority of the market (around 60%) is made up of treatments for so-called "production animals", animals like cattle or swine raised for food, and the rest is for companion animals.
Previously part of Pfizer, Zoetis is easily the largest company in the space. At over $4.5 billion in revenue, Zoetis holds an estimated market share of 20%, with pretty consistent share across its operations (from a low of around 16% share in swine to 22% in cattle). By way of comparison, Merck holds about 16% share, Sanofi holds 13%, and Lilly currently has around 9% share but will grow to 14% with the acquisition of the Novartis animal health operations.
What makes Zoetis a little unusual is that it's very well-balanced. The U.S. is about 40% of sales, but the company has a large global presence. The largest product for the company (ceftiofur, an antibiotic) is about 7% to 8% of sales and the top 10 list of products contributes less than 40% of revenue. By comparison, the parasiticide Frontline accounts for around 30% of Sanofi's animal unit sales, while Lilly and Bayer also get more than 25% of their animal health revenue from a single product/product line.
Zoetis plays in all of the major product categories, with anti-infectives making up nearly one-third of sales and vaccines making up another quarter or so. Parisiticides and medicinal feed are smaller business (15% and 8% of revenue), but still large enough to give the company #3 and #2 global market share, respectively (Lilly is larger in fees, while Sanofi is the largest player in parasiticides). Zoetis likewise plays in all of the large markets – cattle, swine, poultry, and companion animals.
A good place to be for the long term
It's not hard to like the animal health space from a long-term perspective. Rising incomes have thus far correlated pretty strongly with higher animal protein consumption, suggesting that the ongoing development of countries like China, India, and Brazil ought to lead to more demand for livestock, and thus larger herds (and more demand for health care products). Rising incomes also tend to correlate with spending on companion animals, and companies have gotten more aggressive about taking drugs originally designed for human use (particularly in areas like oncology) and adapting them to the companion animal market.
Relative to the human pharmaceutical market, there are some particular positive aspects to the animal health space. As veterinary care and medicine is only about 3% to 5% of the cost of raising food animals, there isn't as much pushback on price (though it's also well worth noting that the nature of raising a food animal is such that you're not going to have an animal treated for arthritis for 20-plus years).
There is also relatively little threat from generics. Only about 20% of Zoetis' portfolio is covered by patents, but generics just aren't much of a threat, even though companies like Sanofi have internal (human) generics operations. Some claim that generics struggle to gain share because of the influence of strong brands, but I believe that a lack of distribution infrastructure plays a bigger role, particularly when individual generic drugs aren't likely to generate substantial revenue. Were a significant generics movement to begin, it would most likely have to come from an existing player and that could be self-defeating if it prompts responses in kind.
Last and not least, developing drugs in this space is a lot easier. Human drugs require over 10 years and $1 billion on average, but animal health products are typically developed in less than five years for less than $10 million. With useful product lives of over 20 years in many cases (and little generic threat), that supports attractive ROIs.
Built to win
I believe the recent move toward consolidation in the animal health space is more of a recognition of the advantages of Zoetis' model than a direct threat. Zoetis has a broad product portfolio, a deep pipeline (over 400 compounds), and the largest sales force (and one that provides strong technical support). While consolidation is likely to make Lilly a better company and there are some incremental opportunities for Bayer, Sanofi, and Boehringer Ingelgeim to get bigger, Zoetis already has the model that others want to copy.
I expect Zoetis to generate revenue growth in the neighborhood of 4% to 5% a year for the long term, with more than double that rate of growth in FCF as the company better leverages investments in overseas/emerging market sales and distribution infrastructure. A services agreement with Pfizer should also facilitate ongoing access to that company's compound library for many years to come (though not necessarily indefinitely).
The bottom line
Compared to human pharmaceutical companies, Zoetis is neither particularly cheap nor worryingly overpriced. I'd also point out that the limited number of close comps in animal health are not exactly cheap by conventional metrics either. I don't see enough margin of safety here to make Zoetis compelling at these prices, but the quality of the underlying business is such that I'd look in on this name from time to time in the hopes that the market overreacts to a quarterly report or similar piece of news and creates an opportunity in the shares.
