Zoetis (NYSE: ZTS) develops, manufactures and distributes animal health products ranging from drugs, vaccines and diagnostics. Since its split from Pfizer (PFE) in 2013, Zoetis has grown significantly and gained a leading position in the animal health industry. With their diverse portfolio, global scale, and strong R&D department, I expect them to have long-term success. Plus, it’s a great investment choice regardless of economic conditions, as people tend to remain committed to the health of their pets. I think Zoetis is a solid investment choice for a long-term investor because:
- Zoetis enjoys a strong economic moat with technological superiority, brand recognition and economy of scale. They are the market leader in many sub-sectors of the animal health industry.
- Zoetis experienced solid growth, while increasing its profit margin.
- Strong growth, profitability and financial position allow them to consistently increase shareholder returns.
Economic swing and attractive market position
Zoetis has a really attractive market position. Animal health (livestock and pets) is becoming increasingly important and the market is growing rapidly. According to research, the animal health market in North America is expected to grow at 10.2% per year. As a leader in various positions, Zoetis will get a big tailwind from this trend.
Moreover, this growth of the animal health market is multifaceted. In the livestock segment, the need for productivity and efficiency, a challenging labor shortage, food safety and animal welfare are driving the growth of medicines, vaccines and diagnostics . In companion animals, the humanization of companion animals and the commitment of pet owners are driving the growth of animal health and specialty care budgets. Overall, a growing global population, rising middle class and increasing protein consumption are the macro drivers for the segment.
Like healthcare companies that focus on human treatment, it’s important for animal healthcare companies to maintain a strong pipeline through R&D investments. Zoetis has been excellent in this area. They employ 1,300 people in R&D operations and have established collaborations with several different companies/research centers. Recent collaborations include Colorado State University (livestock immune system), Texas A&M (transboundary and emerging diseases) and Syngene (monoclonal antibody for osteoarthritis). With substantial investment in R&D, I expect Zoetis to maintain its wide economic moat going forward.
Terrific pipeline and growth
Through R&D and collaborative efforts, Zoetis has built a truly formidable pipeline, which naturally leads to strong revenue growth and increased profit margin. Their revenue has grown 10% annually over the past 5 years and the EBIT margin has grown from 24% in 2013 to 36% in 2022. As a fundamental-focused investor, expanding the profit margin is one of the best indicators of a deepening economic gap and increasing operational efficiency. Combined with the solid growth rate, this makes for a great combination of both worlds.
Solid financial position and shareholder return
Zoetis has a very strong financial position with high liquidity. Their running ratio (2.25x) and quick ratio (1.45x) are well above the industry average. In addition, their operating cash flow has been increasing for several years. This strong financial position and strong cash flow has allowed Zoetis to steadily increase the dividend. The dividend has increased by 21% per year over the past 5 years. In addition, they repurchased common shares ($949 million in the last twelve months). I expect them to continue to reward shareholders for the foreseeable future.
I ran a discounted cash flow (“DCF”) calculation to estimate the intrinsic value of Zoetis. For the estimate, I used EBITDA ($3,246M) as the cash flow indicator and the current WACC of 8.0% as the discount rate. For the base scenario, I assumed 23% EBITDA growth for the next 5 years (average EPS growth rate) and zero growth thereafter (zero terminal growth). For the bullish and very bullish case, I assumed 25% and 28% EBITDA growth, respectively, for the next 5 years and zero growth thereafter.
The calculation shows that Zoetis is undervalued by around 10-20% at this point. With a market-leading position in the animal health industry and a tremendous pipeline, I expect Zoetis to realize this advantage.
Very bullish case
The assumptions and data used for the price target estimation are summarized below:
- WACC: 8.0%
- EBITDA growth rate: 23% (base case), 25% (bullish case), 28% (very bullish case)
- Current EBITDA: $3,246M
- Current stock price: $177.42 (07/19/2022)
- Tax rate: 20%.
Cappuccino Stock Rating
|Strength of the economic gap||30%||5|
|Growth rate vs sector||15%||3|
Economic Gap Strength (5/5)
Zoetis is the largest animal health company in the world, and it will be for quite some time. They hold several leadership positions in several different fields (vaccines, drugs and diagnostics). With its formidable R&D team and strong collaborations, Zoetis will maintain its competitive edge in the future.
Financial strength (4/5)
Zoetis has a strong balance sheet with ample cash ($3.2 billion) and high liquidity (current ratio and quick ratio above industry average). In addition, their operating cash flow is constantly increasing. With an expanding profit margin and revenue growth, their financial strength will only improve.
Growth rate (3/5)
Zoetis has been growing solidly (~10% per year), and will do so for the foreseeable future. A steadily growing pet and livestock healthcare market will provide a tailwind.
Safety margin (4/5)
Market volatility has taken down many large companies, including Zoetis. Their stock price has risen from $250 to its current level, creating a great opportunity for investors. The current price level is undervalued by 10-20% and the stock price will continue to grow in the future.
Sector outlook (4/5)
Just like the human health industry, the animal health industry will experience steady growth in the future. A growing population, strengthening middle class, and increased interest in animal health will all contribute positively to the growth of the animal health industry.
Even with their share price falling, Zoetis’ valuation is still above the industry median. Their P/E ratio (33.89x) is almost double the industry median (18.86x). Moreover, their price-to-sales ratio (10.31x) is also above the industry median (4.66x). This strong valuation represents high market expectations, so if Zoetis misses an expectation of growth in the future, it could lead to a sharp drop in the share price.
During the last quarter, the livestock portfolio declined by 6%, mainly due to the competition for pork products in China and increased competition from generic brands. Combined with inflation, pressure on generic brand prices could reduce Zoetis’ revenue margin. Especially during a recession, farmers and ranchers might be more willing to switch to a generic brand. Therefore, the investor should monitor this development.
Zoetis has grown and expanded its margins over the past few years. They have a strong economic moat, and I expect them to successfully defend that moat for some time with their strong R&D team and collaboration. Their formidable portfolio of healthcare products should generate solid growth. Price pressures from generic brands can pose problems, so investors should keep an eye on the performance of the livestock segment. Overall, I expect a 10-20% upside from here.
Marketplace in preparation
Thank you all for reading my article. I am in preparation for a Marketplace launch soon. Please be excited! Also, let me know what types of analysis or information you would like to see more of in my articles. I will consider it for the market. Thank you all for your support!