ZTS - Animal Kingdom's Ally: Zoetis And Its Path To 10%+ Returns

2024-01-10 13:47:42 ET

Summary

• Zoetis Inc. is a leading veterinarian healthcare provider with a focus on companion animals and the cattle industry.
• The company projects sustained growth through innovative products and strategic investments, targeting a 3-point premium market growth.
• Zoetis is well-positioned to outperform with a strong financial outlook, a diversified portfolio, and the increasing prioritization of pet health.

Introduction

It’s time to talk about one of my favorite healthcare stocks currently on my watchlist. That company is Zoetis Inc. ( ZTS ) , one of the world’s leading veterinarian healthcare providers.

The last time I covered the Pfizer ( PFE ) spin-off was on September 26, when I wrote an article titled " Zoetis Is An Impressive Healthcare Compounder."

Here’s a part of my takeaway (emphasis added):

Its focus on companion animals and the thriving cattle industry positions the company for substantial growth, underscored by robust second-quarter numbers and a clear growth strategy.

Despite market fluctuations, Zoetis projects sustained growth through innovative products and strategic investments , setting a target of 3-point premium market growth .

With a strong financial outlook and a diversified portfolio, Zoetis appears poised to outperform, making it an intriguing choice for investors, potentially offering a 12% annual return amidst market uncertainties.

Since then, its share price has risen by 10%, including dividends, roughly in line with the performance of the S&P 500.

In this article, I’ll update my bull case and explain what to make of the risk/reward going into this year.

Innovation-Driven Growth

As a dog owner, I’m fascinated by the veterinarian healthcare industry, as their capabilities have massively improved in the past decade. On a side note, they have also become much more expensive, which is why I wouldn’t mind finding investments with decent returns.

Zoetis, which has a history of more than 70 years, spun off from Pfizer in 2013, as it would make more sense for the entity to continue as a stand-alone company.

I agree with that decision, as the combination with Pfizer would have made it close to impossible for the market to unlock the value the ZTS ticker brings to the table.

As a standalone company, it provides medicines, vaccines, diagnostics, genetic tests, and other services/products.

Using 29 manufacturing sites and its expertise in seven major product categories, the company has become the market leader in three animal categories, one of them being companion animals.

It also is a top three player in all major product categories and the market leader in North America, Latin America, and Asia.

During the Piper Sandler Healthcare Conference in November, the company discussed the long-term trends in veterinary markets.

Zoetis emphasized the robust tailwinds driving growth, such as the increasing prioritization of pet health, with pets being considered integral family members.

There are plenty of studies supporting this trend, revealing that a significant portion of pet owners would spare no expense for veterinary care.

As we can see below when faced with a 20% decrease in their budget, pet owners will not spend less on their pets - that’s extremely anti-cyclical.

Meanwhile, in the production animal sector (animals we eat), the focus is on innovation to address unmet needs driven by the demand for healthy animal protein.

The growing middle class and population in emerging markets are expected to contribute to sustained growth in this sector, which means that a rising population requires more protein.

As more animals in large barns come with more health risks, this is a steadily growing market for ZTS.

The OECD expects demand for meat to rise by 41 million tons to 382 million tons by 2032.

Furthermore, as the chart below shows, especially nations that are seeing the early stages of middle-class growth are expected to see rapid growth in meat consumption. Once a nation reaches a more developed stage, higher income does not necessarily mean more meat consumption.

Adding to that, the OECD also agrees with Zoetis, as it notes risks related to a more dense farm animal population (in this case, poultry):

However, a high density of poultry production may lead to disease issues. For example, ongoing outbreaks of highly pathogenic avian influenza ("HPAI") affect poultry and egg production in many countries. However, outbreaks are easily detected due to high mortality rates and clinical signs associated with the disease. This allows for the rapid implementation of control measures and effective vaccines to prevent their spread. In addition, once contained, the short poultry production cycle allows for quick recovery.

Going back to Zoetis, the company also noted that despite potential headwinds like labor constraints impacting veterinary visits, it sees that visit growth is not the primary driver of the industry's growth.

The emphasis remains on innovation, higher prioritization of pet health, and the overall well-being of animals, which will eventually see additional tailwinds from easing labor constraints.

Note that despite some headwinds, the company has seen market-beating revenue growth on a very consistent basis, including a surge in adjusted EBIT margins from 34% in 2017 to 38% in 2022.

The company aims to maintain outperforming growth through significant investments in R&D.

By focusing on areas such as chronic kidney disease, cardiometabolic issues, and oncology, the company can stay ahead of market demands and position itself as a leader in emerging therapeutic categories.

As we can see below, despite accelerating revenues, the company maintains elevated R&D investments, spending $0.07 of every dollar in revenue on R&D.

This brings me to its shareholder value.

I Continue To Expect Elevated Returns

In its most recent (third) quarter, the company achieved 8% operational growth in revenue and 13% operational growth in adjusted net income.

Despite challenges in the Chinese market, there was balanced growth internationally. In the U.S., the companion animal portfolio grew by 11%, and the livestock portfolio grew by 3%.

The diagnostics portfolio showed a strong year-over-year performance with 14% operational growth in the third quarter. The company is refining its business to better serve customer needs, emphasizing AI technology and virtual lab services.

Going forward, key companion animal franchises, such as dermatology and parasiticides, are expected to be core catalysts for growth.

Meanwhile, the U.S. launch of Librela, a canine monoclonal antibody for osteoarthritis pain, has been successful. The company is also focusing on increasing the medicalization of cats with products like Solensia.

Furthermore, despite economic and geopolitical uncertainties, the company anticipates continued growth in 2023 and into 2024.

The strong underlying customer demand is expected to persist, although recovery in China remains uncertain.

As a result, the company expects double-digit operational growth for the companion animal portfolio and low single-digit growth in the livestock portfolio.

Unfortunately, due to unfavorable foreign exchange rates, the reported revenue range has been revised.

The company now expects 2023 revenue between $8.48 and $8.55 billion, reflecting a range of 6.5% to 7.5% operational growth. The year-to-date operational revenue growth of 7% aligned with prior expectations.

Adjusted net income is projected to be in the range of $2.49-$2.51 billion, slightly lower due to the aforementioned unfavorable foreign exchange.

Operationally, the growth expectations are narrowed to a range of 7.5-8.5%.

With that in mind, analysts expect the company to maintain consistent EPS growth.

How consistent?

Looking at the chart below, analysts expect 11% EPS growth in 2024, 2025, and 2026.

While the numbers are obviously subject to change, they indicate a favorable risk/reward.

Using the data seen in the chart above:

• ZTS shares are trading at a blended P/E ratio of 35.9x.
• The normalized valuation multiple is 31.1x.
• Over the past five years, the company has traded at a normalized valuation multiple of roughly 34x.
• If the company remains in that valuation range, the expected EPS growth trajectory could pave the road for 7% to 10% annual returns through 2026.

Since its IPO, the stock has returned more than 18% per year.

It has an investment-grade credit rating of BBB with a 0.9x 2024E net leverage ratio, which is very healthy.

If the stock were to drop to $180, which is where the stock was during my prior coverage, the expected total return would exceed 12%.

Hence, as I believe that the market has run hot over the past few months, I'm looking for a possible correction opportunity over the next few months to improve the risk/reward even more.

Needless to say, that strategy comes with missing more potential upside.

Takeaway

Zoetis stands out as a compelling choice. As a leader in veterinarian healthcare, Zoetis capitalizes on strong tailwinds, focusing on companion animals and the booming production animal sector.

Meanwhile, innovation remains at the forefront, with sustained investments in R&D, driving market-beating revenue growth.

Despite economic uncertainties, the company anticipates continued success in key franchises, projecting double-digit operational growth for the companion animal portfolio.

Analysts foresee consistent EPS growth, suggesting a favorable risk/reward for long-term investors.

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