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U.S. cattle populations are at the lowest since 1950, and the likely imminent rebuilding is seen as an opportunity. (Michael Falco For The Globe and Mail)
U.S. cattle populations are at the lowest since 1950, and the likely imminent rebuilding is seen as an opportunity. (Michael Falco For The Globe and Mail)

PHARMACEUTICALS

Could Zoetis’s run start a stampede? Add to ...

Medicating humans is a pretty good business. Taking care of the animal kingdom may be even better.

We might infer this from the success of Zoetis Inc., the maker of animal medicines and vaccines. It is the former animal-science division of pharmaceutical giant Pfizer Inc., spun off earlier this year in an initial public offering. Pfizer sold Zoetis shares at $26 (U.S.) in February, saw them rise more than 20 per cent the first day, and ultimately trade above $35.

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A minor pullback has since knocked a few bucks off the stock price, but Zoetis (pronounced z-EH-tis, a word that was “derived from zoetic, meaning ‘pertaining to life,’” the company says) is still more expensive than the pharmaceutical companies that spend the bulk of their time on humans (shares closed down 43 cents Friday at $31.15). The company’s price-to-earnings ratio tops 21, according to Standard & Poor’s Capital IQ, while its former parent and its competitors all trade between 12 and 16 times earnings. Zoetis pays a paltry 0.8 per cent dividend, while the other big pharma companies all yield more than 3 per cent.

Zoetis’s premium price is deserved, bulls say, because it’s the only game in town for investors who want to bet solely on a big player in animal medicine, a business with strong long-term growth trends and lower risks than human medicine. (“In animal health, you don’t have Medicare cutting reimbursements,” notes Kevin Ellich of Piper Jaffray.)

If Zoetis shares continue to rise, however, investors could find another way to win: By buying big pharma names like Merck & Co. Inc., Sanofi or Eli Lilly and Co., all of which have multibillion-dollar animal science divisions that might also one day see new life as separate, publicly traded concerns.

While it’s tempting to think of Zoetis as a pet story, primarily making medicines for “companion animals,” as they’re known, the company actually gets two-thirds of its sales from medicine aimed at livestock and other creatures that we eat – “production animals,” as they’re inelegantly called.

The world’s population of production animals is set to rise to meet the demands of the worldwide carnivore majority, particularly in developing nations, which are demanding more protein in their diets as living standards rise. “If protein consumption continues to go up globally, there are going to be that many more animals to be raised and treated, and that will drive Zoetis’s results,” says Michael Levesque, an analyst at Moody’s Investors Service who rates Zoetis’s debt.

Because of this, Zoetis is in many ways an agricultural-inputs stock. It rises with the global food-consumption thesis and falls on news of higher prices for corn or wheat, since more expensive feed may squeeze ranchers’ budgets and prompt them to cut back on vaccines and other medications for their herds. Among Zoetis’s products for beef cattle is Excede, an antibiotic for respiratory disease, and Draxxin, another antibiotic used to treat respiratory disease and foot rot.

Piper Jaffray’s Mr. Ellich, who has an “overweight” rating and a $39 price target (versus recent Zoetis trades below $32), recently completed a tour of cattle ranches, where the operators expressed optimism as per-head profits recently turned positive after corn prices fell.

Mr. Ellich says a big part of his optimism regarding Zoetis is based on a historic low in the number of cattle being raised in the United States. “Herds are at the lowest since 1950 because of last year’s drought, and it’ll take two to three years to replenish them. I think that’ll provide a tailwind.”

The one-third of Zoetis’s sales that come from pets also benefit from strong long-term trends. Outside of a blip in the numbers during the recent Great Recession, pet ownership has been on a long-term upward trend, as have the amounts that owners are willing to spend keeping their animals healthy. (The American Pet Products Association estimates U.S. pet expenditures have gone from just under $30-billion in 2001 to more than $55-billion this year, Moody’s says.) Zoetis makes a broad range of medications for cats and dogs, including Convenia for bacterial skin infections and Revolution, which removes fleas and other parasites.

There are other reasons Zoetis’s core businesses are less risky than human care. The health-care analysts at Morningstar note that there are no blockbuster animal drugs that go “off patent” with potential to damage the sales and earnings of the drug makers. Most animal health drugs sell in the tens of millions of dollars or less, Morningstar says.

Additionally, they have gross margins of about 60 per cent, versus human drugs, whose margins of greater than 80 per cent tempt competitors. “There is very little opportunity for a generic manufacturer to come in and undercut on price.”

Morningstar, for its part, views Zoetis shares as overvalued, despite the company being “highly diversified across numerous strong products.” Acknowledging there are no good pricing comparisons to be made other major public companies in the field, its analysts point to two private transactions/joint ventures since 2010 that valued animal-health companies at an enterprise value – equity value plus net debt – of 3.1 times their past 12 months’ sales. Zoetis traded as high as 4.6 times sales earlier this year and is now priced at an EV-to-sales ratio of 4.3, making it considerably more expensive than those deals.

“However,” Morningstar says, “the lofty valuation could entice or pressure other big pharma firms to move forward with a separation” of their animal-health businesses. Morningstar estimates Zoetis’s $4-billion-plus in sales leads the market with a 20 per cent share, but Merck’s Intervet follows closely at 15 per cent. Sanofi’s Merial division has 13 per cent share, while Eli Lilly’s Elanco has 9 per cent, Morningstar estimates.

In an analysis done shortly after Zoetis’s February debut, Morningstar estimated the animal-health divisions, if valued at Zoetis’s multiples, represented around 10 to 13 per cent of the big pharmaceutical companies’ values. And, if the companies were to spin off the divisions, they could add an average 5 per cent to their earnings per share.

That could give their shares a little extra life — unleashing investors’ animal spirits.

Disclosure: The author owns shares of Eli Lilly.

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