Zoetis Inc.

Moat: 3.5/5

Understandability: 2/5

Balance Sheet Health: 4/5

Zoetis is a global animal health company, discovering, developing, manufacturing, and commercializing medicines, vaccines, diagnostic products, and services for companion and livestock animals.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Zoetis has demonstrated a consistent ability to generate strong returns on capital and has a long-standing history in its respective industries.

Business Overview

Zoetis operates in the animal health industry, focusing on both companion animals and livestock. The company’s revenue streams can be broken down into several key categories:

  • Companion Animal Products: This segment includes products for pets such as dogs, cats, and horses. These products include parasiticides, vaccines, pain and sedation medicines, and dermatological products.
  • Livestock Animal Products: This segment includes products for food-producing animals, such as cattle, swine, poultry, and fish. These products include anti-infectives, parasiticides, vaccines, and other medicines that help improve the efficiency of meat, milk and egg production.

Zoetis sells products in over 100 countries, with a significant portion of sales coming from the United States, Europe, Latin America, and Asia-Pacific.

  • Diversification: It is important to have a good global distribution to protect from geopolitical risk, currency risk, supply chain risk, local regulations, and economic risk.
  • Geographic presence: There is a significant difference between US revenue and International revenue in the way those markets are structured.

The business is highly resilient and non-cyclical given its focus on essential animal health products. This business has generally high returns on capital. These are the main drivers of the business that should be considered while valuing the company. The company is expected to continue to expand its presence in fast-growing markets, particularly in Asia and Latin America.

Margins and Profitability

  • Zoetis has exhibited high operating and net profit margins. This is due to its pricing power and economies of scale. * However, we have seen a slight dip in margins in 2022-2023. We will look into the recent call for reasoning.
  • R&D Spend: The company spends around 10% of its revenue on research and development to maintain innovation.

Competitive Landscape

  • The animal health industry is fairly consolidated. There are a few large companies such as Zoetis, Elanco, and Boehringer Ingelheim who dominate. That being said, there are plenty of smaller companies that compete in each area.
  • Competition: Competition comes from other established and emerging animal health companies. This include the likes of Merck and Elanco who try to compete with Zoetis in their product lines. Moreover, there has been an increased emergence of generics which is a big headwind. The growing popularity of private labels is also a major headwind.
*  Zoetis has focused on both human like drug discovery and prevention, which allows them to build specialized expertise that are hard to replicate. For instance, they are trying to use the mRNA technology, that was used to build covid vaccines, for different animal drugs and vaccines.
* This has been quite costly for them in the short run, however, management is hopeful it will provide significant long term benefits.

 The company seems to be working to increase its geographical diversity and introduce specialized and novel product lines to combat competitors in the space.

Financials Analysis

  • Revenue: Consistently high revenues of above $8 billion in the last few years, which is expected to keep growing as long as they can navigate competition well.
  • Profitability: Although consistent, the operating and net profit margins have decreased in recent quarters. This is something to be wary of, and investors should track closely.
  • Cash Flow: The company’s cash flow is strong as long as it does not have any major write offs of assets. There are no significant issues related to cash flows or long term debt.
  • Capital Expenditure: The company usually spends around 5-6% of its revenue on capital expenditure in the last 10 years.
The balance sheet is generally pretty good and is expected to stay that way for the forseeable future.  This allows them to invest and acquire new companies/product lines.

Moat

Based on our assessment, Zoetis has a narrow economic moat. Here’s the breakdown:

  • Brand Strength: It has well-known brands. Brand loyalty for veterinary products is very high, mainly because those are decided by vets, and pet owners often rely heavily on their opinions and recommendations. Moreover, brand helps on price power, a factor that Zoetis has used to its advantage in the past. * For example, their Zoetis branded pain and sedation medicine and their vaccines are very popular among vets.

  • High Switching costs: Switching from one pharma company to another for the healthcare industry is costly because of the time and process in implementing and testing a new system. Veterinarians tend to rely on companies which have been successful in the past. Moreover, new drugs take substantial time to be developed (usually around 5 years) and approved by the relevant authorities.

  • Proprietary technology and scale: Zoetis also has a decent moat due to its specialized drug research and development procedures, which are difficult to replicate for most small time competitors. For instance, the company has been actively using mRNA technology in the production of its various vaccines.

  • Regulatory Approvals: The company also gains some moat through regulatory hurdles that come with the pharma industry. Approvals take time and money, which is difficult for smaller companies to compete.

However, we also noted some factors that lead to the moat being relatively narrow:

  • Commoditized products: Most of the products, in themselves, are not that difficult to produce. We can make an assumption that companies can easily be copied unless they have some patented innovative technology.
  • Competition: As mentioned, there are many larger companies that have similar product lines to Zoetis. The competition in the animal health sector is very tough, which reduces their pricing power.

Risks that May Erode Moat

  • Patent Expiry and Generics: As with human health, patents expire, and they face competition from generic manufacturers. This can hurt the company’s pricing power.
  • Competition: As discussed above, there are plenty of competing companies with similar products. This, coupled with changing consumer preferences, could decrease profits and margins.
  • Technological Innovation: New technologies, or the development of new treatment methods that do not require products could undermine Zoetis. Moreover, advancements in other areas that indirectly affect their earnings may also be a risk.
    • There is a lot of focus on mRNA technologies, and this space is expected to grow drastically in the future. They might also have increased competition in this space in the future.
    • Regulatory risks: Regulations surrounding drug approvals may impact the launch of new products, or decrease profitability.
  • Global Health Emergencies: Major health scares or pandemics would affect a large % of their sales. There were some issues with supply chain and demand issues during covid.
    • Supply Chain issues: Having a supply chain that is stretched all over the world means that the company is susceptible to disruptions due to political reasons, trade reasons, and pandemics. There may be delays and increased costs as well.
  • Animal Husbandry changes: This relates to shifts in the way animals are raised, as well as what animals are being raised by customers.
    • For instance, animal farms with better practices may result in fewer diseases that need to be combatted. Changing diets of pets may also affect sales of some product lines.
    • Consolidation: A merger in the industry may also lead to increased concentration, which increases competition and reduces bargaining power of smaller customers.

Business Resilience

Zoetis appears to have a strong business resilience and can adapt to changes and uncertainties. However, if they do not manage their costs and improve profitability, they may have to reduce their market share, which would affect pricing power.

Understandability

Given that it has various operations across different geographical locations, it is hard to develop a detailed understanding of the business. Furthermore, because of the complexity of the animal pharmaceutical industry, with its various regulatory and patent-related matters, it is difficult to assess what the value of the business is, and what to expect.

Based on this, we are giving a score of **2** on understandability.

Balance Sheet Health

  • The company has a good level of liquidity, with a current ratio hovering around 2.1 for the most recent quarters. This signifies a good liquidity to tackle short term obligations.
  • Their long term debt levels have always been under their asset levels.
  • The overall financial flexibility is really good which enables them to tackle any unexpected issues.

Because of this, we are giving it a score of 4 for balance sheet health.

Recent Concerns/Controversies and Management Stance 

*  **Decline in growth/margins**: The company has seen a fall in organic growth and margins, as a result, management indicated that they are going to be focusing on increasing their efficiency and profitability going ahead.    *     **R&D spend**: Management has indicated that they will continue to invest in new drugs and vaccines while simultaneously focusing on long term growth.   *     **Share buybacks:** Management has stated that there is a slight de-emphasis on share buybacks and more focus on improving their core competencies and looking for value accretive acquisitions. This implies the share price may not see big spikes in the short run. 
    * We will continue to track these plans by their financial statements and results over the next few years.   *      **Revisions in guidance:**  The management has also revised its guidance for 2024 in the recent earnings calls. This included a change in revenue projections, due to various market factors. There are no clear reasons for this, and it is something that the analyst is going to dig deeper into, in coming calls, in order to better understand.   *  **Potential legal issues.** A few ongoing lawsuits will be a point to monitor for long term investors. 
 *     This includes lawsuits over animal drugs and vaccines, which has potential to hurt cash flows in the future.
 *     Management seems to be working through the claims to ensure a favorable outcome.   *   **Competition from Chinese companies**. Some Chinese companies have been trying to aggressively compete in the animal health industry. This is leading to lower price pressure from those companies which may hurt earnings.
   * Management is keeping a close eye on the threat and they have said that they are working to create brand value, develop proprietary technology to stay ahead of competitors in the space.

We will continue to monitor new reports and earnings calls to check if all the goals are being achieved as planned by the management.