Zoetis Is King of the Animal Health Jungle

Senior Equity Analyst

Debbie Wang

Revenue segments as reported by the company.

Companion Animal

Livestock

Contract Manufacturing & Human Health

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Zoetis is the undisputed leader in the global animal health industry, and we believe it possesses the widest moat of all the competitors. Zoetis has set itself apart based on its impressive innovation that shows up across its product portfolio, including a number of drugs for specific pet ailments such as separation anxiety. The firm has also sought to expand its presence into virtually every type of animal-related health market, including aquaculture and pet diagnostics.

The animal health industry had long been largely ignored because these businesses were buried within larger human health companies, but no longer. It has many attractive characteristics, including cash-pay buyers, a fragmented customer base, and minimal generic competition. Due to the fragmented and cash-pay customer base, animal drugmakers hold significant pricing power. On the human health side, firms are traditionally at the mercy of payers. Government payers or large managed-care firms with pharmacy benefit managers have more power to force generic utilization, squash price increases, and even in extreme cases force price cuts onto drug manufacturers. However, animal health products are purchased by a fragmented group of protein producers, veterinarians, and pet owners, allowing very little bargaining power over the highly concentrated animal health firms. 

This industry also benefits from favorable growth tailwinds that should allow Zoetis to increase revenue at a low-double-digit long-term growth rate. Zoetis has successfully shifted its business further toward companion animals, where it benefits from pet owners’ increasingly strong relationships with pets as members of the family, which drastically increases their willingness to pay for expensive treatments. We expect Zoetis to grow faster than the industry and maintain above-average margins due to its scale, as the companion animal segment rises to account for more than 70% of total revenue by 2027. Zoetis' investments in dermatology, parasiticide, and monoclonal antibody innovation have been paying off handsomely here.

Business Strategy & Outlook

Zoetis enjoys a wide economic moat thanks to its intangible assets and cost advantages. Although patents are not essential for maintaining a product in the animal health industry, at least 20% of the firm's revenue comes from products protected by patents that allow Zoetis to charge a premium price and insulate it from competition. The firm's strong brand name is another advantage over competitors. When customers are using drugs on potentially millions of dollars' worth of livestock, or a pet that they love like a family member, they are willing to pay a premium to buy from a firm they trust. Finally, as Zoetis has moved into biologic therapeutics for companion animals, we think the difficulty and cost involved with creating competitive biosimilars could limit competition there even after any patents have expired.

Zoetis also enjoys another intangible asset, in comparison with its competitors that are embedded in larger human pharmaceutical firms: Zoetis is free to develop therapeutics based on unmet animal needs. For competitors, application of therapeutics originally designed for humans to the animal market also means those firms are unlikely to invest in animal-specific therapies. There are sizable opportunities related to unmet animal needs that Zoetis can pioneer, including Cytopoint for canine allergies.

The firm has built an extremely compelling cost structure, partially thanks to its scale, its extensive footprint in animal healthcare markets, and its ability to do direct distribution. As a result, Zoetis consistently holds an approximately 1,150-basis-point gross margin advantage over its rival Elanco.

Scale also provides Zoetis with a key advantage. Because of the highly fragmented customer base, the salesforce, distribution, and relationships are extremely important. Launching a new product is not as simple as getting one large payer (managed-care organization, Medicare, or government) on board; the company needs to individually deal with veterinarians and meat producers. 

Barriers to entry are significant in both capital and time. Although not nearly as expensive or as time-consuming as in human health, it can still be challenging to bring a new animal health product to market. Given the small market size and relatively modest sales potential of products, the reward often will not justify a new competitor pursuing clinical trials to bring a product to market.

In terms of environmental, social, and governance issues, Sustainalytics rates Zoetis as medium risk. Considering the probability and materiality of the key risks, we do not see much risk of an ESG matter permanently impairing Zoetis' moat. From our perspective, most of the risk lies with product governance. There is the risk of potentially defective products harming pets, though we doubt this leaves the firm vulnerable to much in the way of legal liability given the life span and market value of dogs and cats. 

There is also the possibility that medications ingested by production animals makes their way into the human food supply. This issue has taken on a higher profile in recent years thanks to more evidence of rising antibiotic resistance and concerns about milk containing growth hormone given to dairy cows to increase production. We've seen much of the immediate risk dissipate through a combination of greater regulatory scrutiny and industrywide decisions to respond to consumer concerns. This has translated into an industry shift away from using some of those medications, reducing Zoetis' exposure to this risk. 

Finally, we think there is a longer-term risk in the form of more consumers embracing vegetarian diets or reducing the volume of meat consumed in the interest of mitigating the environmental impact of raising production animals, especially in the industrial farm model. Nonetheless, we view this as a gradual transition that is unlikely to disrupt Zoetis' business unexpectedly.

Wide

Economic Moat

Zoetis

Zoetis, Inc. engages in the discovery, development, manufacture, and commercialization of medicines, vaccines, diagnostic products, biodevices, genetic tests, and precision livestock farming technology. The firm operates through the following segments: United States & International. Its products include vaccines, parasiticides, anti-infectives, dermatology products, medicated feed additives, animal health diagnostics, and other pharmaceutical products for both companion animal and livestock customers. The company was founded in 1952 and is headquartered in Parsippany, NJ.

Earnings data Q3 2020

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Zoetis, Inc. engages in the discovery, development, manufacture, and commercialization of medicines, vaccines, diagnostic products and services, biodevices, genetic tests, and precision animal health technology. The firm operates through the United States and International geographical segments. The company was founded in 1952 and is headquartered in Parsippany, NJ.

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