Biotech Values

[Rocky3]

From Barrons re ZTS:

Ever since civilization began with the invention of agriculture, mankind has been preoccupied with trying to feed the planet. Today, investors are justly enamored with companies that might improve our food supply, given Earth's burgeoning population, finite resources, and likely food inflation following central banks' feisty money printing.

The latest variation on this theme launched to rousing applause recently when Pfizer (ticker: PFE) spun out its animal-health unit, which makes drugs and vaccines for livestock and pets. Zoetis (ZTS) raised $2.2 billion in its initial public offering, and its shares jumped from $26 to $34 in just six weeks. That values the Madison, N.J., company at $17 billion.

It's easy to fawn over Zoetis. Two-thirds of its revenue comes from livestock, which benefits from the growing global middle class's appetite for meat and milk. The rest is tied to pets; per-capita spending on them is rising, as they live longer, and Americans become more besotted with them. Even Zoetis' Website wisely eschews needles and vials for lovingly rendered photos of cuddly pigs and frolicking chicks. And while it competes with units of Merck (MRK) and Eli Lilly (LLY), Zoetis has 19% of the $22 billion global animal-health market. That makes it the splashiest pure play for investors eager to nuzzle this hot, new segment.

As a result, this go-to darling already looks fully valued, and investors might want to wait for a better opening. For a start, Pfizer still owns 80% of Zoetis and controls nearly all the voting power through Class B stock. And more shares could become available after lockups expire in late July.

Zoetis already fetches 25 times its projected 2013 profit, nearly twice the 13.8 times for drug makers or the 12.3 times for Pfizer. A premium is warranted, because animal drugs require less research and development expenses, face less generic competition, and carry less reimbursement risk than human drugs. But Zoetis looks rich, even compared with large growing companies from Monsanto (MON) to Mead Johnson (MJN), or the average 21 times for smaller animal-health stocks like Idexx (IDXX), VCA Antech (WOOF) and Virbac (VIRP.France). Morgan Stanley analyst David Risinger calls Zoetis a "compelling alternative to traditional pharma." But given its lofty valuation, he thinks "material earnings upside is required to drive stock outperformance."

It helps that Zoetis' products are sold in 120 countries, with no single item within its diversified portfolio accounting for more than 8% of sales, notes Risinger. Pets also are becoming as narcotized as we are, with the horde of medicated U.S. pets rising to 78% from 57% in 1996. But Zoetis has $3.4 billion in net debt. And while a dividend yield near 0.8% might rise with profits, management probably will steer cash toward deals or to pay down debt.


Risinger doesn't expect the yield to top 1% soon. There also are risks. Nearly 28% of Zoetis' sales are livestock antibiotics. In many countries, especially in Europe, "concerns have been growing about the use of antibiotics in livestock animals, which could result in antibiotic resistance and potentially leave residues in food," notes Goldman Sachs analyst Jami Rubin.

Weather is another wild card. Last year's drought drove up grain-feed costs and made it more expensive to keep cattle hydrated. So farmers culled their herds and turned them into filet mignon, which didn't help sales of antibiotics. Goldman's price target for Zoetis is $33. "We like the company," writes Rubin, "but the stock is ahead of itself."