Despite Lawsuit Risks: Why Zoetis Remains A Compelling Investment (NYSE:ZTS)

Introduction

Last year, I started covering Zoetis Inc. (NYSE:ZTS), the animal health-focused healthcare giant.

My most recent article on this stock was written on January 10, when I went with the title “Animal Kingdom’s Ally: Zoetis And Its Path To 10%+ Returns.”

Here’s a part of my takeaway back then:

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

Fast forward, the company now trades below $200, as it has dropped more than 24% since my January article.

• 18% of this decline is market weakness and the ongoing growth to value rotation.
• The remaining 6% are caused by headlines of potentially massive adverse effects of one of its key blockbuster drugs. That’s also the main reason why I’m writing this update, as countless readers have asked me if this is a serious risk or a buying opportunity.

Hence, in this article, I’ll give you the details of the recent decline and explain what to make of the risk/reward after one of the market’s best compounders in recent years has started to show significant weakness.

After all, despite the sell-off, ZTS is still up close to 470% over the past ten years! That’s almost twice as high as the S&P 500’s return.

So, let’s dive into the details!

Stock-Breaking Headlines

Before we continue, I always like to mention one important thing before I discuss potential lawsuits. At no point will I accuse Zoetis of anything in this article. I’m only reporting on the facts. I provide research. I’m not an activist.

One of the biggest risks in healthcare is lawsuits.

Since 2019, litigation involving pharmaceutical companies has accounted for a significant percentage of all lawsuits. The plurality of these cases are wide-reaching healthcare product-liability suits involving hundreds of plaintiffs. – Law Street

This seems to hit Zoetis as well, as the stock dropped 8% on Friday after The Wall Street Journal published the headline below:

The article started by sharing the story of Daisy, a 12-year-old rescue dog who struggled with a stiff right rear hip.

After trying Zoetis’ new arthritis drug, Librela, the symptoms became worse. Eventually, she had to be put down due to kidney failure.

According to the article, Librela and similar treatments for cats were the first antibody drugs for pets approved by the Food and Drug Administration (“FDA”).

Essentially, they promised to relieve painful arthritis in animals, with Librela being a hopeful drug to potentially turn into a new franchise drug for Zoetis.

This is what Zoetis said about Librela in its February 14 earnings call:

The launch of Librela and Solensia, the first two injectable monoclonal antibodies for the alleviation of osteoarthritis, is fundamentally improving the quality of life for dogs and cats, and strengthening the human-animal bond. That’s why today Librela remains the number one selling OA pain product in Europe. – ZTS 4Q23 Earnings Call

Moreover:

Global growth came primarily from the impact of new launch markets, bolstered by the Q4 full launch of Librela in the US.

And one more:

We moved to a full launch of Librela in the US early in the fourth quarter, and we have been pleased with the results our field force has been able to drive thus far. Librela posted $44 million in US sales in the quarter, which is at the higher end of our initial expectations.

Going back to The Wall Street Journal article, Zoetis reportedly saw side effects in fewer than 1% of the more than 18 million shots of both drugs that were administered so far, with both veterinarians and pet owners having reported success with these drugs.

According to the article:

The FDA received more than 3,800 reports of side effects concerning the drugs through the end of last year. The European Medicines Agency has received more than 12,300 reports of side effects involving Librela and more than 7,700 for Solensia since 2021, when the drugs went on sale in Europe. The figures include reports from the U.S. and other countries outside of the European Union.

As a result, people are now starting petitions to recall Librela for further testing. At least one petition has more than 3,800 signatures.

With all of this in mind, I am not convinced Zoetis is staring into the abyss here. It may be the case, but for now, I believe we need much more evidence to make the case that Zoetis released a drug that wasn’t ready.

Librela and Solensia target a protein called “nerve growth factor,” which allows animals to feel less pain.

One reason for these issues could be that some veterinarians do not perform a complete work-up and examination before administering these drugs – according to the WSJ.

In other words, the drug may not be right for all dogs and cats. I’m not a medical professional (far from it, actually), but I think this makes sense after having listened to hours of lectures from professionals who want to individualize healthcare in general.

Dr. Duncan Lascelles, a professor of translational pain research and management at North Carolina State University’s College of Veterinary Medicine who helped Zoetis design Solensia studies, recommends prescribing the drug to dogs matching the criteria used in the trial. The trials didn’t include dogs with neurological conditions or lameness unrelated to osteoarthritis. – The Wall Street Journal

Based on everything I have read so far, I am not afraid that Librela and Solensia will be banned. While the current trend could be very bad for short-term business, as some pet owners may stay away from these drugs, I believe we could see a more targeted application.

On a side note, this reminds me of IDEXX Laboratories (IDXX), a stock I have a bullish rating on. This company offers diagnostic tools and services. It helps veterinarians to get a better picture of an animal’s health, including laboratory testing and in-clinic analysis.

These Zoetis issues seem to be very bullish for these solutions, as they could potentially make it much easier to get a better understanding of which drugs should be administered.

I’ll likely cover IDXX soon.

Going back to Zoetis, I would not be surprised if the actual impact on sales were to be less severe than some may expect right now.

It also helps that its overall business remains very solid.

The Core Business Remains Strong

During the Annual Global Healthcare Conference from Barclays on March 14, the company noted that its guidance expectations of top-line growth are between 7% and 9% on an operational basis.

These numbers are impressive, as the company has consistently outpaced the market by about 3 points per year over the past decade.

The chart below shows the historical above-market performance as presented in its July 2023 investor overview.

In addition to robust top-line growth expectations, Zoetis expects bottom-line growth above top-line growth, with adjusted net income guidance of 9% to 11% for 2024.

This means the company expects to further improve margins, which allows earnings growth to outperform revenue growth.

Essentially, despite making significant investments across various aspects of the business, including research and development, manufacturing, and supply chain, Zoetis remains focused on driving bottom-line growth, which explains why it expects at least 9% adjusted net income growth in 2024.

Unfortunately, these numbers will likely have to come down. Even if the current arthritis drug issue can be contained, I expect it to result in significantly lower-than-expected sales – at least until the company can restore confidence from pet owners.

Moreover, while the company is seeing some headwinds in China, it believes its mix between companion animal and livestock segments provides resilience against market fluctuations and enables the company to capitalize on various growth opportunities.

Furthermore, ongoing investments in therapeutic areas like renal, cardiology, and oncology could be promising drivers of future growth.

We have meaningful life cycle innovation, which tends to be about 50% of our spend in R&D. When we’ve seen an uptick like we’ve seen recently, it’s a little bit more new versus life cycle innovation, I would say.

[…] we’re very pleased and we have a track record of performance across not only R&D, but how our commercial teams then take the innovation to grow and expand markets. – Barclays Annual Healthcare Conference

The company also has a highly favorable dividend.

While its yield is just 1.2%, the dividend is protected by a sub-30% payout ratio and comes with a five-year CAGR of 23.5%.

So, what does all of this mean for its valuation?

Valuation

After its crash, ZTS trades at a blended P/E ratio of 27.5x. This is below its normalized P/E ratio of 31.7x. Technically speaking, I would give the company a $228 price target if it were to grow EPS as expected.

Right now, using the FactSet data in the chart below, the company is expected to grow EPS by 7% this year, potentially followed by 12% and 11% growth in 2025 and 2026, respectively.

However, I believe we have to assume that the company will see slower growth. As I said before, even if the Librera problem turns out to be temporary, I expect to see a headwind for sales.

Nonetheless, I believe the company is trading at a very attractive price, given its long-term growth prospects.

In the first five years after its spin-off from Pfizer (PFE), the company traded close to 26x earnings. Even if it were to maintain that valuation, it could return nearly 10% per year – theoretically speaking.

Hence, I will stick to a Buy rating.

That said, investors need to be aware that the stock could see more short-term turmoil *if* the Librera issue turns out to be bigger than expected.

Although I do not expect that to be the case, we always need to handle these potential lawsuit situations with extreme care, which means I would never recommend investors interested in ZTS start a full position right away.

Takeaway

Despite recent setbacks, Zoetis presents a compelling long-term investment opportunity.

While facing challenges related to adverse drug effects and market volatility, the company’s robust core business and diversified growth strategies remain intact.

Investors should monitor developments closely but consider the potential for a rebound in sales and sustained growth.

With a solid dividend and attractive valuation, Zoetis warrants a cautious but optimistic Buy rating.

Pros & Cons

Pros:

• Strong Core Business: Zoetis has a resilient core business with a consistent industry-beating performance, supported by its focus on companion animal and livestock segments.
• Diverse Growth Opportunities: The company’s ongoing investments in therapeutic areas like renal, cardiology, and oncology position it for future growth amidst market fluctuations.
• Attractive Valuation: Despite recent challenges, ZTS trades at a compelling price, offering the potential for elevated long-term returns, especially considering its historical valuation and growth trajectory.
• Dividend Stability: With a sub-30% payout ratio and a five-year CAGR of 23.5%, Zoetis offers a stable dividend, providing additional value to investors seeking income.

Cons:

• Short-Term Volatility: The stock may experience short-term turbulence, particularly if concerns regarding adverse drug effects persist, potentially impacting sales and investor sentiment.
• Regulatory Risks: Ongoing litigation and regulatory scrutiny, particularly surrounding the safety and efficacy of new drugs like Librela, pose regulatory risks that could negatively impact the company’s financial performance.