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Zoetis Inc. (NYSE:ZTS ) released their Q3 2022 results last Thursday (November 3). Shares fell 11% on the day of the results and, while they have recovered about half of that loss since, remain 39% down year-to-date. Compared to when we upgraded our rating to Buy in February, ZTS stock has lost 26% after dividends: Canine Apoquel

Librarian Capital's Zoetis Rating History vs. Share Price (Last 1 Year)

Q3 results were worse than our investment case, but mostly due to temporary macro factors. EPS fell 3.7% year-on-year, but largely due to currency and a higher tax rate. Revenue grew 5% operationally, below our investment case, attributed to supply chain disruptions and labor shortages at U.S. veterinary clinics. There were positive developments on the Simparica Trio blockbuster and the new Librela and Solensia products. Supply chain issues are expected to be mostly resolved by year-end, and Net Income is still guided to grow 9-11% operationally this year. Zoetis shares are at a reasonable 30x P/E and 2.5% Free Cash Flow Yield. Our forecasts indicate a total return of 62% (16.8% annualized) by 2025 year-end. Buy.

Zoetis is the global leader in animal health, with a high-quality business that we believe to be capable of growing EPS at a 10%+ CAGR sustainably:

COVID-19 was a net positive for Zoetis, boosting the number of pets and their demand for medical products, though this was partly offset by a reduction in protein demand and lower livestock prices.

Zoetis' operational revenue growth (excluding acquisitions) was 15% in 2021, and averaged 8% in the years before:

Zoetis Components of Op. Revenue Growth (2013-21)

Zoetis’ Gross Margin and EBIT Margin have both been rising over time, including by another 1 ppt each in 2021:

ZTS Gross Margin & EBIT Margin (2013-21)

Q3 results were worse than our investment case, but mostly due to temporary macro factors.

Zoetis’ Q3 2022 results were disappointing, with Adjusted EPS falling 3.7% year-on-year:

Zoetis P&L (Non-GAAP) (Q3 2022 vs. Prior Year)

Source: Zoetis results release (Q3 2022).

However, much of the EPS decline was due to currency and a higher tax rate. Adjusted Net Income fell 5.2% (or $31m) in U.S. dollars but rose 2% operationally. Of the $31m decline, $29m was due to a higher tax expense, the result of a 4 ppt increase in the effective tax rate (in turn the result of a negative geographic mix shift). Adjusted EBIT fell just 1.3% in U.S. dollars, and likely rose by a low-single-digit operationally.

Total revenue grew 0.6% in U.S. dollars and 5% operationally, below our investment case. Revenue still grew by 17% operationally in International Companion Animal, but by only 6% in U.S. Companion Animal (compared to 15% in H1 and 25% in 2021). Revenue declined by 7% operationally in U.S. Livestock and was flat in International Livestock. Management attributed much of the weakness to macro or one-off factors (discussed in more detail in the next section).

Gross Margin fell by approximately 90 bps year-on-year in Q3, primarily (about 70 bps) due to currency. Management has increased prices by about 5% year-to-date on companion animal products, but this was offset by the impact on generic competition on livestock products, giving a price benefit of about 2% overall.

EBIT margin fell by approximately 70 bps year-on-year in Q3, less than Gross Margin, with reductions in discretionary spending having helped reduce SG&A Expenses growth to 3% operationally, 2 ppt less than revenues.

Year-to-date, Zoetis’ Adjusted Net Income has grown 8% operationally but fell 0.5% in U.S. dollars:

Zoetis P&L (Non-GAAP) (Q3 YTD 2022 vs. Prior Year)

Source: Zoetis results release (Q3 2022).

Year-to-date Adjusted EPS is up 0.7% from last year, helped by share buybacks.

Zoetis’ relatively weak operational revenue growth in Q3 can be attributed to macro and one-off factors.

In U.S. Companion Animal, operational revenue growth decelerated to just 6% in Q3, which management attributed to supply chain shortages, impacting Simparica Trio in particular, as well as labor shortages at U.S. veterinary clinics. The reorganization of the U.S. salesforce to create a dedicated Diagnostics field force has again contributed to a decline in Diagnostics revenues, though Diagnostics is only a modest part of Zoetis (with just 4% of group revenues in Q3).

Zoetis Companion Animal Op. Revenue Growth (Since 2016)

Zoetis attributed it supply chain issues to a variety of factors, including COVID-19, capacity constraints, delays at a third-party capacity project, and component parts shortages.

Supply chain issues have been affecting the whole animal health sector through 2022. For example, Elanco (ELAN) also suffered supply chain disruptions in H1, though these have improved by Q3. However, things appear to have got worse for Zoetis in Q3, after some competitors have gained shelf space at Zoetis’ expense, and with higher demand during the parasite season exacerbating the effects of its shortages. As CFO Wetteny Joseph explained on the call:

“We had outages throughout the peak of parasiticide season for Simparica Trio to Q2 and Q3. Though we recovered late in Q3, the impact was such that we allowed competitors to be more aggressive about placing products on shelves, which we saw that impact as we exited Q3 … Supply issues are not unique to us, given the wide variety of products and species. It's relatively commonplace in this industry … we saw more of an impact here in Q3 given the timing of our recovery on some of these”.

In International Companion Animal, operational revenue growth was 17%, demonstrating the segment’s ability to grow where supply is not an issue. There was double-digit growth in both Brazil, despite economic headwinds there, and in China, despite the disruption in that market from COVID-19 lockdowns.

In U.S. Livestock, revenues declined 7% operationally, continuing the weakness since 2021. Supply chain disruptions were an issue here (affecting vaccines especially), but generics competition and increased competition in vaccines were also mentioned as factors.

Zoetis Livestock Op. Revenue Growth (Since 2016)

The impact from generics in Q3 was likely exceptional. Management highlighted two products, DRAXXIN in Cattle and Zoamix in Poultry, as the most affected. Most of the impact was likely due to DRAXXIN, previously Zoetis’ biggest Livestock product with approximately $350m in revenues (equivalent to 12% of 2020 Livestock revenues). (The entire Poultry portfolio was 16% of Zoetis’ global revenues). DRAXXIN’s patent expired in 2021 and management anticipated revenue declines of 20% annually – 2021 was “a bit better” than this while 2022 was worse. Zoetis has only one other product of similar size that will be at risk from generics, APOQUEL (worth approximately 10% of revenues), and new entrants have been repeatedly delayed and now not expected until H2 2023.

In International Livestock, revenues were flat operationally, with growth in Fish and Sheep offset by declines in Swine and in Brazil. The decline in Swine was due to “lower sales across Europe”, with lockdowns in China reducing export demand and inflation pushing up input costs, while the decline in Brazil was due to supply challenges and lower Cattle demand, the latter caused by consumers trading down from beef to cheaper proteins.

There were positive developments on Zoetis’ key products in Q3:

These figures represented a strong performance, especially considering supply chain issues in Q3, which affected Simparica Trio especially and also forced trade-offs between other products like Cytopoint and Librela.

Zoetis believes its supply chain issues have either been resolved already or will be by year-end. As CEO Kristin Peck explained on the Q3 earnings call:

“We had mAbs (monoclonal antibodies) issues; we worked through that. We're now in full supply on our mAbs in all the markets that we've launched in … We did had paras (parasiticides) challenges in Q2. Q3, honestly our supply came in too late in Q3 … But again, I think the paras problem will work itself out as you look into Q4 ...

Some of those (supply chain issues) will continue into next year. But we're really confident that the biggest challenges we were anticipating this year around mAbs have been addressed. As you look at paras, both Simparica Trio, Rev (Revolution), we'll work through that by the end of this year.”

Peck also mentioned that, on the aforementioned delayed third-party capacity project, she is monitoring the weekly output of Simparica Trio and Revolution personally and consequently have “strong confidence” on their resolution.

Zoetis has reduced its full-year outlook, but Net Income is still expected to grow 9-11% operationally in 2022.

Expected 2022 operational revenue growth has been cut to 7-8% (was 9.5-10.5%), and Costs of Sales Margin is raised slightly to 30% (was 29.0-29.5%), offset by slightly lower SG&A and R&D expenses. Adjusted EPS is now expected to be $4.83-4.90 (was $4.97-5.05), from operational Net Income growth of 9-11% (was 11-13%):

Source: Zoetis results presentation (Q3 2022).

The outlook implies that Net Income growth will recover in Q4. We believe this is achievable.

At $142.61, relative to 2021 financials, Zoetis shares are at a 29.9x P/E and a 2.5% Free Cash Flow Yield:

Zoetis Earnings, Cashflows & Valuation (Since 2018)

NB. 2018 figures not pro forma Abaxis acquisition (completed Jul-18).

Relative to the mid-point of the new 2022 EPS guidance, Zoetis shares are at a P/E of 29.3x.

Year-to-date, CapEx has been 34% higher year-on-year as Zoetis continues to expand its capacity, and working capital cash outflows have been $418m worse (including $139m more in inventories), likely to be at least partly related to stockpiling as a remedy to supply chain disruptions.

Zoetis pays a dividend of $1.30 ($0.325 per quarter), representing a Dividend Yield of 0.9%. The dividend was raised by 30% in December 2021, and another hike is likely to be announced next month.

Zoetis has repurchased $545m of its stock in Q1-3, equivalent to 0.8% of its current market capitalization. Out of a $3.5bn share repurchase program authorized in December 2021, $3.0bn remained at the end of Q3.

We have made small changes in our forecast assumptions and reduced our exit multiple.

Our key assumptions now include:

Our new 2025 EPS forecast of $6.95 is 1.4% lower than before ($7.05):

With shares at $142.61, we expect a total return of 62% (16.8% annualized) by 2025 year-end.

We reiterate our Buy rating on Zoetis Inc. stock.

This article was written by

Revolution Pet Med Disclosure: I/we have a beneficial long position in the shares of ZTS either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.