Zoetis Inc. (ZTS) Earnings Call Transcript & Summary

Hi, everyone. We're going to get started with our next and also our final session of the William Blair 40th Annual Growth Stock Conference. Thanks for joining us. Our company for the next 30 minutes is Zoetis. I'm John Kreger. I'm the research analyst here at Blair that covers Zoetis. I am required to inform you that you can obtain a complete list of research disclosures or potential conflicts of interest at williamblair.com. With that exciting info out of the way, let me introduce Glenn David, the CFO. He's joining us for the presentation. We're going to take the next 30 minutes to go through a fireside chat format. For those of you listening in, there is a chat feature that allows you to send questions to me, and I will do my best to ask them, time permitting. So with that, let's launch right in.

Glenn, let's start with sort of the obvious one around COVID-19. You guys have a great global perspective on how the pandemic is impacting various geographies. So can you kind of step back and remind us how you've seen the pandemic impact operations in Asia versus Europe and the U.S.?

Yes. When you look at it across geographies, I think the impact has been relatively similar, particularly on the companion animal side. I think the timing is just a little different, right, based on the timing of the pandemic [Technical Difficulty] each of the markets has seen the impact as well as plan to recovery maybe beginning for the market. So in markets in Asia, such as China, where they're already starting the return back to the workforce and they're opening up more [ ER service ] to see a quicker recovery there obviously, because the pandemic started at an earliest -- at an earlier time. So that -- the biggest difference there is just the timing of when the pandemic occurred. But we've seen similar impacts in terms of clinic visits down and then beginning to recover and things of that nature. From a livestock perspective also, we expect impacts in both the U.S. and the international markets, but that will vary as well, again, based on timing as well as based on some other factors. So there's been a lot of news about some of the impacts that we've seen, the plants within the U.S. with reduced capacity based on some challenges in labor. We haven't seen that same impact necessarily outside of the U.S. And then there's also just different dynamics that are going on. So for example, within China, we've seen very rapid growth in the first quarter in our livestock business as the recovery from African swine fever is beginning. So that's a different dynamic than we may see in other markets as well. So similar across the board, but timing and certain fickle uniqueness from market, obviously, has an impact.

How have the plant shutdowns played out in recent weeks? Has that stabilized? Or is it still a pretty significant issue in terms of throughput?

Yes. No, so we've definitely seen that stabilize in the past number of weeks. At the peak of it, we were seeing plant capacity or processing capacity at about 70% level versus where they were producing prior year. What we're seeing now is more in that 90%-plus level. So we have seen a pretty rapid recovery in terms of the processing capacity.

Great. Sticking with the geographic theme, how about Brazil? We hear some pretty terrifying commentary about how the pandemic is impacting Brazil. Are you seeing it impact your order flow there?

Yes. So when you look at Brazil, obviously, from a companion animal perspective, we're beginning to see some impact there. The livestock, we haven't seen similar impacts that we've seen in the U.S. in terms of plant capacity or plant closures. But that is something that we're monitoring in Latin America, outside, not just in Brazil, as we've seen some impacts outside of Brazil as well in markets like Mexico. So those -- that is something we're monitoring, but we haven't seen the same impacts yet on the livestock side that we've seen, for example, within the U.S.

Great. Okay. Kind of thinking back to the first quarter call. When you guys updated your guidance, I think you talked about some various scenarios. It seems like that visit rebound, particularly in the U.S., has been surprisingly good, at least from our perspective. How -- where are you sort of thinking about the various scenarios, how reality is compared to some of the modeling you were doing?

Right. So obviously, when we gave guidance back in May, there were a number of unknowns at that point in time. And we highlighted that when we talked about the fact that we increased the range of our guidance. Obviously, our revenue range is negative 2% to positive 3% operational growth. And we said there were a number of factors that would drive that range. A, the speed of the recovery in terms of how quickly that visits would start to return to normal levels. Also how the livestock market adapted to some of the new scenarios that we were seeing: a, big shift from the restaurant and food service sector to the grocery sector; and also some of the challenges that we're seeing with plant closures in the U.S. We also talked about some longer-term factors as well in terms of the second half of the year in terms of the impact of a recession as well as the uncertainty around the second wave of the disease. So those factors, obviously, are still unknown and exist. But in terms of some of the other factors that we've seen in terms of progression, the fact that vet visits, what we're seeing is at peak, back in May, vet business were down anywhere from 20% to 30% across the U.S. depending on which state. We've seen that rebound to about -- down about 5%. But even more encouraging is we've seen revenue in the clinics actually up 5% in the last couple of weeks. So we've seen a nice rebound there. And that would lead us to more some of the positive expectations that we would have for the year. Again, some of the issues that can come up in the second half, those are still unknown. But some of the things that we're seeing in the second quarter in terms of the rebound, in terms of vet visits as well as the recovery in some of the livestock processing has been positive.

That's great. That revenue metric of plus 5%, what -- where -- how low did it get at the trough do you recall?

I don't recall the specific revenue metric. But it's important to understand that while the vet visits were down 20% to 30%, that doesn't necessarily translate directly to our revenue, right? There are alternative channels for customers to get their prescriptions filled via some of the alternative channels online, but also via the vet as well. Many of them were offering curbside support, whether through the prescription or even to do some of the vet visits for the animals. So there are a number of factors that impact our revenue beyond just the visit drop or the absolute revenue within the vet clinic, because there are other ways for the prescriptions to be filled.

Got it. Sticking with the sort of recovery theme here for a second. Have you seen any data that would suggest whether or not that rebound in visits and revenue, there was some pent-up demand that might sort of roll over? Or do you think it's sustainable?

Yes, that's one of the questions that it's a little too early to see, right? We've seen that rebound in the past couple of weeks. We would anticipate there would be some pent-up demand, right? The percentage difference between the number of visits being down 5% in the data that we have and the revenue being up 5% is wider than you would typically see, right? We've seen revenue per visit increasing over time, but the breadth is a little wider than we would typically see, which would lead you to believe that there may have been some pent-up demand in those numbers that is driving the incremental revenue.

Got it. Okay. All right. I'm going to change gears for a little bit since we covered a lot of the COVID things. I'd love to dig into diagnostics a bit. I think this is one of the more interesting and maybe surprising parts of your strategy in recent years. So just kind of talk us through why are you here? Why did you buy Abaxis? And sort of where do you stand with the strategic rollout at this point?

Yes. So obviously, when you look at Zoetis, we are focused on providing a full range of offerings to our customers across the continuum of care, right, and diagnostics is a key part of that. And when we looked at Abaxis in the space, we saw that it was a very rapidly growing space and there was a clear link to our core portfolio. So that led us to enter the point-of-care area of diagnostics. And then as we began to learn more about the space, it became very clear that there was opportunity, not just in point-of-care, but in reference lab as well, which is why we did some of the acquisitions that we've recently done, acquiring some of the reference labs within the U.S.. So our intention there is to continue to expand organically by building additional labs and establishing a nationwide network of reference labs within the U.S. and then to follow a similar strategy outside of the U.S., really leveraging the global presence that we already have from a commercial perspective within those markets. So we think it very much aligns with our continuum-of-care strategy. We think we're in a unique position with our relationships with the veterinarians as well as the breadth of our portfolio, from a companion animal perspective, to really be able to leverage both our core portfolio as well as the diagnostic offerings with our customers.

Great. The Abaxis rollout, where does that stand in terms of taking it beyond the U.S.? I don't think they were very far along when -- before the acquisition?

Yes. No, so we've made significant progress. Obviously, with our commercial presence already having a presence in many of the international markets. Our products, from a diagnostics perspective, are available in the majority of the markets that we operate in. So obviously, we're in 45 markets with a direct presence, and our Abaxis products are available in the majority of those markets as well as via distributors to a broader set of markets.

Do you think you can accomplish the reference lab rollout organically? Or are you going to rely on M&A to do that? And should we assume -- I know some of the deals you've done, I think you've talked about it being a little dilutive in the near term. So how should we just think about that impacting the P&L?

Yes. So to your point, some of the deals that we've done as well as this strategy in the short term as we will make organic investments to grow that business, particularly in the U.S. We've done a number of acquisitions that gave us an established presence and also brought in capabilities that we didn't necessarily have from the reference lab perspective. We will then be able to build within the U.S. off of that, which will require investment and be dilutive to earnings to the tune of a few pennies during this year, and we'll then turn to profitability in a few years. We then will do -- this will probably follow a similar strategy outside of the U.S., look to acquire a few regional players that will establish our presence to then grow off of. So it will be a combination of both organic and inorganic expansion. Probably a little more organic within the U.S., starting inorganically outside of the U.S. and then building off of that.

Okay. And then commercially, are you -- I would assume there's an opportunity to sort of bundle this building diagnostic portfolio with your therapeutics and vaccines and the like. Have you pulled that lever yet? Or is that something down the road?

No, that is definitely a lever that we've begun to pull. One of the things with the Abaxis acquisition is we need to integrate it into our core ERP system of SAP. And we completed that in the first quarter of this year, which then gives us the ability to really provide one face to the customer and accelerate the offerings from a bundling perspective. And we have the broadest companion animal portfolio. You combine that with diagnostics, that puts us in a unique position to really offer some compelling offerings to our customers that makes sense for them, but also makes sense for us.

Got it. Okay. Good. Let's switch over to the companion animal business and parasiticides. There's a lot of buzz around Simparica Trio. I'm guessing the pandemic made the launch of that product a bit tricky. So could you just talk about how -- what sort of pivots you had to make to pull the launch off and how it's gone?

Yes. So we think the launch is going well. Obviously, within the first quarter, we had about $15 million in sales. A lot of that was initial stocking to distributors within the U.S. And we launched direct to our veterinary customers in April of this year within the U.S. We referenced on the call that because of the impact of COVID-19, we reduced the incremental sales that we expect to get, from Simparica Trio this year, from $150 million to $100 million to $125 million, which is still significant sales for the product. We are getting very positive response from our customers related to the product. And while COVID-19 does pose some challenge, it does pose some opportunities as well. One of the things that we're always committed to was rapidly starting direct-to-consumer advertising for Simparica Trio. And with the fact that many people are home, watching their TV more, we do believe that, that will lead to a greater impact of our DTC ads. And the other, while our reps weren't able to have in-person interactions with our customers, the actual number of visits that we have, albeit being done either via video or phone, was up during this period as our reps were still active, just not doing necessarily in-person business. So that's another opportunity. Obviously, as the vet -- our vet customers, they'll have to switch patient that can require a discussion in some parts. So that is a bit of a challenge, but overall, we're very pleased with the way the launch is going, and obviously, still expecting $100 million to $125 million in sales for the product within a 9-month period during COVID-19, we think, would be a very positive now.

Have you seen any rebound in face-to-face detailing opportunities? Or is it still really confined to virtual at this point?

No, we definitely have seen a rebound. We are just beginning to have our reps start interacting with our customers in a face-to-face manner. Obviously, that's something that we're going to do responsibly, making sure that the customers are comfortable with us visiting as well as that the rep is comfortable going to the clinics at this point in time. But that is something that we have begun to reinstate in terms of those live interactions, and we'll continue to roll that out throughout the quarter.

And how far along are we in the global launch of Trio at this point?

Yes. So we are launched in all the markets in Europe. There are a number of markets where the registration is still pending, and we're seeking approval. But we are pretty far along with many of the markets and hoping the other markets come across quickly.

Got it. Okay. Related question, another kind of surprising move from our perspective was the Pumpkin launch. Your -- and I think there is both kind of an insurance and a wellness component of that. And I'm guessing a lot of that was sort of driven by Trio, but maybe not. Can you just walk us through what Pumpkin's all about and what the strategy is behind it?

Yes. So I mean the key strategy is, obviously, we're committed to having animals get the best level of health care. And we believe an insured animal does get a better level of health care. When you look at the U.S. right now, it's very under-penetrated. There's less than 2% of pets that are currently insured. And we believe with our position, with the relationships that we have with the vets as well as the relationships that we have with pet owners, that we could help accelerate that adoption of insurance. Also with the preventative side of the care, ensuring that a pet gets an annual wellness visit, ensuring that they get their annual vaccines, obviously, that only improves the health of the animal. So that's really our focus on Pumpkin is helping to increase the adoption and penetration into insurance. It's also rapidly growing, although it be off a small base, and we believe we are in a unique position to help accelerate that trend.

Got it. One more on parasiticides from a longer-term perspective. I think your share in this category is maybe a little bit lower than it is in some of the others. Is that accurate? And do you think Trio is a strong enough offering to sort of vault you into a leadership position over the 2, 3, 4 years?

Yes. So we absolutely were under-penetrated in parasiticides. But we've made significant progress over the last number of years, and we think Trio would just help accelerate that. So if you go back, with the launch of Simparica, we started to gain a good amount of share with that product, even though we were third to market. Also the launch of Revolution Plus, doing very well with that product as well, and ProHeart 12 growing rapidly there. So now with the launch of Simparica Trio, we do expect that we will be able to continue to gain share in what is the largest market within the companion animal space. And we believe we have a very robust offering now between Simparica Trio, Simparica, ProHeart 12, ProHeart 6, Revolution Plus. We think that positions us very well in the space moving forward.

In terms of your longer-term budgeting, at what point are you assuming you'll have competition for Simparica Trio in the U.S.?

Yes. So that's a big unknown, right? And we get similar questions across APOQUEL as well in terms of when we expect competition for some of our bigger products. Obviously, because of the space that we're in, our customers don't -- our competitors don't necessarily disclose their time lines nor do we disclose ours. I can say that our guidance for 2020 does not assume that we will have competition for either Trio or APOQUEL. But when that competition may come is still somewhat of an unknown, which is part of the reason why we don't provide big sales estimates for either of those products.

Understood. Okay. Good segue. I wanted to switch to both APOQUEL and CYTOPOINT. Those products have done remarkably well and I think grown a lot more than what many people thought. Is there room left? Or do you think about those as relatively mature at this point?

No, we definitely think there is room left for growth in those products from a couple of different areas. So obviously, when you look at the proportionality of sales of our derm portfolio, between the U.S. and international, it's definitely geared towards the U.S. And part of the reason we've been able to gain more rapid adoption in the U.S. is because of our ability to do direct-to-consumer advertising. So within the U.S., we're going to continue to invest in that area. And I think if you've seen, we've shifted a little more towards a branded focus for APOQUEL, which we do see it providing positive returns. So we think that will lead to continued growth within the U.S. And then within international, utilizing our field force and our direct presence, we do expect to continue to get more rapid growth out of the dermatology portfolio in international than what we do in the U.S. because of the fact that we have more room to grow, but just at a slower pace, because we don't have that opportunity from a direct-to-consumer advertising perspective. And then also across the portfolio, we will continue to look for life cycle enhancements as well within our derm portfolio that could extend to other species as well. So we do see this as an area of continued growth. Obviously, competition is something that is a bit of an unknown. But with the quality of our products, both from an efficacy perspective as well as a safety perspective and the fact that we have both APOQUEL and CYTOPOINT, we think that will distinguish us even in light of competition.

Given that you guys sort of built this category in derm, when you do inevitably get competition, are you -- should we expect sort of the typical price and share erosion that we might see, for example, from a generic? Or do you think these products can hold up better in the face of competition when it does happen?

No. We think these products can hold up better, right? It's a growing space. It's a growing market. We helped build the marketing. I think if you look at the parasiticides with the orals, you'll see that there was room for more than one competitor in the space. So we would expect it to help market growth. Can it have some impact to our revenue growth? Obviously, we would expect that the pace of revenue growth would slow with competition, but there's still a lot of unknowns in terms of what does the product look like, how strong is it, how does it compare to us in our overall portfolio?

Got it. Okay. One more on the companion side. You've talked a little bit about being excited about some pain -- chronic pain products for dogs and cats. Just bring us up to speed on where those stand in the regulatory process.

Yes. So still -- as we stated in previous discussions, we still expect approval for both the canine and the feline product in 2021 for both of those products we expected to.

Got it. Are those -- do those have names yet?

They do. I'll say them incorrectly so I won't go do it, but they do have names. We are branding those as we go, and we're very excited about both the canine and the feline.

Excellent. And I assume you don't know timing within '21 at this point, early versus late?

We haven't disclosed timing within '21.

Got it. Got it. Okay. Okay. Let's go back to livestock, and I know you touched on this a little bit. But maybe as a starting point, years ago, you guys talked about your livestock market, not just your portfolio, but the market as sort of being in mid-single-digit growth. We've gotten a fair amount of crises since then. Do you still view the market as mid-single digit? Or have you revised that?

Yes. So I mean taking this year out of the picture, obviously, because of the impact of COVID-19, right, we do still see livestock growing sort of in that low to mid-single-digit range. And it will vary across markets, right? Some of the more established markets will probably grow to the lower end of that range. But we do expect to continue to get rapid growth in markets such as Brazil, in markets such as China. And more of the emerging markets, we expect livestock will grow at a faster pace. So overall, net-net, we would expect it to grow in that low to middle single digits, but it will vary by market and the phase of the market. Once we get to a point where we start to see more innovation coming out of livestock, we would then expect livestock to grow more in line with the overall animal health market in terms of that 5% to 6% or 4% to 6% rate that we typically see from the animal health. There's obviously just been more innovation coming in the short term in companion animal, but we do expect over the medium to long term that livestock will have innovation as well driving growth.

Got it. Okay. Can you talk a bit about last year's crisis, African swine fever? How that's placed out -- played out? Are we stable in terms of the spread of that? And how is China, in particular, responding now that, that's hopefully in the rearview mirror?

Yes. So we're seeing China respond well. I think when you look at our first quarter performance, we saw very rapid growth in China in both companion animal as well as livestock, and livestock obviously being driven by swine. So we are starting to see a recovery in African swine fever. At the end of last year, when we were looking at it, we were hoping that we would see sort of a flat to slightly positive growth in swine within China. We're seeing much more rapid growth than that. So that's been ahead of our expectations in terms of the pace for the recovery from African Swine Fever, particularly in China. There are other markets within Asia where we're still seeing some impact from African swine fever, but the offset and the positive response that we're seeing in China is above that. So that's going ahead of our expectations in terms of the recovery.

Great. Maybe broadly, given the recession that has been triggered by the pandemic, do you guys expect any shift kind of down in species in terms of what animal proteins are consumed?

Yes, there's definitely the potential for that. A, even what we're seeing today with the shift, particularly in the U.S., from the restaurant sector to more of a grocery sector, more premium cuts of beef are generally consumed within the restaurant sector. So that, by itself, is impacting a little bit of a shift to the lower cost of proteins. But then in a recessionary environment, we do see sometimes a shift across the protein channel. Now that, again, just emphasizes the benefit of the diverse portfolio that we have and the leadership position that we have across species, because we're able to still be very productive with all of our customers and balance across the species when there is a shift of it in the market place.

Got it. Got it. Okay. How's dairy doing? I know that was also under a lot of pressure in the last year or 2. Are you still seeing downward pressure or any signs of stability?

No. We are still seeing downward pressure in dairy. That continues to be a challenging market in terms of profitability for our customers as well as overall supply-demand balance. So that does continue to be a challenge, and we are seeing downward pressure in dairy.

Got it. Got it. Okay. Thank you. We've got, I think, just about 5 minutes. Maybe turning back to the margin side of things. When I think about what you guys have accomplished since the spin out of Pfizer, we get the question a lot, is there any more room to go? So how do you think about what you want to do on the margin front? Do you have room to take that higher? And if so, what are the key opportunities to do so?

Yes. So there are a number of areas that we're focused on. A, it all starts with revenue, right? We need to make sure that you're continuing to grow your revenue. And our goal is to continue to grow the revenue at a pace at or faster than the market. And I think with all of the new product launches that we have and the growth that we're seeing in companion animal space, COVID-19 aside, we do expect to be able to do that, which then provides us opportunity from a gross margin perspective, obviously. The more products that you're producing, the ability to continue to take price and also some of the mix impact that we're seeing with the expectation that companion animal will grow at a faster pace than livestock in the next few years. That does help us from a margin perspective as well. There are investments that we're making, obviously, to support the growth of the products that we're seeing that will have some impact on margin. But net-net, the impact of price, the impact of mix should be beneficial to margin over the next few years. There are always some unknowns in terms of foreign exchange that could impact the margin. But from an operational perspective, we'd see an improvement in gross margin based on the mix as well as the pricing component. When you look at the OpEx base, there are a number of different things to consider. We are committed to continuing to deliver innovation. So we would expect R&D to grow at a pace pretty similar to revenue. And to the extent that it actually grows faster than revenue, if there are opportunities, that's something that we'll continue to invest in, because we see a very positive return from our investment in R&D. But then when you take it down to the selling and general administrative expenses, that is something that we should be able to grow at a pace somewhere between inflation and revenue, which then would lead to increasing margins. And then we'll continue to make investments in areas that we see for growth, areas such as reference labs, which may be dilutive to earnings in the short term, but overall, will provide right financial return. So we don't necessarily target any particular margin, but we do see opportunity for continued margin expansion within our business based on the dynamics that we just discussed.

Great. How about manufacturing and fulfillment? From your perspective, have you optimized that area of the business at this point?

Yes. So we continue to optimize that area, but we always see areas for continued improvement. Will we see the step change that we've seen over the past 5 to 7 years? Probably not. But obviously, there is continued opportunities to enhance our cost structure, which we'll always look at. And our manufacturing group is very good at being very efficient. And really our goal there is to try to offset some of the inflationary impacts that we see from our suppliers, with us becoming more efficient within our operations. And our manufacturing group has done a tremendous job in that in the past. Obviously, like I said, there are areas that are important for investment within manufacturing as well to support the new product launches as well as support the continuity of supply. Our team has done a great job this year in the impact with COVID-19 of maintaining supply, and that's not by chance. It's by the quality of our manufacturing team as well as investments that we've made in the past to make sure that we have multiple sources for many of our key products and that our production is -- continues to be stable, even in light of a challenging situation. So those are areas that we'll continue to invest in.

Got it. Okay. We've got one minute. I think the final question that I want to put to you is M&A. One of your competitors is getting ready to close a pretty big deal. Where does M&A fit on your priority list? How active do you want to be, particularly in this crisis environment?

Yes. So I think you've seen that we are very active within M&A. The size of the deals that we can do because of our position within the marketplace, being the largest within the market, we don't expect any large-scale M&A within our core. However, based on our continuum-of-care strategy, there are opportunities for us in other areas as well, like we did with the Abaxis deal. So we see our M&A being more tuck-in, complementary type spaces versus a large acquisition within our core. But you'll continue to see us be very active in those bases. From an overall capital allocation priority, obviously, the first will always be investing within the business. That gives us the highest return. M&A has been an area that we're very focused on and continue to expand and grow within our core, but as well within other areas, probably more within that tuck-in size. And then we'll look to return excess capital to our shareholders. Obviously, we've continued to grow our dividend. And obviously, we've currently suspended our share repurchase because of COVID-19, but that is an area that we'll also use to return excess capital to shareholders.

Great. Okay. I think that brings us right up to the time. So let's cut it off there. Glenn, thanks. That was a great overview. And thank you all for -- those of you that were listening. Hopefully, this was helpful.

Thank you.

Great. Thanks.