Zoetis Inc. (ZTS) Earnings Call Transcript & Summary

Hi, everyone. Good afternoon. My name is Erin Wright. I'm the Morgan Stanley Healthcare Services and Distribution analyst, which -- it also includes animal health in there. I'm pleased to have with us Zoetis' CFO, Wetteny Joseph with us here today. Zoetis is the world's largest, most diversified manufacturer of animal health products globally. For important disclosures, please see Morgan Stanley research disclosure website at morganstanley.com. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, I think we'll just kick it off with Q&A, if that works for you.

It works.

Yes. So let's start with 2022. And you narrowed your guidance from a top line perspective operationally to 9.5% to 10.5%, excluding FX. What are some of the key assumptions embedded in there from a companion animal perspective, from a livestock perspective? Should we anticipate a decline in livestock, for instance, for the year? And how should we be thinking about that quarterly cadence? Because I think that's important too in terms of how we're modeling it out for the rest of the year.

Yes, Erin, indeed. We -- our guidance, 9.5% to 10.5% operationally this year. Of course, FX has been a bit of a headwind given where the U.S. dollar has been trending. But really pleased to see solid growth on top of last year. Mind you, we delivered 15% operational growth last year with 14% of that being in volume growth and to be in this range after that is really phenomenal. So far, on a year-to-date basis, we posted about 9% operational growth at the top line. You've seen that really driven by our companion animal business largely. And as expected, we've seen some headwinds in livestock, particularly in the U.S., given the generic competition on DRAXXIN largely driving that. And then to some extent, also the swine market in China, starting about halfway point last year, has had some headwinds with respect to pricing that we anticipated coming into this year. So companion animal driving the growth for us in the first half. And with the 9.5% to 10.5%, we expect that to be more back-end loaded as we look at the back half of the year and a number of items that are driving that. If you look at so far this year, we've actually seen a bit more supply constraints in a number of areas than we've seen in prior years. In fact, I get a number of questions around demand. We continue to see demand being really strong across all markets, particularly when you look at the U.S., for example. And so we've had to really deal with more supply-related constraints that have, to some extent, limited the growth that we've seen so far by more than demand, really, which, again, has remained really strong for us. So as we exit the year, we will continue to ramp our supply of Librela, which has gotten off to a really fast start in Europe. Expect to be a blockbuster this year, and that will continue to ramp through the back half. So that will be strong as we exit the year, stronger in Q4 than Q3, Q3 stronger than Q2, et cetera for Librela. And then we've been running the early experience program for Solensia in the U.S. That will go into a full launch as we enter into Q4. So that's going to contribute to how we exit this year. Certainly, we're continuing to see really strong growth behind our Simparica franchise, particularly with Trio in the U.S., posted a 72% growth rate operationally in second quarter. Again, more growth expected for that as we exit the year. And one last item, I'll say, contributing to that sort of cadence, if you will, from a top line perspective is DRAXXIN. So as we exited last year, in -- deep into the fourth quarter, we took some price adjustments on DRAXXIN given some additional generic competition that was coming in that becomes an easier comp for us as we exit the fourth quarter this year. So from a top line perspective, that's what's factoring into our guidance in terms of the cadence that we expect Q3 to Q4, where Q3 may look a bit more like the first half where we did 8%, 9%, so 9% year-to-date than what the full year implies. And then in the third quarter last year, we had a very favorable tax rate, which as we said this year, we'll see more of a consistent rate about 20% in each of our quarters. So that's a comp item in that regard. And the last point I'll make is we have a much easier comparison from an OpEx perspective in the fourth quarter, where we started to ramp up on a number of areas in the fourth quarter last year. So that easier comp will translate into a much faster bottom line operational growth in fourth quarter compared to, say, third quarter where you have the tax dynamic plan as well.

Okay. Got it. And everyone's been looking at this success data on the companion animal side and trying to understand what's going on in terms of that underlying growth and what that means for Zoetis, which I think is an important key part of that. But what's embedded in your guidance in terms of underlying utilization trends or what's embedded in your expectations for veterinary office visit growth and how that really ultimately impacts your business?

Yes. So we track those as well. One thing I'd say we try to make sure we highlight is not only vet visit numbers but what is the revenue per visit and total revenue growth for the vets, which we think is even more important for us in terms of a correlation to our growth rates. And so I'll go into that in a little bit more detail. But first, let's address the point around visits. Clearly, we saw a bolus of visits last year, particularly in the first half of last year, leading into the third quarter a little bit, but mostly in the first and second quarter last year, where there was a bolus of visits from new pets as well as from the shutdowns from the pandemic. And when we saw that, not only were visits really strong, revenue per visit was abnormally strong. In some cases, we saw double-digit growth on revenue per visit. And we said, "Look, this is not going to be necessarily sustainable." We expect things to normalize but will remain above pre-pandemic levels. And if you look at the visit numbers, while the comp is very strong, they're still running above where they were in 2019 on a pre-pandemic basis. And on an annual basis, we've typically seen about a 1% increase in visits. And it's the revenue per visit as we have higher standard of care, higher willingness to pay for that by pet owners and more innovation, driving that is the revenue per visit number that has been running at about 7% if you look at the CAGR that really bodes well for the overall industry, and we've seen that really sustain as well. And so looking ahead, certainly, that's important for us given as we continue to innovate in terms of products, whether it's in the parasiticide area, derm, osteoarthritis pain, et cetera, in terms of what that translates to in addition to the fact that you now have 5% to 10% more pets in the U.S. And while I don't have an exact number for outside of the U.S., it seems like same sort of developments were occurring in emerging markets even where that's a permanent increase, if you will, in pet population that over time is going to bode well for the industry as well. As the pets get older, throughout there, if it's a dog, 12-, 13-year life span, there will be on parasiticides. Some subset will have dermatology sort of allergic issues that will require our products. And then as they get older, some will have osteoarthritis pain. And so we believe that will accrue well for a long time to come.

Yes. They will -- they all will be on Librela, right? On -- I'm going to shift gears to the livestock segment, and then we'll get into some of the products as well. But livestock update on underlying demand trends in the key livestock categories that you participate in, which is all of them. But the impact of the inflationary environment, how livestock customers are impacted. And how do you expect these dynamics to impact? So what is both in near term, like over the second half of the year, but also going into kind of 2023, what are some of the key things that we should be watching out for?

Yes. So livestock, the performance has been in line with what we expected, as I mentioned earlier, with DRAXXIN. But overall, we are very diversified when it comes to livestock, both in terms of geography and in terms of species. So across geography, we're obviously global. We've got the U.S., Western Europe markets. You've got China, which is a big swine market, in addition to places like Brazil with cattle, et cetera. We have a aqua business. It's been growing double digits, very strong growth for us. In fact, I was just in Chile a couple of weeks ago and got a chance to visit our operations and some of our customers on the aqua side. And just to see the impact we've had from a productivity perspective, even as the fish population has grown steadily but not particularly high growth, the productivity out of those in terms of lowering mortality rates and having products to battle against sea lice, et cetera, has contributed to much higher productivity. And I think that's really the theme overall when you look at livestock regardless what species you look at is that we've been able to drive productivity, whether you look at how much dairy cattle it takes to produce milk, in terms of what that output has been over the last number of years has been really phenomenal. And so the question is when is the next phase of innovation that's going to drive yet another sort of growth spread and livestock beyond sort of the typical 3% to 4%, right? And so I think that's what we're working on across our portfolio. There'll be some things that aren't sort of needle movers in there, but you stack them up, they drive growth over a period of time. And then longer term, it's immunotherapies that might be helpful in terms of alternatives to antibiotics and things of that nature that will drive much bigger growth. And I remind folks sometimes, although I was not in the business at the time, when Zoetis spun from Pfizer at the time, livestock was growing faster than companion animal. And so there are certain cycles that this part of the business goes through. And as we run through the comps on the generic competition, we expect to be more in line with where the market should be, which is around that 3% to 4%. We see that in the '23, '24 time frame. And really, there's a level of resiliency that this market has through difficult economic times. You've seen growth in this space. Even when livestock was a bigger proportion of our business, you've seen 2% to 3% growth back at the last economic downturn. So I think people are going to consume proteins and animal proteins. You have emerging markets that have growing middle class, et cetera, that are going to consume that. You have increase in population growth, all of those long-term driving secular growth for this segment. And consumers will absorb a certain level of price increases. They might sort of migrate between animal proteins from whether it's beef to poultry or to pork, et cetera, but we're in all those species and across virtually every significant market as well.

And I do want to break down China a little bit on livestock. What are you seeing right now in terms of the China swine market and underlying pricing trends there compared to what's embedded in your expectations? Is that progressing according to plan, better than planned?

Yes. Look, China is a very important swine market, the biggest wine market actually in the world. And we've seen a period of really depressed pricing that has put pressure on producers there. And about, I would say, the June time frame or so, we've seen prices start to increase in China. They have sustained a much higher level, which will bode well long term from a swine perspective in China for us. And so we're looking forward to seeing that in addition to just the market opening up more in terms of some of the lockdowns, which will drive consumption in terms of looking across foodservice and restaurants and so on. So we believe that those will bode well as we look ahead. One point on China that is quite phenomenal, it's just seeing the growth on companion animal. I know the question is livestock related, but it's just been quite a shift to -- from where livestock was the majority of the business in China to where now it's about the same size as our companion animal business. And in fact, even through some of the lockdowns, we've seen really, really strong growth in companion animal during the shutdowns, which we expect will continue and drive sustainable growth across China for us long term.

Great. And speaking of sustainable growth, can we talk a little bit about Simparica Trio? And we get a lot of questions on the evolving kind of landscape there. But I think that as I take a step back and I think about this market and the opportunity and the evolution of parasiticides, whether it was from topicals to oral to oral to [ triple to triple ] to combination. There's a long runway here. And tell me if I'm wrong, but like I do think that's something that maybe is underappreciated. Can you talk about how Simparica Trio and your broader parasiticide franchise plays into that where you have been also historically under-indexed?

Well, I couldn't agree with you more. And we have been historically under-indexed in parasiticides and have been catching up here of late with a number of products, especially our Trio offering, which is the first triple combination in the U.S. But to your bigger point, parasiticide is a very important category for us, and we have some really important franchise -- franchises, especially with Simparica and Simparica Trio that we'll continue to invest in to drive that. And what we've seen is this evolution from, like you said, topicals and collars into the oral prescribed parasiticides and that's driven significant growth within that subsegment, if you will, of parasiticides. And the movement to triple combination is still relatively new. We launched our triple combination product in 2020 in the middle of the pandemic. Yes, it's done phenomenally well, but there's still a long way to go in terms of driving that growth within parasiticides from collars and topicals into orals and especially within orals into the triple combinations. And one data point I would remind here is when we look at our Trio growth, about 30% of the dogs that are being prescribed Trio weren't treated with a prescription oral medication before. So you can see some of the data points indicating that expansion ability. And as we expect competition to come into this space, it's really important to remind everyone the importance of being first to market. And this is really about expanding this and more advertising and promotion from ourselves and others into the space, it's only going to drive more pets into the clinic which would then accrue to us in addition to whoever else is in this market because it's about bringing more awareness to this much more convenient, very effective and safe product. And as more advertising promotion happens, more pets come to the clinic, and they'll be prescribing our product as well as whichever other product, but we believe being first to market in a product that's proven to be safe already in the market for more than 2 years is going to benefit us even from other A&P that's done in this space.

Do you have any details or data points on brand loyalty in this market? I mean we hear about it a lot in parasiticides. But how can you leverage that being first to market with Trio, but also your competitive positioning, just generally speaking, you don't have an incumbent kind of stand-alone leadership positioning in parasiticides that you will be cannibalizing. You can leverage that position, you leverage your positioning with distributors. What other levers are there that people maybe aren't thinking about as well?

Yes. So a number of levers, but going back in terms of history that we've seen here, if you look at the oral -- you talked about the migration from collars and top of those into orals. Well, we were not the first to market with an oral, we're third. At the time that our products launched, there were 2 other products in the market. And those 2 other products were running somewhere in the mid-$200 million range from a revenue standpoint. And both of those products are north of $900 million today. And so when you're first to market, it does have a significant advantage in this space is the first thing I would say. The second one is that if you look at being the biggest innovator in the space, we're innovating not only with in parasiticides. And by the way, we have a broad portfolio of parasiticides across dog and cat, et cetera. And our Trio product is growing outside the U.S. in certain markets where heartworm is prevalent, markets like Japan, for example, and elsewhere, we actually posted about $30 million of revenue in the second quarter for Trio outside the U.S. And Simparica product for fleas and ticks continues to grow quite nicely outside the U.S. as well. So the entire franchise is growing quite well for us and driven much free in the U.S., of course, but we continue to see very strong growth across our franchise here. But also we're innovating. We're launching our monoclonal antibody products for osteoarthritis pain. These are important products to vets and their practices that we can leverage in terms of the relevance and importance to them to drive growth across our offerings, not just within the specific categories.

And can you speak to atopic derm, you've basically built this market and your ability to maintain share in that space. And when inevitably, it will become more competitive. But at the same time, you have life cycle innovations like chewable tablet for APOQUEL. You also have CYTOPOINT could you convert customers to CYTOPOINT, for instance, that would be inherently stickier. What other dynamics are at play alongside brand loyalty that we typically see in the space?

It's a very important market and franchise for us. If you look at our derm portfolio, which has grown 25% in the last couple of years. Of course, we expect that to normalize and not sustain for products have been in the market for years, but there's still significant room to expand here. When you look at the U.S. market, for example, there's still about 6 million dogs that suffer from itchiness, if you will, that are not being treated. And then there are about 8 million dogs being treated and that builds about 5 million on our products. But there are 3 million that are still on antihistamines or some sort of topical. So there's still room to grow from those 3 million plus the 6 million that are not being treated, and we're only talking about the U.S. If you look at our performance, you've seen really strong growth coming from our international markets in derm, partly because we're also putting more advertising and promotion, unbranded even because certain markets, you cannot do branded promotions. But even unbranded promotions are driving more traffic to the clinic, and then they're getting prescribed our products to the extent that they have the need. So we're seeing really strong growth across international markets. And then lastly, as you alluded to, we're going to continue to innovate here, not only with respect to APOQUEL chewable, which is actually launching across markets outside the U.S., that's still pending approval in the U.S. But -- so that's 1 element that will drive here. And you may see us enter into other species from dermatology perspective as well. So we'll continue to innovate here, very important franchise both across the U.S. and outside the U.S.

It's always a tricky dynamic given that it's always underappreciated what's in the pipeline because you don't disclose it. But 300-plus projects in there. Have you ever thought about providing a little bit more disclosure just to help with some of the questions that we get from investors, for instance, around the competitive landscape. And again, I don't think there's a right answer either way. But curious what your thoughts are on there in terms of the strategy around disclosure.

Look, I think if you look at our track record and what we've been able to do here and what we continue to do in terms of investing in R&D, this is a space that doesn't typically unveil a lot of details that is in the pipeline, and we have more at stake for doing that. So I don't think we're going to change that mode per se. We are very intentional although in terms of investing in a number of fronts, in a number of areas. So when you look at now having mAbs, starting with our derm product CYTOPOINT, now with our osteoarthritis pain products, we're proving that we're able to not only innovate in terms of what we do in R&D, but what we do in terms of scaling these products, and we'll continue to use that as a platform from which we can go after different therapeutic areas. And we have talked about certain therapeutic areas that we like that without getting into a whole lot of specifics whether it's chronic kidney disease or diabetes, cancer, et cetera, there are a number of areas that we've said, hopefully, that we like. But with $500 million of R&D investment growing at about 10%, you can imagine there are a number of facets in a market that has grown to a point and continues to have underlying dynamics that point to significant growth on a go-forward basis, that bodes well for whatever we're working on in terms of what the addressable market is for the therapeutics. And so we continue to be driven by advancing careful animals through these therapeutic areas as well as others in diagnostics, et cetera.

Okay. And then moving on to Librela, so I definitely want to spend some time here. Can you give us an update on the launch progress, what we're waiting on in terms of U.S. approval? And any sort of update on the supply chain challenges overseas as well?

Sure. Look, Librela has had a phenomenal start. And if you look across Europe, it's already #1 pain product in its first year and will be a blockbuster this year, which in animal health, that's $100 million a year. So the fastest product, I believe, on record to get to a blockbuster status, especially considering it's in Europe where adoption tends to be a little bit slower than in the U.S. So I think that bodes well. And if you look at the number of attributes that we're seeing so far, they really point towards a lot of reason for optimism across Librela long term. If you look at the expansion into those that had not been treated before, it's about 40% of dogs that are being treated with Labella. If you look at months on therapy, I would say those are trending above our expectations, et cetera. So given the safety profile and efficacy here, the product is off to a really hot start. For the U.S., we continue to work towards an approval, which we expect to happen sometime later this year. As we've said many times, that approval is also dependent on inspections that need to happen outside the U.S. just as a reference point for the approval of Solensia, which is the osteoarthritis pain product for cats in the U.S. that approval also required an inspection outside the U.S., which occurred in the middle of the pandemic. So certainly, we continue to work through that process. And once that approval happens, we will then launch an early experience program. We find that to work really well. It worked well for Solensia in Europe. It's working now for Solensia in the U.S., where we'll be doing a full launch fairly soon. On Solensia, but we've been running the early experience program. We did the early experience for Librela for dogs in Europe, and we'll plan to do the same here in the U.S. with a full launch sometime in the second half of next year is the plan. So we continue to drive through. You've seen it in our numbers as well for Librela in Europe, increasing sales each quarter as we have more and more throughput through -- to our supply chain and manufacturing.

I mean I think it's an important thing to know how big this product can be, but what would have sales been if you didn't have supply chain issues?

Look, I don't know if I would put a number here for you, Erin, on this. But I would say this, we continue to run on allocations in Europe on the product. And largely, this is because this is a chronic condition. And so we want to be very responsible about allowing dogs get on the product. We have to know and be confident that we can continue to supply every single dog that gets on it, right? And so while we'll be a blockbuster this year, as I mentioned in what appears to be a record time, it would be a higher number than what you're actually going to see, and we continue to work intently to get the ramp continuing beyond this year, obviously, for the market.

That I would try. So on IP for the product, it seems like based on our checks with multiple different players and partnerships that we've seen across the space is that you're going to be the only player with the monoclonal antibody in pain for quite some time?

Look, I think the other thing that I would say is we don't stop working on innovation, right. Whether it's incremental for existing products or new products, we have about half of our spend that goes into each area. And any time we have products on the market that are being launched, we're already working on various aspects of those beyond that. We shared some examples -- I shared some examples earlier with respect to dermatology, for example, and that holds true across our spectrum. So it's great to be able to go after an unmet need out there with a safe and efficacious product, but we don't stop because we continue to work on those with our focus on R&D.

I have 2 other pages of questions and 3 minutes left, but -- do you want to talk a little bit about margin dynamics, margin expansion is expected to be more subdued, obviously this year, you are investing in these product launches and commercial activities associated with them. But do you expect margin expansion to return to historical levels in 2023 and beyond? Or is this more of a multiyear cycle of investment above and beyond the norm?

What I would say, Erin, if you look at the business' ability to drive operational leverage on the P&L, it certainly is above what you're actually seeing now, right? And we're deliberately making investments in our field force, investments in certain areas to drive growth that we see line of sight in a strong and attractive return from. So this investment in our field force, for example, in our petcare business in the U.S., this investment to separate out the diagnostics and so on. We see a strong return coming from those. And -- but we remain committed to drive bottom line growth above the top line growth, even if it's at a lower differentiator than the business is capable of doing. And so long term, given the mix shift that we have with respect to companion animal and as we continue to innovate, we expect to have the ability to continue to expand margins in the business. I would say, from a CapEx perspective, we'll continue to drive capital investment in capacity beyond this current year. But from an OpEx perspective, I think you've seen some pretty meaningful investments in terms of our field force and so on that will drive growth with these products that we're launching and existing products that are continuing to grow for us.

And capital deployment priorities there. M&A, I mean, 1 part of me thinks you can just eat up this market. But there's also limitations from an antitrust perspective. But how are you thinking about the pipeline? How active are you looking at potential opportunities to bolster the offering and bolster kind of the portfolio?

Yes. So we actively look at M&A. Clearly, our first priority is on investing in the business, and we're doing that across R&D. And I'm not going to repeat the areas that we've touched on today already. And then M&A is the next lever to look for opportunities to accelerate our growth in areas that are strategically important for us. Now as you said, there are some limitations given the state of the market in terms of concentration across big players. And so some of the deals that we do, maybe tuck-ins like the Jurox acquisition that we announced in Australia and New Zealand, for example, or the Basepaws acquisition we announced recently and closed recently with respect to being able to drive this emerging area, but also will be very important to us in terms of informing our R&D investments and so on around genetic markers and so on a for cats, which we really think is an opportunity to drive more medicalization across cats compared to dogs, they trail dogs pretty significantly in terms of medicalization rates. And so we're going to continue to innovate for cats just like behind the Solensia monoclonal antibody for use osteoarthritis pain and drive more products in that arena and so on. So M&A is going to continue to be important for us. That's never something you can really predict timing of and so on. Meanwhile, we do see opportunities in the market to buy back shares, and we take those opportunities but have the flexibility to turn that dial up and down depending on what we see from an M&A perspective.

As well as commitment to the dividend?

Exactly.

Okay. All right. Thanks so much. We're out of time, unfortunately. But appreciate it, and hope you have a great conference. Thank you.

Thanks, Erin.