Best in Show Zoetis Earns a Wide Moat Pfizer's animal health unit has a wide moat in an attractive industry, but the proposed offering range looks to fully price in the firm's advantages. January 29, 2013 Contributing Analysts Zoetis' IPO will be the first opportunity for a pure-play investment in one of the major animal health manufacturers. The underfollowed industry has historically been buried within big pharma firms and largely ignored, but we believe David Krempa Associate Equity Analyst it has very attractive characteristics. As the market leader, Zoetis is the best-positioned firm in the industry, and Specialty Pharmaceuticals we believe it warrants a wide economic moat. Its scale, fragmented customer base, cash-pay market, and minimal [email protected] generic competition all contribute to the firm's ability to earn returns well in excess of its cost of capital. +1 312-696-6633 Damien Conover, CFA TRANSACTION SNAPSHOT Director Pharmaceuticals [email protected] Zoetis is scheduled to begin trading on the NYSE on Feb. 1 under the ticker symbol ZTS. Pfizer will offer 86.1 million +1 312-696-6052 Class A Zoetis shares of the 504.5 million (17.1%) total diluted shares to be outstanding at the time of the offering assuming a $23.50 pricing, the midpoint of the $22-$25 proposed offering range. The $2 billion offering would value Zoetis at $11.1 billion-$12.6 billion. Pfizer will hold all Class B shares, which carry 10 times the voting power of Company Stats Class A shares, and has said it may subsequently make a tax-free distribution to its shareholders of all or part of its Zoetis (ZTS) Fair Value: $22 Trend: Stable remaining Zoetis stake. Moat: Wide Uncertainty: Medium 2011 2012E 2013E KEY INVESTMENT CONSIDERATIONS Adj EPS $1.00 $1.18 $1.31 FV/EPS 22.0x 18.6x 16.8x × At the midpoint of the filing range ($23.50), Zoetis would trade at 18 times our 2013 earnings per Pricing Range: $22.00-$25.00 share estimate. Our discounted cash flow-driven fair value estimate is $22, suggesting that valuation, at the Market Cap: $11.1 - $12.6 Billion proposed offer price, leaves limited upside for long-term investors. We forecast a five-year revenue compound annual growth rate of 7% and a five-year EPS CAGR of 9%. × As the biggest firm in the industry, Zoetis has scale that gives it significant advantages over Offering Stats competitors. Its large product portfolio can justify an extensive salesforce and reduce distribution costs while Lead Underwriters: smaller competitors must rely on expensive and less efficient distributors. J.P. Morgan Merrill Lynch × With leading positions in the emerging markets, Zoetis is best positioned to capitalize on growth, Morgan Stanley in our opinion, as rising standards of living drive wider adoption of meat-heavy diets. Zoetis has Expected Pricing Date: market-leading positions in the fast-growing Latin America and Asia regions, which allows it to invest in January 31, 2013 salesforces and infrastructure, further distancing itself from competitors. Proposed Offer Range: × The lack of government payers and large health insurance firms makes animal health a very $22-$25 per share attractive industry with strong pricing power and minimal generic competition. Zoetis sells to a Proposed Max Offering Amount: highly fragmented group of cash-paying customers, so it is able maintain significant pricing power. The lack of Base: $2.15 billion Over-allotment: $323 million large payers to force or encourage customers to switch to generic treatments leads to very low generic utilization. SELECTED FINANCIALS ($mm) FYE December 2009A 2010A 2011A 2012E 2013E 2014E 2015E 2016E Revenues 2,760 3,582 4,233 4,318 4,613 4,929 5,250 5,574 % yoy change 30% 18% 2% 7% 7% 7% 6% Adj EPS $ 0.37 $ 0.55 $ 1.00 $ 1.18 $ 1.31 $ 1.43 $ 1.55 $ 1.67 % yoy change 49% 82% 18% 11% 9% 8% 8% Morningstar Institutional Equity and Credit Research Morningstar Institutional Equity Research: Zoetis IPO Perspective 2 January 29, 2013 Our $22 Fair Value Estimate Points to Low End of Proposed Range Our DCF valuation of the firm is $22 per share, which is 17 times our 2013 EPS estimate and implies an enterprise value of 12 times our 2013 EBITDA estimate. We forecast a 7% five-year sales CAGR and a 9% EPS CAGR. We believe the firm's leading position in the fastest-growing markets should allow it to grow slightly faster than the global market. We expect slight margin improvement over the next five years. Zoetis has recently seen margin improvement due to synergies from the acquisitions of Fort Dodge (Wyeth) and Alpharma (King Pharma) and from Pfizer's companywide cost-reduction program. Management expects continued margin expansion as a result of additional cost-saving initiatives and operating leverage, but has yet to give specifics. We forecast the operating margin improving from 24.0% in 2012 to 24.6% in 2016. We expect operating leverage and efficiency programs to be partially offset by lower-margin emerging markets making up a growing portion of Zoetis' sales. Limited comparable metrics for Zoetis. Acquisitions in the industry have not yielded many comparable valuation metrics. All recent deals have been for undisclosed terms or have been part of a larger health-care firm, such as Pfizer's acquisition of King Pharma (Alpharma). The only data point worth noting is the valuation used for the proposed Merial-Intervet merger, which was later terminated. The firms had agreed that a 3.1 enterprise value/trailing sales multiple would be appropriate for both. Because of its consumer focus, Merial posts higher margins than Intervet, but this was deemed to be offset by the more attractive growth prospects Intervet carries as a production animal-focused business. Our $22 fair value estimate would imply an EV/sales multiple of 3.2. Zoetis will be the only one of the major pure-play animal health firms that is publicly traded, although the eighth- largest player, Virbac, is publicly traded in France. Given its small size, it may not be an appropriate comparable, but Virbac trades at 19 times 2013 consensus EPS estimates. Cost Advantages and Barriers to Entry Earn a Wide Moat for Zoetis Zoetis earns a wide economic moat as a result of its intangible assets and scale. Although patents are not essential for maintaining a product in the animal health industry, 20% of the firm's revenue comes from products protected by patents that allow Zoetis to charge a premium price and insulate it from competition. Its strong brand name gives Zoetis another advantage over competitors. When customers are using drugs on potentially millions of dollars' worth of livestock, or a pet that they love like a family member, they will be willing to pay a premium to buy from a firm they trust. Scale also provides Zoetis with a key advantage. Because of the highly fragmented customer base, the salesforce, distribution, and relationships are extremely important. Launching a new product is not as simple as getting one large payer (managed-care organization, Medicare, or government) on board; the company needs to individually deal with veterinarians and meat producers. Zoetis' broad portfolio can support its own salesforce, allowing the firm to bypass distributors. Barriers to entry are significant in both capital and time. Although not nearly as expensive or as time-consuming as in human health, it is still very challenging to bring a new animal health product to market. Given the small market size and relatively modest sales potential of products, the reward often will not justify a new competitor pursuing clinical trials to bring a product to market. ©2013 Morningstar, Inc. All rights reserved. The information contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security. Redistribution is prohibited without written permission. For licensing or permission to use this information, call +1 312-696-6869. Morningstar Institutional Equity Research: Zoetis IPO Perspective 3 January 29, 2013 One of the best examples of the strength of Zoetis' moat is its pain medication for dogs, Rimadyl. The product lost patent exclusivity in 2001, but sales are currently 35% higher than they were in 2001. Vets' relationship and trust in Zoetis have allowed Rimadyl to maintain and increase sales despite generic competition. Source of Moat Application to Zoetis Intangible Assets: Patented product and trusted brand name Switching Costs: Direct switching costs are low, but switching to an inferior product could lead to substantial losses for meat producers Network Effect: Not applicable Cost Advantage: Scale plays significant role, leverage the sales force across many products, and avoid relying on distributors Efficient Scale: The small size of individual product categories offers little reward for new entrants relative to the high initial investment Source: Morningstar. Mature Industry Warrants a Stable Moat Trend We believe Zoetis has a stable moat trend. The firm competes in a very mature industry that is not experiencing any significant changes. With the heavy concentration among top firms and few revolutionary products in development, we do not expect the industry to face any material changes to its competitive landscape. Zoetis Is Top Dog in a Very Attractive Industry Zoetis' initial public offering will be the first opportunity for a direct investment in one of the major global animal health players. We believe the underfollowed industry carries very attractive characteristics. Animal drugmakers sell to a highly fragmented market of cash-pay buyers, so they possess significant pricing power and see very low generic utilization.