Zoetis (NYSE: ZTS)
Events: Quick Idea Write-Up
December 1, 2014
- Recent PPS: $44.93
- Shares Out: 502.45 million
- Market Cap: $22.58 billion
- Enterprise Value: $25.63 billion
- 2015E EPS: $1.63
While on the surface buying ZTS here appears to be a plain vanilla coattail ride on the back of Pershing Square, I view it more as an “event” created by Pershing’s involvement. I believe the current investment opportunity is largely independent of the Company’s underlying fundamentals (i.e. the projected return will likely come from a sale of the Company rather than an earnings surprise or new product launch), and as such this write-up is a very short “situational” analysis rather than a deep-dive into the Company’s business.
At its most recent closing price of $44.93, ZTS trades for between 27 and 28 times estimated 2015 EPS. With projected top-line growth of between 5% and 7%, and EBIT margins in the mid-20% range, on a stand-alone basis I believe ZTS is fairly valued at best. When I first began mulling ZTS as an investment idea, my working assumption was that ZTS had room to grow margins, and as a result the headline PE was not as high as it appeared. Pershing Square typically does not become involved in situations that do not have the ability to double in value over a 3- to 5-year time frame, and unless margins could expand I did not understand why Pershing would buy an asset for well over 20 times earnings. After some good discussion on Twitter about this idea, I no longer believe ZTS has room to expand margins, as its 26% EBIT margin is smack in line with other animal health companies – as such, Pershing’s investment appears to be nearly 100% reliant upon a sale of the Company.
In its 2014 Third Quarter Letter Pershing states the following:
“Zoetis’ business model passes Pershing Square’s high bar for business quality…Despite over 80% of its products lacking patent protection, generic competition in markets where Zoetis competes is minimal…We believe Zoetis is a scarce asset, similar to our investment in Beam, which was acquired earlier this year in a large premium transaction.”
As an event-driven investor, naturally I was interested in the break-up of Fortune Brands, from which Beam originated. Post-spin, I could never get on board with the idea that Beam was a “scarce asset”, as I believed the valuation already reflected this premium value. For obvious reasons I regret that stance – with the “scarce asset” concept back on the table in ZTS, I am forcing myself to reconsider.
Using Beam as a template, 30 to 40 times earnings appears to be a reasonable take-out valuation range for a “scarce asset”…as egregious as that sounds. At 35 times 2015E EPS, ZTS is worth approximately $57 per share; and if a sale was consummated within 12 months, the IRR would be approximately 27%. At the high-end of the range, or 40 times earnings, ZTS would be worth $65, for an IRR of 45%. Admittedly I am doing a bit of back-and-filling on the valuation here, as I believe Pershing will catalyze a sale of the Company; but, I do believe the Beam template is reasonable for valuing “scarce” assets in a take-out scenario.
At present, I am unsure how I will fund a ZTS position. Because it is so large, my instinct is to trim the VRX position first – however, purely from a technical perspective, VRX is behaving extremely well at present, so I will likely let the VRX position run for now and perhaps trim into strength in order to buy ZTS on weakness. Regardless, this write-up is to document that I am on watch to establish a ZTS position in the near future.
Note: The ZTS 2015E EPS figure is off the top of my head and might not be accurate to the penny. I know it is in the $1.60 to $1.70 range, however. I will update the post once I have access to the actual figure.