Events: FV Update
May 6, 2015
- NYSE: ZTS
- Recent PPS: $45.68
- Shares Out: 502 million
- Market Cap: $22,931
- 2017E EPS: $2.27
- 2017 PE: 20.2X
With ZTS selling for approximately 92% of its standalone fair value, a successful investment from current levels requires a catalyst. While I continue to believe Pershing Square’s involvement will eventually catalyze a sale of the Company, the recently announced restructuring program and subsequent management commentary indicates ZTS is likely, at least for now, to pursue an acquisition program. Given the favorable M&A environment, Pershing’s involvement, the recent appointment of ACT chairman Paul Bisaro and ZTS’s relatively fully valued stock price, this is likely a highly attractive alternative to a sale, particularly if a larger ZTS eventually merges into a larger entity down the road.
Restructuring Program. In its 1Q15 earnings presentation, ZTS outlined a robust restructuring program that seeks to expand EBITM to 34% by 2017 from 25% in 2014. In addition to incurring approximately $497MM in after-tax restructuring charges (cash), 2017 Revenue and Gross Profit will decline by approximately $280 and $100 due to a nearly 40% reduction in the SKU base. In a “shrink to grow” strategy, ZTS will look to grow north of 5% per annum off of a 2017 Revenue base of $4,950. Additionally, margin expansion will continue beyond 2017 as Opex growth is projected to lag Revenue growth.
Leverage. Management indicated a leverage floor or 2.5 times EBITDA (I use 3X EBIT as a proxy), at which I estimate ZTS has just under $1B of incremental 2015 capacity ($1.84 per share).
“Maintenance” R&D. Management indicated that “life-cycle management” R&D (i.e. product maintenance R&D) is approximately 50% of total R&D. Using 2017 as a base, this works out to an estimated “retained earnings ratio” of approximately 12%. In other words, after-tax Growth R&D is roughly 12% of “core” Net Income. If ZTS can grow 5% in perpetuity while retaining 12% of earnings, that implies an ROE of approximately 42%; if 6%, then the ROE is 50%. Point is, ZTS is an extremely high quality business, thus it warrants a premium multiple.
Standalone Valuation. Utilizing management guidance thru 2017; a 2017-2020 Revenue CAGR of 6%; 50bps of annual margin expansion from 2017-2020; a 30% tax rate; and a 20X terminal PE, ZTS is worth $49.73 per share with a 3-year IRR of 13.5%. At a 22.5X TPE it is worth $54.50 with a 17.4% IRR; and at 25X, $59.27 with a 21.1% IRR.
“Scarcity” Valuation. In my December 2014 ZTS write-up I highlighted Pershing Square’s commentary regarding ZTS’s status as a “scarce” asset. As I said back then, I ignored the BEAM “scarce asset” thesis to my detriment due to my belief that BEAM was expensive on a standalone basis. Given how closely Pershing is working with ZTS, I believe there is a high probability of ZTS being taken out in a “large premium transaction”. As such, I estimate ZTS could go for between 25 and 35 times 2017E EPS of $2.27, or between $57 and $79.