INDUSTRY FOCUS // Healthcare // 08-31-2016

By Markets Fool.com

Americans are spending more money on their pets than ever before -- and that's been good news for people investing in pet stocks. Companies like Zoetis Inc. (NYSE: ZTS), VCA Inc. (NASDAQ: WOOF), and IDEXX Laboratories, Inc. (NASDAQ: IDXX) have enjoyed sales and profit growth, while small up-and-comers like Aratana Therapeutics Inc. (NASDAQ: PETX) are building entire businesses around pet medicine. Can tailwinds supporting pet profits continue rewarding investors?

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In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by contributor Todd Campbell to discuss whether pet stocks will remain portfolio-worthy.

A full transcript follows the video.

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This podcast was recorded on Aug. 31, 2016.

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Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's August 31st, 2016, and I'm your Healthcare show host, Kristine Harjes. On the phone is Motley Fool healthcare contributor Todd Campbell. Thanks for joining me today, Todd.

Todd Campbell: Glad to be here, Kristine.

Harjes: Today is the show that you've all been waiting for. We're finally doing our episode on investing in pet healthcare. We've been building up to today's episode for a while, ever since we got a request earlier this month from Jenny Gustavson in The Motley Fool Podcast Facebook group. Jenny noted that she was trying to take the Foolish advice of investing in what you know. And what she knows is she's been spending a lot of money taking care of her elderly dogs.

Anyone that owns a pet knows it can be awfully expensive. Todd, do you have pets?

Campbell: I do. Where do I start? I have a dog. I have two cats. I even have a bearded dragon.

Harjes: A bearded dragon?

Campbell: Yeah, my 14-year-old.

Harjes: That's pretty awesome. Are they expensive to take care of?

Campbell: (laughs) Absolutely.

Harjes: I'm sure the grooming on that beard couldn't be cheap.

Campbell: Yeah, pet care, veterinary care -- anyone who has animals knows, especially as they get older, they require just a little bit more care than ever before.

Harjes: Yeah, and this is something that a lot of U.S. households are going through. Everybody that I know, it seems like, owns a pet. Maybe that's just because I don't and I'm jealous. But this is a market that's very, very large and very prevalent throughout the country.

Campbell: It's absolutely huge, and to hammer that point home, I thought it might be fun to play a little game with you and our listeners.

Harjes: Okay! Lay it on me.

Campbell: Great. I was thinking we could do a little over/under, where I say a particular category, and I say, "What do you think? Are there more of these or less of these?" And, of course, listeners can play along at home.

Harjes: Okay, sounds good. I'll give the listeners a second before I give my answer.

Campbell: Fantastic. Let's start off with dogs. Do you think there are more or less than 50 million dogs in the United States?

Harjes: 50 million dogs in the U.S....I'm going to go with over.

Campbell: You would be correct. There are 73 million dogs in the United States. 73 million! That's 73 times larger than the state that I live in, population-wise.

Harjes: That's insane.

Campbell: And there's another 43 million dogs in Western Europe, so if you include Western Europe and the United States, you get 116 million dogs. Let's go to the next one. Do you think there are more or less than 1 billion chickens?

Harjes: 1 billion chickens...that's tough. I'm going to go with less on that.

Campbell: There are 19 billion chickens --

Harjes: No!

Campbell: -- in the world. Yeah, I read that and I was a little shocked as well.

Harjes: That's crazy! You have to think, most of their life spans aren't really that long, so that's a lot of chickens being born every single year.

Campbell: That's a lot of chickens, absolutely. Do you want to do one more?

Harjes: Yeah, let's do one more.

Campbell: Are there more or less than 500 million cats on the planet?

Harjes: 500 million...that's tough. I feel like there are a lot of cats that aren't household pet cats. And do we take tigers into consideration? Or are we just talking --

Campbell: Small cats.

Harjes: OK. What was the number again?

Campbell: Small cats: This includes wild cats, like feral cats.

Harjes: 500 million?

Campbell: Yes. More or less?

Harjes: I'm going to go with less again.

Campbell: Errr. 600 million cats worldwide.

Harjes: Wow. That's a lot of cats.

Campbell: We're talking about billions of pets: tons of animals globally that are receiving care, either because they're going to be used for livestock to feed the world's population, or because they're animals that have become a member of our family. When you start thinking about the size of this addressable market, it probably shouldn't be too surprising to find out that we're spending tens of billions of dollars a year on pet care alone.

Harjes: Clearly you've looked into the numbers behind this. Do you happen to know how much Americans spent last year on their pets?

Campbell: The American Pet Products Association -- we'll do one more over/under, how's that?

Harjes: OK. This is cheating, though, because I know the answer.

Campbell: OK, we'll do it for our listeners. Do you think Americans spent more or less than $50 billion on their pets last year?

Harjes:This is me pausing, giving our listeners some time to think about it.

Campbell: You know the answer, so I'll just dive right in. We spent $60.6 billion last year on our pets, according to the American Pet Products Association.

Harjes: We did, and that's a rising number: That's up 4% year over year. There's an estimated $62.75 billion on the way for 2016; that's another 4.5% climb. Meanwhile, there are polls out there saying that 9 in 10 people say their pets are part of their family, so it's understandable why this market is growing so rapidly. People want to take care of their pets, in good times and bad.

Campbell: Yeah. You look at some of the other numbers and studies that have been out there, showing how this has changed over time. If you look at seniors -- they own a lot of pets, as well -- their views on pets are different than, say, millennials. Millennials are buying more toys, providing more pet care, are willing to make more sacrifices than any other age group. That suggests that the tailwinds toward spending on pets in the future are pretty strong.

Harjes: I do wonder with that whether there is something to be said for a pet being your first pet ever, or if maybe you've had five dogs before -- if that influences it a little bit, and skews those numbers about millennials versus people that are in older generations.

Campbell: It might...it'll be interesting to see how that plays out over time. You could also argue that millennials haven't seen some of the economic hardship that the seniors have, depending on their age.

Harjes: That's a good point, too. With all of this overviewing, I think it's pretty clear that pet spending is a big spending force. How can an investor take advantage of this? What companies are in the space?

Campbell: Well, the big kahuna that investors need to focus on, or at least spend a little time getting familiar with, is a company called Zoetis. The symbol on that stock is ZTS. This was formerly the animal-health products division of Pfizer; it got spun off by Pfizer back in 2013, when Pfizer was downsizing, after it lost patent protection on its multibillion-dollar cholesterol drug Lipitor.

Zoetis is a very intriguing company. It's the biggest player out there. It's a pure play on animal health. They operate both companion-animal businesses and livestock businesses.

Harjes: Right, we haven't really touched on livestock business very much, but that's a pretty big part of a lot of these companies, in addition to what you would imagine when you think of pet healthcare, with your medicines and vaccines and vet trips.

Campbell: Right, you want to keep your livestock healthy. If you're a farmer and you have cattle, you want to make sure that they're healthy when they make it to market. So, you have vaccinations and other things that you do to make sure these animals are healthy.

Harjes: Exactly. One other part of the Zoetis story that I think is worth mentioning is that there's some involvement with a famous billionaire named Bill Ackman; he runs Pershing Square Capital Management. Their latest 13F revealed that they actually dumped a ton of their stakes in Zoetis: They now own 55% less of it than they did at the end of the first quarter. This has something to do with them having an activist campaign, trying to get the company to cut costs.

And as always, when we talk about billionaires, you should not follow them blindly. What do you think, Todd? Is this an instance where you might want to follow Ackman? Do you find the stock interesting?

Campbell: I think you have to take it with a very big grain of salt. Anyone who's listened to our program in the past knows that Ackman has a big stake in a company called Valeant (NYSE: VRX). Valeant's shares have been hit pretty hard. It wouldn't shock me if some of the sale in Zoetis, which is up 56% since February 2013, some of that is profit-taking to free up some cash. I think investors are much better served, when it comes to looking at the pet category, to ignore the machinations of the billionaires who may be trafficking in and out of these stocks, and just simply look at the long-term potential for sales and earnings.

Harjes: Right. With that, I will reiterate -- this is your biggest pure play. It can be kind of hard to find pure-play stocks in animal health. The norm is that it's a small subsection of another bigger company -- of Merck, Bayer, Eli Lilly -- all have relatively small parts of their business devoted to animal health. But with Zoetis being spun off from Pfizer, it stands alone as: "I want to invest in this trend, and this is a way that you could do so."

Campbell: And that gives it a lot of advantages over these other companies. Think about this: All of the efforts for Zoetis are focused solely on driving sales growth and profit growth in the animal-health business. It doesn't have to compete with other pharmaceuticals, like if you're talking about Merck, for research dollars. So, there can be a lot of advantages associated with buying a company like Zoetis, rather than trying to say, "OK, I'm going to buy Merck & Co. because it's the second-biggest maker of animal-health products." It's a much smaller piece of Merck's puzzle.

You look at Zoetis' competitive advantage, they say they're 45% bigger than the next-biggest. So, it's a massive company. They expect they're going to do about -- I think it's $4.8 billion in sales this year -- they think they can grow that to $5 billion-plus next year. It's a profitable company, it makes some money. Investors should probably bank on somewhere around single-digit top-line growth from here, like 3% to 6%, and maybe better than that on the bottom line. Maybe earnings are going to grow closer to double digits because of some cost savings, into being able to leverage greater sales against fixed costs.

Harjes: Right. We've talked about Zoetis, the big guy in pure-play animal health, and we've mentioned some of the other large pharmaceutical companies that have their hands in this market. There are also a ton of other smaller companies that are also pure plays, but on a much smaller scale than Zoetis.

One of them that I thought we should talk about was Aratana: The ticker there is PETX. They're up 56% year to date, and have been incredibly volatile along the way. Last September, they lost 50% of their value due to poor trial results. This mirrored something you might see in a human-health company. They were testing two different drugs for dogs with B-cell lymphoma. The trial came out with negative news; the stock shed a bunch of value. It goes to show, the risks tied to a lot of early-stage biotechs in human health are kind of similar to the ones here in animal health.

Campbell: Yeah. And as we get wealthier as a nation, and start spending more and more on our pets, you're probably going to see an increasing trend toward our willingness to spend money on life-extending therapies, something we maybe didn't do 20 years ago.

Aratana is an interesting company. It's a pure-play developer of next-generation therapies for animals. But where Zoetis is the tried-and-true proven leader, this is a very unproven, new, young, clinical-stage company, and a tiny one at that. It only has a $321 million market cap. A lot of the value in this is going to be: "Can they develop these drugs for things like lymphoma, or some of these other drugs they've been working on, and get those to market and turn those into top sellers that allow them to turn a profit?"

Harjes: And they do have a few drugs that are approved and on the market. They have Entyce, which is an appetite stimulant for dogs. They have a drug called Galliprant, which is licensed to the Eli Lilly animal-health segment, which is called Elanco. They also have two drugs called Blontress and Tactress, which are lymphoma treatments for dogs.

But product sales in the second quarter only totalled $230,000, which is really not much at all. This is out of total revenue for the company of about $21.1 million. The vast majority of that -- actually, more than that net income number -- came from revenue from Elanco and that partnership.

Campbell: Yeah. This is definitely a company that you have to do some digging on. Don't just look at the top-line number and say, "They did $30 million in revenue in the second quarter." That's not true. They received a big licensing payment from Elanco in the second quarter, and that swelled their top-line and bottom-line number. Really, it's too early to know whether or not these are going to be big sellers for this company, and whether or not this is going to translate into meaningful and consistent sales and profit going forward.

Harjes: Another part of this pet health market would be your veterinary operators. The name to know here is VCA -- ticker, appropriately enough, WOOF. They, like I said, are a veterinary clinic operator. They have 682 animal hospitals in the U.S. and Canada, which is the vast majority of their revenue, about 79%. They also operate a vet diagnostic lab, which is 16% of the revenue. What do you think about them, Todd?

Campbell: This is an interesting story. You're able to invest in the vets...maybe it's a hedge against your own pet spending. If you have to bring in your dog or pet for care, maybe it feels a little less painful when you're at the checkout counter, knowing that you have some shares in the veterinary clinic.

Harjes: Yeah, some part of this bill will go into your pocket.

Campbell: Right. Let's do an over/under one more time. Do you think there are more or less than 30,000 pet hospitals in the United States?

Harjes: 30,000 pet hospitals...I think that sounds really high. I'm going to go less.

Campbell: It is less: 26,000. But that just goes to show how much opportunity for growth could exist for WOOF. If you think about it, they have only less than 700 hospitals, yet there are 26,000 out there. A lot of the growth, historically, for this company has come from acquiring existing hospitals and rolling them in, and using the best practices they've learned over time to make them more profitable.

Harjes: Right. This is something they've been doing consistently. They just acquired a company called CAPNA in the second quarter. That was another 56 hospitals, and I'd say it looks like they're going to continue to expand their network, too.

Campbell: Yeah, they added about $200 million in annual revenue via acquisitions in the first half of the year. That represented a lot of the top-line growth. If you're just looking at numbers, you're going to say, "Wow, sales were up that much?" You have to remember that some of that came from acquisitions.

That being said, you're still getting solid mid-single-digit same-store sales growth at the existing hospitals that have been around at least one year. This is a growing market. It's probably not a barn-burner market, but it's definitely one that's intriguing, that investors might want to consider.

Harjes: Exactly. One more company to add to your watch list is called IDEXX Laboratories. These guys are in the market of animal-health testing and analytics. They mostly do diagnostics within their companion-animal group segment. They also do some tests for livestock and water quality and dairy animals, poultry, that kind of segment. But really, what they do is provide in-house analyzers and diagnostic equipment to these vets, so they can analyze what's going on with your pet. In particular, the in-house segment of that is really intriguing, because if a vet can deliver the results right back to you immediately, that's really sticky. And they do have customer retention of 96% to 99%.

It's a win-win-win. It's a win for the vet, because it's greater customer satisfaction, it keeps people coming back, it's a quicker turnover for them. It's a win for the customer, because they can get the answers they're looking for quicker. And, it's a win for IDEXX as well.

Campbell: Again, we're talking about a company that does a fair amount of revenue. This is a company with $1.7 billion in trailing 12-month sales. That's great. It's a profitable company, which is also great for investors to know. Investors may also want to know that this isn't necessarily a cheap stock; this isn't one that's been running under the radar that they can buy on sale. I think the forward P/E ratio for this stock is around 40, so you might want to throw this one on a watch list to see whether or not it pulls back.

But I think if you're talking long-term, and you're saying, "If we understand, as humans, when we go in, we want immediate feedback on what's wrong with us, and we assume pet care is going to be similar -- when we go to the vet, we're going to want to know what's wrong with our cats or dogs as soon as possible" -- I think that's a really good opportunity for this company to grow over time. Management of the company has said they expect to grow sales 10% annually from here, and their earnings should grow faster than that as they leverage those additional sales.

Harjes: So, this is a fast-growing company. But like you mentioned, it's not exactly a cheap one. They're up 53% year to date. If you got in in January, congratulations -- that's a fantastic return over the last eight months or so. Even just this month, a great second-quarter report pushed this stock up another 13%. Whether or not it's a good time to get in now...you know as well as I do that you never want to try to time the market like that. But this is definitely a company that, for me, I would put it on a watch list and wait for the price to go down a little bit.

Campbell: I agree. I think that makes sense. You want to invest in what you know, but you don't want to blindly invest. The reality is, stocks do go up, and they do go down. A lot of this is going to have to do with your time horizon. I think, overall, the demand for caring for pets globally is on the rise, and that's going to provide natural tailwinds that make all these companies interesting.

Harjes: Exactly. It's the same thing that you see in the human-health market. This is kind of similar. I guess that's why we're talking about it on the Healthcare show. This is an industry that is relatively immune to recession, much like you see in human healthcare. It doesn't matter if times are good or bad economically: If you need to take care of a person or a pet that you view as a member of the family, you're going to spend that money.

Meanwhile, you still have drugs going through the FDA, so you still have that risk and everything associated with that. Interesting thing I found when I was doing my research -- we talk about PDUFA dates all the time, as in the date when a drug is going to get approved. The animal equivalent of that is the Animal Drug User Fee Act, which is the ADUFA. I thought that was kind of interesting.

There are a lot of similarities between these markets. How are they different? If you're looking at the pet healthcare market, what do you need to keep in mind if you're used to the human side of things?

Campbell: Probably the biggest difference between the two is the fact that you really don't have a lot of third-party payer issues in the pet side, at least not yet. You're seeing more and more insurance companies offering pet insurance; I actually have pet insurance on my animals. But for the most part, those are reimbursement-type scenarios. You don't have, for example, the veterinary hospital waiting for the insurance company to pay it. Instead, you're paying the insurance company, and then getting reimbursed by the insurance company for that.

Harjes: That's probably a good thing for these vets and these hospitals -- they get the money immediately.

Campbell: Absolutely, and there's less of an ability for the insurance company, maybe, to go to each individual veterinarian and say, "No, I'm only going to pay you $X for this service."

Harjes: One other thing I'll point out as a difference between investing in human medicine and animal medicine is the seasonal fluctuation that's present here. Demand for vet services is actually higher during the warmer months. It make sense, if you think about it. Pets are spending more time outdoors when it's nice out, so they're more likely to be injured, they're more susceptible to disease and parasites. It's something to keep in mind if you're looking at quarter-over-quarter trends.

Here's one more: generics. This was interesting to me. They don't exist as prevalently in pet medicine, whereas this is something that's all over the landscape of human medicine. But it's just not as common to see generic versions of pet drugs.

Campbell: Right. There's not as much price competition. As consumers, we don't like that. But for a burgeoning or growing industry, as investors, maybe we have a slightly different view on that.

Harjes: Exactly. Thank you so much for your thoughts today, Todd.

To close out today's show: If you guys have been listening to Industry Focus over the past few weeks, you know that I've been calling for submissions to call and leave a voice mail and tell us either a story about your pet, and maybe some crazy reason you had to take it in to the vet, or just give a tip for saving money. So, we'd like to put a couple of these voice mails that we received from listeners.

Louis Wilson: Hi, Fools! This is Louis Wilson. I'm calling Industry Focus specifically on how to save money on pet healthcare. The tip I'm going to give you is for new pet owners, specifically if you're getting a pet that hasn't received their shots. Shots can be a lot of the expense up front of owning a pet, at least from a medical perspective.

I recommend that you go to these mobile clinics. You can find them, they'll be setting up -- at least in Orange County where I'm from -- will have Walgreens or CVS host clinics once a month. That is, again, put on by the county. If you're a new pet owner, I recommend you do a quick Google search on the mobile clinics that do shots for pets. Thank you.

Brian Feroldi: Hey, Industry Focus! This is Brian Feroldi; I'm from North Kingstown, Rhode Island. I've got a funny dog story and a tip for you. We had a chocolate lab a few years back that was really into eating random things, and one time she got ahold of one of my wife's sewing needles. We saw her put it in her mouth, immediately ran over to try and get it out, in which case, she immediately swallowed it -- so we had to take her in for emergency surgery, which cost us $600. That was not fun. Unfortunately, she still had a habit of swallowing random things, which one time included a chewed-up piece of a dish towel.

But, we did hear from our vet that if they do swallow things that are soft and/or poisonous, there is a trick to get it out of them cheaply and easily. That is, you take an old syringe, you fill it up with hydrogen peroxide, and then you force-feed it down their throat. When you do that, the dog will immediately vomit everything up that's in their stomach. We had to do that two times on our dog. It's an unpleasant experience, but it saved us two trips to the vet again. So, anyone that has a dog that likes to eat things they shouldn't, I would suggest keeping an old syringe and some hydrogen peroxide around the house.

Thank you, Industry Focus! Have a great day. Bye!

Harjes: There you have it, life hacks from pet owners Louis Wilson and Brian Feroldi. Thank you to everyone who called in.

As always, people on the program may have interest in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook and Valeant Pharmaceuticals. The Motley Fool recommends Idexx Laboratories.

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