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Flagship Report: Toward Transparency Antibiotics and Animal Health: Value-Chain Implications in the US Antibiotic resistance a growing concern. The proliferation of antibiotic resistance is primarily attributed to the misuse and overuse of the drugs in human medicine and animal agriculture. With respect to the latter, a confluence of regulatory action and heightened consumer awareness is exerting pressure on livestock producers to reassess their usage of antibiotics. In this report we aim to provide transparency on trends in antibiotic use as well as on other nutritional feed additives. What’s currently used to maintain animal health and promote growth? Antibiotics are a simple and cost-effective way for meat and poultry producers to increase production and manage animal health. But there are a number of other specialty and nutritional feed additives that are utilized for similar purposes. We review the range of feed additives that are currently used and in development. Investment implications. In offering a framework for further inquiry, we assess the impact of curbing antibiotic usage in livestock and poultry production across several parts of the animal nutrition value chain. For animal health companies, we believe regulation in its current form presents limited near-term risk to earnings, though shifting consumer demand and more stringent regulation could have a more significant impact longer term. Specialty and nutritional feed additives are generally produced by major chemical companies and represent a small portion of overall revenues. However, for companies with more concentrated exposure, prebiotic and probiotic feed additives appear to offer the greatest growth potential. From a producer standpoint, poultry processors that are proactive and innovative in reducing antibiotics use are well-positioned to meet consumer- driven demand. Key public companies highlighted in this report: Animal health – Phibro Animal Health, Zoetis; specialty and nutritional feed additives – BASF, DSM, DuPont, Novozymes; processors – Tyson Foods, Pilgrim's Pride, Sanderson Farms. ©Christin Lola/Crystal Graphics Michael Shavel Global Thematic Analyst Sebastian Vanderzeil Research Analyst Dehao Zheng Research Associate Global Thematic Research October 5, 2015
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Page 1: Antibiotics and Animal Health: Value-Chain Implications in the US ...

Flagship Report: Toward Transparency

Antibiotics and Animal Health: Value-Chain Implications in the US

Antibiotic resistance a growing concern. The proliferation of antibiotic resistance is primarily attributed to the misuse and overuse of the drugs in human medicine and animal agriculture. With respect to the latter, a confluence of regulatory action and heightened consumer awareness is exerting pressure on livestock producers to reassess their usage of antibiotics. In this report we aim to provide transparency on trends in antibiotic use as well as on other nutritional feed additives.

What’s currently used to maintain animal health and promote growth? Antibiotics are a simple and cost-effective way for meat and poultry producers to increase production and manage animal health. But there are a number of other specialty and nutritional feed additives that are utilized for similar purposes. We review the range of feed additives that are currently used and in development.

Investment implications. In offering a framework for further inquiry, we assess the impact of curbing antibiotic usage in livestock and poultry production across several parts of the animal nutrition value chain.

For animal health companies, we believe regulation in its current form presents limited near-term risk to earnings, though shifting consumer demand and more stringent regulation could have a more significant impact longer term.

Specialty and nutritional feed additives are generally produced by major chemical companies and represent a small portion of overall revenues.

However, for companies with more concentrated exposure, prebiotic and probiotic feed additives appear to offer the greatest growth potential.

From a producer standpoint, poultry processors that are proactive and innovative in reducing antibiotics use are well-positioned to meet consumer-driven demand.

Key public companies highlighted in this report: Animal health – Phibro Animal Health, Zoetis; specialty and nutritional feed additives – BASF, DSM, DuPont, Novozymes; processors – Tyson Foods, Pilgrim's Pride, Sanderson Farms.

©Christin Lola/Crystal Graphics

Michael Shavel Global Thematic Analyst

Sebastian Vanderzeil Research Analyst

Dehao Zheng Research Associate

Global Thematic Research October 5, 2015

Page 2: Antibiotics and Animal Health: Value-Chain Implications in the US ...

2 Please see important disclosures at the back of this report.

Table of Contents

What’s driving the conversation? .......................................................................... 3

Antibiotic resistance is a growing concern ............................................................. 3

Increasing regulation .............................................................................................. 4

Heightened consumer awareness .......................................................................... 6

Company announcements ...................................................................................... 8

What is currently used to maintain animal health and promote growth? ............... 9

Investment implications ..................................................................................... 11

Antibiotics and medicated feed additives ............................................................ 11

Specialty and nutritional feed additives ............................................................... 15

Processors ............................................................................................................. 18

Tyson Foods .................................................................................................... 19

Pilgrim’s Pride................................................................................................. 19

Sanderson ....................................................................................................... 19

Perdue ............................................................................................................ 20

Going forward – what are we looking for? ........................................................... 21

Prices of publicly traded companies (October 2, 2015 close) Company Symbol Price Company Symbol Price

Archer Daniels Midland Co. ADM $42.42 McDonald’s Corp. MCD $99.79

BASF SE BAS.DE €66.71 Merck & Co. MRK $50.14

Bayer BAYN.DE €113.15 Novartis AG NVS $93.27

BRF SA BRFS $18.08 Novozymes NZYM-B DKK283.00

Bunge Ltd BG $74.57 Panera Bread PNRA $194.73

Carrefour SA CA.PA €26.51 Phibro Animal Health PAHC $33.28

Chipotle Mexican Grill Inc CMG $724.45 Pilgrim’s Pride Corp PPC $19.85

Chr. Hansen A/S CHR.CO DKK376.90 Starbucks Corp SBUX $58.08

Costco Wholesale Corp. COST $145.86 Tesco PLC TSCO.L £179.85

DSM NV DSM.AS €42.35 Tyson Foods Inc. TSN $44.39

DuPont DD $49.26 Vetoquinol Co. VETO.PA €40.13

Evonik Industries EVK.DE €29.98 Virbac VIRP.PA €156.50

Fonterra Co-op. Group Ltd FCG.NZ NZD5.25 Walmart Stores Inc. WMT $64.98

JBS SA JBSS3.SA BRL16.82 Whole Foods Market Inc. WFM $33.92

Kroger Co. KR $37.14 Zoetis Inc. ZTS $43.02

Page 3: Antibiotics and Animal Health: Value-Chain Implications in the US ...

3 Please see important disclosures at the back of this report.

What’s driving the conversation?

Antibiotic resistance is a growing concern

Antibiotic resistance occurs when an antibiotic can no longer effectively control

or kill bacterial growth. Resistant bacteria survive exposure to the antibiotic and

continue to multiply in the body, potentially causing more harm and spreading to

other animals or people.

The phenomenon was first identified in 1940, only 12 years after penicillin, the

first commercialized antibiotic, was discovered1. While the emergence of drug-

resistant bacteria is not a recent phenomenon, public health officials widely

agree it represents a growing health concern worldwide. In the US alone, the

Centers for Disease Control and Prevention (CDC) estimates more than two

million illnesses and 23,000 deaths are caused by antibiotic resistance each year.

Research indicates that multi-resistance, whereby strains of bacteria are

resistant to numerous antibiotics, is on the rise (Figure 1)2. According to the

White House’s recently published National Action Plan for Combating Antibiotic-

Resistant Bacteria, “drug choices for the treatment of many bacterial infections is

becoming increasingly limited, expensive and, in some instances, non-existent.”

Figure 1: Antibiotic resistance of E.coli in the US

Source: Emerging Infectious Diseases Journal, Cornerstone Capital Group

Multi-resistance, whereby strains of bacteria are resistant to numerous antibiotics, is on the rise

Page 4: Antibiotics and Animal Health: Value-Chain Implications in the US ...

4 Please see important disclosures at the back of this report.

The proliferation of antibiotic resistance is primarily attributed to the misuse

and overuse of the drugs in human medicine and animal agriculture. With

respect to the latter, a confluence of regulatory action and heightened consumer

awareness is exerting pressure on livestock producers to reassess how they use

antibiotics.

Increasing regulation

Regulatory action that addresses the use of antibiotics in animal feed has largely

been limited to the developed world, with the most progressive policies enacted

in Europe.

Figure 2: Notable regulation on the use of antibiotics in animal feed

Source: Cornerstone Capital Group

Sweden banned the use of antibiotics for growth promotion and disease

prevention in 1986 and 1988, respectively. Denmark also moved early in phasing

out antibiotics; in 1995 the country banned avoparcin, an antibiotic growth

promoter (AGP), and limited veterinarians’ profit from the sale of antibiotics.

Germany, Switzerland, and the EU followed suit, and by 2006 the EU had

instituted bans on all AGPs (with exemptions in a few member states).

A confluence of regulatory action and heightened consumer awareness is exerting pressure on livestock producers to reassess how they use antibiotics

Page 5: Antibiotics and Animal Health: Value-Chain Implications in the US ...

5 Please see important disclosures at the back of this report.

Relative to their European counterparts, US regulators have taken a gradual and

piecemeal approach to this issue, though the pace and scope of regulation is now

increasing.* Since 2010, the FDA has published annual summary reports of

antimicrobials for animal feed to inform stakeholders about sales and

distribution of such products. In 2013, the FDA released its final Guidance for Industry (GFI 213) and draft Veterinary Feed Directive (VFD), the full

implementation of which will result in a ban on medically-important AGPs in

2016. Importantly, the VFD final rule in 2015 requires a VFD by a licensed

veterinarian for use of VFD-governed drugs, including many medically important

antimicrobial drugs.†

Elsewhere, Taiwan has been phasing out AGPs and requires veterinary

prescription of antibiotics in food-producing animals. Other countries with such

requirements include Brazil, Hong Kong, Japan and Mexico. Notably, large

economies including Australia, Brazil, Canada, mainland China, and Japan have

no formal restrictions on AGPs at the national level.3

Figure 3: Summary of regulatory actions globally

Country National ban on

antibiotic growth promoters National veterinary

prescription requirement

Australia No No

Brazil No Yes

Canada No No

China (Mainland) No No

Denmark Yes Yes

EU Yes Yes†

Germany Yes Yes

Hong Kong No Yes

Japan No Yes

Mexico Yes† Yes

Netherlands†† Yes Yes

Sweden Yes Yes

Taiwan Yes Yes

US In progress* Yes (VFD)

† with exceptions.

†† calculations include Netherlands Antilles.

* Banning medically important AGPs

Source: Globalization and Health, Cornerstone Capital Group

* The USDA and the FDA are primarily responsible for the safety and wholesomeness of the US human food supply. The FDA regulates foods intended for human

consumption and, through the Center for Veterinary Medicine (CVM), regulates the manufacture and distribution of animal drugs that will be given to animals from which human foods are derived.

† A VFD is a written (nonverbal) statement issued by a licensed veterinarian that authorizes the use of a VFD drug or combination VFD drug in or on an animal feed. A VFD is different from a prescription (Rx) but essentially serves the same purpose. For further detail, please see the FDA’s website: http://www.fda.gov/AnimalVeterinary/DevelopmentApprovalProcess/ucm455417.htm

In the US, the pace and scope of antibiotic regulation is increasing

Page 6: Antibiotics and Animal Health: Value-Chain Implications in the US ...

6 Please see important disclosures at the back of this report.

Heightened consumer awareness

Consumer demand for meat and poultry raised without the routine use of

antibiotics is driving change throughout the meat production supply chain.*

According to market research firm IRI, while antibiotic-free (ABF) beef, pork and

chicken account for only about 5% of meat sold in the US, that share is growing

quickly.

Antibiotic-free chicken is of particular focus for two reasons: It’s easier for

suppliers to reduce antibiotics usage in chickens due to their relatively short life

cycle, and US consumers are now eating more chicken than any other meat. IRI

notes that during the 52 weeks ending January 25, 2015, sales of antibiotic-free

chicken increased 25% in dollar terms, representing 11% of overall chicken

sales. They also note that sales of organic chicken, which is, by definition,

antibiotic-free, increased 33% during the same period.4

In addition, various surveys and companies indicate that consumers are

concerned about overuse of antibiotics in agriculture and that they’d be willing to

pay more for antibiotic-free meat and poultry. We recognize that consumers

sometimes say they will pay more for sustainable products but don’t actually do

so. Still, we believe these data points are directionally informative.

Consumers Union, the advocacy arm of Consumer Reports, conducted a

survey in 2012 that found 86% of consumers think meat raised without

antibiotics should be available in their local supermarket. It also found that

61% of consumers would pay an additional 5 cents or more per pound (a

level cited as being attainable based on prior studies), and 37% indicated

they would pay $1.00 or more extra per pound.

Technomic, a research and consulting firm focused on food and food services,

released its 2014 Healthy Eating Consumer Trend Report, which revealed

that more than one-third of consumers said they would pay “significantly

more” or “slightly more” for items that were antibiotic-free (Figure 4).

Cited in an NRDC case study, online grocer FreshDirect says that its overall

meat sales continue to grow despite the meat industry as a whole seeing flat

or declining sales volumes. It attributes this largely to a shift in customer

demand to antibiotic-free and organic meats (Figure 5).

* “Meat raised without the routine use of antibiotics” refers to meat raised entirely without antibiotics as well as meat raised without routine, sub-therapeutic uses

of antibiotics.

Antibiotic-free chicken is of particular focus

Page 7: Antibiotics and Animal Health: Value-Chain Implications in the US ...

7 Please see important disclosures at the back of this report.

Figure 4: Consumers purchase and pay more for food that gives them peace of mind

Numbers to the right of each bar represent the percentage of consumers surveyed who said they would be more likely to purchase food or beverages described by the term on the vertical axis (e.g., preservative-free). The numbers within the bar reflect how much more, if at all, those consumers are willing to pay.

Source: Technomic, Cornerstone Capital Group

Figure 5: FreshDirect is seeing antibiotic-free and organic chicken taking share

Source: NRDC, FreshDirect, Cornerstone Capital Group

11%

10%

9%

8%

10%

9%

7%

10%

6%

10%

26%

27%

27%

21%

24%

20%

22%

19%

17%

21%

39%

38%

38%

44%

36%

38%

36%

33%

39%

28%

76%

75%

74%

73%

70%

67%

65%

62%

62%

59%

Preservative-free

Hormone-free

Antibiotic-free

Having no artificial sweeteners

GMO-free

Natural

Unprocessed

Clean

Real

Organic

I would be more likely to purchase and am willing to pay __ for food or beverage described as ...

Significantly more (5% increase or more) Slightly more (up to a 5% increase) No more

Page 8: Antibiotics and Animal Health: Value-Chain Implications in the US ...

8 Please see important disclosures at the back of this report.

Company announcements

Shifting consumer preferences have been met with a range of responses by

retailers, restaurants and supermarket chains.

In the quick-serve restaurant (QSR) industry, the Pew Trust reports that 22 QSR

chains including McDonald’s, Chipotle and Chick-fil-A have announced policies

intended to reduce the amount of antibiotics used in meat for their menu items5.

An analysis of the antibiotics announcements made by several QSR chains shows

substantial differences, which result in various levels of antibiotic use (Figure 6).

The policy at McDonald’s aligns with the FDA’s new directives, while Chick-fil-A’s

policy exceeds the FDA’s guidelines, banning all antibiotics by 2016.

Figure 6: Quick-serve restaurants’ antibiotics policies

Quick Serve Companies Meat Antibiotic-free items on menu

Prohibit antibiotic growth promotion

Prohibit use of antibiotics use by humans and animals

No antibiotics to be used in meat production

Carl's Jr. Beef

Chick Fil-A Chicken *

Chipotle Mexican Grill* Chicken, beef, pork **

McDonald's Chicken

Panera Bread Chicken, turkey, ham

Shake Shack Beef

*Antibiotic free by 2016

**Chipotle retains the option to purchase meat from sources where antibiotics have been used on individual, sick animals at times when antibiotic-free meat is not available.

Source: Company announcements, Cornerstone Capital Group

Supermarkets are a major end market for meat and poultry consumption. Some

are concerned that the premium prices required for antibiotic-free meat (due to

higher production costs) create a risk to sales. To this end, various studies have

arrived at conflicting conclusions. A USDA study concluded that eliminating

antibiotics in growth promotion and sub-therapeutic applications in hog

production could increase wholesale meat prices by 2.3%.6 A separate study

presented in the Journal of Agriculture and Applied Economics stated that

production costs for hogs would rise 9% as a result of banning AGPs7.

Antibiotics policies for several major supermarkets include:

Costco –Announced in March 2015 that it would phase out the use of both

medically and non-medically important antibiotics, but did not provide a

timeline for such action.

An analysis of the antibiotics announcements made by several QSR chains shows substantial differences

Page 9: Antibiotics and Animal Health: Value-Chain Implications in the US ...

9 Please see important disclosures at the back of this report.

Kroger – Launched the Simple Truth brand, including an organic line of

chicken, though it has not disclosed a broad antibiotics policy for other meat

sold in stores.

Walmart – Announced in May 2015 a new position on antibiotics use in meat

production that focuses on guidelines set by the American Veterinary Medical

Association and the FDA. The announcement prohibits AGPs but allows

antibiotics to be used for treatment and prevention.8

Whole Foods Market – Meat from any animal that is treated with antibiotics,

even for therapeutic reasons, cannot be sold in its stores.9

What is currently used to maintain animal health and promote growth?

Antibiotics are a simple and cost-effective means for producers to increase

production and manage animal health. But there are a number of other

medicated and nutritional feed additives that are utilized for similar purposes.*

Figure 7 shows the range of feed additives that are currently used and in

development.

Figure 7: Antibiotics and feed additives

Source: Cornerstone Capital Group

* There are other methods of maintaining animal health, e.g. free range, vaccines, and biosecurity, but we focus on antibiotics and feed additives for the purpose

of this report.

Page 10: Antibiotics and Animal Health: Value-Chain Implications in the US ...

10 Please see important disclosures at the back of this report.

There are two primary applications for antibiotics in livestock production:

Growth promotion – The use of low-dose antibiotics in livestock,

particularly in the US, has been noted to increase an animal’s ability to retain

nutrients and develop greater amounts of protein. The move to ban the use of

the antibiotics in growth promotion is based on the fact that broad usage of low doses in livestock promotes optimal conditions for bacteria to develop

antibiotic resistance.10 Additionally, a 2014 study by the USDA determined

that antibiotics used for growth promotion weren’t particularly effective,

accounting for an increase in hog production of less than 2%.11

Therapeutic – The FDA classifies therapeutic use of antibiotics as treatment,

control or prevention of disease. Previous terminology classified

“therapeutic” as the use of prescribed doses of antibiotics to treat clinically ill

animals, and “sub-therapeutic” as the use of lower-than-prescribed doses to

control and prevent disease. Control and prevention applications are

particularly important for livestock production in low-quality environments

such as feedlots and large farms.*

There are also two classifications for antibiotics in livestock production.

Medically important – According to the FDA, the term “medically important

antimicrobial drugs”— sometimes called “human use antibiotics” —

generally refers to antimicrobial drugs that are important for therapeutic use

in humans. The category contains common drugs like tetracycline and

penicillin, and others more critical to human medicine, such as cephalosporin

and fluoroquinolones.

Non-medically important – The remaining antimicrobial drugs are not

currently deemed “medically important” and are sometimes referred to as

non-human-use antibiotics.

Other specialty and nutritional feed additives that assist in managing animal

health and promoting growth have long been utilized, and interest is increasing

with the growing pressure to reduce antibiotic usage:

Organic acids provide support for digestion of food. Fumaric acid, citric acid,

formic acid, lactic acid and sorbic acid as well as salts have been

demonstrated as effective in improving health in livestock such as piglets.12 A study found that organic acids can also offset negative effects of

environmental pollution on animals.13

* FDA no longer uses “sub-therapeutic,” as it believes the term lacks sufficient clarity

There are two primary applications for antibiotics used in livestock production: growth promotion and therapeutic

US regulation is focused on medically important anti-microbial drugs

Interest in specialty and nutritional feed additives is growing as antibiotics usage is reduced

Page 11: Antibiotics and Animal Health: Value-Chain Implications in the US ...

11 Please see important disclosures at the back of this report.

Amino acids provide additional support for immune system resilience to

foreign bacteria and viruses. The addition of amino acids to conventional feed

can maximize growth in young animals as well as prevent disease.14

Enzymes increase an animal’s ability to absorb and utilize nutrition, and

reduce the impact of poor or unsuitable feed.15 Enzymes were first

introduced in the 1980s and are now included in 95% of broiler chicken

diets. When used in conjunction with probiotics, enzymes can improve

growth at a lower cost. A study on the use of enzymes and probiotics in

chickens showed a net benefit of 14% in cost per kg live weight relative to

using AGPs.16

Probiotics affect the composition of intestinal microbiota, providing growth

and health benefits. A meta-study found that probiotics offer greater

protection against pathogens and enhanced immune response, though there

are still questions about the effectiveness of probiotics in large groups of

livestock.17

Prebiotics are fibers and other compounds that feed beneficial

microorganisms and protect against harmful ones in the stomachs of

livestock18. Prebiotics have been shown to benefit digestion, animal growth

and the immune system.

Essential oils are compounds present in plants and spices that provide

immune and nutritional benefits to animals.

Vitamins are a group of complex organic compounds present in small

amounts in natural foodstuffs. They are essential in promoting normal

metabolism and preventing deficiency-related diseases.

Investment implications

We assess the impact of curbing antibiotic usage in livestock and poultry

production across several parts of the animal nutrition value chain, including

producers of antibiotics and medicated feed additives, producers of specialty/

nutritional feed additives, and processors.

Antibiotics and medicated feed additives

Animal health (AH) companies manufacture products such as anti-infectives,

medicated feed additives, vaccines, and parasiticides. Antibiotics are a sub-

categorization of products that make up anti-infectives and medicated feed

additives.

Page 12: Antibiotics and Animal Health: Value-Chain Implications in the US ...

12 Please see important disclosures at the back of this report.

The animal health industry represents a portion of the much larger

pharmaceutical industry, with six of the ten largest AH players representing

divisions of such companies. The question of reduced antibiotic use in animal

feed represents a relatively minor risk to parent company revenues.

Figure 8: Example Animal Nutrition Value Chain

Note: This is not an exhaustive list of companies and focuses on the European value chain.

Source: DSM

For stand-alone animal health companies, antibiotics restrictions represent a

more significant risk. Zoetis, the leading producer of anti-infectives (antibiotics

and anti-bacterials, antifungals, antivirals, etc.) for animal use, states that the

animal health industry will grow 5-6% annually over the next five years while

antibiotics sales will grow by 2-3% annually, primarily due to the restriction in

some markets on the use of antibiotics. Phibro Animal Health says it expects

medicated feed additives to deliver mid-single-digit growth annually as certain

markets transition away from the use of antibiotics for growth promotion.

The animal health industry is largely a part of major pharmaceutical organizations

Antibiotics restrictions represent a more significant risk for stand-alone AH companies

Page 13: Antibiotics and Animal Health: Value-Chain Implications in the US ...

13 Please see important disclosures at the back of this report.

Figure 9: 2014 AH reported sales and % growth (including non-AH Sales)

Source: Vetnosis Executive’s Guide 2015, Zoetis, Cornerstone Capital Group

While there is discussion of this risk, consensus believes that US antibiotics

regulation (FDA Guidance #213) has little chance of decreasing overall quantities

of antibiotics used in livestock production. This is largely because there is

significant overlap between antibiotics used for growth promotion and those

used for disease prevention.

Furthermore, the usage of antibiotics for growth promotion is relatively limited.

Animal Health Institute, an industry group, estimates that 5-15% of antibiotic use

in the US is for growth promotion. This estimate includes both medically and

non-medically important antibiotics (Figure 10).

This overlap likely explains why AH companies appear cautiously optimistic

regarding this risk. Zoetis points out the following:

The focus in the US is around AGP and antibiotics deemed critical for human

use, which, in aggregate, represents a small percentage of the company’s

portfolio. Zoetis presents Europe as a point of reference. In 2013, the

European antibiotics market declined by 7% while Zoetis’s portfolio in the

same region declined by 2%.

The company has products in its portfolio that can replace those that might

be eliminated from the market. For instance, Zoetis says producers will need

to increase the use of vaccines to protect animals when they move away from

antibiotics.

Despite regulatory challenges, antibiotics will continue growing globally due

to the increasing demand for protein in emerging markets.

4.9%

2.7%

4.5%

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Page 14: Antibiotics and Animal Health: Value-Chain Implications in the US ...

14 Please see important disclosures at the back of this report.

Figure 10: Overlap between growth promotion and disease prevention uses in food animal antibiotics

Antibiotic class FDA ranking of importance to human medicine Antibiotic name Approved uses by animal

Cattle Poultry Swine

Macrolides Critically important Tylosin X X

Erythromycin X X X

Lincosamides Highly important Lincomycin X X

Penicillin Highly important Penicillin G Procaine X X

Streptogramins Highly important Virginiamycin X X X

Tetracyclines Highly important Chlortetracycline X X X

Oxytetracycline X X X

Pleuromutilins Highly important Tiamulin X

Glycolipids Not ranked Bambermyciins X X X

Polypeptides Not ranked Bacitracin X X X

Quinoxalines Not ranked Carbadox X

Ionophores Not ranked Monensin X X

Lasalocid X X

Laidlomycin X

An “X” indicates FDA-approved growth promotion uses, including weight gain and improving feed efficiency. Light blue shading denotes the overlap between antibiotics approved for growth promotion and disease prevention purposes. Light green shading denotes antibiotics not ranked by the FDA as important to human health.

Source: Government Accounting Office analysis of FDA data; Cornerstone Capital Group

In addition to these comments, Phibro Animal Health originally estimated a

potential impact of $15-20 million associated with Veterinary Feed Directive

(VFD) changes, but recently lowered the estimate to $10-15 million. This

represents only 1.5-2% of the company’s guidance for revenue in 2016.

While regulations in their current form may present limited risk to antibiotics

sales, we believe there are two factors that could heighten the risk.

1) Shifting consumer demand may continue to drive additional companies

throughout the value chain to phase out antibiotics beyond the level

required by FDA guidelines. While organic livestock is still a niche market

at 5% of total production in developed markets, it is growing rapidly.

Producers selling products in the US cannot use the “organic” label if

antibiotics are used even once (this is more stringent than in Europe,

where an animal can be treated three times with antibiotics and keep the

organic label).

2) If GFI 213 and VFD fail in reducing the levels of antibiotics used in meat

production, we believe more restrictive guidelines could be put in place.

There is historical precedence for this. In the Netherlands, when AGPs were banned in 2006, therapeutic drug usage increased to levels that

While regulations in their current form present limited risk to antibiotics sales, shifting consumer demand and more restrictive regulation should be considered

Page 15: Antibiotics and Animal Health: Value-Chain Implications in the US ...

15 Please see important disclosures at the back of this report.

kept total antibiotic use static. In response, the Dutch issued a mandate to

reduce antibiotic usage by 50% over a three-year period (using 2009 as

the base year) and established a registration process for veterinary

prescriptions of antibiotics (Figure 11). Regulation in the Netherlands is

notably different than in the US, and we don’t believe the FDA would follow the same path, but investors would be wise to anticipate a re-

evaluation of policies and practices should regulation in its current form

prove ineffective.

Figure 11: Dutch antibiotic sales for therapeutic use in animals (in kg x 1,000), 1999-2014

Source: Netherlands Veterinary Medicines Authority (SDa), Cornerstone Capital Group

Specialty and nutritional feed additives

We believe specialty and nutritional feed additives have significant potential for

growth, though we temper our expectations in the short term given the need for

research and large-scale trials to demonstrate efficacy and optimize

combinations of additives.

Our research indicates that the global feed additives market, which we estimate

is valued at approximately $15 billion, could experience mid-single-digit growth

annually through 2020. However, the opportunity and growth outlook isn’t

uniform across additives. Amino acids and vitamins dominate the market but will

be characterized by slower growth and more intense competition. Probiotics and

0

100

200

300

400

500

600

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

1,0

00 k

g

betalactams tetracyclines macrolides/lincosamides

aminoglycosides (fluoro)quinolones trimethoprim/sulfonamides

other

Specialty and nutritional feed additives have significant growth potential, but we temper our expectations in the short term

Probiotics and prebiotics are forecast to grow more quickly than other feed additives

Page 16: Antibiotics and Animal Health: Value-Chain Implications in the US ...

16 Please see important disclosures at the back of this report.

prebiotics are less developed, but are forecast to grow more quickly and face less

competitive pressure.

Figure 12: Feed additives outlook

Bubble size denotes the current size of each market; market growth outlook is estimated through 2020.

Source: DSM, Novozymes, DuPont, Grandview Research, Transparency Market Research, Cornerstone Capital Group

Figure 12 provides an overview of our estimates for the current market value,

growth outlook and competitive environment for various feed additives. We are

mindful that the market is opaque and data reliability is an issue, and will update

our estimates as data availability improves.

Figure 13 provides a summary of the product portfolios for the major feed

additive companies.

Amino acids

VitaminsMycotoxin solutions

Acidifiers/Organic acids

Enzymes

Probiotics

Prebiotics

Antioxidants

0.0%

4.0%

8.0%

12.0%

0 3

Ma

rke

t G

row

th

CompetitionHigh Low

Hig

hLow

High Low

Hig

hLow

Page 17: Antibiotics and Animal Health: Value-Chain Implications in the US ...

17 Please see important disclosures at the back of this report.

Figure 13: Major feed additive companies’ product portfolios and annual animal nutrition revenue

Company

Animal Nutrition

Revenue - FY2014 Feed Additives

€1.2 billion

(100% of sales)

Amino acids and organic acids targeted at poultry, pigs and dairy cows

Rovabio product provides enzymes to poultry and pigs that assist in digestion

Developing a probiotic product in partnership with Novozymes

Range of products that provide vitamin supplements for poultry, pigs and cattle

€1.0 billion*

(2.7% of sales)

Provides a range of vitamins for livestock including poultry, pigs and cattle

Enzyme products that improve digestion of poultry and pigs in collaboration with Direvo and via its purchase of Verenium

Range of products for poultry and pigs

€120 million

(15% of sales)

Leading proponent of probiotics (BioPlus) as growth promoter for pigs, poultry and cattle

Undertakes significant research and development in probiotics for livestock, has developed proprietary strains of probiotics

€2.1 billion

(22% of sales)

Developed a range of feed enzymes in partnership with Novozymes

Leading provider of livestock vitamins through Optimum Vitamin Nutrition (OVN) approach and range of vitamin products (ROVIMIX and Hy-D)

Acids to help livestock with digestion

Essential oil products (CRINA) that support livestock growth and health

Probiotic feed additive that limits the growth of harmful bacteria in animals

$1.4 billion

(4% of sales)

Launched enzymes over 25 years ago for poultry, pigs and cattle

Markets a range of probiotic products as well as a probiotic/enzyme mix which is promoted as an active replacement to antibiotic growth promotion

Provides essential oil blended products for poultry and pigs

€2.1 billion**

(16% of sales)

Leading amino acid producer with a range of amino acid products

Distributes Chr Hansen probiotic products in Asia

€230 million***

(14% of sales)

Developed enzyme products in conjunction with DSM

Entered in partnership with Adisseo to develop probiotic products

*Denotes “Health and Nutrition” business unit sales. We use this as a proxy for animal nutrition sales as this business unit produces and markets essential amino acids for animal nutrition.

** Denotes Nutrition sales for livestock and companion animals

*** Exchange rate from Danish Krone to Euro on Sept 14, 2015

Source: Company information, consultation and Cornerstone Capital Group

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18 Please see important disclosures at the back of this report.

Processors

The US poultry producer market is concentrated, with the top four producers

representing 53% of ready-to-cook pounds. It’s also vertically integrated, with

the large producers’ operations consisting of breeding stock, contract growers,

feed production, processing, and marketing and transportation. Because of the

vertically integrated and concentrated nature of the industry, the policies

adopted by the large players influence the supply chain materially.

Figure 14: US chicken production (based on ready-to-cook pounds)

Source: Tyson, Watt Poultry USA (March 2015), Cornerstone Capital Group

Antibiotic-free chicken commands higher margins than conventional chicken.

Based on industry sources, it costs 10-15% more to produce but sells at a

premium which, in many instances, more than offsets the increased cost. We

believe this mix shift to higher-margin poultry offers some benefit in the near

term.

Some experts believe, however, that a ceiling exists for the number of birds that

can be produced without antibiotics. As it stands, birds that become ill are given

antibiotics but are moved out of the antibiotic-free flock to the conventional

flock. As antibiotic-free production increases, this strategy becomes less

attractive. Using an extreme example for the purposes of illustration, if 100% of

production were to become antibiotic-free, there wouldn’t be a conventional

flock to which antibiotic-treated birds could be moved.

Tyson Foods22%

Pilgrim's Pride17%

Sanderson Farms7%Perdue Farms

7%

Other47%

We believe the mix shift to higher-margin poultry offers some benefit in the near term

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19 Please see important disclosures at the back of this report.

This supports our view that processors that are proactive and innovative in

reducing antibiotics use are well-positioned to meet consumer-driven demand.

From this standpoint, Perdue Farms is a leading performer while Sanderson

Farms is a laggard.

Tyson Foods

Responding to demand from consumers, Tyson, the largest US meat packer by

sales, is increasing its efforts to reduce antibiotics use in its animal feed. The

company has stopped using antibiotics at all of its 35 hatcheries (where eggs go

through a vaccination robot when the chicks are almost ready to hatch), and

eliminated medically important antibiotics from all chicken feed (for broiler

chickens). Between 2011 and 2014, use of medically important antibiotics on

Tyson’s farms declined by 84%.

Tyson substituted the use of medically important antibiotics with vaccines,

biosecurity advancement and probiotics. The company’s CFO, Dennis Leatherby,

said that “the additional cost associated with raising chicken is minimally more

expensive and often times at parity with other traditional methods.”

For retail customers, Tyson also offers “no-antibiotics-ever” meat products via its

NatureRaised Farms brand.

Pilgrim’s Pride

Pilgrim’s Pride, the second-largest US chicken processor after Tyson, says it will

eliminate all antibiotics from 25% of its chicken production by the end of 2018,

up from the current 5%. It is also working to eliminate all medically important

antibiotics from its hatcheries and broiler flocks.

As with Tyson, the company says it has invested in probiotics and biosecurity

measures to reduce reliance on antibiotics. The company acknowledges that

reducing antibiotics entails additional costs, but expects to charge a premium on

some of its products: “As we convert more of our production to A.B.F., we will be

able to sell an increasing amount of whole bird equivalents, which includes the

back half, for a premium in domestic markets.”

Sanderson

Unlike other major US poultry producers, Sanderson has resisted the industry’s

moves to curb antibiotics use. The company’s position can be summarized as

follows:

Processors that are proactive and innovative in reducing antibiotics use will be well- positioned to meet consumer-driven demand

Tyson is investing in vaccines, biosecurity and probiotics…

…as is Pilgrim’s Pride

Sanderson has resisted the industry’s moves to curb antibiotics use

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20 Please see important disclosures at the back of this report.

Use of antibiotics is necessary to treat certain types of disease, thus it

contributes to animal welfare;

Without antibiotics, animals would take more time and resources to reach

market weight, inconsistent with the company’s sustainability and

environmental responsibility programs; and

Ceasing the use of antibiotics increases the company’s food safety risks.

Sanderson also rejects the scientific argument behind the industry-wide trend,

saying “there’s no evidence whatsoever that using these antibiotics really does

cause antibiotic resistance bacteria”. The company states that should credible

scientific data become available supporting this notion, it will re-evaluate its

position.

Perdue

Perdue has been the most aggressive in moving away from antibiotics. The

company recently announced that it is raising more than half of its chickens with

no antibiotics, and that 96% of its flocks never receive medically important

antibiotics.

In achieving these reductions, Perdue is incurring higher costs. It has estimated

that antibiotic-free chickens cost 10-15% more to produce than their

conventional counterparts, though they also can retail for up to $2 per pound

more (depending on the cut, this represents a premium of up to 200% according

to Bureau of Labor Statistics’ average retail chicken prices). To better capture the

price premium in a growing market, Perdue is increasing its product offerings

with the “No Antibiotics Ever” label.

Supporting our optimistic view on probiotics growth, Perdue is adding more

probiotics to its chicken feed, and in 2014 stated that it had increased the

amount of probiotics by five times over the past five years.

Perdue has been the most aggressive in moving away from antibiotics

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21 Please see important disclosures at the back of this report.

Going forward – what are we looking for?

Our research raises questions for further exploration and identifies trends to

watch as consumer awareness of antibiotics use and potential alternatives

increases. Below are pertinent questions that we’ll look to address as the issue

evolves.

Margin profile – To what extent will economies of scale, alternative feed

additives, and producer experience drive down costs for antibiotic-free

chicken? Will retailers and producers continue to realize the current

premiums charged for antibiotic-free chicken?

Consumer demand – How will consumers respond to retailers, restaurants

and supermarket chains’ announcements to reduce antibiotics? Will

consumer demand force suppliers to be more aggressive in phasing out

antibiotics beyond what’s required?

Antibiotic alternatives – How will additional research and large-scale trials

influence uptake of specialty and nutritional feed additives? Will certain feed

additives, such as probiotics, make it through the FDA’s approval process,

thereby allowing manufacturers the ability to make product claims on labels?

Expanding focus on cattle/swine – How will a more pronounced shift away

from antibiotics usage in cattle and swine impact the supply chain? Company

announcements to reduce antibiotics usage have primarily been focused on

chicken opposed to cattle and swine. There are additional challenges in

reducing antibiotics usage in animals that have longer lifecycles.

Vaccines – Will animal health companies benefit from increased use of

vaccines as antibiotics usage is reduced? To what extent will new vaccine

products be able to address disease that was once only treated with

antibiotics?

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22 Please see important disclosures at the back of this report.

Sources cited in this report:

1 http://www.cdc.gov/drugresistance/about.html 2 Tadesse D.A., Zhao S., Tong E., Ayers S., Singh A., Bartholomew M.J., et. al., “Antimicrobial drug resistance in Escherichia coli

from humans and food animals,” United States, 1950–2002. Emerging Infectious Disease Journal [serial on the Internet]. 2012 May.

3 http://www.globalizationandhealth.com/content/9/1/48 4 http://www.bloomberg.com/news/articles/2015-04-28/the-biggest-chicken-seller-in-the-u-s-is-eliminating-antibiotics 5 Pew Trusts, 2015, “Top Food Companies Moving Away from Overuse of Antibiotics on Industrial Farms,”

http://www.pewtrusts.org/en/research-and-analysis/fact-sheets/2014/04/09/top-food-companies-moving-away-from-overuse-of-antibiotics-on-industrial-farms

6 Matthews, 2001, “Antimicrobial Drug Use and Veterinary Costs in US Livestock Production,” USDA, http://www.ers.usda.gov/media/480677/aib766_1_.pdf

7 G.Y. Miller, P.E. McNamara, and E.J. Bush, 2003. “Productivity and Economic Effects of Antibiotics Used for Growth Promotion in Pork Production.” Journal of Agricultural and Applied Economics 35: 469-482.

8 Walmart, 2015, “Position on Responsible Use of Antibiotics in Farm Animals,” http://corporate.walmart.com/article/position-on-responsible-use-of-antibiotics-in-farm-animals

9 Whole Foods Market, “Animal Welfare Basics,” http://www.wholefoodsmarket.com/mission-values/animal-welfare/animal-welfare-basics

10 Hughes et. al., “Antibiotic Growth Promoters in Food Animals,” http://www.fao.org/docrep/article/agrippa/555_en.htm 11 USDA, 2014, “Antibiotics Used for Growth Promotion Have a Small Positive Effect on Hog Farm Productivity,”

http://www.ers.usda.gov/amber-waves/2014-july/antibiotics-used-for-growth-promotion-have-a-small-positive-effect-on-hog-farm-productivity.aspx#.VfiaZhFVhBc

12 Dr. Jiri Broz, Dr. Christophe Paulus, “Eubiotics: Definition and different concepts,” DSM 13 Luckstadt, 2011, “The Use of Organic Acids In Animal Nutrition, with Special Focus on Dietary Diformate Under European and

Austral-Asian Conditions,” Recent Advances in Animal Nutrition – Australia 18 (2011) 14 Wu, 2010, “Functional Amino Acids in Growth, Reproduction and Health,” American Society for Nutrition,

http://advances.nutrition.org/content/1/1/31.full.pdf+html 15 Novozymes, “Animal nutrition – enzymes,”

http://www.novozymes.com/en/solutions/agriculture/animal-nutrition/Pages/default.aspx 16 Romero, 2015, “The Role of Feed Enzymes in Poultry Gut Health,”

http://animalhealthmedia.com/wp-content/uploads/2015/05/14.-The-Role-of-Feed-Enzymes....pdf 17 Musa et al, 2009, “The Potential Benefits of Probiotics in Animal Production and Health,” Journal of Animal and Veterinary

Advances, http://www.medwelljournals.com/fulltext/?doi=javaa.2009.313.321 18 Jacela JY, DeRouchey JM, Tokach MD, et al. “Feed Additives for Swine: Fact Sheets – Prebiotics and Probiotics, and

Phytogenics,” Swine Health Prod. 2010;18(3):132–136. https://www.aasv.org/shap/issues/v18n3/v18n3p133.html

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23 Please see important disclosures at the back of this report.

Michael Shavel is a Global Thematic Analyst at Cornerstone Capital Group. Prior to joining the firm, Michael was a Research Analyst on the Global Growth and Thematic team at Alliance Bernstein. He holds a B.S. in Finance from Rutgers University and is a CFA Charterholder.

[email protected]

Sebastian Vanderzeil is a Research Analyst with Cornerstone Capital Group. He holds an MBA from New York University’s Stern School of Business. Previously, Sebastian was an economic consultant with global technical services group AECOM, where he advised on the development and finance of major infrastructure across Asia and Australia. Sebastian also worked with the Queensland State Government on water and climate issues prior to establishing Australia’s first government-owned carbon broker, Ecofund Queensland.

[email protected]

Andy Zheng is a Research Associate at Cornerstone Capital Group. Andy graduated from Bowdoin College with an interdisciplinary major in Mathematics and Economics and a minor in Visual Arts. He spent his junior year studying abroad at the University of Oxford and the summer prior to that at the Sorbonne in Paris. Andy passed Level I of the CFA Program in January 2014.

[email protected]

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24 Please see important disclosures at the back of this report.

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