Analysis: For Merck, bringing cattle feed Zilmax back won't be easy

Thu Oct 31, 2013 3:43pm EDT

(Reuters) - U.S. pharmaceutical giant Merck & Co (MRK.N) faces significant challenges bringing its controversial feed additive Zilmax back to market in the United States and Canada, even after a vote of confidence from South Korea on Thursday.

South Korea plans to begin accepting meat from cattle raised with the muscle-growing supplement early next year, a senior official in the country's food ministry said, opening the door to beef imports after a government risk assessment found the additive could be permitted at certain levels.

To resurrect the once popular drug in the United States, Merck will need to shake this summer's controversy over animal welfare problems - and convince ranchers, feedlot customers and meatpackers that Zilmax was not to blame for some cattle that arrived at slaughter plants having difficulty walking and apparently in pain.

It could be a tough sell: On Wednesday, agricultural giant Cargill Inc CARG.UL told Reuters it would not allow Zilmax-fed beef to enter its supply chain until questions over cattle health issues have been resolved and "until Asia and other trading partners accept it in their markets.

The move by Cargill underscores how the U.S. livestock industry is being pulled in opposing directions: It needs to produce more meat for a growing global population, and it needs to assure corporate customers and an often skeptical public that the use of livestock drugs in meat production is safe.

Merck declined to comment on Cargill's action.

In August, the New Jersey-based pharmaceutical company voluntarily suspended sales of Zilmax in the United States and Canada after Tyson Foods Inc (TSN.N) said it would stop accepting Zilmax-fed beef as it had observed some cattle arriving for slaughter in physical distress.

Merck defended its product, and launched an audit to ensure that the federally approved livestock drug was being properly used in the field and that customers were not misusing it. The company also formed an industry and academic advisory board to study the effects of Zilmax on animals.

Reuters on Tuesday reported that Merck was working toward reintroducing the product, news that appeared to catch Cargill and other companies by surprise.

JBS USA JBS.UL and Tyson Foods Inc (TSN.N) declined to comment on the matter. National Beef Packing Co NBEEF.UL did not return calls for comment.

Sources at JBS and Tyson said animal health experts at the companies remain concerned about the still unknown reasons why cattle displayed signs of distress when arriving at slaughter plants this past summer.

A RIVAL WAITS

Although Zilmax's $159 million in U.S. sales last year make up a small slice of Merck's $47.3 billion in annual revenue, the problems with the additive have caught the attention of Wall Street. Merck's chief executive officer, Kenneth C. Frazier, faced questions on Zilmax's fate during the company's quarterly earnings conference call on Monday.

The suspension of Zilmax in the United States and Canada took a bite out of worldwide sales of Merck's animal health products, which has been a high-margin business. The unit's sales fell 2 percent in the third quarter, to $800 million, and Frazier said Zilmax "was a major issue," though he added that the fundamentals of the animal health business remain solid.

Asked by an analyst whether Merck is considering a spinoff of its animal-health unit, Frazier said the company is "sharpening our focus" on its animal health and consumer care groups.

"We are currently evaluating those businesses the way we are evaluating everything, to figure out whether those businesses produce the most value inside our portfolio or outside our portfolio," he said.

The hurdles for Merck in reintroducing Zilmax get higher the longer the product is off the market. Competitors include Eli Lilly & Co's (LLY.N) Elanco Animal Health unit, with its Optaflexx product.

The Merck and Lilly products are part of a drug class called beta-agonists. Zilmax is based on an active ingredient called zilpaterol, while Optaflexx is based on ractopamine. Ractopamine has not been linked to any of the recent animal health concerns.

"It will be challenging for Merck to regain traction given the negative public attention Zilmax has received following the announcement from Tyson Foods," said Alex Arfaei, equity research analyst for BMO Capital Markets. "There are other options, such as Lilly's Optaflexx, which are less controversial."

INDUSTRY STRESS

The debate over Zilmax comes at a time of stress in the cattle industry. Thousands of feedlots have gone out of business in recent years as drought and rising feed costs undercut their business model. The size of the national beef herd has fallen to its lowest level in 61 years, and domestic beef consumption dropped more than 8 percent from 2002 to 2011.

For nearly a decade, many of the country's 75,000 cattle feedlots have relied on weight-gain feed additives - Zilmax was often the beta-agonist of choice because it added around 30 pounds of lean meat to animals that average around 1,300 pounds when they go to slaughter.

For Optaflexx, the company says its additive can add about 20 pounds of lean meat to a beef carcass.

Today, the absence of Zilmax is being felt at slaughterhouses. Cattle carcass weights have dipped in recent weeks, and fewer animals are coming to market, a combination expected to lead to record cattle and beef prices at least through the coming year, analysts have said.

Feedlots have favored Zilmax, even though it leads to a leaner meat that is less favored in the marketplace, because weight is more important for their profitability than meat quality, said Jim Robb, director of the Colorado-based Livestock Marketing Information Center.

"The industry needs to decide where they want to be positioned," Robb said. "Merck and some of the cattle feeders are pushing for tonnage, which is part of what they get paid for, not so much quality."

The European Union and other key export markets have grown increasingly firm on the banning of meat raised with beta-agonists. In the end, demand from overseas could become a key factor determining Zilmax's fate, analysts said.

Taiwan and South Korea accept imports of beef fed with ractopamine, but they are among a number of Asian countries, including China, that have not approved zilpaterol.

Taiwan's Food and Drug Administration on Tuesday said it found zilpaterol-tainted beef in a restaurant, prompting authorities to increase checks on U.S. meat imports. Earlier this month, South Korea suspended some U.S. beef imports after detecting zilpaterol in meat supplied by a unit of JBS USA.

But with South Korea shifting its stance on accepting zilpaterol, analysts say other countries may follow.

"With exports being one of the growth areas for the next few years, it gives you some pause as to how this is going to affect that trade." said Altin Kalo, an economist at Steiner Consulting Group.

(Reporting by P.J. Huffstutter in Chicago and Lisa Baertlein in Los Angeles; Additional reporting by Tom Polansek and Theopolis Waters in Chicago; Editing by David Greising, Tiffany Wu and Douglas Royalty)