Zoetis Inc - Class A (ZTS) — Q1 2016 Earnings Call Transcript

Thank you, operator. Good morning and welcome to the Zoetis first quarter 2016 earnings call. I'm joined today by Juan Ramón Alaix, our Chief Executive Officer; and Paul Herendeen, our Chief Financial Officer. Before we begin, I'll remind you that our remarks today will include forward-looking statements and actual results could differ materially from those projections. For a list and description of certain factors that could cause results to differ, I refer you to the forward-looking statement in today's press release and our SEC filings including, but not limited to, our 2015 annual report on Form 10-K and our reports on Form 10-Q. Our remarks today will also include references to certain financial measures which were not prepared in accordance with generally accepted accounting principles or U.S. GAAP. A reconciliation of these non-GAAP financial measures to the most directly comparable U.S. GAAP measures is included in the financial tables that accompany our earnings press release and in the company's 8-K filing dated today, May 4, 2016. We will also cite operational results, which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramón.

Thank you, John, and good morning, everyone. We delivered another solid quarter, demonstrating our steady and predictable growth, and confirming the strength of Zoetis as the industry leader in animal health. The diversity of our portfolio in terms of geographies, species, and therapeutic areas, as well as our business model, continues to drive our performance. In previous years, we have seen different species leading our growth based on changes in market trends and the mix of products in our portfolio. For example, in 2013, our growth was driven largely by swine and poultry products. In 2014, it was driven by cattle and swine. And in 2015, companion animals and cattle led the way. This quarter, the most significant operational growth driver by far has been our portfolio of companion animals, a trend we expect to continue through 2016. Our companion animal business is growing thanks to the increasing sales of APOQUEL, the addition of Abbott Animal Health products, the introduction of new vaccines in Europe and the U.S., and the overall positive performance of the rest of our portfolio. It is important, as we experience softer growth in livestock, that we continue to invest across our portfolio, and during the first quarter, our R&D investment continued to show many positive results, including the approval of SIMPARICA, our new oral parasiticide in the U.S., Brazil, and Canada. This quarter also marked the completion of our ERP implementation. After nearly two years, all our commercial operations, manufacturing plants, and support functions are on a single platform, enabling us to achieve greater efficiency. Overall, we have been able to accelerate our operational efficiency program with a positive impact in 2016, and we expect to exceed the initial savings target of $300 million by 2017. I am pleased to say that with the positive momentum in the business and the help of improved foreign exchange rates, we are increasing our guidance for the two years, 2016 and 2017. Coming now to more detail on our first quarter results. Operational revenue growth was 12%, and you can find a slide on our webcast that breaks this down. These reflect six extra days in the quarter due to the accounting calendar, as well as the negative impact of changes in markets like Venezuela and India, and the product SKU rationalization that we communicated last year. Adjusting for these factors, the growth will be 10% operational and 6% excluding the additional impact of recent acquisitions. In the quarter, we grew adjusted net income by 28% operationally, once again growing faster than revenue and helped by the fact that our OpEx increased only 2% operationally compared to the 12% revenue growth. We continue to deliver on our long-term valuable position of growing adjusted net income faster than revenue. In looking at the overall market, we continue to see the animal health industry performing well, despite global economic challenges. We have seen good growth in most markets as greater consumption of proteins and increased medical spending on pets continues to help create customer demand for our products. As always, while I'm very pleased with the quarterly results, I also want to emphasize the need to look at our business on a full-year basis to account for some of the seasonal situations and timing patterns in animal health. Let me now update you on our new product launches and R&D developments. APOQUEL is showing steady growth. We have continued to launch APOQUEL in each of our markets such as Canada, Australia, and New Zealand, and we plan in the coming months to introduce the product in the rest of the markets where it has been approved, including Japan, Brazil, and Mexico. This month, the product will be available to customers without restrictions. In the first quarter, APOQUEL sales were approximately $50 million, an increase of about $40 million from the year-ago quarter. As previously communicated, we expect APOQUEL to generate peak sales of more than $300 million. As far as SIMPARICA, our new once-monthly chewable tablet for the treatment of fleas and ticks, it was launched in the U.S. and in several European markets. It is early, but we are hearing a positive response from our customers, and we expect performance to ramp up in the remainder of the year. We are also developing combinations of the sarolaner molecule in SIMPARICA with other agents. This would cover a broader spectrum of parasites, including heartworm, and we see sarolaner as a strong platform for future lifecycle innovations. Our canine antibody therapy that targets and neutralizes IL-31 to help treat atopic dermatitis in dogs has been introduced to veterinarian dermatologists in the U.S. under a conditional license. We received another conditional license in Canada in the first quarter. We are hearing very positive customer feedback, and we are gaining market experience with the product. We continue to allocate our capital for investments in key commercial activities, R&D programs, and business development opportunities that can generate faster revenue growth. For example, vaccines and genetics are two areas we are expanding our portfolio, as we put greater R&D emphasis around disease prevention. In the first quarter, we had several positive developments. We received approval of RUI LAN WEN, the second vaccine resulting from our joint venture in China and the first combination vaccine in China to help protect pigs against a certain locally prevalent disease. We also gained approval in China for our poultry vaccine to help prevent Marek's disease. In the U.S., we have now received licenses from the USDA for a new VANGUARD B Oral vaccine and three new VANGUARD Rapid Resp Intranasal vaccines. Zoetis is now the first and only manufacturer to offer oral, intranasal, and injectable options for vaccinating dogs against Bordetella bronchiseptica. We also granted a conditional license in the U.S. for an Avian Influenza Vaccine to help prevent diseases caused by the avian influenza virus H5N1. We are participating in a process to supply the USDA with this vaccine for the stockpile should they decide a vaccination strategy is needed. We're also seeing progress in genetic tests, as our farm animal customers want more information about traits and conditions that can help them build a healthier and more productive herd. During the quarter, in the U.S., we launched CLARIFIDE Plus, the first commercially available genetic test that gives dairy producers a direct way to predict risk factors for costly diseases in dairy cattle. And just last month in Chile, we launched the ALPHA JECT LiVac SRS vaccine for salmon, the first attenuated live vaccine against SRS. This was a significant R&D achievement by PHARMAQ, and a much-needed product to help Chilean fish farmers—great news for the industry and a terrific new opportunity for Zoetis. In summary, we are off to a good start for 2016, based on the strength of our diverse portfolio and the continued benefits of our R&D investment. We have been able to accelerate our efficiency program and expect to exceed the initial savings target of $300 million by 2017. Finally, with improved foreign currency rates and the positive momentum of the business, we are increasing our guidance for 2016 and 2017. With that, let me turn things over to Paul.

Thank you, Juan Ramón. I'm going to hit on many of the themes covered by Juan Ramón because they're important to the financial review of the quarter. So, let's talk about our first quarter performance. I'll walk you through a number of factors that you should consider to gauge how we did in Q1. There's some helpful information on the webcast slides and, of course, included in our press release. I'll then touch on a few other highlights in the quarter results and discuss our updates to guidance. Now, before I jump into the quarter, let me say that we know that the U.S. financial markets are quarter-centric and not to annoy quarterly modelers, but in any quarter, a lot of noise can and does creep into the comparison with the prior-year period. In our discussion and our webcast slides, our objective is to try to highlight for you the major elements of the noise in our results so that you can calibrate how our reported performance might influence your thoughts about our future prospects. The most important thing about our first quarter performance is that the results for Q1 supported an improvement to our outlook for the full year 2016. With that background, let me cover two important points that will enable me to put our 12% operational revenue growth in perspective. First, we operate on a 4-4-5 financial week calendar, with our International operations closing one month ahead of the U.S. Now, this is a carryover from our days as part of Pfizer. Under our 4-4-5 calendar, every handful of years you'll have a quarter in a year that has as many as six extra calendar days in it. That's what we have in Q1 2016 compared with Q1 of 2015. We estimate that the additional days account for approximately 6% of the 12% operational revenue growth for Q1 2016 versus 2015. Important safety tip for those with quarterly models out there, our fourth quarter this year will have five fewer days than the prior-year quarter, and full year 2016 has one more calendar day than 2015, this being a leap year. So, that's the extra days. Second, our operating efficiency initiative was a drag on our operational revenue growth in the quarter. We estimate that the combination of the eliminated SKUs and the changes to our business models in Venezuela, India, and other countries reduced operational revenue growth by some 4%. So, think about it like this: 12% operational growth for the quarter, minus 6% for the extra days, plus 4% for the impact of the efficiency initiative equates to a normalized growth rate of approximately 10%. Of that 10%, roughly 4% came from acquisitions, including Abbott, PHARMAQ, and other smaller transactions. So, our organic operational growth in Q1 was about 6%, and including acquisitions, it was 10%. So, not 12%, but pretty good, right? Now, highlights for the first quarter, very high level. We've now entered what I previously referred to as the golden age of our companion animal business. With the full supply of APOQUEL, the launch of SIMPARICA, a refreshed companion animal vaccine line, and the conditional license for IL-31, we are positioned to deliver significant growth in our companion animal business in 2016 and beyond. On a normalized basis, organic operational revenue growth, which adjusts for the six extra days, the impact of the operational efficiency initiative, and M&A, we had about 20% growth in companion animal in Q1 compared with Q1 of 2015, and the growth was reasonably consistent between the U.S. and the International segments. On the same normalized constant currency basis, livestock was up 1% with solid performance in the International segment, offset by a decline in the U.S. Q1 of 2015 was a particularly strong quarter in U.S. livestock, and there were a number of other factors that I'll touch on later. Our livestock business both in the U.S. and International segments are healthy and poised to contribute to revenue growth in the remainder of the year. Stepping down the P&L, our adjusted gross margin hit an all-time high of 67.4% in the quarter, a bit above the high end of our full-year guidance range. But I'll point out that from a gross margin perspective, many things fell on the favorable side of the line during the quarter – mix, level of scrap, et cetera. Our expectations for gross margin for the full year continue to be in the range of 66% to 67%. In operating expenses, total adjusted OpEx grew 2% on an operational basis, but if you remember those extra six days, they impact our expenses as well. Our progress in reducing operating costs continues, and we are on track to deliver on the promises of our operational efficiency initiative in 2016 and expect to enter 2017 having taken more than the targeted $300 million of costs out of our company. With our gross margin expansion and active efforts to contain operating costs, our 12% reported operational revenue growth translated into 37% operational growth in adjusted operating profit and 35% operational growth in adjusted income before tax. The EC's actions last January were a key driver of the 350 basis point rise in our adjusted effective tax rate to 30.9%, which resulted in our adjusted net income in the quarter rising 28% operationally. Our purchase of shares, which began in Q1 of 2015—started in January 2015—helped to reduce our fully diluted share count from 503.2 million in Q1 of 2015 to 499.5 million in the current quarter, and that led to operational growth of adjusted diluted EPS of 29%. So, that was a very quick walk down our P&L for the quarter. Here are a few more contextual details that I believe will help you think about our performance. First, FX. Dare I say that we may have found the bottom of the cycle? Maybe not, but the environment has improved for sure. Foreign exchange had a negative 700 basis point impact on our revenue growth in the first quarter compared with Q1 of 2015. That's a big hit. But based on current rates, the FX impact on our growth will lessen over the remainder of the year. While we continue to measure our performance on an operational or constant currency basis, it just feels better when the gap between operational and reported results narrows. Next, the SKU reduction and the changes to our business models in countries like Venezuela and India reduced our operational revenue growth by roughly 400 basis points. You should expect the growth drag on the full year to be roughly 500 basis points, so more of a negative factor compared with the prior year for the next nine months and particularly in Q2 and in Q3. Importantly, the impact of the SKU reduction and the changes in business models are felt more in our International segments than in the U.S. and more in livestock than in companion animal. Let me step through the elements of the 12% operational revenue growth in Q1. Price accounted for 3% of the growth, APOQUEL volume another 3%, 4% from acquisitions, 6% from growth of in-line products and minus 4% from the impact of the SKU reductions and changes to business models in Venezuela, India, and other countries. Companion animal was the star of the quarter. Revenue growth normalized for both the six extra days and the impact of the efficiency initiatives increased 20% operationally. APOQUEL was the major driver, but other products contributed as well including vaccines as well as the Abbott acquisition. We also expanded U.S. customers' access to a number of our companion animal products to third-party distributors, and that change led to a one-time in semi-permanent buildup of their inventories during the quarter to establish their base level. In livestock, we had lots of puts and takes. The normalized organic revenue growth was 1% operationally, with the International segment up 5% and the U.S. segment down 9%. First, let's talk about International. The France livestock rebounded as the anti-infective sales in the quarter were higher when compared with a very light Q1 of 2015, which was caused by new legislation last year. Australia livestock also contributed to a strong quarter with better weather playing a role. In Brazil, we benefited from above-average price increases and continued favorable conditions in the cattle segment, which were in part offset by the negative impact or SKU reductions. In U.S. livestock, a mild winter was a major driver of lower cattle product sales in the quarter. With milder weather, there was less risk of disease incidents, and that impacted our premium products. We also saw a decline in swine products due to increased competition. In summary, after adjusting for the noise, we had a solid quarter from a revenue perspective and through the ongoing programs to improve efficiency, delivered an improved gross margin, contained operating costs, and posted strong growth and profits. Switching to restructuring charges, let me quickly review this quarter's one-time charges related to certain significant items. First, the stand-up costs, which are mainly associated with our separation from Pfizer, totaled $12 million in the quarter, down about half from the prior year. That work continues to wind down and will be substantially completed later this year. In the second bucket, costs related to the efficiency initiative, we recorded $5 million of costs, which were more than offset by $33 million gain associated with the sale of four manufacturing sites in certain products as part of the efficiency initiative during the quarter. Interesting — rather than the gain, I like to think about it from a gross cash perspective. Gross pre-cash proceeds from the sale of the sites was $75 million. We have additional assets for sale including a transaction in Taiwan, which closed last Friday, and any impacts from those sales would further affect costs in this second bucket. Finally, we recorded $3 million of cost associated with our ongoing supply network strategy initiative. We're still in the early days of that initiative. We also did record a one-time net tax charge of approximately $35 million in the quarter relating to the nullification of our Belgium tax ruling by the European Commission for periods from 2013 through 2015. Now, turning to guidance. There are four factors that lead us to narrow and raise our guidance for 2016. First, let me cover the easy one, FX rates. We refreshed our guidance for our current FX rates, and that was certainly a help in our guidance. Second, in the first quarter, our International segment was stronger than we had expected, and we're confident that strength will carry through the balance of 2016. Third, we are more confident in our expectations for APOQUEL as we put supply issues behind us and have launch plans in place in new markets, and they are well underway. And fourth, we reduced our guidance for our 2016 effective tax rate on adjusted income by 100 basis points. This is due to changes in our projected mix of income by jurisdiction as a result of internal restructuring of our International operations. If you want to calibrate the various factors, at the midpoint of our guidance range for adjusted EPS, we raised guidance by approximately $0.10 a share, I'd be remiss if I didn't say it's actually $0.105, but it's $0.10 a share for this purpose. Roughly $0.03 comes from FX, roughly $0.04 comes from stronger operational performance, and the reduced tax rate added roughly $0.03. I hope that helps you think about the change for the guidance. For 2017, the only change we made at this point is based on changed FX rates. So, to go through it for 2016 and 2017. For the full year 2016, we now expect revenue between $4.775 billion to $4.875 billion, reported diluted EPS of between $1.41 and $1.56 per share, and adjusted diluted EPS of between $1.83 to $1.90 per share. For the full year 2017, we now expect revenue between $5.075 billion to $5.275 billion, reported diluted EPS of between $2.01 to $2.19 per share, and adjusted diluted EPS between $2.24 and $2.38 per share. Now, to summarize, we enjoy a diverse product portfolio, global footprint, and productive R&D that together enable us to balance fluctuations across different species, therapies, and markets, and deliver consistent revenue and profit growth over time. We are well down the road of improving the efficiency of our operating expense structure, leading to improved margins, and we're on track to achieve an adjusted EBIT margin of 34% in 2017. With the continued focus on expense efficiency, we expect to deliver operating profit growth faster than revenue growth. Last but certainly not least, we strive to intelligently allocate our capital and actively manage our capital structure to drive shareholder returns. That's it from my prepared remarks. Let me turn it back to Juan Ramón before we get to Q&A.

Thank you, Paul. And before we begin the Q&A, I wanted to mention our personnel development. So beginning July 1, John O'Connor will be promoted to the role of Vice President of Corporate Strategy, Business Analytics, and Enterprise Risk Management for Zoetis; and Steve Frank will now lead our Investor Relations program; John will be reporting to Alejandro Bernal, Executive Vice President, President, and Group President of Corporate Strategy, Commercial, and Business Development. John has done a great job as Head of Investor Relations over the last two years, and I wanted to thank him for those contributions. He will continue to be a valuable advisor to me, to Paul, and Alejandro in his new capacity. I am pleased to say that John will leave the Investor Relations program in good hands, and that is Steve Frank. Steve has great knowledge of our industry and business, having worked in animal health for the last 15 years, and has been involved in our recent acquisition of PHARMAQ and Abbott, as well as our IPO. Many of you know Steve, and he has been working with John in IR since 2014 to prepare for this opportunity. I'm sure we will have a seamless transition. With that, let me open the lines for Q&A. Operator?

Good morning folks and congratulations on the quarter, and congratulations, John, on the promotion. I'm not sure if I got the April cost sales. If you don't mind repeating what the April cost sales were by region? And could you also comment on some of the vaccines that you are developing in your livestock business, particularly the avian vaccine? Thank you very much. We'd appreciate it.

Okay. So, the first question on APOQUEL. Total revenues for APOQUEL in the quarter were $50 million, and the U.S. generated $35 million, and in International markets $15 million. I guess, it's answering your question on APOQUEL. You also asked about new vaccines. On new vaccines, we have new vaccines for companion animals, and this has been introduced in Europe as well as in the U.S. I mentioned new vaccines that are in the U.S. covering oral, injectable, and intranasal, and I mentioned this for a specific Bordetella bronchiseptica disease. So, this is something that definitely represents a significant upgrade in our portfolio for companion animal infections. We also launched a new vaccine in China, used for swine, and it is a combination of vaccine for PRRS with a combination for swine fever in pigs. So, another opportunity for increasing our presence in China, and increasing our presence in the swine market in China. That is a significant opportunity for Zoetis. Next question, please.

Hi. Thanks for taking my question. So you guys talked about maybe exceeding your operational efficiency target of $300 million. I was wondering if you could give more color there on the potential upside, and then how this could positively impact your 2017 guidance and margin expectations? Thanks.

Well, we already incorporated in our guidance for 2017 the potential exceeding of the $300 million. At this point, we have not provided any concrete amount on this existing opportunity; this is something that in the future, as we move into the programs, we'll be sharing that with you. Next set of questions, please.

A follow-up to that question on the restructuring, SKU rationalization, and overall cost structure initiatives. How should we think about the quarterly progression throughout the year? And then as a second question, how would you characterize the current environment in the U.S. livestock business? You mentioned weather impacting the business in the quarter, but how should we think about the dynamics now? Thanks.

Yes. Erin, it's Paul. I'll take the question about how to think about the OpEx rollout. As we said, we expect to enter 2017 with the cost structure trimmed down to its new inefficient level. We have some work to go on that and I think that if you're a quarterly modeler, I know you are, you got to think about it as continuing to show a positive impact through Q4. It's not like we're going to finish this in Q2, we're not going to finish in Q3; there is more to come that you will see evidenced in our cost structure in Q4. So, I don't know if that exactly answers your question. But, yes, suffice to say that the improvements will continue to occur throughout 2016 and with a good chunk in Q4 2016. Do you want to take the last one?

Yeah. Let me cover the question on the U.S. livestock. Let me start with the cattle. On the cattle, there are two segments, beef and dairy. Let's talk about beef. Beef, we reported that there were probably milder winter conditions that impacted our premium net products, but the fundamentals of the beef market are very strong. We have seen that the increase in placement in feedlots. We also expect that it will continue for the rest of the year and at the end of the year, we expect that the number of cows in beef will increase by 2% to 3%. Even if we have seen some temporary impact in the first quarter, we want to also see this business on a yearly basis, and we're confident that on a yearly basis, the market remains very strong. In dairy, what we have seen is that the global prices for milk have been going down. This is also resulting in some negative impact on dairy customers. In some cases, we expect that they will be reducing the number of dairy cows. Again, so it's a cycle that we have seen in previous years. After a cycle of low price reduction of cows, it will be another cycle where prices will go up, and then they will be rebuilding the herd. So, we don't see that this is something that is concerning for the medium to long term process for the business. In swine, we reported that we are facing some additional competition for vaccines. It's a similar case that we saw in the past with companion animals. We identified this need in companion animals, and we have been working to upgrade our vaccines. Now our vaccines in companion animals are very strong, and we are doing the same with swine. So, we are working to upgrade our swine portfolio for vaccines and we're confident that this will bring us the opportunity for growth in the future. We don't expect the swine to be a significant driver of growth in 2016. And finally, poultry. Poultry in the U.S. is a positive segment. We expect to generate net positive growth in 2016. Next question, please.

Hi. Thanks very much. Can you just talk a little bit about the strategy around dermatitis in dogs now that you've got IL-31 out there as well as APOQUEL? What are you learning about the market and how best are you using those two products? Thanks.

Well, it's still very early because first, APOQUEL has been, due to the limitations in terms of supply, mostly used in chronic dogs with dermatitis. We expect now that in May we are opening the market without restrictions. They will be expanding the market not only to chronic but also to acute. In the case of IL-31, IL-31 has been introduced as a conditional license. We are gaining experience in the market by doing some activity with dermatologists. This also has the objective of collecting data to support full license in terms of efficacy of the product, but we are convinced that there are two products that are very complementary—one is oral, the other one is injectable. There are some dogs that do not manage well swallowing pills. This is something that IL-31 will cover. Not everyone is responding the same way to treatment. APOQUEL is working very well in some cases; IL-31 is also working very well in some cases. So, the veterinarian will have the option to choose what is the best treatment there, depending on specific cases of dogs with atopic dermatitis or any kind of skin condition. Finally, APOQUEL will have broader indications, while IL-31 will have the indication of atopic dermatitis. Next question, please.

Great. Thanks very much for the questions, and congrats, John. First, just an update on SIMPARICA and how you're thinking about the rollout of the product? I guess, should we think about a slower ramp here, given entrenched competition, and what type of share do you think Zoetis can ultimately capture in this obviously very large end market? Thanks.

So, as I mentioned, it's early with the introduction of SIMPARICA. SIMPARICA has been introduced in the U.S. and in a few European markets. We just plan to introduce the product in the rest of the markets where the product has been approved. SIMPARICA has been launched with very strong publications that compare SIMPARICA against other products, both oral and topical. And we have seen that SIMPARICA is showing very positive comparisons in terms of faster action! So it's very quick on killing ticks and fleas, which is also very important. So, SIMPARICA is maintaining full efficacy during the duration of the treatment, which is also crucial and much better than some of our competitors. We are definitely convinced that SIMPARICA will have a place in the market. I think we are not yet establishing what is the target in terms of market share, but definitely, we expect that we will gain the market share that corresponds to a company with our strengths, capabilities, and operations in the market.

Yeah, it's Paul. I just want to follow on that. I think that the overall market size for parasiticides is about $4 billion. The dogs' portion is about $2.5 billion; the fastest-growing segment are the oral parasiticides. But if you want to think about the market, it's kind of in that $2.5 billion market and I think that we believe that there are two things. One, with our footprint and the quality of our salesforces, we have the opportunity to certainly penetrate that $2.5 billion market and participate in the fastest-growing segment. The second thing I want to point out is, this is a self-developed product, and that means the economics of this product to us compared with the economics of the product to Merial and Merck that are in license through third-parties. This is a very good product for us and we're really excited about both the prospects of penetrating the market, but also getting the fruits of our investment in R&D. So this is a great story, and we'll see how it plays out.

Next question, please.

Hi. Good morning, everyone. Thanks very much for taking my questions. So Elanco licensed a new canine osteoarthritis drug just in the last quarter. I wonder if you could talk about that in terms of why you didn't feel compelled to license that asset and just remind us what products do you have in that area and if you're very active in terms of R&D late-stage development there and how that might impact your franchise? Thanks very much.

Well, thank you for the question, Jeff, and we believe that we have a portfolio in pain, which is very strong. We have RIMADYL in all markets. We also have in the European market another product, which is also complementary to RIMADYL, called TROCOXIL and very importantly. So we have a lot of experience in this area, and this expertise is not only in terms of commercial but also in R&D. And in R&D, it's an area of focus, and we have programs in pain that I'm convinced will strengthen our portfolio in the future. Next question, please.

Hello. Hi, guys. Thank you for taking my questions. It's actually Vlad Nikolenko on behalf of Mark Schoenebaum. Congrats on the strong quarter, and John, congrats on the promotion. So I have two somewhat related questions. First, more about macro trends in general. So your official guidance for 2016 and 2017 implies strong operational growth in terms of revenue like mid to high single-digits. So I'm wondering if we can think about this revenue growth over the longer term that just will continue to grow in line with the rest of the industry – animal health industry or at some point, we need to expect some slowdown of this trend. And second, somewhat related question is about segments. Do you have more color about the potential long-term growth in different segments of products, antibiotics versus vaccines versus other pharmaceuticals and other segments that you report? Thank you.

Thank you, Vlad, and let me first describe what are the macro trends. We see that the overall macro trend that maybe is lowering down the growth in some markets is not affecting our industry the same way. An example is that we have seen in Brazil, the GDP is declining, while the GDP for agriculture including livestock is growing. So, in the animal health industry, I think we cannot extrapolate the macro trends that are affecting other sectors to our trends. Our trends are based on population, which is still continue growing; middle class, which is still increasing, and also they need to improve productivity because the world is being challenged with the need for more food with fewer resources. Companies like us can bring this type of innovation; we have a significant opportunity for growth. The same drivers are also impacting companion animals. More people and a growing middle class are increasing pet adoptions and the amount that pet owners are spending per pet in keeping these animals healthier and allowing them to live longer. We're very confident that the macro trends remain positive for the animal health industry. For Zoetis, we have been targeting to grow in line with or faster than the market. In the first two years as an independent company, we had been growing faster than the market. In 2016, because of some one-time impacts related to our operational efficiency, the reported growth will be lower. Adjusted for this factor, we expect that we will grow in line with or faster than the market. The same for 2017. We've projected for 2017 a growth that at the midpoint, is faster than the projection of the market, and we have no reason to believe that in the future we won't continue growing in line with or faster than the market. One of the things that are very important is that we have already all that is needed to maximize our portfolio. Moreover, our R&D investment continues delivering strong results. We have been continuing to bring into the market new products, and just as importantly, bringing into the market lifecycle innovations, which is also helping to protect our future growth. Maybe Paul can talk about trends in therapeutic areas—antibiotics, vaccines, pills—that are part of our efforts to ensure that we have the right balance and the right opportunities for our growth.

Sure. And when you think about—when people talk about anti-infectives or antibiotics, people look at our portfolio and say, gee, you're a market leader in anti-infectives. I hear this and I see this in the news, therefore we have a lot of revenues at risk. To put it in perspective, I think what people mostly focus on is the amount of anti-infective sales that we have in livestock. They're not necessarily as concerned with the anti-infectives that are used in the treatment of companion animals. We see about $1.3 billion of anti-infectives in the livestock segment. But importantly, Vlad, first, I’m going to talk about our company and our outlook. Included in that $1.3 billion, about $1 billion of that are in the form of high-value injectable products that are dosed to animals when they are sick and where the alternative is that the animal could die, and the animals around that animal could die. And that's why we characterize this as the responsible use of anti-infectives, and that is the overwhelming majority of our portfolio was products that fall into that category. While there continues to be pressure or concern from folks generally about the use of anti-infectives and wanting to minimize their use, they are mainly focused on the use of anti-infectives in ways that would, for example, promote growth. Within our portfolio, about $300 million balance in livestock, that is mainly anti-infectives that are used in feed and in water. Our work with our customers and our own diligence strongly suggest that those products are being used in what we would call a responsible way—not in sub-therapeutic doses to promote growth, but to treat sick animals. Even still, if I were looking as an outsider, I would look at that $300 million as a piece I need to keep my eye on; I’d be concerned about it. Now, back to the overall trends. Our anti-infectives continue to grow, but they grow slower than the balance of our portfolio. Just so, well, real quick, of course, that's baked into our 2016 expectations, our 2017 expectations, and frankly is baked into what folks who look at our industry generally consider the long-term growth prospects for the industry. It's an important part of the industry, and so that's baked into the macro view of our industry to be able to grow mid-single digits or better for the foreseeable future. I’ll continue on because it’s a very interesting topic. We pivoted many years ago away from the development of additional anti-infectives to a focus on vaccines because the best way to reduce the use of anti-infectives is to reduce the incidences of disease. That’s the best way. We have been very successful in pivoting our R&D portfolio and now our product portfolio to feature vaccines and assist producers in maintaining the health of their herd so they would have to use fewer anti-infectives. So, that's a big area for us. And I'm focusing all of this on the livestock segment because I think that's where your question lies. I’ll stop there.

Hi. Good morning. Thanks for the questions. Just on the IL-31, what is your expectation in terms of timing for going from a conditional to a full approval and just obviously there's some limitations in terms of your promotion of the product right now. Just how widely is that being used in terms of veterinarians?

Thank you, Doug, for the question. We expect, but this is something that will depend on the final approval from the USDA. We expect this approval by the end of the year. So now what we are doing is gaining experience, and also collecting the data in terms of efficacy, and this will be submitted to the USDA for the final approval of the product. In the U.S., we have similar partners in Canada and a different one in Europe. Also, we expect this product approved in the future in Europe. Today, it is used under this conditional license. Therefore, the use is quite limited because we're just going to fewer customers in the U.S., mostly veterinarian dermatologists; some other customers are using the product. Now the objective is not to generate significant revenue growth but to gain experience of the product and ensure that the product is generating the data that would support full license. We're convinced that IL-31 will be an important product in our portfolio and very important for Zoetis; it's developing a franchise for skin conditions, itching, and atopic dermatitis. With two products in the market, we have very strong positioning with great future opportunities. Next question please.

Good morning. This is Divya Harikesh on behalf of Jami Rubin. Just wanted to get your latest thoughts on capital allocation. Are there other assets that look more attractive at the current valuation, or areas that are of particular interest to you? Also, how much leverage would you consider, given the market's increasing concern on leverage levels for companies? Thank you.

This is Paul. I'll take that on the capital allocation front. Of course, we continue to—I think like most companies—we focus first on what kind of capital we can allocate within our company to drive incremental revenue and profit growth; that’s always going to be a very high return activity. So, first, we do try to maximize programs inside that can drive revenue, and that falls into categories—yeah, that could be incremental salesforce, investment in DTC advertising to grow markets, incremental investment in R&D to develop new products, or incremental CapEx to create a technology platform. So it's all those things. So we do that first. The second piece, which is I think what you’re asking about is outside. So we look outside on what sorts of opportunities we see. We see a very consistent flow of what I’ll call smaller deals that we do every single year, none of which I think on an individual basis is going to be exciting to the market at large, but in the aggregate help us one, feed our R&D effort because we can acquire technologies that feed R&D. Second are small add-ons that we just continually do; that can be anywhere from $40 million to $75 million a year in activity, and that's relatively consistent. The next bucket would be sort of the mid-sized M&A and I think last year, I’d put PHARMAQ in that category, and maybe even Abbott in that category as well. Lastly, we were fortunate enough to close two deals. I wish we could do that every year. The challenge is not our desire; we will do these deals 100 out of 100 times if they present themselves. So we are— as I used to always love to say—we're tanned, rested, and ready to do those deals when they present themselves, and we're spring-loaded to go after them when they present themselves. But now predicting when they're going to be available is the challenge. On the larger scale M&A, really, I guess, what you think of as potentially transformative, we've said many times over, our transaction with one of the top five companies is very difficult for reasons of antitrust; think of it as FTC-type issues because there's a lot of concentration now among the top, say, five companies. So, the prospect for a transaction, I’d say, never say never; it’s not zero, but it would be pretty hard. There are opportunities there that we continue to look for, and I should say we’re also very proactive in targeting assets that we think would be interesting and valuable to add to our company, but of course, we're not going to disclose what our list of targets might be at any moment. Lastly, the last bucket is the one that I think is important. I referenced it in the tail end of my prepared remarks, and that is returning capital to shareholders. As we enter 2017, we have lots of the standup costs and the operational efficiency costs behind us—not just from a P&L perspective, but also from paying out the accruals, etc.—and we put that cash flow behind us. As we enter 2017, we expect to throw off a fair amount of cash. The question is, well, gee, if you don't have anything to do with it, what are you going to do? Well, a couple of things. One, we have a dividend; we're making a commitment this year of around $190 million for that dividend in 2016. We have a share repurchase program, and we are currently purchasing shares at the rate of $75 million a quarter under a program that we announced way back in November of 2014. Long-winded, but we intend to the extent that we can't deploy that capital either in our business or outside our business, to return it to shareholders in the form of dividends and share repurchases over time. We think that's appropriate. Cash is a non-productive asset for us to have around, but this also dovetails nicely into the discussion of capital structure, which you inquired about as well. We have articulated that we expect to operate in the normal course of business in the trailing EBITDA range of 2.5 to 3.5 times for a debt level for our company. Operating in that range will enable us to maintain an investment-grade rating—we believe will enable us to maintain an investment-grade rating—and that's important, as you pointed out. The market is taking a different look at leverage levels today than they might have two or three years ago, and we're cognizant of that. Because we get this question a lot, I'll restate it. People say, would you ever do a deal that would cause you to be above that range? The answer is yes. We would go above the top end of that range to pursue what we felt was a value-generative M&A. Would we go above that range to buy more stock? Probably not, in fact, I’ll say definitely not. But we would in the context of making an acquisition. So, we get below 2.5 times, we probably would put some leverage on; we get above or up to the top end of the range at 3.5, you'd expect us to manage that leverage down. The objective is to try to operate in that range. Now I’ll stop there.

Next question please.

Right. Thank you very much. So, I was a little bit on and off the call. I just have a couple of questions on the guidance changes. So for the 2016 guidance, Paul, what percentage of the EPS guidance increase was due to operations and what percentage was due to FX? And then for 2017, obviously, you haven't updated that guidance for operating performance; you've only updated it for FX. When do you expect to update it for operating performance? Could we expect that after the second quarter results, or do we have to wait until the company goes through its full-year annual planning in the fall? Any color on that would be helpful. Thank you.

Yeah. Sure. Thanks for the question, David. It's Paul. I'll take that. I'll go through the—at the midpoint in the range $0.10 up, $0.03 from FX, $0.04 from stronger operational performance, and then the tax rate was a $0.03 helper, as well, and that gets you to the $0.10 raise at the midpoint of our range in 2016. You're quite right. For 2017, we said we updated our guidance solely for the favorable change in FX rates. It’s 2017 guidance. We're one quarter into 2016. We have a broad range there, so you can take this to mean that our outlook continues to be in that range; otherwise, we would have adjusted—or adjusted that range. There's no set time at which we would change our operational view of 2017, but to the extent that we were outside the range for 2017, we'd change it. I'll stop there.

Thank you. Good morning. First, I just had a follow-up on the sarolaner. Could you confirm that you do have full supply now, so you're ready for full global launch? And was there any stocking in the first quarter of sarolaner? Second question has to do on the SKU reduction; you've targeted 5,000 or roughly in total. Can you give us a sense of where that's out right now, and does that—is that something that just sort of goes away slowly as the year unfolds, or is it more dramatic that they're kind of there until year-end? Also, a sense of what therapeutic categories those SKU reductions are coming from. So as we look at that, we can get a sense of where some of those reductions will be coming. Thank you.

Okay. Let me start with sarolaner, SIMPARICA now. The name in the market is SIMPARICA and we have no restrictions for this product. We have enough of our product to introduce the product in all markets where the regulatory authorities have approved established. In the U.S., all new markets, we also have operations in Canada and some other countries. At the time of the launch in the U.S. and in Europe, there was no significant loading of the product in the country; most of this product was related to samples that we provided to the veterinarians to familiarize themselves with the product. As such, we didn't generate significant revenues in the first quarter, but we expect that these revenues would ramp up during the rest of the year. We have very good expectations for the product. As I mentioned in some of the other comments, we have very strong publications supporting the efficacy of the product. As I said, this product works very quickly and also shows strong efficacy during treatment. So there is no drop in efficacy at the last day of the treatment—in contrast, it maintains efficacy. In terms of SKU, I think we have made significant progress on SKUs. Most of the SKUs have been already eliminated from our portfolio, and maybe a few remaining SKUs will be eliminated from now until the third quarter, which are related to SKUs that will be replaced by other products we are introducing in the market. The large majority of SKUs have already been eliminated from our portfolio.

Let me continue on that because I think you asked the question about how it plays out over the course of 2016, and this is also important. We've eliminated an SKU from the portfolio. If we sell it, we sold that product along with it, obviously. But if we eliminate an SKU and stop producing it, we may still have inventory and we still sell it. That's why you're seeing it play out over the course of 2016. But let me frame it: Q1, we said the impact of SKU reductions was about 4%. We said that we expected it to be about 5% and this is growth versus prior year. For the full year during the nine months, Q2, Q3, and Q4, it will be greater than 5% impact from a growth perspective versus the same period in the prior year. Finally, I said that during the nine months, the impact of the SKU reduction will be primarily felt in Q2 and Q3; at that point it would moderate in Q4. We did, however, start to see an impact in Q4 of last year. Entering 2017, there will still be some drag because we still sold some of these products at the beginning of 2016. But if you look at the kind of run rate entering Q1 of 2017, that will be fully reflective of all of those SKUs being gone, and again, the impact being heavier in Q2 and Q3 of this year, moderating in Q4. There is still some impact in Q1 of next year and Q2 next year, but it diminishes pretty substantially. The cool part is, we will have this activity behind us entering 2017. Next question, please?

Great. Thanks so much. Also, I still don't see a balance sheet in the release. I guess my bigger question here is what can you accomplish in the way of working capital improvements near-term, and to address the high inventory days? And then also, how much was the distributor stocking contribution in the quarter? I assume that's related to the vaccine business. Was that material?

Yeah, it's Paul. Let me take the balance sheet and working capital questions. Yeah, we’re working very hard to shrink and eliminate the gap between reporting our earnings and the release of the balance sheet. We are expecting to file our Q on Friday of this week. So, we’ve shrunk it to a couple of days. It had been substantially more than that. We could not shrink those days in the context of also changing all of our ERP systems, etc. So we are working on that, and our goal is to be like most other companies, to have our balance sheet on the same day that we report earnings. That’s a priority for us, and we will get there. Regarding working capital, you pointed out the days sales of inventory we’re on at the end of the year. We expect that we can have some pretty sizable improvements in our investment in working capital efficiency. With the completion of our SAP implementation, where we have every part of our company up on one instance of SAP, we now have the opportunity to activate the tools that will enable us to manage our investment in inventory more tightly while having a high service level to our customers. That’s not instantaneous; that’s something that we explored. I’ve said in public forums before, we expect to make progress against that in 2016. We’d expect to make much more substantive progress in 2017 as we get the tools to better manage our supply chain. We are pretty good in accounts receivable; I’d say pretty good; we’re good in accounts receivable and we are also good on accounts payable. So it’s really inventory that we are focused on, expect modest improvement in 2016 and more significant improvements beginning in 2017 as we get the tools up to better manage our supply chain. Your question regarding distributor stocking is in the U.S.; that was related to companion animal products to increase. So, the amount that went in was approximately $18 million in the quarter. And so, it’s something you should take into consideration. Next question please?

Great.

Thank you very much for your attention. I'm looking forward to the following quarters and also the interaction with all of you. Thank you.