Zoetis Inc - Class A (ZTS) — Q4 2017 Earnings Call Transcript

Thank you, operator. Good morning, and welcome to the Zoetis Fourth Quarter and Full Year 2017 Earnings Call. I am joined today by Juan Ramón Alaix, our Chief Executive Officer; and Glenn David, our Chief Financial Officer. Before we begin, I'll remind you that the slides presented on this call are available on the Investor Relations section of our website and that our remarks today will include forward-looking statements and that 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 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, February 15, 2018. We also cite operational results which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramón.

Thank you, Steve. Good morning, everyone. Two weeks ago, we celebrated our fifth anniversary as a public company. And since our IPO in 2015, we have been able to improve the ways we innovate and serve our customers, grow as a profitable stand-alone business, and build a track record of delivering results. Over the last 5 years, we have maintained a high level of R&D productivity and developed new and enhanced products that address the more relevant needs of our customers. New innovative products like Apoquel, Cytopoint, and Simparica, as well as lifecycle innovation for our existing portfolio, have supported our leadership in the animal health industry. On an operational basis, Zoetis' revenue has grown an average of approximately 7% over the last 5 years compared with the 5% to 6% for the animal health industry. And our adjusted net income for the same period has grown operationally an average of approximately 21%. Over the last 5 years, we have been able to deliver on our commitment of growing our revenue in line or faster than the market and growing our adjusted net income faster than sales while also targeting value-added investment opportunities and returning excess capital to our shareholders. And for the next 5 years, we remain committed to achieving these elements of our value proposition for shareholders. In 2017, Zoetis became the first animal health company to deliver more than $5 billion in revenue as we continue to demonstrate the strength of our business model and the growth opportunities in animal health. We achieved operational revenue growth for 2017 of 8% based on the diversity of our total portfolio and balanced performance across the U.S. and major international markets. And once again, we grew our adjusted net income 5% sales at 21% operationally as we continue to realize the benefits of our operational efficiency initiatives and deliver our long-term value proposition. The strength of our diverse portfolio of approximately 300 product lines helped to absorb economic challenges in certain markets and to offset all issues like the implementation of the Veterinary Feed Directive, or VFD, in the U.S. Our companion animal business led the way again in 2017. It grew 14% operationally based on the continued penetration of Apoquel and ramp-up of Cytopoint and other new products like Simparica, which has gained share in the large and highly competitive parasiticide market. We believe 2018 will be another year of above-market growth for our companion animal business. We see further opportunities for gaining share and expanding the market for dermatology products with our innovative treatment options. We expect to achieve more than $500 million in combined sales from Apoquel and Cytopoint in 2018. We'll also continue to support these products, as well as our oral parasiticide, Simparica, with direct-to-consumer campaigns in the U.S. and other markets. Simparica has been able to gain market share in the U.S. in 2017, and we expect further growth there and internationally in 2018. Meanwhile, we delivered 5% operational growth in our livestock business for the year. International markets grew faster than the U.S., where we felt the impact of the VFD implementation in our cattle and swine anti-infective products. For 2018, we see more favorable market conditions for livestock, particularly in the U.S. Glenn will discuss the details of our fourth quarter results and guidance in a minute, but I would like to say that we feel very confident about our prospects for 2018. In addition to revenue growth, we have also been focused on improving our operational efficiency and margins. And in 2017, we achieved an adjusted EBIT margin of 34.1%. This was an improvement of 900 basis points in the last 3 years. With our improved cost structure, margin expansion, and revenue growth, we have been able to almost double our operating cash flow for the year in 2017 compared to the previous year. That improved cash flow, along with the long-term benefit of the recent U.S. tax reform, is providing us the flexibility to invest for long-term growth. In terms of long-term growth, we'll continue investing significantly in R&D for our core species and geographies, look to strengthen our cattle, fishing areas, livestock monoclonal antibodies, vector vaccines, genetics, diagnostics, devices, and automation, and define new technologies in areas like data analytics and sensors. We'll continue supporting our key products like Apoquel and Simparica with direct-to-consumer advertising and other marketing campaigns. We'll also increase our field force in diagnostics to better support the interaction of new products in the future growth expected in this area. We'll be allocating capital to support many of the manufacturing and supply improvements I have discussed recently in places like China, Ireland, and the United States. And as always, we'll continue to look at external partnerships and business development that could accelerate our ability to grow in our core business and in complementary spaces like genetics and data analytics. All these investments will support our goal of more integrated solutions, which cover the entire lifecycle of animal care that our customers need. In conclusion, as we mark our fifth anniversary as an independent company, I'm grateful for the colleagues at Zoetis who have delivered our strong performance and will support our future of profitable growth. We continue to drive innovation, believe in customer excellence, simplify our operations, and increase our cash flow. And as we look to the future, we'll remain committed to strengthening our interconnected capabilities in direct sales, R&D, manufacturing and look for additional investment opportunities to enhance our growth. With that, let me hand things over to Glenn, who will provide more details on our fourth quarter results and full year guidance for 2018.

Thank you, Juan Ramón, and good morning, everyone. Before I get into the details on our fourth quarter performance and guidance for 2018, I will provide a few comments on the results for full year 2017. This year, we delivered operational revenue growth above the market, grew adjusted net income faster than revenue, and almost doubled our operating cash flow. Reported revenue for full year 2017 was $5.3 billion with operational revenue growth of 8%. Of this 8%, 3.5% came from our dermatology portfolio, 3.5% came from Simparica and other new products, and the remainder of growth came from price and volume. Our product rationalization initiative had an unfavorable impact of 1% on volume for the year. Adjusted net income for full year 2017 was $1.2 billion and grew 21% operationally. Adjusted net income continues to grow faster than revenue driven by the continued impact of our operational efficiency initiative and a lower adjusted effective tax rate. Our performance this year, again, reaffirms our ability to execute on the financial targets that we set in May of 2015 when we provided long-term guidance through to 2017. With the results that we are reporting today, both our top and bottom line in 2017, beat the goal outlined nearly 3 years ago. For the full year, we've performed well across all the species and key markets where we compete. The diversity and durability of our existing portfolio, our market-leading commercial and manufacturing capabilities, and the innovations we bring to the marketplace have allowed us to outpace the animal health industry market growth for the last 5 years. Our income growth and our increased discipline on the balance sheet have enabled us to almost double our operating cash flow in 2017. This was the result of lower cash outlays for termination benefits and stand-up costs, increased profitability, and inventory improvements. In 2017, we reduced our months on hand of inventory by more than a month. We have more work to do in this area but are pleased with the progress in 2017. Turning now to quarterly results. Q4 2017 was an exceptional quarter, with top line growth coming from new products in our companion animal portfolio and strong livestock performance in our U.S. and International businesses. Our product rationalization initiative had no material impact on our growth this quarter and will not have an impact on our revenue growth going forward. Total company revenue in the fourth quarter grew 13% operationally, excluding the favorable 1% impact from foreign exchange. Our key dermatology products, Apoquel and Cytopoint, once again surpassed the $100 million marketing revenue, with sales in the quarter reaching $125 million and $428 million for the full year 2017. Sales of Simparica were $18 million in the quarter, growing 102% over the same period in the prior year. Fish products also contributed to growth with sales of $39 million, growing 44% operationally versus the same quarter last year. Our recently introduced PD vaccine in Norway was the primary driver of growth as it continues to gain share and help increase the penetration of other related vaccines in our portfolio. Now let's discuss segment revenue. Our International revenue grew 13% operationally in the fourth quarter, with companion animal operational growth of 18% and livestock growth of 11%. The International segment continues to drive growth across multiple dimensions with growth coming from our dermatology portfolio; new products, such as Simparica, our PCV combo vaccine, and our PD vaccine; and volume and price from our in-line portfolio. Turning to some key market highlights in the quarter. In Brazil, we grew 13% operationally, driven by the strength of both our livestock and companion animal businesses. In cattle, investments in our field force have led to increased penetration and coverage in key regions within the market while favorable export market conditions also continued to contribute to growth. In swine, increased sales of IMPROVAC, or Vivax as it's called in Brazil, were driven by higher usage and greater penetration with larger customers. The higher companion animal revenue in Brazil benefited from the continued growth of Simparica through the increased promotional activity and higher veterinary clinic penetration. In Japan, we experienced operational revenue growth of 27% in the quarter. Growth came from Apoquel as a result of the timing of distributor purchases last year and the additional market penetration we achieved, as well as the launch of premium injectable products for livestock. France grew 23% operationally over the same period last year due to a timing impact related to our price changes and new products across both companion animal and livestock. China grew 13% operationally on a continuing strength of the companion animal business, driven by increasing medicalization of pets. Our swine business once again showed modest growth this quarter due to softening pork prices, which we have expected and discussed on recent earnings calls. Our optimistic outlook and long-term view of the market remain unchanged as we continue to invest in our local operations there. To summarize, a very strong quarter for our International segment with growth across the diversified portfolio, including all of our core species and key markets, favorable market conditions, strategic investments in our portfolio, and a focus on execution are all helping to drive consistent commercial results. Turning to the U.S. Revenue grew 13% in the fourth quarter. Companion animal grew 15% while livestock grew 11%. Companion animal sales in the quarter were driven primarily by key dermatology products, Simparica and a number of other recently launched products. U.S. dermatology sales for Apoquel and Cytopoint were $86 million for the quarter and exhibited substantial growth over the same quarter in the prior year. While we did see a small decline on a sequential quarter basis, Q1 and Q4 are impacted by seasonality, with the warmer spring and summer months experiencing peak activity. Simparica grew over the same quarter last year as DTC investment and field force efforts led to higher clinic penetration in both key corporate accounts and smaller clinics. Additional contributions to companion animal growth came from a number of line extensions to our Vanguard vaccine franchise, DIROBAN, a recently launched product for the treatment of heartworm, and CLAVAMOX chewable, a trusted antibiotic in a new easy-to-administer tablet. Our U.S. livestock business saw a return to growth in the fourth quarter, with sales increasing 11%, thanks to the performance of our cattle and poultry businesses. During the fourth quarter, growth in cattle products was driven by increased sales of premium products, which was supported by a greater risk of disease outbreak and incidents due to the weather, as well as the timing of promotional activities in 2016. Our beef cattle business also benefited from higher numbers of animals moving through feedlots than in the comparable 2016 period. Our livestock business continued to be impacted by the Veterinary Feed Directive, or VFD, with another $10 million hit to revenue in the quarter. For the full year 2017, the VFD had about a $40 million impact on revenue. In poultry, the weather's portfolio of alternatives to antibiotics and medicated feed additives continue to be the primary driver of growth as certain producers expand their 'No Antibiotics Ever' labels. The weather works with customers to provide the necessary product and technical assistance that can help them switch over whenever they choose. Now moving on to the rest of the P&L. I will quickly cover a few key line items and then move on to our guidance for 2018. Adjusted gross margin of 68.9% increased 450 basis points in the quarter on a reported basis and reflects the benefit of cost improvements in our manufacturing network as well as the reduction of inventory waste charges versus the same quarter last year. Operating expenses in total grew at 2% operationally versus the same period last year, which was significantly lower than the operational revenue growth of 13% as we benefited from the final stages of our operational efficiency initiatives. The adjusted effective tax rate for the quarter was approximately 27.6%. This is higher than the rate in the comparable 2016 period due to the favorable impact of certain one-time discrete items that we experienced in the same quarter last year. Our reported effective tax rate of 43.5% reflects the provisional net tax charge of $212 million in the fourth quarter, which is the result of the recently enacted tax legislation in the U.S. Adjusted net income for the quarter grew 37% operationally through a combination of strong revenue growth and margin expansion and cost improvements in manufacturing and leveraging our global scale and infrastructure. Adjusted diluted EPS grew 39% operationally in the quarter versus the same period in 2016. Turning now to guidance for the full year 2018. A table of our guidance is included in both our press release and the presentation slides provided for this earnings call. Please note that our guidance for 2018 reflects foreign exchange rates as of early February. Building off a strong 2017, we see another year of operational revenue growth above the long-term trend we see in the industry overall. Our projected reported revenue range for 2018 is $5.675 billion to $5.8 billion. This represents operational revenue growth of between 5% and 7% over our full year results in 2017. Foreign exchange is expected to add an additional 2% for this revenue growth. We continue to expect more balanced performance across companion animal and livestock in 2018. Livestock growth is expected to reflect improved conditions in the U.S. and a relatively similar performance in 2017 in our International segment. While companion animal continues to grow faster than livestock, its growth rate will moderate as our dermatology portfolio and other new products grow off a larger base in 2018. Our adjusted cost of sales as a percentage of revenue is expected to be approximately 32% in 2018, an improvement of around 100 basis points over 2017, driven by manufacturing cost reductions, price increases, and favorable product mix. We expect SG&A for the year to be between $1.37 billion and $1.42 billion. Similar to revenue, foreign exchange is expected to increase these expenses by approximately 2% on a reported basis. We will continue to fund our DTC programs for Apoquel and Simparica in the U.S. These programs have been successful, and we expect they will continue to help our sales teams drive market expansion in dermatology and market share in parasiticide. As our diagnostics pipeline continues to advance, we are beginning to fund additional investments in commercial capabilities in both the U.S. and International to be prepared to offer our customers these products with the level of service and support we offer them on our other portfolios. We expect R&D expenses to be between $400 million and $420 million, a step-up in the level of spending we have had in prior years. Over the course of 2017, we made a number of decisions to either expand investments or accelerate investments where we saw the opportunity to do so in areas such as monoclonal antibodies and key emerging markets. The increase in adjusted interest expense and other income deductions reflects the incremental interest expense associated with our recent debt offering. For the full year 2018, the company expects its adjusted effective tax rate to be in the range of 21% to 22%. The decrease versus prior year is primarily the result of the tax changes enacted in the U.S. in December. The target range for adjusted net income for the full year 2018 is between $1.45 billion and $1.52 billion, representing an operational growth rate of 20% to 26%. Growth here includes the favorable impact of continued operating margin expansion and a lower adjusted effective tax rate. Our guidance for adjusted diluted EPS is between $2.96 and $3.10 for the full year. Turning to capital allocation. Our priorities remain the same, investment in our own business and internal R&D programs, then external business development opportunities, and finally, returning excess capital to the shareholders. With the impact of the recent tax law changes, we'll have greater flexibility to execute on these priorities. I would also point out that given the level of investments we have discussed in manufacturing facilities, you should expect capital expenditures in 2018 to be approximately $100 million higher than the $224 million we reported in 2017. In terms of returning excess capital to shareholders, we increased our dividend by 20% for Q1 2018 and had share repurchases of $500 million in 2017. It's worth mentioning that we still have $1 billion left on our current share repurchase program. To wrap up, we had strong performance in 2017 and see those fundamental business and market drivers continuing into 2018. We have the capital and cash flow generation to invest in growth opportunities across the animal health industry. And we have the talent and capabilities to maintain our market leadership in this attractive market and create more value for our customers and shareholders. With that, I'll hand things over to the operator to open the line for your questions. Operator?

My question is just on R&D. We always get a lot of questions on this since you don't disclose a lot of detail. I'm just wondering, where are your greatest unmet needs in animal health? How are you addressing these? And will we hear more about these products in 2018? And also, can you provide any measures by which you can measure your R&D productivity?

Thank you, Louise, for the question. We still see unmet needs in our animal health industry. One of the unmet needs is related to pain in dogs and cats and bringing some solutions for the current treatments. And this is why we are focused on a number of current treatments that we'll be providing alternative solutions for dogs and cats. We also see opportunities in combination oral parasiticides for internal and external parasite control. And definitely, we see the opportunity of enhancing productivity in livestock with the new technologies that will replace existing ones. So there are areas that definitely we have internal problems. And we mentioned many times that our competitors, because they are part of pharmaceutical companies, do not disclose any details. For us, providing this information could create a negative impact on our ability to compete successfully in the future. In terms of how we measure productivity, I'll let Glenn provide some details.

So in terms of measuring the productivity for R&D, as we prioritize the projects across the portfolio, we use EMPV and EROI to ensure that we're appropriately prioritizing across the portfolio. We'll also look retrospectively from a return on invested capital perspective to see the return that we get from our investments. Based on the productivity we've had over the last number of years, we've been very pleased with our return on our R&D spending.

So very, very strong results this quarter, guys. And it's great to see the rapid growth in companion animal as well, the recovery at livestock that you expect. Glenn, you made a comment about more balanced growth between livestock and companion animal in 2018 and even moderating growth in dermatology. Can you just give us a little bit more detail behind what you expect in companion animal? Should we be thinking about 10% companion animal growth versus 8% livestock? Or any help on that front?

Yes. In terms of the growth that we expect for 2018, I'm not going to give specific numbers, obviously, between livestock and companion. But I think when you look at 2017 for the full year, we had 5% growth in livestock and 14% growth in companion, so there was a big differential in the growth. As we move into 2018, with a very strong performance that we had in our companion animal portfolio in 2017, we've established a new base to grow off of, particularly in our dermatology portfolio as well as Simparica. So while we still expect those products to grow in 2018, the overall contribution that we'll have for the total companion animal growth will be smaller just as they're off a much larger base. So that's going to cause our companion animal growth to decelerate as we move into 2018.

In terms of the development pipeline, a follow-up here. I guess can you speak to some of the focus areas outside of traditional therapeutics? So for instance there, you launched a new diagnostic offering at VMX, you also have SMB opportunities and you mentioned some sales force investments there. Is that going to be a focus area for you in terms of new product launches near term? Will it be a more organic or inorganic initiative? And then, just could you speak to some of the other areas or ancillary areas outside of traditional therapeutics where you see growth opportunity?

Thank you, Erin on that. We see Zoetis as a much more integrated offer to our customers, including products in medicine, but also diagnostics and genetics. What we have to describe as a healthcare cycle of intention also prediction, prevention, and treatment. And definitely, we'll continue to focus on our core business. In the core business, we'll continue generating the majority of our revenues and profit. But we see opportunities to accelerate our growth by investing in some of these complementary spaces. Definitely, in genetics, diagnostics, and data analytics are part of these efforts. We have now in diagnostics around the pipeline that we'll be focused on delivering in the next coming years. We also presented in the last congress of VMX a new Carysta, high-volume chemistry that is part of our efforts to become a key player in diagnostics. But in a way, that will be integrating more all these portfolios in our offer to customers. As well, we will be investing in data analytics essentials that will complement our offer to our customers.

A couple of questions on the quarter and then just a longer-term follow-up. Really strong results in U.S. livestock this quarter. I know it's a bit of surprise relative to what we are looking for. And particularly, U.S. cattle had a great number. You mentioned some of the disease conditions, but you also talked about feedlots and cattle herd size. I recognize that the weather and the days, months is more transient, but the feedlot data you should have pretty good visibility in. And I was just wondering if you could talk a little bit how the outlook there is sort of the first part of 2018. Is the feedlot strength sustainable? Is that something that you think it will continue for several quarters? And then broader on the '18 guide, you talked about a pretty sizable gross margin improvement, 120 bps year-over-year. Is the longer-term targets are still what you talked about, 200 bps by 2020? Or is there upside opportunity there, given how much improvement you're looking for this year?

Thank you, Mike. I will address the results from U.S. livestock, and then Glenn will share details about our gross margin improvement and future targets. In the U.S., we had a strong fourth quarter, driven by several factors, including weather conditions and animal movement. We chose not to implement promotional activities in the third quarter, which influenced sales moving from Q3 to Q4. The results align with our expectations communicated in the previous quarter. We saw limited growth in U.S. cattle earlier this year, but we anticipated reporting revenue growth by year-end, and this quarter has confirmed those projections. There has been movement of animals to feedlots, and we're pleased with the performance across our cattle business in the U.S. Looking ahead to 2018, we see positive trends in our beef segment. The number of animals is still growing, although at a slower rate than in prior years, and placements are expected to remain positive. We also expect weather conditions in 2018 to be more favorable for animal health compared to 2017. Overall, we anticipate growth in the beef segment and prices to rise in line with the market. However, we foresee challenges in the dairy segment during the first half of 2018 due to lower milk prices, which could impact that period. We expect a more positive second half for dairy. Overall, cattle is projected to show positive growth this year, aligning with market trends. Now, Glenn, could you please cover the question regarding gross margin?

Yes. Mike, in terms of the gross margin, when you look at the 2018 guidance of approximately 32%, that's more in line with the second half of 2017, which is more reflective of our underlying cost structure as we've discussed on some of the previous calls. In terms of the 200 basis point improvement by 2020, we remain committed to that improvement. And as we've said all along, that improvement is driven by the supply network strategy efforts. To the extent there's additional opportunity based on price, based on volume, based on mix, which can grow in either direction, that can either have an incremental impact or an incremental improvement over the margin over that time or take away a little bit. But the 200 basis points was always based on the supply network strategy, and to the extent that we have favorable movement in price and mix, that would add additional margin improvement.

Congratulations on the product performance and all the progress during the past 5 years, it's really remarkable. On the U.S. livestock business. Clearly, much better than expected. The difference is particularly striking, given what we are hearing from some of your competitors, particularly Elanco. So I'm just wondering if you could highlight what are some of the differences that's driving better performance for your portfolio versus what we are seeing from some of your competitors? And then on the companion animal business, could you comment on the base business, excluding dermatology and Simparica? Is that stable? Or is it under pressure as some of those franchises mature?

Thank you, Alex. I should focus on the factors contributing to our growth, primarily due to our well-balanced portfolio across various therapeutic areas, particularly in livestock. This diversity supports us in navigating different cycles, opportunities, and challenges, allowing us to achieve consistent results, and in some instances, outpace our competitors. We do not observe any negative fundamentals in the U.S. livestock sector. For 2018, we anticipate positive growth in the combined cattle business, including beef and dairy. We also expect continued growth in the swine and poultry sectors. Specifically, for swine, we predict that Zoetis will expand faster than the market due to the introduction of new products. The challenges we faced in 2017 regarding the PCV2 vaccine have been resolved, and we are launching new vaccines that will enhance our growth in 2018. For poultry, we expect positive growth in the U.S., aligning with market trends. Overall, we are very satisfied with our performance and optimistic about the livestock sector in the U.S. Regarding the companion animal business and factors driving growth in 2017, Glenn, could you provide details on new products, pricing, and volume growth for the portfolio?

In terms of companion animals in 2017, obviously, a lot of the growth was driven by our new products, and we had new products in a number of categories. So the ones that get the most attention are Apoquel, Cytopoint, and Simparica. But we also have significant growth coming from our vaccines as well. And these products were the focus of our field force in 2017. In terms of the rest of the portfolio, what you then called the in-line portfolio, performance in those categories was relatively flat as we did experience some pressures from generic competition in line with what our expectations would have been, particularly in the U.S. And that was offset by some strong performance in our emerging markets that continue to grow as increasing medicalization rates in markets, such as China and Brazil, continue to benefit us. So overall, relatively flat performance of our in-line portfolio, but a really strong performance from our new products as that was the focus of our field force with the tremendous products that we had to launch and continue growth in.

Two questions. Glenn, I have OpEx as a percent of revenue, that improved by 270 basis points in '17. It was just huge. And the guide for '18, I believe, implies about a 70 basis point improvement, OpEx as a percent of revenue with a rate of revenue growth that really isn't too dissimilar in '18 versus '17. So I want to be clear, the 70 bps is nothing to sneeze at, but maybe if you can talk to the increased investments that you guys are pursuing and when those will yield a return or they just a function of sort of moving further away from the operational efficiency program. And then just to pivot, Juan Ramón, I really don't expect specifics, but any thoughts if you believe you will have a new blockbuster companion animal product in '19 and maybe that's from the triple or something out of the pain portfolio from Nexvet. Any details you guys can give there?

Jon, in terms of the OpEx improvement that we experienced in '17 versus what the expectation may be for 2018, it was really the latter of your comments. In 2017, we continued to benefit from the remainder of our operational efficiency initiative, and we were able to grow revenue significantly faster than OpEx in 2017. Now as we move into 2018, we still expect to grow revenue faster than OpEx but not to the same magnitude as we don't have the same level of improvement coming from our operational efficiency initiative. The other thing I'll point out for 2018 is there are investments that we're making in SG&A to support the continued development of our diagnostic portfolio and to make sure that we have the right commercial support behind those products as they become ready for launch.

We see potential opportunities for launching future blockbuster products that can drive significant growth. I mentioned monoclonal antibodies for pain and combinations of parasiticides to enhance productivity in livestock. It's still too early to comment on when these products will be launched. However, we believe we can continue to grow in line with the market with our existing portfolio, and potentially by adding a blockbuster along with several other products to support our revenue growth. In our industry, we are not reliant on achieving blockbuster sales to maintain consistent growth, unlike the pharmaceutical sector, where generic deceleration has a noticeable impact. We are satisfied with our pipeline and our return on investment in R&D, and we will keep focusing on generating internal value growth, while also exploring external opportunities for expansion.

Can you just expand a bit more on the diagnostic strategy? Not talked about it this much in the past. Should we think about that as more focused on companion animal or livestock and more sort of centralized or sort of point-of-care type of products?

Thank you, John. Let me say that we see diagnostics as an area that is growing faster than the average of animal health. And we see diagnostics also as very complementary to our offer to customers and also an opportunity to leverage our existing relationships and infrastructure in many markets. The focus today is on developing our internal pipeline to bring these products into the market. We see that there is significant competition in companion animal, especially in the U.S., and many more opportunities to offer penetration in the international market in companion animals. And because we have expertise and presence in livestock, we see this area as a significant potential opportunity for Zoetis. This should be in areas like rapid test point-of-care tools but also equipment. So this is where we are focused today in Zoetis. These types of point-of-care diagnostic tools will help veterinarians in companion animals and livestock to make decisions at the point of care.

I have two questions. The first is, could you provide a little bit more color on the ramp of new products, and specifically, new companion animal products ex U.S. in 2018? And then second, with respect to cash flow for 2018, could you please discuss the outlook for operating cash flow and free cash flow in 2018 relative to 2017?

I'll provide some comments on the companion animal products outside of the U.S. Glenn also will maybe expand on some of the details for international markets and definitely will be commenting on the operating free cash flow, that's the question that you raised, and also the outlook for 2018. We have seen in international markets a very high growth in companion animals. International markets are a combination of the new product launches, Apoquel, to a lesser extent, Cytopoint, Simparica. But also the growth that we have seen in some of the major markets in companion animals where the rates of medicalization have been growing very fast. And we have seen in countries like Brazil and China significant growth. In countries like China, we started new product launches, so we still see the opportunity for growth in the future once we introduce Apoquel, Cytopoint, and Simparica in the Chinese market. We expect in 2018 to continue enjoying growth in international markets in companion animals. Maybe, Glenn, you can expand some details on this question and also on the free cash flow one.

In terms of our free cash flow and the cash flow that we expect for 2018. Our operating cash flow, we expect to grow pretty much in line with our growth in adjusted net income. As I also mentioned in my prepared remarks, with the increased expenditures we have for CapEx, free cash flow will grow slightly lower than what we expect to grow for operating cash flow.

I wanted to ask a bit more about the dermatology segment. Juan Ramón, it seems you have raised your guidance for the Cytopoint and Apoquel franchise to $500 million in 2018. Can you clarify if this increase is primarily due to Apoquel or Cytopoint? Additionally, what is the current penetration rate for dermatology conditions in dogs?

Thank you, Kathy. Definitely, we have seen that the adoption of Apoquel and Cytopoint has been growing in 2017 very fast. That's why we are now projecting for 2018 already to generate $500 million in sales or more. Both products' performance is still strong. Pet owners are leaving the clinics with either Apoquel or Cytopoint for dermatology issues. The direct-to-consumer advertising has been helping to accelerate their adoption and also to expand the market. In terms of penetration, definitely, the penetration in the U.S. and international market is different. In the U.S., we reported last quarter that we have a penetration in terms of patients of about 59%. We have seen in the fourth quarter that this penetration is stable. And it's something that, in some ways, was suspected because it's a quarter in which most of the use is for chronic, while we have seen increase in the penetration because of the use of acute and seasonal. Seasonal and acute are mainly in the second and third quarters, and we expect in 2018 to continue growing in these acute and seasonal uses, which will also help with the increase of awareness regarding dermatology issues with our continued DTC campaign in 2018. We have not seen too much cannibalization of Apoquel because of Cytopoint. It's about 26%, which is what we were expecting. We are offering both solutions to the veterinarians, and we are very pleased with the performance of these two products.

Just a quick question on the tax rate. You've guided to a tax rate of 21% to 22% for 2018. Can you comment on your outlook for tax beyond 2018 and the opportunity for this to be reduced further over time?

Thank you, Liav. Glenn will answer this question.

In terms of the tax rate, as you mentioned, for 2018, we've guided to 21% to 22%. We haven't provided guidance for beyond 2018. There are additional costs that will be kicking in for us beyond 2018. We need to fully understand the impact of that. But again, the guidance for 2018, based on current understanding, we're comfortable with the 21% to 22% for 2018.

Thank you, Glenn. A clarification on the dermatology penetration. I mentioned data for the U.S., but definitely, in international markets, we have a lower patient share. We still see a lot of room for growing in terms of patient share and also expanding the market.

I have two quick questions. First, even though you don’t provide quarterly guidance, is there anything we should consider regarding the quarterly trends of both revenue and earnings when comparing 2018 to 2017? Second, I would like to follow up on your comments about Apoquel and Cytopoint. Can you share more details on the potential for growth in this franchise beyond 2018? Additionally, what do you anticipate peak sales could be for these products as you progress through 2018 with the $500 million-plus figure? Is there still considerable growth potential, or are we reaching a point where peak sales for these assets may be occurring?

Thank you, Chris. I'll cover the question on the dermatology portfolio, and then Glenn will discuss the quarterly projections for 2018. We still see growth not only in 2018 but in future years for the dermatology portfolio. The growth in the market that the products have been introduced into, like in the U.S., will be moderated in the future. But there's still, in many international markets, we are just introducing Cytopoint. Apoquel definitely has a lot of opportunity to continue growing. I mentioned China as a country where we don't have yet Apoquel, and we expect also China to generate growth in the future. So we don't see that 2018 will be our peak sales for Apoquel. Cytopoint, on the contrary, will continue growing. Definitely, the growth will be moderated, but we expect it to continue growing. We'll see growth coming from volume but also growth coming from prices.

In terms of the 2018 quarterly production, as you mentioned, we don't give 2018 guidance by quarter. But just a couple of things to think about. We do expect more balanced growth in 2018 than we saw in 2017 and a more steady performance in terms of cost of goods as a percent of revenue than we saw in 2017, in particular. The other thing I'll point out is we are moving from a 4-4-5 accounting calendar to a month-end accounting calendar, and that will have some small impact per quarter. The greatest impact that you'll see will probably be in Q4, where it could negatively impact our growth in Q4 2018 by almost 2%. So those are the only things that I would point out.

Curious whether you saw any headwinds or benefits tied to the consolidation of vet clinics in the U.S. I realized there wouldn't be material effect for the whole year, for the whole company, but curious on that team as it continues to build. And my other question is about the environment overall in some of your competition. One of the elephants in the room this year is Lilly exploring options for Elanco. I know Juan Ramón, you've commented in the past that mergers among the larger players in the industry would be difficult from an antitrust perspective. But how would you view a spinoff of Elanco if that's what they decide to do? I'm curious on your thoughts there, operationally and otherwise, as it relates to any effects, good or bad for Zoetis.

Thank you, Gregg. We have seen a consolidation of vet clinics in the U.S. and also seen not too much consolidation of clinics outside of the U.S. But there may be buy-in groups that are also having an impact. So far, we are managing very well the relationship with these clinics. In some cases, we have been able to reach exclusive agreements for Simparica with one of these larger groups, and we see this as a very positive outcome. We understand that in some cases, we may encounter some pressure in terms of prices, which is part of the projections in our model. But at the same time, we see the opportunity to expand healthcare through better services to veterinarians. We have a portfolio of specialty care that is also providing significant benefits to this change of clinics, and we are managing extremely well. It was a very positive collaboration with man field in the past, and we also have had good collaboration with VCA. We expect that the combination of the two groups will also continue to be positive for Zoetis. In terms of the decisions of Elanco, I would prefer not to comment on other companies' strategic reviews. We went through our process 5 years ago. It was the right decision for Pfizer and also for us. I'm very pleased with our performance, and we have seen the benefits of being at Zoetis, having a singular focus on animal health and providing value to our customers and shareholders.

This is Candace Richardson on for Jami Rubin. I have two quick questions. Tempered growth in the U.S. companion this quarter appears to be related to tougher comps from certain products that launched last year. When should we expect this to annualize? And then secondly, your recent dividend increase of nearly 20% is among the highest in the industry. We're wondering if there's a specific payout ratio you're looking to achieve. And given that you're the only stand-alone public animal health company, what comps do you look at when you evaluate your dividend policy?

Yes. So in terms of U.S. companion animal growth for 2017, for the full year, we had 13% operational growth in U.S. companion animals. In the quarter, we had 15% growth. So we saw another continued quarter of very strong growth in U.S. companion animals. So not necessarily tempered growth for Q4. In terms of our dividend policy, we generally grow our dividend at or pace faster than our growth in adjusted net income. That is our commitment moving forward, that we'll continue to grow our dividend at or faster than income and have a focus on dividend growth. We're also focused on share repurchases as another way to return excess capital to our shareholders. We currently prefer share repurchase as it gives us a little more flexibility to manage the other priorities we have for capital allocation, being our internal investments as well as business development.

Just focusing on the companion business. You referenced some greater amount of competition for the in-line products. Just curious if that is a trend that you expect to continue. And then just when you think about the growth for the dermatology franchise going forward, should we assume that a lot of the growth going forward will come from outside of the U.S.? And if you think about that peak potential, do you think that the ex-U.S. opportunity could ultimately be as big as what we've seen in the United States?

Thank you, Doug. We don't see that the competition has been increasing in companion animals for our in-line portfolio. We have seen the impact of generics in line with previous years and also in line with our predictions. Vaccines, which have been growing very fast in our opinion, have also been growing faster than the market for companion animals. We understand that there have been new problems in the pain market in 2017 that have impacted RIMADYL. But this is not something we see as greater competition in our in-line products. Our in-line portfolio has been affected because of many new products that have been launched in the previous year. As you can imagine, the level of attention of our field force during this period has been intentionally focused on these new products. We are very pleased also with the performance of our in-line products, and we see that this in-line will be performing according to our projections. In terms of the dermatology portfolio opportunity outside the U.S., there is probably a couple of years or 18 months difference in terms of the interaction of Apoquel in international markets. Cytopoint, which was introduced in the U.S. at the end of '16 or mid-'16, has been introduced at the end of '17 in Europe, and it is still not introduced in many international markets. I mentioned that even Apoquel is not yet approved in China, and we expect approval in the future. So there is significant opportunity for growing our dermatology portfolio outside of the U.S. But there will still be opportunities for continue growing in the U.S. We will be supporting this growth with a DTC campaign in 2018 in our U.S. markets.

You talked a bit about your positive expectations for U.S. livestock. But can you comment on kind of the international livestock business, specifically in your key markets, like cattle in Brazil, hogs in China, et cetera? And if you expect the strength that you saw in 2017 to continue in '18?

We see livestock in international markets also continuing positively. China shows companion animals, 20% growth in '17. This was the combination of companion animal and livestock. There are always, as we mentioned many times, in current cycle prices of pork in China and some of our markets there that can temporarily affect some of the growth drivers. But one of the advantages of Zoetis is the diversity of our business in all the geographies. In terms of Brazil, we don't see any change in the fundamentals of our business in Brazil. The cattle business is doing very well, and swine is doing very well. We faced some challenges in 2017 in our poultry business in Brazil. Overall, we see projections for livestock international as positive for 2018. We may see some quarterly fluctuations in some of the markets. However, these are not indicative of the fundamentals of the markets that should rise over a longer period of time. We don't see any significant challenges in terms of the projections for 2018 in international markets for livestock.

So my question is, some of our research suggests that veterinarians prefer ordering in bulk and from one vendor for additional discounts. With the derm portfolio now approaching $500 million in sales, what's the opportunity to add to the product bag of the veterinarian? There’s Simparica and vaccines, and what's the cross-selling opportunity as derm becomes a $500 million drug?

So this is Glenn. We believe there are certainly chances to utilize our portfolio effectively, and in many of our markets, we have programs that offer extra incentives for purchasing more products from Zoetis. This allows us to make use of the scale we have with Apoquel, Cytopoint, Simparica, and various vaccines to offer additional discounts for buying our full portfolio instead of just one of our individual products.

When we talk about the total portfolio, we include products like rapid tests and diagnostics or, in the future, equipment. That's why we see the advantage of integrating a larger portfolio and offering this portfolio to our customers.

Well, thank you very much for joining us. Thank you for your questions, and I look forward to having another discussion for the first quarter of 2018. Thank you very much.