Zoetis Inc - Class A (ZTS) — Q3 2019 Earnings Call Transcript

Good morning everyone and welcome to the Zoetis third quarter 2019 earnings call. I'm joined today by Juan Ramon Alaix, our Chief Executive Officer; Glenn David, our Chief Financial Officer and also by Kristin Peck, our CEO-elect. 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 statements 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 for 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, November 7, 2019. We also cite operational results which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramon.

Thank you, Steve. Good morning everyone. Today, you will hear commentary on the market dynamics and quarterly result from me and Glenn. I am also pleased to have Kristin Peck, our next CEO, joining us to share some remarks with her appointment in the future of Zoetis. As we near the end of the year, let me provide some context around recent market dynamics. The animal health industry in 2019 has been facing a challenging year for swine and livestock, while we have seen a very good performance in companion animal and poultry. We have seen a growing appetite in the companion animal market for spending on innovation and pet care and we once again expect to grow much faster than the market in companion animals for 2019. We are excited by the new products and lifecycle innovations giving pet owners more advanced ways to assist with skin conditions and parasites. The pathology treatment continues to be a critical need, and Zoetis has been rewarded for the innovation we have developed in this space. We have continued market penetration and our goal expansion of our key dermatology products Apoquel and CYTOPOINT, which are on track to achieve more than $700 million in sales for 2019. In recent years, Zoetis has also been strengthening its position in parasiticides. This year we added two new products to our parasiticide portfolio, Revolution Plus to protect cats against ticks, fleas, and internal parasites and ProHeart 12, a once yearly injection to prevent heartworm disease in dogs. Additionally, we are planning to launch Simparica Trio in European countries and Canada in the first quarter. In the U.S., we expect the FDA to complete the review of Simparica Trio at the end of the first quarter. If approved, we will launch shortly after. Based on these assumptions, we project to generate incremental global sales of Simparica Trio in 2020 at around $150 million. In other areas like pain, alternatives to existing treatment for dogs and cats present a significant opportunity. And in the case of GILTI tax, it is a largely unmet need today. We are excited by the potential for our researcher programs with our monoclonal antibodies in this area. As I mentioned in the last quarter, we initiated the filing process in the EU and U.S. for a new feline monoclonal antibody candidate to treat osteoarthritis pain in cats and also initiated the filing process in the EU and U.S. for a canine monoclonal antibody candidate to treat osteoarthritis pain in dogs. If approved, we anticipate this product coming to market in 2021. Meanwhile, African swine fever, trade uncertainties, and weather conditions affecting mainly U.S. cattle are having a significant negative impact on the livestock market. As a result, we expect the overall animal health market to grow rationally between 3% to 4% in 2019 compared to 5.6% in 2018. As noted in our guidance, we expect to outpace the market with operational revenue growth over 6% to 7%, excluding the positive impact of Abaxis. Turning now to our third quarter results, we continue our strong performance with 9% operational revenue growth in the third quarter driven by sales of our companion animal and poultry products. Our companion animal portfolio continues leading the way, with 23% operational growth based on strong sales of our parasiticides, our key dermatology products, and diagnostic portfolio. Diagnostic revenue from the Abaxis acquisition accounted for 2% of the overall growth. In terms of livestock, we saw an operational decline of 4%. Growth in poultry was 5%, but it was offset by declines in cattle mainly due to lower feedlot placements in the U.S. and the impact of African swine fever in China. Our third quarter results demonstrate how our diverse portfolio and focus on meaningful innovations are driving our success. These trends remain the foundation of our consistent and long-term performance. In the third quarter, we grew our adjusted net income by 10% operationally. We continue to benefit from increases in revenue, improved gross margins, and moderate growth in operating expenses. We remain confident in our latest innovation, future pipeline, and core business for future growth, and we will deliver our 2019 guidance, which Glenn will discuss later. As we look ahead, we are making good progress with innovations and investments that will generate our future growth. As I said, we are preparing for the launch of Simparica Trio in European markets and Canada at the beginning of next year with the product currently in production. All regulatory reviews remain underway in Australia, Brazil, and Japan, with a further submission expected in China and Mexico. In the U.S., we have been expanding our field force to better support our growing companion animal portfolio, including the diagnostic products and in preparation for the launch of Simparica Trio next year, once approved. We continue to enhance our vaccine portfolios for livestock. In October, Zoetis received USDA approval for Poulvac, Procerta, HVT-ND, the company’s first vector vaccine for poultry. It will help to protect against both Marek's disease and Newcastle disease, which are highly contagious infections for poultry. The product complements our market-leading innovative vaccine delivery system for poultry producers and is the first in what is expected to become an important new global vaccine franchise for Zoetis over the next several years, especially in international markets. We are also taking important first steps to address African Swine Fever, having reached a non-exclusive license agreement with the U.S. Department of Agriculture in late September. This agreement gives us access to three patents and materials related to African swine fever vaccines and will be incorporated into our research. While it could take several years to complete the development of our vaccine, our work with the USDA and other partners provides a comprehensive approach to addressing these three infectious diseases. In addition to new product approvals and lifecycle innovations, Zoetis continues to support future growth through business development activities. Last week we announced the acquisition of Phoenix Lab, a Seattle-based reference laboratory that is highly valued by veterinarians for quality assurance and customer care. This acquisition marks Zoetis' first entry into the veterinary reference laboratory space and is expected to further strengthen our overall diagnostic portfolio, building off our 2018 purchase of Abaxis, a leading provider of point-of-care diagnostic instruments. We view reference labs as another important part of our comprehensive diagnostic offering, and we plan to build our presence in reference labs over time through organic expansions and other small acquisitions in this space. Now I would like to say a few words regarding our leadership transition. As we announced in October, I am retiring at the end of the year. This has been an amazing opportunity to be at a company like Zoetis over the last seven years. I feel very positive about the future of Zoetis based on our proven strategy, solid track record of execution, diverse and innovative portfolio, and the growth investments we are making for the long term. I am confident our talented colleagues and management team, led by our next CEO Kristin Peck, will continue to capitalize on the growth opportunities ahead for Zoetis and create significant value for our company, customers, and shareholders. Kristin has been with the company since its inception and currently serves as Zoetis Executive Vice President and Group President of U.S. Operations Business Development and Strategy. I have worked with Kristin for many years and believe she is the right leader for Zoetis' next phase of growth and industry leadership. She's a strong advocate for our customer needs, a champion of Zoetis culture and values, and a collaborative leader for our people and industry. Her track record of strong performance, operational experience, innovative strategies, and deep customer knowledge positions her well to drive Zoetis' continued growth. She will build on our long-term strategy alongside the rest of the Zoetis management team and bring her own vision to lead the next stage of Zoetis’ journey. I will remain an advisor to Zoetis during the course of 2020, and Kristin and I are already working closely to ensure a smooth transition and maintain the momentum of our business growth. Before Glenn discusses our third quarter results, I have asked Kristin to say a few words.

Thank you, Juan Ramon. I'm honored to be named the next CEO of Zoetis, and I look forward to leading our company into its next phase of industry leadership and value creation. I want to thank Juan Ramon for establishing Zoetis as the world's leading animal health company. I have deep respect for Juan Ramon and his track record of creating value for our customers and delivering strong returns for our shareholders. His innovative mindset has kept Zoetis at the forefront of the industry, and I share his confidence in our company’s solid foundation and prospects for continued growth. We have a diverse and innovative portfolio, deep expertise in animal health, and a winning culture shared by our talented colleagues around the world. We know how to partner with our customers to address their evolving needs across the continuum of care, from prediction and prevention to detection and treatment of disease. We have a promising pipeline of new products and lifecycle innovations, and we are focused on making investments in digital technology, data, and analytics that will fuel our future growth. As CEO, I will continue to drive forward with our successful long-term strategy. I will look for opportunities to accelerate our progress in the most meaningful areas for our veterinary and producer customers, and I’m committed to building on the strategies, diverse portfolio, and financial discipline that have been critical to our success. To that end, I've been working with Juan Ramon, Glenn, and the rest of the Zoetis team, as well as the Board, over the last few weeks to ensure a seamless transition. As we look ahead, I continue to view animal health as a very valuable sector for investors, with steady growth prospects as the fundamental macroeconomic drivers of global population growth, innovation, and a growing middle class in emerging markets will drive growth in both companion animal and livestock. The long-term history of animal health and Zoetis is a testament to the resiliency of our business. The drivers in pet care and animal agriculture are fundamental to the global economy and core to people's connections with animals for both companionship and nutrition. I'm excited by the new opportunities for raising the standard of care with innovative new medicines, biologics, and integrations across the continuum of care. As I prepare for my new role, a key priority for me has been directly connecting with our stakeholders around the world to better understand their perspectives and how we can build on our company’s success. I look forward to engaging with many of you as part of this process and sharing more on our outlook for the market and plans for 2020 early next year. And now Glenn will cover the financials.

Thank you, Kristin, and good morning. Before discussing our Q3 financial results, I first want to congratulate Juan Ramon on his upcoming retirement and welcome Kristin as the next CEO of Zoetis. In his role as CEO, Juan Ramon has led our business through a remarkable transformation from a business unit advisor to an independent and publicly traded industry leader in animal health. Indeed, revenue and adjusted net income growth have been above the market during that period while managing acquisitions and a significant restructuring. Personally, I am very thankful to have worked with him over the past decade and appreciate that we will continue to benefit from his insight and knowledge as he remains an advisor and Director on the Board. I'm also very excited to work with Kristin as she transitions to her new role, building upon Zoetis' strong foundation and delivering the next phase of growth. Kristin and I have worked together at Zoetis for many years, and we share a commitment to customers, colleagues, and value creation, which has driven our company's success. Now let's review the financial results. We delivered another healthy quarter with operational revenue growth of 9% and adjusted net income growth of 10%. These quarterly results, which build upon our strong performance from the first half of the year, give me confidence in delivering on our full-year improved earnings outlook. For the full year, we are narrowing operational revenue growth at the high end of the range, increasing operational growth for adjusted net income, and increasing and narrowing adjusted diluted EPS. Reported revenue growth for the third quarter was 7%, including a negative 2% impact from foreign exchange. Foreign exchange was primarily driven by the strengthening of the dollar against the Euro, Argentinian peso, and the Australian dollar. Operational revenue growth of 9% for the quarter was driven by 1% price and 8% volume. The volume contribution of 8% includes 3% from key dermatology products, 2% from new products, 2% from legacy Abaxis products, and 1% from other in-line products. Breaking down our operational revenue growth by species, companion animal grew 23%, which was partially offset by livestock declines of 4%. Companion animal revenue growth was driven by our parasiticides portfolio, including new products Revolution Plus and ProHeart 12, and key dermatology products. The impact of the Abaxis acquisition contributed to the growth. Excluding the impact of the Abaxis acquisition, companion animal products grew 20% operationally. Equine also had strong growth in the quarter, benefiting from the acquisition of Platinum Performance, a nutrition-focused animal health company. However, livestock products declined in the quarter primarily due to market weakness in the U.S. beef and dairy sectors. The ongoing impact of African Swine Fever and the revenue recovery from the Brazil truck driver strike that increased revenue in Q3 2018 also contributed to this decline. These headwinds were partially offset by growth in poultry. Our key dermatology portfolio demonstrated continued strength this quarter with sales of $217 million, representing 27% operational growth. This is our first quarter with revenue greater than $200 million. The positive performance in this portfolio was driven by the ongoing expansion of the addressable market, increasing market share, and continued uptake of both Apoquel and CYTOPOINT in markets where they were recently launched. As Juan Ramon mentioned, we are clearly on pace to exceed a combined $700 million in revenue this year. New products, especially Revolution Plus and Stronghold Plus, as it's known internationally, and ProHeart 12 swine combination vaccines contributed to overall growth in the quarter while cannibalization of the original formulations highlights the success of our investments and lifecycle innovation. Sales from legacy Abaxis products totaled $68 million in the quarter, representing 10% operational growth over the prior year's pro forma revenue. Other in-line products contributed 1% growth in the quarter, including Simparica with $55 million in revenue and 28% operational growth. This growth was partially offset by declines in U.S. cattle and the ongoing impact of African Swine Fever. Now let's discuss the revenue growth by segment for the quarter. U.S. revenue grew 11%, with companion animal growing 26% and livestock declining 9%. Excluding the impact of the Abaxis acquisition, U.S. revenue grew 10%. Strong companion animal product performance in the quarter was driven by growth of our parasiticide portfolio, key dermatology products, and the impact of the Abaxis acquisition. Excluding the impact of legacy Abaxis products, companion animal growth was 25%. Our parasiticide portfolio, including in-line products such as Simparica and ProHeart 6 and new products such as Revolution Plus and ProHeart 12 that launched in the quarter, contributed to this strong companion animal growth. U.S. dermatology sales were $154 million for the quarter, growing 28%. Growth this quarter was driven by market expansion, increasing market share, returns on direct-to-consumer investments, and pricing. Positive companion animal performance was partially offset by U.S. livestock declines driven by cattle and, to a lesser extent, swine. Sales of our cattle products were negatively impacted by unfavorable market conditions in the beef and dairy sectors, while feedlot placements during the quarter affected sales of our products as well as pricing pressure driven by competition. While we continue to see good adoption and growth of the Fostera Gold swine vaccine, we also encountered declines in other product sales due to the lowest swine revenue this quarter, primarily due to the timing of promotional activities. These challenges in cattle and swine were partially offset by continued growth in poultry, primarily due to sales of our portfolio of alternatives to antibiotics in medicated feed additives. In addition, we capitalized on competitive challenges, including lack of efficacy and supply constraints. To summarize, the U.S. business had a very positive quarter, with diversity and innovation driving results despite challenging market conditions in the cattle sector. Our International segment also contributed to growth this quarter with operational revenue growth of 5%. Companion animal operational revenue growth was 16%, while livestock declined 1% operationally. Excluding the impact of the Abaxis acquisition, international revenue grew 4% operationally. Companion animal product growth was driven by key dermatology products, the addition of legacy Abaxis products, and growth in emerging markets such as China. Excluding the impact of the Abaxis acquisition, companion animal operational growth was 13%. International livestock declined modestly, primarily due to the impact of African Swine Fever as well as an unfavorable comparison to the prior year, which included the revenue recovery from the Brazil truck driver strike. Growth in cattle and poultry partially offset the declines in swine, driven by favorable market conditions in key markets including Mexico, the U.K., and Canada. Poultry also benefitted from increased sales in China, Australia, and Brazil. Now, I would like to review in more detail a few markets in the quarter. Beginning with China, revenue declined 9% operationally, driven by the ongoing impact of African Swine Fever, partially offset by continued double-digit growth in companion animal. Our livestock portfolio declined 40% operationally in China, driven by swine declines that were partially offset by growth in poultry and cattle. As we indicated in last quarter, we expect the full-year impact of African Swine Fever on our revenue to be approximately $50 million. While the outbreak has continued to spread to other markets in Southeast Asia, our full-year estimate remains consistent. In the medium to long term, we continue to anticipate that other regions will increase exports of pork and other proteins. However, we have not seen increases in production to any significant extent. Our companion animal products continue to grow significantly in China, increasing 43% operationally. Sales from parasiticides, vaccines, and Apoquel were the primary drivers of growth, aided by field force expansion and effectiveness. Moving on to Brazil, sales grew 1% operationally driven by companion animal growth of 17%, partially offset by livestock decline of 5%. Companion animal revenue growth in Brazil was driven by our key dermatology portfolio, including CYTOPOINT, which launched in the second quarter, as well as growth in Simparica. Livestock declines in Brazil this quarter were driven by an unfavorable comparison to the prior year when sales recovered due to the resolution of a national truck drivers' strike that occurred in Q2 of the prior year. In Mexico, sales grew 22% operationally driven by livestock growth of 15% and companion animal growth of 46%. Livestock benefited from sales of our premium products for cattle, while strong companion animal performance was driven by growth in legacy Abaxis products, parasiticides, and vaccines. Other emerging and developed markets also contributed to international growth this quarter, particularly in companion animal driven by parasiticides and key dermatology products. Overall, our International segment continued to perform well, demonstrating the importance of our global diversity and helping to offset the impact of African Swine Fever. Now moving on to the rest of the P&L. Adjusted gross margin of 70.1% increased approximately 140 basis points in the quarter on a reported basis compared to the prior year. The increase is driven by foreign exchange, product mix, and price partially offset by tariffs on certain products and the inclusion of the lower margin legacy Abaxis portfolio. Total adjusted operating expenses, including the impact of the Abaxis acquisition, grew through 6% operationally. The increase is primarily related to compensation-related expenses and investments to support the future growth of the business. The adjusted effective tax rate for the quarter was 20.5%. The increase from the comparable 2018 period is primarily related to the impact of the global intangible low tax income or GILTI tax, which is effective for Zoetis in 2019. Adjusted net income for the fourth quarter grew 10% operationally and adjusted diluted EPS grew 11% operationally, again outpacing revenue growth. The combination of revenue growth, improving gross margins, and disciplined operating expense growth enabled us to deliver strong bottom line results while still investing strategically for long-term sustainable growth. Now moving on to guidance for the full year. As a result of our strong performance in the first nine months of the year, we are narrowing operational revenue growth at the high end of the range, raising operational growth for adjusted net income, and raising and narrowing the range for adjusted diluted EPS. Please note that guidance reflects foreign exchange rates as of late October. I'll now walk you through each of the individual line items, beginning with revenue. We are now expecting to deliver revenue between $6.2 billion and $6.25 billion compared to our previous range of $6.175 billion to $6.275 billion. The dollar decrease in revenue guidance at the high end of the range is related to unfavorable foreign exchange. Operational revenue growth is now expected to be between 9% and 10%, compared to our previous estimate of 8.5% to 10%, reflecting the continued momentum of our companion animal portfolio. Our organic operational revenue growth, which excludes the impact of Abaxis, is now expected to be between 6% and 7%. We are now projecting adjusted cost of sales as a percentage of revenue to be approximately 30% compared to our previous range of 30% to 31%. Adjusted SG&A for the year is expected to be between $1.525 billion and $1.55 billion compared to our previous range of $1.505 billion to $1.545 billion. The increase and narrowing at the high end of the range reflects our focus on critical investments to support revenue growth, including promotional activity on key companion animal products. Adjusted R&D expense for 2019 is now expected to be between $445 million and $455 million for the year compared to our previous estimate of $450 million to $465 million. The decrease was related to the timing of project spending. Our full-year adjusted interest and other income deductions are expected to be approximately $190 million, and our full-year adjusted tax rate is expected to be approximately 20%, which are both consistent with previous estimates. Adjusted net income is now expected to be in the range of $1.72 billion to $1.745 billion, representing an increase of $10 million at the high end of the range. The updated adjusted net income range represents operational growth of 11% to 14% compared to the previous range of 9% to 12%. The improved outlook for adjusted net income is primarily driven by gross margin favorability. We are also increasing our adjusted diluted EPS to a range of $3.57 to $3.62 compared to our previous guidance of $3.53 to $3.60. Our range for reported diluted EPS is now increasing and narrowing, now expected to be between $2.99 to $3.08 based upon operational increases. We expect approximately $450 million to $475 million in capital expenditures this year, with increased investment in information technology and manufacturing to support our Abaxis acquisition, improve cost efficiencies, and increase capacity. We anticipate continuing an elevated level for the next few years as we invest in manufacturing and infrastructure to support future growth and product launches. We also repurchased approximately $450 million of Zoetis shares in the first nine months of the year. We have $1.9 billion remaining under the multi-year share repurchase plan that was approved last year, and we remain committed to our capital allocation priorities of internal investment, M&A, and returning excess cash to shareholders. Our guidance for reported and adjusted earnings per share reflects the shares repurchased through the end of Q3. While we cannot provide guidance for 2020 until February, we view next year as a continuation of strategic investment to support recent and future product launches, our recent acquisitions including Phoenix Lab and Platinum Performance, and other strategic priorities. Now to summarize, before we move to Q&A, we have consistently delivered strong top and bottom line growth in the first nine months of the year despite market challenges in cattle and swine. We are narrowing our outlook for operational revenue growth at the high end of the range, and we are increasing and narrowing our outlook for adjusted net income and adjusted diluted EPS, reflecting the strong performance year-to-date. Our investments in R&D, diagnostics integration, manufacturing capabilities, and field force expansion will provide a solid platform for continued growth in 2020 and beyond. Now, I will hand things over to the operator to open the line for your questions.

Good morning. Juan Ramon, it's been great working with you, and I hope you enjoy your retirement and get to play a lot of golf.

Thank you.

Congratulations. We all know you're going to do a terrific job succeeding Juan Ramon. The questions I have first, I think you guys talked about some Simparica Trio saying that your assumption is if it's approved in the U.S. by the end of Q1, revenue would be about $150 million in 2020. Did I get that right?

Yes. The incremental sales that we expect for Trio over our existing portfolio is $150 million.

And what is the underlying assumption there, Glenn, in terms of pricing? How much will come from the U.S. versus international and how much cannibalization?

So in terms of the breakout between U.S. and international, like we've said all along, we expect the majority of the sales for this product to be in the U.S. I really don’t want to go into details on price from a competitive perspective at this point, but like we’ve said, we do expect it to be priced at a significant premium to Simparica and the cannibalization impact, obviously there’ll be some cannibalization to Simparica, but we also expect to take significant share from competition.

So Juan Ramon, we will miss you and Kristin, congratulations on the new role. My first question is for you, Kristin, as the new CEO of Zoetis, what will you do differently from Juan Ramon? And then also just on 2020, I know you're not giving guidance until February, but how should we think about the pushes and pulls as we look into next year? Thank you.

Sure. Thanks so much, Louise. I'm going to be focused on really continuing the strong path of value creation. If you look at the strategy that we’ve had, I feel it has delivered significant results both for our customers and for our shareholders. It has been a dynamic strategy that has always been predicated on continuous innovation and disruption, which I think has really helped us stand out. It’s also been characterized by a great diversity of our portfolio and my goal is to maintain that strong momentum to stay ahead of competitors. I think if I look into 2020 and 2021 and beyond, I’m really going to be focused on innovation, making sure we continue to bring to market products that really solve both our customers' and animals’ challenges. I will continue a relentless focus on our customers, making sure that we’re finding ways to make their jobs easier and to make them more productive. I’ll also be looking for ways to better leverage our digital and data, both to make us more efficient internally and to drive better productivity and greater growth in some of our data and digital revenue products, both in diagnostics and precision livestock farming. So that will be my focus as we look into 2020 and some of the sources of where I think you'll see our continued growth.

In terms of the pushes and pulls for 2020, starting with the revenue line, we continue to see good momentum in our companion animal business and particularly with the expected launch of Simparica Trio subject to approval. We expect to see very strong performance there, as well as the continued growth in some of the new products that we launched this year such as ProHeart 12 and Revolution Plus. Also, when you take into account the impact of African Swine Fever that we had this year, we would expect that to stabilize this year and not to be a negative detractor to growth in 2020, so that should benefit us as well. When we look at the expenses, obviously there'll be some investments to support our new product launches. We want to ensure that we get those products off to a strong start, and also some investments to support the recent acquisitions that we have in place. So overall, we would expect revenue to grow faster than the market again in 2020, and we would expect that we will grow our income faster than revenue.

Great, thanks and Kristin congratulations, Juan Ramon as well. It's obviously been very, very nice working with you. I had a quick question on Simparica Trio - $150 million in 2020. It's a little bit higher, I guess, than what we were contemplating on a net basis. I just want to confirm some of the assumptions that you're making. Does it assume that you launch ahead of ZeoMAX, and does it assume that you'll be the only player in the U.S., and does it also assume puppy indication or other label caveats from a safety perspective? A separate question here, but can you also speak to the diagnostic strategy in the reference laboratory market? I guess, how quickly can you scale up the U.S. lab footprint, and what are some of your plans internationally from a reference lab perspective as well? Thanks.

So, Kristin will answer all this question, so please Kristin.

Sure, so starting with Trio. We do not expect to be launching ahead of ZeoMAX and Western vet, but we do expect to be launching in a very important Q2, Q3 parasiticides season. So I think we will not be there, but I do think if you look at the $150 million, to your point, we still expect to deliver a very strong year there. We do expect to get puppy claims, that is part of the assumptions that is in there, that’s obviously subject to back to approval, but that is our going-in assumption as we look at that. So as I move towards the reference lab, we continue to believe that diagnostics is an important part of our go-forward portfolio. It is critical to that, and as a part of the business that will stay there, we think it enhances Zoetis' current value proposition, and is a great complement to our existing portfolio. It’s a large and very fast-growing market. The market has been growing at 10% plus, and we strongly believe that we can accommodate a third player. We’ve also noted that customers are looking for a third-party alternative. If you look at different MSAs, shares of third-parties have actually been significant, as our acquisition of Phoenix demonstrates; they had over 50% share in the MSA they operated in. Our plan in this space is to invest both organically and inorganically over the next few years, and we remain committed to the space.

Great, thanks very much for the question. I guess my first one was on Apoquel and CYTOPOINT ex-U.S. Can you just provide any additional color in terms of where penetration rates stand in some of the bigger markets in terms of Europe, Brazil, et cetera, and where do you think those penetration rates can go over the next several years? And my second question is, sorry I keep going back to the $150 number, but I'm still not quite clear—can you help me understand again how much of that $150 is incremental revenue on top of what your parasiticide business is already doing as compared to erosion from, I guess, legacy Simparica and some of your heart products, etc.? I'm trying to understand the magnitude of overall growth I should be thinking about for parasiticides next year. Thank you.

Glenn will provide some data related to the penetration range and also details of the $150 million in terms of how much is incremental revenue.

So when you look at Apoquel and CYTOPOINT, particularly in the U.S., we see that we are plus 60% share in that market. The data internationally is not as clear in terms of we don’t get the same level of data; however, we know we are not at that penetration rate. Also, we’ve launched CYTOPOINT later internationally than we have in the U.S., so we do think we have continued uptake there. Thus, we see significant opportunities internationally as we continue to gain share and move closer to the levels that we have in the U.S. We also see continued opportunities in the U.S. as we continue to expand that market and raise disease awareness of dermatology and atopic dermatitis. So we see continued opportunity in the U.S. as well. In terms of the $150 million revenue for Simparica Trio, I want to be clear that this is incremental sales overall what we see for Simparica alone, and that does include the cannibalization effect. So we would expect greater sales of Trio than $150 million as a standalone product.

And I want to mirror the earlier comments. Congrats Juan Ramon. It’s been great working with you and Kristin. I look forward to working with you going forward. Two quick questions from me. One on some of the moving pieces in the quarter and sort of looking forward. I would say one of the bigger surprises this year has been in the entire market, not just specifically but some of the challenges in U.S. livestock, particularly given the negative tone of ASF internationally. There is an expectation that you will see some stabilization in U.S. livestock in the market in cattle and swine. It’s been a little bit slow—probably slower than expected this year if you look back from the last six months earlier. How do you see some of these dynamics playing out? We talked about ASF internationally, but if you think about the cattle herd in the U.S. and some of the feedlot pressures that we've seen this year in terms of placements, if you could talk about that automatically over the six months to twelve months. And then a quick follow-up on the seasonality question. You talked about the Simparica Trio approval likely at the end of Q1, early Q2 launch. Could you talk about the timing that you think about the veterinarians purchasing a lot of the ordering by that happens relatively early in the year? So how much wiggle room do you have built-in, and how quickly can you ramp up manufacturing to ensure that you don't miss a fleas season if there is a month or two movement either way?

Let me answer the question on Simparica Trio, and then Kristin will cover the trends and also the challenges that we have seen in the U.S. livestock market, as well as talk about the African Swine Fever. We expect approval in late first quarter from the FDA, and then shortly after, we will launch the product in the market. We are preparing to ensure ample supply of the product as soon as we obtain approval in the U.S., so we don’t think that the supply will be deficient in terms of capturing the opportunities of the high season, mainly in Q2, following into Q3. We are confident that once the product is approved by the FDA, we will be able to generate a significant opportunity for Simparica in 2020. So moving into the U.S. livestock, Kristin?

Sure. As you saw, our numbers for both dairy and beef in the U.S. continue to be weak. As we said in previous conversations in previous quarters, we expect this to continue for the rest of the year. From a dairy perspective, we've seen depressed milk prices versus historical trends, limiting producer profitability income. In the last few months, there has been a small improvement in pricing, but it's not yet sustained enough for producers to believe in recovery or to start investing significantly. On the beef side, we're at the end of what’s been a very long expansion period, so we expect a bit of contraction or flattening out over the medium term. In terms of beef, there has also been a lack of innovation that has driven significant pricing and competitive pressures. We had a wet spring, which kept cattle out longer this year, and as you’ve seen, there’s been a significant increase in some live cattle prices, encouraging producers to wait until their animals are heavier and older to put them in the feedlot. So as we look at U.S. cattle, I think we’ll continue to see challenges there as we look into next year. And concerning ASF, as we've spoken about previously, we believe with China specifically, we see about a $50 million impact on our revenue primarily based out of China. As we move into next year, we hope for this to stabilize and to see moderate recovery, but that remains to be seen based on how it evolves. We do see offsets with the Chinese swine, as we anticipate imports from the EU, Brazil, and the U.S. to compensate. We have seen significant price increases in pork globally, and we see Brazil and the EU well-positioned to capitalize on this. The U.S. will also look to gain a greater share. We remain quite committed, and we believe the impact of ASF should flatten out as we move into next year. So hopefully that explains the situation.

This is Jon Kaufman on for Kreger. Juan Ramon, we wish you well, and Kristin, congrats on the new role. One of your competitors has talked a lot recently about the importance of alternative channels. Can you guys talk a little bit about that? How important are the online and mass market retail channels for you today? How has your strategy evolved here over the past year or so, and as you think about the future outlook for the company, how much of the growth do you think will come from these alternative channels? Thank you.

We have seen changes in how pet owners are getting products from different channels. We have observed this mainly in the U.S. but also in some other markets, and there are changes that have really impacted the veterinary space, but Kristin will provide much more insight on how things are changing in the U.S. and how these affect the market, manufacturers, and alternative channels.

Sure. If you look at our portfolio, the contrast with others is that the majority of what we sell requires a prescription. Our goal is to work with veterinarians to make our product available to pet owners in the way that works best for them. What we’ve seen is in areas such as parasiticides and chronic medications; many pet owners have looked more to e-commerce and retail to buy their products. As such, we’ve evolved our own strategy to work more directly with e-commerce and retail. We implemented, as we discussed on previous calls, the minimum advertised pricing or MAP policy, which is an agreement with all e-commerce and retailers to ensure that they cannot advertise our products beyond a certain price. This has allowed us to legitimately sell our product, eliminate some of the gray market, and provide veterinarians and pet owners the convenience to fill their prescriptions where and how they want. This is an evolving thing; to give you context, still, 50% of what we sell will have to remain, no matter what, in the clinic. It’s definitely expanding quickly, but still, on a relative basis is a small part of our business today, but it is something we’re monitoring closely, and we're ensuring that we continue to develop and enhance our capabilities to best serve this new channel as we move forward.

And maybe just a handful of small questions most of which are clarification. First, clarification for companion animal: Did you guys see both canine and feline labs targeting U.S. approval in 2021? One clarification for ASF: I was a little mixed up there in the thought that the drag for 2020 will be less than the $50 million incremental hit in '19, but you still think there could be additional incremental headwinds for 2020? And then lastly, Glenn, not going into 2020 guidance but just as we think about that COGS in sort of hitting the 70% bogey for 2019, which is certainly impressive; I would think you're still going to have a favorable mix shift in 2020 as companion grows faster than livestock based on all the commentary, but do some of your investments in manufacturing offset that? Thanks, guys.

Thank you, John. Let me confirm that we have filed both antibodies for cats and dogs in the EU and the U.S. We expect to launch these two products in the U.S. in 2021. Moving into the African Swine Fever, the assumption that we are making on the comments that we provided today is that we are assuming there will not be a further spreading of African Swine Fever outside of China. We have seen cases in Southeast Asia, Korea, the Philippines, and to a lesser extent also in Eastern European markets. However, we expect that customers now are improving their biosecurity measures and practicing better protection against African Swine Fever. We are not expecting any further growth in terms of cases, and we may see a slight increase in production in China. We definitely see the opportunity in other markets to assist in the compensation of the supply of meat in the Chinese population through increased production from Brazil, European markets, Spain, and Germany, as well as from Canada and the U.S. This shift will help to generate livestock growth in 2020. Now moving into the third question regarding gross profit, Glenn, would you like to cover that?

Yes, John, regarding gross margin. When you look into 2020, there should definitely be a favorable mix impact as we would still expect companion animals to grow faster than livestock in 2020. Just one thing to note about Trio being the first year of product launch not achieving as favorable a gross margin as the rest of the companion animal portfolio typically goes. Over time, we do expect that product to have favorable margins. However, during the first year of launch, there are always learnings and efficiencies that will be delivered over time. Another thing to consider is that FX had a very positive impact on our overall gross margin in 2019; we do not expect it to be positive in 2020 and it will probably be somewhat of a detractor in 2020.

I echo the congratulations. So just in terms of market sizing, can you help us size the market for the cat opportunity given that there is no existing market? Just any sort of framework so that we can think about in terms of population age, etc.? And then secondly, a competitor called out the ASA-African Swine Fever vaccine market is a multi-billion dollar market. Can you maybe give us a framework on the size of that as well? Do you agree with that assessment? What are the puts and takes there? Thank you.

Okay, let me provide some comments on the market size for cat and local antibodies. So first, there is no specific product today in the market developed specifically for cats. We know that the number of cats is lower than that of dogs, and even more, the number of medicalized cats is lower than the number of medicalized dogs in the U.S. and worldwide. If I compare the dog market in terms of managing their pain, it's about $400 million to $500 million worldwide. With the comments I made regarding medicalization rates and the number of cats, you should expect that the market potential for cat pain management is less than these $400 million to $500 million; however, the advantage is that we will be entering a space that has no clear products addressing pain issues in cats and that we think we can generate significant growth opportunities in this area. Regarding the African Swine Fever market, well, I’m not sure if the question refers to the impact on African Swine Fever and the vaccine. We see significant opportunities in China to develop this vaccine, but also in other markets. The need to protect against African Swine Fever across other regions is also pressing. We are convinced that this can be one of the top vaccine products worldwide, even exceeding FMD or PCV2.

And let me please add my congrats to you both, Juan Ramon and Kristin. So my two questions are first with respect to U.S. ticks. Could you help us understand what percentage of the U.S. dog market needs tick coverage? Obviously, there are no ticks in the south; I just don't know what percentage of dogs reside in tick-infested areas in the country? And then second, could you comment on livestock pipeline launch opportunities in the next year or so? Thank you.

Thank you, David. Kristin?

Sure. If you look at the U.S. tick market, there is very significant tick coverage across the United States. There are different ticks. In the South, you might see more Gulf Coast ticks, which is actually a very difficult tick to treat versus the Northeastern tick. We do believe that most pets in the United States need comprehensive tick protection. There may be some geography where there are fewer ticks, but I think there may be varied tick species, and insect protection is crucial as we move across the U.S. As we think about our livestock pipeline opportunity, we are quite focused on driving innovation across livestock. We announced a partnership with Colorado State to look at antibiotic alternatives in the livestock space. We’re also focused on immunotherapies in livestock as alternatives to antibiotics and are excited about some projects in this regard. We are also looking at precision livestock farming to make producers more productive and to better predict when an animal is looking sick. We are also excited in the area of genetics, where we can breed healthier animals that are also more productive. As we've discussed in previous calls, we are looking to bring more shoot-side and farm-side diagnostics into play.

This is Prakhar on for Mavin. I had two questions. First, on Simparica Trio, one thing we are hoping to get more clarity on is around the duration of therapy. So tick-free products are more seasonal, which is not typically the case with hardworm products. So how are you thinking about the duration of therapy for Simparica Trio? Do you expect this to be predominantly used in the tick season, or could the duration of therapy be more consistent? And secondly, on Abaxis, you've talked about expansion into OES markets as a key opportunity, so could you provide an update on the expansion plan? Have you identified target markets or regions that might be ideal? And longer term, could Abaxis reach similar size in international markets as it has in the U.S. market? Thank you.

Thank you very much for the two questions. Let me answer the duration of therapy. One thing is that what should be the duration of therapy that we believe should be many of the markets—12 months. What is the actual duration of therapy? That is probably three months or less. Thus, there’s a significant opportunity in terms of compliance, and we may see some high seasonal requirements for ticks and fleas depending on warmer weather, but they need to protect animals year-round. Definitely, in the case of a warm climate, there is a 12-month need for these products. I would like Kristin to talk about our budgeted expansion plans for both U.S. and international.

Sure. When we announced the acquisition of Abaxis, we talked about the fact that we think we can continue to operate the business in the U.S. much better and drive more efficiencies and growth, but acknowledged that the competition in the U.S. is a bit steeper. As we look into international, we strongly believe in the opportunity because there are significant growth opportunities. It's more of a blue ocean with a more fragmented base. The use of diagnostics also varies dramatically by market. We're very focused on building our own direct demand generation field force, which has been lacking across most companies. We looked at 2019 as a platform year to establish ourselves there, and we plan to move to direct distribution from some of our existing distributors across most markets as we look into 2020. We do think there is a significant opportunity in Abaxis to reach a similar if not higher share than we have in the U.S., just given it is a less mature market with much more fragmentation. But it will require a market-by-market approach.

Thanks for the questions, and let me also offer my congratulations. On the triple combo, have you guys gotten feedback from the FDA just on where they are in their review process, and what is driving your expectations for maybe a later approval than you originally expected? And can you also talk about the timing for a submission, and when you would expect approval for the triple combo in China and some of the other geographies that you mentioned like Mexico?

Let me make some comments about the process of approval in the U.S. There is something which is part of the normal process of questions and answers. We get some additional requests for information from the FDA, not related to safety or efficacy, and we already answered these questions. Now we are waiting for feedback, and we expect the final decision on Simparica Trio by late Q1 next year. But this is part of our regulatory discussions with regulatory authorities across the globe. We said before we were expecting approval and launch in the first quarter. We have already obtained approvals in Europe and Canada, and we have the first quarter launch planned for those markets. We’ll be ready for launching shortly after approval in the U.S. As I mentioned, we are currently taking steps to have ample supply to meet market needs in 2020. Regarding approval timing in China, this is difficult to answer at this stage. We are preparing the filing in China, and then after that filing, we will gain more clarity on the timing. We do expect to launch Simparica first in China as a standalone product, as well as CYTOPOINT, which is another important product we plan to launch in China. Eventually, we'll be launching Simparica Trio, but that may take some years. However, we have other products coming to the market in China that will generate positive growth momentum in this market. Next question please.

First again, Juan Ramon and Kristin, congratulations to you both. Just a couple of questions. First on the canine pain map that you filed. Can you tell us if that is the compound that you acquired from Nexvet a couple of years ago? Second, I noticed that fish sales were down 9% this quarter, and that's somewhat unusual; that's been a growing market. Is that something temporary, or is there a change in the outlook? And last question, when we look at African Swine Fever, I think it took everyone by surprise. Are there any other diseases that you're monitoring that could impact your business over the next three to five years? Thank you.

Thank you for the question. Let me start with answering the question about the monoclonal antibody for dogs. So we have multiple programs in our R&D activity. The product that we are now planning to launch is an internal product for dogs, while the one we are planning to launch for cats is coming from Nexvet. You also asked about the decline in the quarter related to fish. We have been growing very fast in previous years in the fish sector. This year, we had some challenges related to the PD vaccine in Norway. We expect that this is a temporary adjustment and expect fish to continue growing faster than the overall animal health market. The long-term opportunities in fish involve adding new vaccines to protect species other than salmon. Today, we have a majority of our revenues concentrated in salmon in Norway and Chile. However, we expect to continue developing new vaccines to protect species beyond salmon and review the use of antibiotics being the only treatment for infections in species like tilapia or other fish. We continue investing in fish, and we are confident that it will be a growing opportunity in the future.

A couple of longer-term questions for Kristin. Clearly, Zoetis is the leader overall in the industry, but are there areas or areas where you would like to see Zoetis be more of a leader than it is today? And secondly, on the companion side, do you think pet owners are anywhere close to maxing out what they can afford or what they choose to afford in caring for their pets? I realize fleas, ticks, heartworm is not in this category, but thinking over the three to five years plus down the line, what’s the outlook for biotech products, etc.? I’d appreciate any comments on that longer-term outlook. Thank you.

So let me answer the first question, and then Kristin will cover the second. From what we see, we can improve our market share and become a leader, especially in the area where we recently obtained approval of a vaccine for poultry related to vector technology, which is an area we believe can offer significant growth opportunities. We are starting that with one vaccine, but our objective is to develop a complete set of vector vaccines to cover multiple diseases in poultry, which will also help us maximize opportunities with our leadership in lower vaccination approaches used in countries to protect chicks before reaching the hatchery. The second area where we believe we can improve significantly is through the launch of Simparica, followed by the launch of Revolution Plus and ProHeart 12, with parasiticides, where we expect our market share to grow. Kristin?

Sure, regarding your second question, we’ve seen increased spending over the last few years per pet, largely due to demographic shifts in developed markets where people are having fewer children and spending more time with their pets. Millennials, in particular, are much more engaged with their pets. We’ve noted that the increase in spending starts when they transition from backyard pets to being part of the family and ultimately sharing their bed. So we don’t see an end in this market; it’s been resilient even in challenging economic times, where people continue to spend on their pets. We don’t currently see indicators that spending per pet will decrease. The market remains strong as we look to the future, and if you consider urbanization and the emerging middle class in emerging markets, we see significant growth, which leads to more people keeping pets and consequently more medicalization occurring.

So one quick one—thinking about African Swine Fever in a different way, down the road when it's time to re-populate the herd, just wondering how much benefit that could bring to Zoetis, especially given your presence in genomics and genetics?

Sure. Looking at repopulation, as we anticipate that once they do, they will move towards more industrialized production and away from small backyard farms. This transition plays to the strengths of innovative companies like Zoetis, so we do see the future opportunity from African Swine Fever as they recover leading to more technologically-based production, which we see as a benefit for Zoetis. If we are able to create a vaccine for African Swine Fever, that would also significantly enhance our prospects.

Thank you very much, and since this will be my last earnings call, I want to thank all of you for the support you have given to me and to Zoetis over the last seven years. It has been an amazing journey, and I’m very proud of the value that we have created. I know that you will enjoy the same ongoing commitment to our value proposition from Kristin, Glenn, and the rest of our leadership team as I think toward the next phase of growth. In closing, I remain confident in a brighter future for Zoetis. This company and its people have the capabilities, experience, and customer focus to continue delivering world-class service for our customers and shareholders. Thank you very much.