Zoetis' CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb.11.14 | About: Zoetis (ZTS)

Zoetis Inc (NYSE:ZTS)

Q4 2013 Earnings Conference Call

February 11, 2014 8:30 ET

Executives

Dina Fede - Vice President, Investor Relations

Juan Ramón Alaix - Chief Executive Officer

Richard Passov - Chief Financial Officer, Executive Vice President

Analysts

Chris Schott - JPMorgan

Kevin Ellich - Piper Jaffray

Louise Chen - Guggenheim

Alex Arfaei - BMO Capital Markets

Erin Wilson - Bank of America

Mark Schoenebaum - ISI Group

John Kreger - William Blair

David Risinger - Morgan Stanley

Ariel Herman - Goldman Sachs

Liav Abraham - Citi

David Krempa - Morningstar

Operator

Welcome to the Fourth Quarter 2013 Financial Results Conference Call and Webcast for Zoetis. Hosting the call today from Zoetis is Vice President of Investor Relations, Dina Fede.

The presentation materials and additional financial tables are currently posted on the Investor Relations section of zoetis.com. The presentation slides can be managed by you, the viewer, and will not be forwarded automatically.

In addition, a replay of this call will be available approximately 2 hours after the conclusion of this call via dial-in or on the Investor Relations section of zoetis.com.

At this time, all participants have been placed on a listen-only mode and the floor will be opened for your questions following the presentation. (Operator Instructions) In the interest of time, we ask that you limit yourself to one question and then queue again with any follow ups. Your line will be muted when you complete your question. When posing your question, please pick up your handset to allow optimal sound quality. (Operator Instructions)

It is now my pleasure to turn the floor over to Dina Fede, Vice President of Investor Relations. Dina, you may begin.

Dina Fede

Thank you, Zack. Thank you, everyone and good morning, and welcome to Zoetis Fourth Quarter 2013 Earnings Call. I'm joined today by Juan Ramón Alaix, our CEO; and Rick Passov, our CFO.

Our remarks today will include forward-looking statements, and actual results could differ materially from those projections. For a list and description of certain factors that could cause results to differ, I refer you to the forward-looking statement in today's press release and our SEC filings, including, but not limited to our 2012 10-K and 2013 10-Qs.

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 11, 2014.

And finally, since Zoetis was not a standalone company in 2012, our financial statements covering periods prior to the IPO do not necessarily reflect what the results of operations would have been, had we operated as a standalone public company, which may make comparisons to prior periods difficult in certain instances.

With that, I will turn the call over to Juan Ramón.

Juan Ramón Alaix

Thank you, Dina, and good morning everyone.

On February 1st, we celebrated our one-year anniversary. And in this first year, we have made a significant progress in standing up as Zoetis has an independent public company, building the infrastructure to support our business and delivering on our financial and strategic objectives.

We concluded the year with operational revenue growth of 7% and adjusted net income growth of 32%. At species level, we deliver 8% operational growth in companion animal and operational growth of 6% in livestock. Companion animal products now account for 36% of our total annual revenues with livestock progress accounting for 64%.

In companion animal, sales of products for cats and dogs grew by 8% driven by a strong performance in the U.S., Latin America and Asia. And moderate growth in Western Europe and Australia with 4% decline in the sales of equine products. In some countries such as the U.S., there are signs of recovery in the equine market after five years of decline.

With addition of APOQUEL in 2014 to our already strong companion animal portfolio we expect to continue the positive sales growth in this segment. And I will talk more about this product later on today's call.

In livestock, sales of swine and poultry portfolio grew operationally by 12% and 10%. These industries have recovered faster than expected from the drought that affected the U.S. in 2012. These were due to feed costs and higher meat prices in 2013 and given the shortened production cycle allowing operations to more rapidly replenish the supply of animals.

In cattle, where we deliver operational growth of 2%, in the U.S. had strong show in 2013, especially in the fourth quarter. We also saw a strong performance in India and Mexico. These performances continue to be balanced by the impact of ongoing drought conditions in a number of markets including Australia.

Now, let me share with you the performance of our four regions. In Asia Pacific and on operational basis, the revenue grew in line with total Zoetis revenue. It is consistent with our expectations which have lowered during the year to reflect the continued impact of the drought in Australia and New Zealand. These two markets represent 1/3rd of revenues for the region. Significant growth in the region came from the emerging markets of China, India and Southeast Asia as well as good performance in Japan, another large market for Zoetis. This was tampered by the flat growth in Australia and the New Zealand where as I mentioned, dry weather conditions remain.

In Canada, Latin America, as I have noted previously results of the region are primarily influenced by the performance of the two largest markets of Brazil and Canada. These countries account for over 60% of the region sales. For 2013, Brazil was the key driver of the regions growth. With the market as more companion animal business, growing at a significant pace.

We deliver slower growth rate in livestock with a strong growth in poultry and swine offset by the flat growth in cattle. Despite relatively flat industry performance in Canada, Zoetis deliver growth in this market and this was driven by market conditions positively impacting our anti-infective portfolio and cattle virus and stronger than anticipated sales of flea-and-tick sale products.

In Europe, Africa, Middle East, emerging markets contribute significantly to 2013 growth. In Russia, we see a longer term growth trend in the livestock industry where there is an increasing focus on sales efficiency in the food supply. In Western Europe, where we had our largest market, while economy challenge remained for our customers we grew modestly.

We deliver by strong growth across all species in the U.S., our largest region. In companion animal, we saw the benefit of realigning our field force to more effectively cover our customer base. This was in addition to the positive outcomes of our new cross-portfolio pricing programs.

In livestock strong growth in poultry and swine was offset by the two very different six month performance periods in cattle, the largest species in our U.S. livestock business, it was a year of two-half, if you like. In the first half of 2013, the cattle business saw the impact of higher corn prices affecting the producers demand for our products. Growth in cattle sales picked up in the second half of the year as corn prices fell. For 2014, we expect limited growth in our cattle business as ranches hold back heifers from slaughter for breading purposes. This action, while tempering growth in 2014 is a positive long-term trend for the animal health industry as it indicates the beginning of herd rebuilding. For total Zoetis, operational revenue growth of 7% comprised approximately 5% volume growth and 2% price.

Now let me provide some recent business highlights from the quarter. This demonstrates the importance of the three core interconnected capabilities of our company. We continue to benefit from our best in class field force. The commercial team remains focused on partnering with our customers to make their businesses successful. We are deepening these relationships with our customers to development of aligned platforms, so they might easily access to our produce as well as to help them better engage their clients.

According to the latest available external market data, Zoetis grew its revenues faster than the market for both the nine and 12-month periods ending September 30, 2013. This performance is based on the latest information available and we expect to continue to grow faster than the market on a total year basis for 2013.

Our investments in R&D have been productive. Through the year we have delivered a number of minimal additions and enhancement to our product portfolio. In fact, in 2013 we received many approvals including those for new medicines, claim extensions or entrance into new markets. Some of our most recent approval has been for poultry and swine.

In swine, we have continued to maximize our investment in the FOSTERA brand with the approval of FOSTERA poultry vaccine in new markets including Mexico, Korea and Thailand. Building on the success of FOSTERA and thanks to the continued innovation from our R&D team, we recently received U.S. approval of our FOSTERA PCV MH product. This is a new combination vaccine for swine and it's the first to offer one bottle, one dose convenience with the flexibility of two dose administration.

Also in the swine portfolio and during 2013, we launched the first product for our China joint venture Rui Lan An. This product is performing very well. We believe that the product could account for a growing percentage of our revenues in China and become a top 10 product in our portfolio in the market in 2014.

And now a few words on APOQUEL. This exciting new product was recently launched in the U.S., Germany, Austria and the U.K. APOQUEL is scheduled to launch in the rest of European Union as well as New Zealand in 2014. APOQUEL has been well-received by veterinarians and those of their client that participated in our clinical trials and in the early experience programs in the U.S. Customer demand to-date has already been very high and we are truly excited about its long-term potential. However, as an innovative probably a novel mechanism of action and with only a few weeks in the market it is hard to estimate what the ultimate rate of uptake will be in this product's first year.

To help manage expectations at this earlier stage we currently believe that APOQUEL could contribute approximately 1% of our revenues in 2014. This is of course dependant upon customer acceptance levels. Changing gears, through the year I have spoken about how our customer's businesses have been impacted by a number of disease outbreaks.

You would recall that we have talked previously about foreseen epidemic diarrhea virus or PEDv, which is affecting swine herds. This has been a serious impact on the industry in the United States and is now active in 23 states. Cold weather is contributing despite of the outbreak which is impacting according to recent reports up to 30% of sows in the U.S.

With information available today, we expect a reduction of approximately 4% of the U.S. swine herd and this impact has been incorporated in our guidance range. We will continue monitoring the evolution of the outbreak in the swine industry and the impact in our revenues.

As you may know, Zoetis recently announced research partnership with Iowa State University, to identify vaccine candidate to help control the virus. The partnership is one element of Zoetis ongoing effort to support swine veterinarians and pork producers in the control of PEDv.

Also in 2013, Zoetis began correlating with the University of Minnesota to develop a diagnostic test for the disease. Another disease outbreak albeit on a smaller scale has been a new strain of bronchitis affecting poultry flocks. This is a virus that has been first identified by poultry producers in the U.S. State of Georgia in 2008. But one that had began to spread to other southern U.S. states.

In 2013, in line of the continuing impact of the disease we formed an internal taskforce to deliver the USDA conditionally-licensed vaccine intended for this virus. This provides a valuable tool for our customers in reducing the affects of the disease. Efforts are currently underway to obtain a full USDA license for the vaccine. Our responses to both of these diseases outbreaks further demonstrate our partnership with our customers and the way in which our colleagues work to meet their needs.

We have remained focused on issuing a steady supply of quality medicines to our customers and the market. In 2013, we deliver sustained improvement in our product availability metrics ensuring that we can more reliable meet the demands of our customers around the world.

In 2014, our manufacturing and supply organization will include a full-year cost associated with central manufacturing functions that were build through 2013.

We are also facing some product mix headwinds higher sales in medicated feed additives on poultry together with some products not fully meeting our expectations. One example of these products is Improvac/Improvest. This is an innovative global product that changes animal husbandry practices in the swine industry in a very important way.

We have been successful with these products in Latin America, but not yet realized its full potential in Europe and U.S. All these elements will represent a challenge to gross margin improvements in 2014.

Zoetis first year results as well as our 2014 guidance illustrate the importance of our diverse portfolio and the strength of our business model. We are committed to our long-term objective to deliver revenue growth inline with or faster than the market and realize adjusted earnings growth faster than revenues.

I believe as we are well-positioned to bring added value to our customers, colleagues and shareholders.

With that I will now ask Rick to walk us through the financial results. Rick?

Rick Passov

Thank you, Juan Ramón, and good morning.

I will start with a review of the fourth quarter results and then I will lay out guidance for full-year 2014.

Turning to the income statement slide, for the fourth quarter revenue was approximately $1.25 billion, an increase of approximately 7% year-over-year including a negative impact of 2 percentage points from foreign exchange.

Adjusted net income was a $180 million and diluted earnings per share was $0.36. Adjusted net income for the quarter excludes the after-tax impact of $75 million or $0.15 per diluted share for purchase accounting adjustments acquisition related costs in certain significant items.

As we mentioned on last quarter's call, our fourth quarter reported results include $13 million and one-time charges related to the integration of our branded generics R&D into our global R&D operations, the divestitures of certain assets in our agricultural business and our decision to exit the manufacturing of intermediate ingredients that we believe we can source more effectively from third parties.

Also as I mentioned on our last call, during the fourth quarter, we continued to assess the carrying value of certain assets. As a result, we took a one-time charge of $17 million to reflect the impairment of one of our manufacturing facilities.

And finally, in the fourth quarter, as we continued the transition to our own shared services operation, we wrote-off approximately $17 million of inventory and intercompany accounts that would be transferred to us as part of the separation from Pfizer. Because of these expenses relate to the periods prior to 2012, and prior to our initial public offering, we do not consider them to be reflective of our current operations and are therefore, excluding them from our adjusted earnings a non-GAAP measure.

Turning now to our adjusted net income statement slide, which I will speak to on an operational basis. Again, revenue was up 9% excluding the impact of foreign exchange. Companion animal sales grew $27 million or 7% and livestock sales grew $76 million or 10%. Adjusted cost of sales was 35.4% of revenue versus 36.3% in the year ago quarter, this reflects the impact of a favorable comparison to the year ago quarter, which included certain expenses associated with establishing our own compensation plans as well as other items related to separating from Pfizer.

Adjusted SG&A decreased by approximately 6% in the fourth quarter, this reflects good expense control as well as similar to COGS a favorable comparison to the fourth quarter of 2012. Adjusted R&D expense decreased approximately 1%, adjusted other income and deductions decreased to $0 in the fourth quarter of 2013. This was primarily due to a royalty true-up combined with losses on foreign exchange exposures.

Our effective adjusted tax rate for the fourth quarter was approximately 29% reflecting the jurisdictional mix of income and the full year benefit for the U.S. R&D tax credit. And again, on an operational basis, our adjusted net income was $180 million.

Now, on to our segment results, I will discuss these on an operational basis and it should be noted that segment earnings are pre-tax numbers and reported on an adjusted basis. Beginning with the U.S., fourth quarter revenue was $516 million, an increase of 7%. Sales of livestock products grew 8% with contributions across cattle's, swine and poultry.

Cattle products showed stronger than expected growth particularly during the later part of the quarter driven by the continued improvement of market conditions in the U.S. Swine and poultry products continue to benefit from customer acceptance of recently-launched vaccine products.

Sales of companion animal products grew 5% and U.S. segment earnings increased by 11% due to revenue growth and improvements in gross margin driven by price and volume.

Now turning to our Europe, Africa and Middle East region, in EuAfME fourth quarter revenue was $330 million, an increase of 9% operationally. Sales of livestock products grew 9% driven primarily by recently launched swine and poultry vaccine products particularly in Germany and Russia. Sales of companion animal products also grew 9% and benefited again this quarter from increased sales associated with third-party manufacturing agreements. Excluding these sales, companion animal products sales grew 5%. EuAfME segment earnings increased 24% operationally driven by revenue growth and expense efficiencies in the quarter.

Turning to our Canada and Latin America segment or CLAR, fourth quarter revenue was $223 million, an increase of 8% operationally. Sales of livestock products grew 7% driven largely by improved market conditions for cattle in Brazil and by increases in sales of medicated feed additives in poultry.

Sales of companion animal products grew 14% largely driven by sales in Canada due to favorable weather conditions and increasing medicalization of pets in Brazil. CLAR segment earnings increased 24% operationally driven by revenue growth and expense efficiencies as well as a favorable comparison to the year ago quarter.

In our Asia Pacific or APAC region, fourth quarter sales were $185 million, an increase of 14% operationally. Sales of livestock products grew 16%, India had strong poultry and cattle products sales. For poultry, this was in part due to the resolution of a prior year product registration issues for several of our vaccines.

In Japan, swine sales benefited from recently launched vaccines and China was also a leading contributor mainly in swine products. Growth in these markets more than offset the negative impact of drought conditions in Australia on sales of cattle and sheep products.

Sales of companion animal products grew 8% led by good performance for recently launched products primarily in Japan. This was partially offset by a decline in sales in Australia, reflecting the benefit in the year ago quarter of equine vaccine sales from the launch of our Hendra vaccine.

APAC segment operating earnings increased 70% operationally benefiting from revenue growth, expense efficiencies, the timing of promotional spend as well as our favorable true-up and pricing for certain purchases.

Now let me turn to guidance for full-year 2014. Our guidance for 2014 reflects foreign exchange rates from late January. For full-year 2014, we expect reported revenue of approximately $4.65 billion to $4.75 billion.

This reflects an unfavorable impact of approximately 2 percentage points or approximately $100 million related to the year-over-year impact from foreign exchange. Our guidance on adjusted cost of goods sold for full-year 2014 is approximately 35.5% of revenue roughly flat year-over-year. This reflects the anticipated benefit of price, volume and ongoing cost saving efforts offset by the full-year impact of cost incurred to build our global supply functions as well as among other things headwinds from unfavorable mix.

Adjusted SG&A expenses are expected to be between $1.43 billion and $1.48 billion. Adjusted R&D expenses are expected to be between $390 million and $405 million. For the full-year 2014, the midpoint of our guidance implies an improvement in the ratio of a total adjusted SG&A and R&D to revenue of approximately 50 basis points.

We are targeting this improvement despite the fact that 2014 will reflect a full-year of expenses for the standalone corporate functions that were ramping up throughout 2013. Also as we pointed out during the first two quarters of 2013, total adjusted SG&A and R&D expense was less than the full-year run rate.

As a result, year-over-year growth rate comparisons for the first two quarters of 2014 are expected to be unfavorable. Our effective tax rate on adjusted income is expected to be approximately 29% for the full year, this guidance does not reflect the potential renewal of the U.S. R&D tax credit in 2014. And we expected adjusted EPS between $1.48 and $1.54 per share.

In addition to the FX impact and revenue discussed earlier, our EPS guidance also includes approximately $0.01 impact in OID from the recent evaluation of the Argentine peso. For 2014, we estimate pre-tax charges between $165 million and $185 million which primarily relate to stand-up and acquisition related cost including the impact of these items, our reported diluted EPS for the full-year 2014 is we expected it to be between $1.15 and $1.21 per share.

Our annual guidance reflects our confidence in the diversity of our portfolio, the strength of our business model and our view of the evolving market conditions for animal health product this year.

In closing, now that we have a year behind us, I would like to provide an update on our perspectives on capital allocation. First, we remain committed to maintaining an investment grade rating and feel that we would be able to do this while targeting a leverage ratio debt-to-EBITDA of approximately 2.5x. In the near term, we remain focused on completing this stand-up of Zoetis, and were incurring our recurring costs in 2014, which I discussed earlier.

For 2015, we expect stand-up and acquisition related costs to be less than half of what we expect to occur to incur in 2014. And we will continue to selectively invest in opportunities to profitably grow our business. Beyond that we will look to return capital to shareholders.

In our first year of operations as a public company we increased our dividend by 11%. As we move past the elevated spend associated with standing up our infrastructure, we believe our free cash flow should support increasing our dividends at or above earnings growth for some period of time. Of course, this is based on current expectations and any future increase would be subject to Board approval.

That concludes my prepared remarks and now we will open the line for your questions. Dina?

Dina Fede

Operator, we are ready for questions.

Question-and-Answer Session

Operator

The floor is now open for questions. (Operator Instructions) Thank you. Our first question is coming from Chris Schott of JPMorgan. Please go ahead.

Chris Schott - JPMorgan

Great. Thanks very much for the question. The first question, you reported two consecutive very strong top line results with roughly 9% constant currency growth because I was a bit surprised by the 3% sales growth guidance in 2014, I guess more like 5% constant currency. Just elaborate a little bit more what's happening here that you are seeing a slower growth.

The second question was on operating margins. I think you mentioned 100 to 150 basis points of expansion this year despite some unfavorable year-over-year expense comps. How do we think about long-term leverage in the model, when we look beyond 2014 and some of these one-time factors kind of getting behind the company? Can we think about maybe more on the 150 end or even larger operating margin expansion opportunities over time? Thanks very much.

Juan Ramón Alaix

Let me take the first question on our revenue position for the 2014. And in 2013, we had significant growth in two species, swine and poultry. Swine grew by 12% and poultry by 10%. We also and we think that this two species will have more moderated growth in 2014 much more in line with the market growth.

The second element that we also included in our projections for 2014 was in companion animal, we expected the entrance of new classes of molecules in parasiticide. We also expect some additional competition for Rimadyl, generic competition for Rimadyl in the U.S. and of course this will be balanced with the launch of APOQUEL that also will generate a significant growth.

In cattle, which is the largest livestock species, we expect that in 2014, the cattle ranches will rebuild the herd and as a consequence of that there will be less animals place in the feedlots and this will have an impact in terms of – and the sales of our products.

Considering all these elements, we think that the projections that we are making for 2014 are realistic and also in line what we can expect also from the market growth. May be Rick can provide some details on gross margin?

Rick Passov

All right. Yes. Chris, I just want to make sure that my numbers were heard correctly and that I understood the numbers that you discussed. So on operating margin in 2013 roughly there is a 300 basis point improvement. What I said in my comments was that the ratio of SG&A to R&D in 2014 based on the midpoint of our guidance is going to be roughly 50 basis point improvement there about. And then as we also spoke on the call, gross margin had a modest improvement in 2013 and our outlook there is flat for 2014 and we described some of the reasons that are driving that.

So and in terms of a longer term perspective, again, we go back to the basic premise, we believe we will grow at or in line with market. We believe over the long-term our expenses will grow considerably less than that. And we think that margin from there kind of cancels out.

Dina Fede

Operator, next question please.

Operator

And we will go next to Kevin Ellich with Piper Jaffray. Please go ahead.

Kevin Ellich - Piper Jaffray

Good morning. Just following up on kind of the underlying market growth assumptions, are you seeing greater use of medications by hog farmers with PEDv going around the country and also with 9 million pounds of beef recalled out in California and a plant shut down, doesn't that make the existing cattle herd even more valuable so that could also drive increases in medications?

Juan Ramón Alaix

Thank you for the question Kevin. And you are right. We expect that with fewer animals, these animals will have more valuable to the cattle businesses and we expect that also they will ensure that they have the right healthcare protocols to keep these animals for that business. But this will be compensated in someway because of the fewer animals that will be available for placement in 2014 based on the assumption that the ranchers will probably rebuild the herd and this will keep these animals for this purpose.

In terms of greater use of medicines because of PEDv what we have seen is that definitely the PEDv it's reducing the number of animals available. I mention that the sows affected by the PEDv in the U.S. it's about 30% and it is expected to have an impact of reduction of 4% in terms of total animals available in the market. What the producers are indicating is that the way that they expect to compensate these fewer animals it will be to have these animals longer in terms of reaching higher weight that will also contain the number of pork available to the market. This may represent an opportunity if they keep these animals longer also to keep these animals under certain healthcare protocols. Although when they reach certain weight they are less vulnerable to infections or other diseases.

Dina Fede

Operator, our next question please.

Operator

And we'll go next to Louise Chen with Guggenheim. Please go ahead.

Louise Chen - Guggenheim

Hi, thanks for taking my question. So, we had a quite a few calls this morning from investors regarding the guidance that you gave for 2014 and maybe some more explanation behind it, but I'll just delve back on that again. So I'm kind of curious how we should think about modeling your top line and bottom line growth longer term. I understand some of the headwinds this year and, should we just be patient the 2013, 2014 there are some meaningful headwinds and then after that we should kind of get to the kind of growth rate that people had expected at the time of the IPO, which is more 6% to 7% top line and double digit bottom line growth?

Juan Ramón Alaix

And in terms of revenues, we see that Zoetis will be growing in this five years companion animal growth in line with the market and the market is expected to grow around 5% to 6%. We also expect that our expenses will be inline with inflation and we also expect that we will generate gross margin improvement over time. Let me provide may be some comments on why we are not meeting our objective for 2014 in terms of gross margin.

So one element it's the mix of products. So in 2013, we have the significant growth in swine and poultry especially in poultry that the margins are lower and these also creating some mix challenge in terms of gross margin. We also had some geographies that also impacting the mix of geographies are also impacting our geography, we are growing faster in some of the major markets and these are major markets they still have lower margin that than more developed markets. The third element is that in 2014, we are facing some unexpected synergies like freight. Again, so it's something that definitely we are working and we expect this something that will not have a long-term impact since we will be able really to achieve our target in terms of this kind of cost.

We see that also some of this additional impact in cost will be offset by cost reductions also will be offset by pricing but there are some elements that also are affecting our gross margin improvement in 2014. We were expecting to generate significant growth out of a product that has a significant potential, it's a product that it's called Improvest/Improvac this product has been extremely successful in Brazil and we were expecting the same kind of success in Europe and the U.S.

Unfortunately the market acceptance is taking longer in these two important regions and these are having an impact in terms of revenues but also in terms of volume that it will be absorbing significant cost in our operations. We still remain convinced that this product is really providing a significant opportunities not only in terms of replacing surgical castration in pigs to eliminate boar tint but also having feed enhancement that will result also in higher productivity for the swine producers.

These products have a significant opportunity and we expect that this product will generate revenues and also a positive impact in our gross margin in the future. We expect that our actions that we are taking in 2014 will result in cost, of course improvement in 2015 and 2016 and also beyond. So we are committed to improve our gross margin and we see that this situation in 2014 is a temporary situation that we expect to solve in the future.

Dina Fede

Operator, next question please.

Operator

We'll go next go to Alex Arfaei with BMO Capital Markets. Please go ahead.

Alex Arfaei - BMO Capital Markets

Good morning and thank you for taking my questions. Could you please talk about your business development strategy and whether you are primarily focused on livestock and companion animal businesses, it would seem there are number of promising companion animals which add new assets out there?

And if I may follow up, your revenue this quarter benefited from again from third party manufacturing agreement, how should we think about this opportunity in 2014? Thank you.

Juan Ramón Alaix

Okay. Let me start with the business development and also Rick can provide comments on the third party manufacturing agreements. In terms of BD, we will remain focused on ensuring that we maximize the opportunities that we have in our portfolio and also the opportunities that will generate through our investments in R&D will not exclude opportunities in terms of adding products for a certain species or certain therapeutic classes in where we can really fill gaps or also expanding our presence in some of the markets.

But definitely, it's something that we will consider opportunities as they come. And there will be two conditions that always will be in our analysis, one the strategic feed and the second the financial to support that acquisition. We are not really focused on either livestock on companion animal, I think something that we will be open to any opportunity that will meet these two conditions.

Rick Passov

And then Alex on the question on the third-party manufacturing to remind us again of what that is, we're obligated to provide supply for some of the divested products plus we also now have a small component of third-party manufacturing that we do on behalf of Pfizer. We do expect that the amount of this volume for us will decline around 15% year-over-year probably in the early 50 millions to somewhere in the early 40 millions and we haven't made a long-term decision about the extent to which we'll decide to continue on some of these contracts as they decline or what kind of partnership will remain with Pfizer we're on – in the long-term where this fits into our overall manufacturing operations.

Dina Fede

Operator, next question please.

Operator

We'll go next to Robert Willoughby with Bank of America. Please go ahead.

Erin Wilson - Bank of America

Hi, it's Erin Wilson. Juan Ramón, I guess going back to the revenue growth questions in the press release and then in the prepared remarks do you see that the 2014 outlook supports your overall long-term goal of faster than market growth? But the guidance seems to call for at least in line if not below the industry trend, what's the disconnect there in light of kind of the new product launches and recent strength you've see?

My second question would be just broadly speaking to the slower growth in livestock markets and inherently lower margin business positively impact the product mix on a gross margin standpoint, so could there be upside to your estimates there?

Juan Ramón Alaix

Okay. In terms of our performance against the market, while the information available today its the third quarter year-to-date where we have been growing significantly faster than the market in 2013. And we expect also the fourth quarter to confirm these results. If, what we always communicated, it's our commitment to grow inline or faster than market on a companion animal terms. And if you take our growth in 2013, and also with the projections that we are making for 2014, we think that this growth in companion animal growth will be faster than the market.

We expect that the new products will add some additional revenues and APOQUEL is a very good example. But you need to also to keep in mind that in 2013, we also launched a significant number of products, so we generated very positive growth of new products in 2013. And I think it's something that definitely we are convinced that at the end of the year, so the growth that we will be generating will be supporting this growth faster than the market or inline with the market.

The second question was slower livestock growth and positive for gross margin. While there are many different elements in this statement, so one its -- I mentioned that we are growing now faster than in poultry and swine than in cattle. And this is having an impact in our gross margin. Second element, we have also been growing at least in 2013, so we have now a higher base of medicated feed additives also with the lower margin than pharmaceuticals or vaccine.

And the third element is the growth in emerging markets and this growth in emerging markets it's – well, there are two components definitely the companion animal but also they are growing very fast in terms of livestock. All these elements are driving our gross margin performance in 2014.

Rick, I don't know if you want to add any other comment?

Rick Passov

The only small amount of color, I would add is just that if we look also Erin, I think you had said that the lower growth that we might be anticipating on a relative basis year-over-year in livestock would be an improvement in margin. I think Juan Ramón answered that I think also its worth pointing out that in companion animal we have new products and we also have some new competitors and those things are balanced in our forecast for the companion animal growth in 2014 as well.

Dina Fede

Operator, next question please.

Operator

We will go next to Mark Schoenebaum with ISI Group. Please go ahead.

Mark Schoenebaum - ISI Group

Hey, guys thanks for taking the question. Also thanks for all the quick very clear commentary. I just, hey, Rick, I just want to make sure I've got some math correct. You mentioned I think I heard you say something like $100 million currency impact to your 2014 guidance, just clarify that should we basically just be adding if you wanted to do constant currency should we just be adding $100 million to your revenue guidance. And if I were to do that to try to create more of a like-for-like comparison it looks to me like your operating margins in 2014 will expand not 50 basis points, but about 130 basis points. Is my math correct or was there also some kind of offsetting impact on the OpEx line from the fluctuations you expect in currency?

And then just a follow up is, if your revenue guidance proves conservative, if it were as analyst investors should we still look at your SI&A (sic) SG&A and R&D dollar guidance as the number that you are going to shoot for? Even if you get lucky and say your revenue growth is 2% or 3% higher than what you're projecting? Thanks again for all the detail.

Rick Passov

Mark, no problem. Let me just start back at the very beginning of the question. So at the average rate of FX for us over the course of 2013, we're giving you this range of about $100 million of lost revenue. If we were to apply the average rates in 2013 across how we expect the numbers to roll-out for us in 2014, exactly how that falls through the P&L there are a lot of different ways that you can do it, we haven't really worked out that math for us but you can use the P&L is an indicative model or hair cut that in a number of different ways.

And in terms of -- to the extent that we get more or less revenue what is going to be the impact on SG&A as a percent of sales. I think it depends on a lot of factors, we can find ourselves in periods of time where revenue growth is also being accompanied by more promotional activities. So it's hard for me to give you a fixed line there. And also want to make sure that I'm not misquoted on the 50 basis points that I spoke to. Again, in my prepared remarks, I was simply saying that if you take the midpoint of the guidance for just SG&A and just R&D as a percent of revenue, you'll see that they were targeting in that midpoint range roughly 50 basis point improvement.

I'm simply pointing out that in a year when we are facing peak to synergies as part of the standup from – in our standup efforts, we're still showing you at least in this ratio cost improvement benefits. And then I'd also point out that we had negative SG&A growth in 2013. So, if you add up 2013 and 2014, I think you get a year representative of what Juan Ramón has described as an average year that's representative of what Juan Ramón has described as our longer term goals.

Dina Fede

Operator, next question please.

Operator

We'll go next to John Kreger with William Blair. Please go ahead.

John Kreger - William Blair

Hi. Thanks very much. Just a couple of quick follow-ups on the underlying assumptions for the 2014 guidance. Are you assuming any improvement in the economic environment particularly on the companion side? And what about the price versus volume mix that underlies that 2% to 4% revenue growth expectation? Thank you.

Juan Ramón Alaix

Probably the answer to that, it's not completely straight forward. So we expect some economic improvement in some of the European markets. At the same time there are uncertainties at this point in some of the emerging economies. And in these economies, I think it's something that at this point we are taking some questions in terms of growth that these economies will generate and also the impact that these growth will have in the animal healthcare industry.

That's why we're still providing this range that is reflecting these uncertainties that we still have not only related to the economies but also related to some environmental factors that can be affecting our business. On the second question, it's what about the --

Rick Passov

Pricing.

Juan Ramón Alaix

The pricing volume in – so in 2013, we generated higher volumes than price in our total revenue growth. I mentioned that on the 7% operational growth, 5% was volume, 2% was price. We expect that in 2014, the growth will be balanced between price and volume. And definitely we see opportunities of price increases in both livestock and also companion animal and also both in developed animal healthcare markets. Although, we see that emerging markets we will have a much more moderated price increases than a developed markets.

Dina Fede

Next question please.

Operator

We'll go next to David Risinger with Morgan Stanley. Please go ahead.

David Risinger – Morgan Stanley

Yes. Thanks very much. Good morning, Juan Ramón and Rick. I have a couple of questions mainly about the financials. So, first with respect to FX, Rick, could you just talk about the impact of FX on the bottom-line in 2013? And then obviously, FX benefits your operating expenses in 2014.

Is there any way to characterize the FX driven reduction in operating cost for 2014? And then separately with respect to corporate costs, could you just remind us where your corporate costs are, where they were in 2013 and how we should think about that number trending over time and whether there are any meaningful cost reduction opportunities or not? Thank you.

Rick Passov

Thank you for the question, David. Let me start with the FX piece. The FX impact for 2013 was considerably less than what we're seeing in 2014. And yes, there is an FX component that would be somewhat of a benefit to SG&A but less so than you might think depending on which geographies we're making investments for growth and as well less so from an R&D perspective.

And then – I'm sorry what was the – the second question was the kind of -- how to look at our corporate costs. So, one thing that is between 2012 and 2013 is a reallocation between what's in R&D which is part of our corporate function and what was in unallocated overhead bucket in our carve out financials that helps you sort of see 2012 and 2013 change.

And then as we spoke in the other parts of what we call our corporate costs are a couple of things the build up of essential organization for manufacturing, so we built our own global supply points. And then as well those functions that resided in Pfizer where there was no analog in Zoetis. So, tax, treasury P&A to a large degree, internal audit and so on and as well the IT function.

And the majority of the standup delta if you will, maybe I could use the word synergies have been occurred to-date and I think we've done a very good job of offsetting them. They don't on a – where you'll see the largest impact if you will is comparing the rate of growth in SG&A for example in Q1 of 2014 to the rate of growth in Q1 of 2013 and that's because in Q1 of 2013 and in Q2 of 2013 we called out that – the SG&A plus R&D as a percent of revenue was below what we expected the run rate would be for the full-year or even our indicative run rate.

And so, when you make those quarter-over-quarter, year-over-year comparisons, you'll see somewhat unfavorable growth but it will certainly balance out pretty well as we get through the rest of the year. And then going forward, again, I think that the operating leverage is going to come from that basic tenant that we keep going back to growing at or faster than the market and controlling operating expenses to be roughly in line with inflation and modest gross margin improvement.

Dina Fede

Operator, next question please.

Operator

We'll go next to Jami Rubin with Goldman Sachs. Please go ahead.

Ariel Herman - Goldman Sachs

Hi, this is Ariel Herman in for Jami. So, wanted to follow up on two things. First, is there an updated view on your thoughts around M&A and further industry consolidation? And do you guys see yourself as participating with that and if so do you guys need M&A to sustain margin expansion.

And then just separately going back to the revenue outlook, so I understand there is some one-time events in 2014 such as the moderate growth in swine and poultry, but 2013 also had some one-time event such as drought that I would have thought would have made good comps for 2014. So just thinking longer term, how do you get back to that 5% to 6%? And how should we think about growth in each regional segment within that overall company growth? Thanks.

Juan Ramón Alaix

Thank you, Ariel, for the question. Let me answer first the second question on the projections for 2014 and the different impact of the drought. The drought of the U.S. in 2012 had different impact depending on the species. Definitely on swine and poultry, we saw that the impact in these two species in 2013 was much softer than we expected. In fact these two species recovered very fast even in the first half of 2013 from the drought, because of mainly at that time, the meat price grew significantly. And then in the second half of the year, the prices remained high, but also the prices for corn were much lower than 2012.

So, in these two species the drought had a very little impact, in fact swine and poultry for us grew by 12% and 10%. It is a different – the situation for the cattle industry. So the cattle industry in the first half of 2013 was affected by the drought but had a significant recovery in the second half of the year. So in total as I mentioned these species grew by 3% in our revenues.

What we expect in 2014 is to have full-year of normalized weather conditions. But, because of the projections on cattle are now positive, the ranchers have decided that to increase the herd. The result of increasing the herd as I mentioned will be less animals place in the feedlot where the majority of the process are used and then the better situation in terms of weather conditions will be in some way offset by the fact that there will be fewer animals to treat in the feedlot.

If I move to the first question in terms of my views in terms of M&A. So definitely, it has been a lot of news recently from other animal health companies, I think we will not enter in speculating what will be the outcome of all these strategic reviews that other competitors are making. We are convinced that our internal growth will be supporting our objectives of growing in line or faster than the market in this companion animal growth in middle to long-term. And we see maybe opportunities on some of the complementary spaces or some of the process that will be filling gaps in our portfolio.

And one important element is that we already have our market share which is close to 20%, 19%. This can create some challenge in terms of antitrust. And it is something that we will really -- understanding and monitoring all the different decisions that our competitors will be making and then we'll decide depending on what will be available in the market.

Dina Fede

Operator, next question please.

Operator

We'll go next to Liav Abraham with Citi. Please go ahead.

Liav Abraham – Citi

Good morning. Just one quick question on your tax rate. Rick, did you see any opportunities to reduce your effective tax rate going forward and is this a focus for you at all? Thanks very much.

Rick Passov

Thank you, for the question. We get that a lot. Tax is obviously, for a number of reasons, are out in the– somebody has their line open -- are in front of us quite a lot. I would say that we're seeing the opportunity for some marginal lowering of the effect of tax rate just based on the good cash flow generation in the business and what we see our future needs are. And in terms of what the ultimate degree of freedom is for us to change our tax rate.

We're pretty much where we're going to be plus the benefit of the R&D tax credit which we'd like to see at some point during 2014 and perhaps could add the opportunity to lower the 29% by up to about 50 basis points. And then I think there that's going to be good long-term estimate of what the effective tax rate is for Zoetis.

Dina Fede

Operator, I think we have time for one more question please.

Operator

We'll take our last question from David Krempa with Morningstar. Please go ahead.

David Krempa – Morningstar

Thanks for taking my question. Just quick follow-up on that tax question, would you guys ever be open to an inversion that would significantly lower that tax rate but might also bringing in some human health products?

Rick Passov

That's an interesting question. I can understand the reason why it's asked. And obviously, a number of companies have found something in that strategy that works for them, but it's not something that we're contemplating.

Dina Fede

Thank you. That concludes our call. Have a good day.

Juan Ramón Alaix

Thank you very much.

Operator

Thank you. This does conclude today's teleconference. A replay of today's call will be available in two hours by dialing 1800-688-7945 for U.S. listeners and 402-220-1370 for international. Please disconnect your lines at this time. And have a wonderful day.

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Zoetis (ZTS): Q4 EPS of $0.36 beats by $0.02. Revenue of $1.25B (+6.8% Y/Y) beats by $40M.