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Zoetis (NYSE:ZTS)

Q1 2014 Earnings Conference Call

May 6, 2014 8:30 am ET

Executives

Juan Ramon Alaix – Chief Executive Officer

Glenn David – Senior Vice President of Finance Operations, Chief Financial Officer (acting)

John O’Connor – Head of Investor Relations

Analysts

Jessica Fye – JP Morgan

Kevin Ellich – Piper Jaffray

David Redford – BMO Capital Markets

Wesley Nurss – ISI Group

John Krieger – William Blair

Erin Wilson – Bank of America

Chris Caponetti – Morgan Stanley

Louise Chin – Guggenheim

Liav Abraham – Citi

Ariel Herman – Goldman Sachs

David Krempa – Morningstar

Operator

Welcome to the First Quarter 2014 Financial Results conference call and webcast for Zoetis. Hosting the call today is John O’Connor, Head of Investor Relations for Zoetis. The presentation material 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 forward automatically. In addition, a replay of this call will be available approximately two 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 in a listen-only mode and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star, one on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. In the interests of time, we ask that you limit yourself to one question and then queue up 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. Lastly, if you should require operator assistance, please press star, zero.

It is now my pleasure to turn the floor over to John O’Connor. John, you may begin.

John O’Connor

Thank you. Good morning and welcome to the Zoetis first quarter 2014 earnings call. I’m joined today by Juan Ramon Alaix, our Chief Executive Officer, and Glenn David, our Senior Vice President of Finance Operations and acting Chief Financial Officer. Juan Ramon and Glenn will provide an overview our quarterly results and then we will open the call for your questions.

Before we begin, let me remind you that the earnings press release and financial tables can be found on the Investor Relations section of Zoetis.com. We are also providing a simultaneous webcast of this morning’s call which can be accessed on the website as well. A PDF version of today’s slides and a transcript of the call will be available on the website later today.

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 2013 10-K and 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. These non-GAAP adjusted figures exclude the impact of purchase accounting adjustments, acquisition-related costs, and certain significant items such as the non-recurring cost of becoming a standalone public company. 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 press release and in the company’s 8-K filing dated today, May 6, 2014. We also cite operational results which exclude the impact of foreign exchange.

Prior to the completion of our IPO last year, Zoetis was not an independent public company and the first quarter of 2013 includes results from periods that were derived from the consolidated financial statements and records of Pfizer, which can make comparisons difficult in certain instances.

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

Juan Ramon Alaix

Thank you, John. Hello everyone. Before moving into some of the details of our call today, I would first like to address a recent change in the company’s executive team. On April 22, we announced that Glenn David, Senior Vice President of Finance Operations was named the company’s acting Chief Financial Officer. I’m delighted that Glenn is here with me on today’s call and he will speak with you as we move through the details of our first quarter performance. But first, let me share some of the highlights from the quarter, beginning with our high level financials.

We concluded the first quarter with revenue growth of 1% or 4% operational. Adjusted net income for the first quarter was $191 million or $0.38 per diluted shares, increases of 7% and 6% compared to the first quarter of 2013. As a result and due to our ability to successfully navigate multiple headwinds in the first quarter, we are reaffirming our guidance for revenue and adjusted net income for the full year 2014.

At the species level, we delivered 6% operational growth in companion animals and 4% operational growth in livestock. The 6% growth in companion animals was driven by a strong performance in Latin American countries due to the continued increase in the medicalization rates and the positive impact of our new canine product, Apoquel, in the U.S., U.K., and Germany. Companion animal sales in the quarter were affected by the cold weather in the U.S. which reduced the number of pet owner visits to veterinarian clinics. In livestock, sales of our swine portfolio grew by 6%. This growth was tempered by the continued spread of porcine epidemic diarrhea virus, or PEDv, especially in the United States. Our poultry portfolio performed well, also growing by 6% in the U.S. Our Rotecc product which enhances our ability to deliver solutions focused on sound rotation principles for coccidiosis management, has been an important driver of this performance. Avian flu in some markets continued to impact the poultry industry. In cattle, we delivered operational growth of 13%. Performance in the U.S. and in Latin America was strong while performance in Australia and some European markets declined.

I would now like to share with you some of the performance highlights for our four regions. In Asia Pacific, we delivered operational revenue growth of 4%. Revenue for the region’s emerging markets grew by 14%, offsetting a decline in the more developed markets. We remain confident that for the full year, operational growth for the region will be faster than the average of Zoetis. Despite positive performance in Japan, New Zealand and China, sales of companion animal products declined by 2%. This was mainly due to the timing and price and promotional activities in Australia, a market that represents 36% of our companion animal revenue in the Asia Pacific region. In livestock, our business grew by 7%. The strong revenue growth in countries like China and India was partially offset by the negative growth in Japan, New Zealand and Australia. In Australia, it was due to the ongoing conditions of the weather in the market.

Our business in Canada-Latin America delivered operational growth of 10% with companion animals and livestock growing 15% and 9%. Companion animal growth in the region was driven by the continued increase in the medicalization rates in the majority of the Latin American countries and the positive results in Canada. In livestock, we delivered strong performance in our poultry business in Brazil, Mexico, Venezuela, and Peru. Here demand for our medicated feed additives was particularly strong. We saw positive performance of our cattle business with strong contributions from Venezuela, Mexico, Brazil, Argentina, and Uruguay.

Our business in Europe-Africa-Middle East declined by 4% operationally. This performance was primarily associated with the declines of our livestock product sales, which Glenn will cover in his remarks. During the first quarter of 2014, the companion animal business in EuAfME grew by 1% thanks to the successful launch of Apoquel in the U.K., Germany and certain other markets. In addition, we saw a positive response to our promotional activity for our parasiticide portfolio in France, Italy and several emerging markets in the region. We also saw additional competition for our vaccines and (indiscernible). Livestock sales in the region declined 6% operationally. Despite this decline, we saw positive performance of the cattle business in southern Europe and in some emerging markets in the region.

Now to the U.S., where the business grew by 6%. This result was driven by a number of factors. First in companion animals, the business grew by 18%. Here we saw the positive impact of the launch of Apoquel which partially offset the impact of cold weather conditions that reduced the number of visits by pet owners to veterinarian clinics. Then in livestock in the U.S., we delivered 7% growth. This was positively impacted by the performance of our cattle business which was due in part to a higher number of feed lot placements, the higher price of (indiscernible), and the cold weather that increased demand for respiratory vaccines and antibiotics. We are encouraged by signs of the U.S. cattle being rebuilt after drought conditions (indiscernible). Poultry in the U.S. continued its strong performance. Many factors have contributed to this growth. These include our Rotecc program mentioned previously and the successful introduction of our conditionally licensed Georgia 08 vaccine, and in addition we have seen growth in our (indiscernible) poultry vaccine line.

Our swine business in the U.S. continued to be impacted by the ongoing spread of PEDv. As a result of the virus, the USDA forecasts a reduction in the size of the U.S. swine herd of approximately 10%. Despite this, we delivered growth due to the positive performance of the products that we introduced in 2013, such as Draxxin 25 and Engain.

As in previous quarters, the business of both our producers and veterinarian customers continued to feel the impact of a number of external factors such as weather and disease outbreaks. These factors have a degree of impact on our own performance given the nature of the direct relationships that we have with our customers. On climate, customers in the markets in the southern hemisphere such as Australia and New Zealand have continued to be adversely affected by the drought conditions. These conditions negative impact our livestock business due to the pressure they place on producers to feed and maintain large herds. In the northern hemisphere, a very cold winter has negatively impacted our customers. In our livestock business, these conditions created an increased need for anti-infective vaccines. In our companion animal business, it had reduced the number of visits being made to vet clinics in the quarter. While these conditions have been particularly harsh and extreme in some markets, they are the reality that our customers face on an ongoing basis.

Moving now to disease outbreaks, the spread of PEDv that we have talked about previously continues. During the last quarter, PEDv has continued to spread into the U.S. as well as in Mexico and Canada. In the U.S., 30 states have now confirmed at least one case of PEDv and reports suggest that approximately half of the U.S. sow population has been infected. In Mexico, the virus has reportedly infected nearly a third of swine herds. The virus has also continued to be active in Asia Pacific with active cases present in a range of new markets, including Japan, South Korea and Taiwan. These add to instances of the virus having been reported in China, Thailand the Philippines. Herds are being hit hard by the outbreak and fewer piglets are surviving.

With higher prices being paid for swine herds when they go to the market, we believe that producers may now be investing more in keeping those still in their herds healthy. This means that they will likely turn to premium products to achieve a greater return of investment from growing pigs, especially as market prices for pork products continue to increase. At Zoetis, we have advanced our research efforts to understand the safety, efficacy and manufacturing of an effective vaccine candidate. This is in partnership with Iowa State University and we continue to make progress in pursuit of a diagnostic tool in collaboration with the University of Minnesota. We are actively monitoring the continued evolution of the PEDv outbreak on the swine industry as well as any impact in our revenues.

One of the core characteristics of our business is the depth and diversity of our product portfolio. This enables us to actively minimize the challenge created by any given species, geography, therapeutic area, or product. As we have shared with you previously, our R&D effort is focused not only on the development of new products but also the life cycle development and continuous improvement of all our brand assets. During the first quarter of 2014, we continued to secure regulatory approvals for existing products that have been introduced into new geographies or that have their indications or claim extended. Furthermore, during the first quarter we launched a number of new products. This includes Bovishield Gold Oneshot, Fostera PCV, Fostera PRRS in Canada, Latin America and Thailand. Also on the topic of new products, I will provide a brief update on Apoquel.

Apoquel is an historic product for Zoetis and also for the industry. It joins our portfolio of already gold standard products and industry-leading brands across species and will have a positive impact on our business moving forward. In the first quarter, we continued to see high levels of customer acceptance for this innovative new treatment. The product was launched in the U.S., U.K., Germany, and certain other markets. The strong demand we have seen for the product has exceeded our initial expectations and has been generated by customers switching faster than anticipated from existing treatment options to Apoquel.

The manufacturing process for Apoquel is complex and lengthy. This means that our ability to significantly ramp up production quickly to meet the high level of demand is limited. As a result, there are some restrictions on stock availability. To ensure that dog currently on Apoquel continue to receive treatment, we are allocating current product availability to those patients. Based on current reactions, we expect the situation to be normalized by the end of the first quarter 2015 and for Apoquel to represent approximately 1% of revenue by the end of 2014.

Moving now to the close of my remarks. First, let me say that I see our overall performance for the first quarter of 2014 as positive. This is because we delivered operational growth in revenue of 4% and in adjusted net income of 8% while absorbing multiple headwinds. Second, Zoetis remains committed to its full-year guidance number on revenues and EPS previously provided. Our revenue growth for the year is in line or faster than expected market growth, now that the (indiscernible) has reduced their industry outlook for 2014. They now expect growth to be at the rate of around 2% in nominal U.S. dollar terms and around 5% in constant currency terms.

With that, thank you for your attention and I will now ask Glenn to walk us through the financial results. Glenn?

Glenn David

Thank you, Juan Ramon. It’s a pleasure to be here today and to join you as acting Chief Financial Officer. As some of you know, I have been working with Juan Ramon since 2011 when I joined the Pfizer animal health business, and I’ve been part of the Zoetis earnings process for the last year in my role as Senior Vice President of Finance Operations. Let me start today with a review of the first quarter results and then discuss our guidance for full-year 2014.

Turning to the income statement slide, for the first quarter revenue was approximately $1.1 billion, an increase of 1% year-over-year including a negative impact of 3 percentage points from foreign exchange, so operational growth excluding currency was 4%. Reported net income was $155 million or $0.31 per diluted share and adjusted net income was $191 million or $0.38 per diluted share, representing growth of 7% and 6% respectively. Adjusted net income for the quarter excludes the after-tax impact of $36 million or $0.07 per diluted share for purchase accounting adjustments, acquisition-related costs, and certain significant items.

Let’s now turn to our adjusted net income statement slide, which I will discuss primarily on an operational basis. Again, operational revenue growth was 4%. Companion animal sales were 35% of sales in the quarter and grew $12 million or 3%. Livestock sales were 64% of sales in the quarter and grew $28 million or 4%. The remaining 1% of sales is attributed to client supply services which was realigned this quarter. I will explain more about that in a minute.

Adjusted cost of sales declined operationally by about 2% due to the impact of unfavorable items in the prior year’s quarter. Adjusted cost of sales was 34.2% of revenue versus 36.5% in the year-ago quarter, reflecting the operational decline in cost of sales as well as a 50 basis point benefit in the current quarter from foreign exchange. We expect our cost of sales to increase as a percent of revenue in the remaining quarters, particularly in the second half of the year, and bring us in line with the full-year guidance we are reaffirming today. This reflects the recognition of additional costs from building our global manufacturing and supply organization which will be most evident in the second half of the year, as well as our expectation that foreign exchange will not have as favorable an impact on gross margin.

Meanwhile, adjusted SG&A increased by 4% operationally in the first quarter. In the first two quarters of 2013, we were still building out many of the corporate functions needed to support Zoetis as an independent public company. We largely completed this process in the third quarter of last year and this unfavorable comparison is the primary driver of SG&A growth in the first quarter of 2014, accounting for approximately half of the increase in this expense. Adjusted R&D expense decreased 2% operationally.

Interest expense was up $7 million in the quarter due to the completion of our debt offering at the end of January 2013. This reflects the impact of an additional month of interest expense versus the prior year which is greater than the one month of interest allocation we received from Pfizer in our carve-out financials. Overall, we did a good job on expense management in the first quarter. Our operating expenses grew at a slower pace than revenue, even when including the unfavorable comparison in SG&A that I mentioned.

Adjusted other income and deductions was negatively impacted by $5 million in FX losses related to the Argentine peso. In the year-ago quarter, we reflected the impact of the currency devaluation in Venezuela. In our segment reporting, you will find the impact from the Argentine peso in our corporate line item while the impact of the devaluation in Venezuela in 2013 is reported as part of our Canada-Latin America segment.

Our effective adjusted tax rate for the first quarter was approximately 31%. This rate is elevated versus prior periods due to the impact of a discrete item in the quarter, but we continue to expect an effective tax rate for the year of approximately 29%. Again, our adjusted net income was $191 million, representing reported growth of 7% and operational growth of 8%. This performance demonstrates our ability to grow adjusted earnings faster than revenue despite the challenges we have outlined.

Now onto our segment results. I will discuss these on an operational basis, but it should be noted that segment earnings are pre-tax numbers and reported on an adjusted basis. I will also highlight some of the more significant foreign exchange impacts in the regional results. I want to mention that effective this quarter, we have realigned our segment reporting with respect to our client supply services organization, or CSS, which provides contract manufacturing services for third parties. The revenue and earnings associated with CSS are now reported within other business activities separate from the four reportable segments. In 2013, CSS results were reported in the EuAfME segment. First quarter results for 2014 and 2013 reflect the new segment structure.

Beginning with the U.S., first quarter revenue was $479 million, an increase of 6%. As Juan Ramon discussed earlier, sales of livestock products grew 7% with contributions across cattle, poultry and swine. Sales of companion animal products grew 3%. This was driven by the introduction of Apoquel which was partially offset by the effects of cold weather conditions in the first quarter. Meanwhile, U.S. segment earnings increased 19% due to revenue growth, improvement in cost of goods, and the delayed timing of promotional investments based on the unfavorable weather impact in the quarter.

Now turning to our Europe-Africa-Middle East region, or EuAfME. In EuAfME, first quarter revenue was $270 million, a decrease of 4% operationally. Sales of livestock products decreased 6% operationally. This decline was largely driven by the U.K. and is the result of two major factors: first, an unfavorable comparison to the year-ago quarter regarding rebates which should normalize throughout the year; second, in 2014 we have taken actions to more tightly monitor and manage customer inventory build-ups that normally occur in advance of price increases. These efforts negatively impacted our livestock product growth in the quarter.

Meanwhile, poultry products were negatively impacted by regulatory issues which have since been resolved, and swine products were impacted by competitive pricing issues and a reduction in the use of anti-infectives. All of these items were tempered by the growth of cattle product sales in emerging markets. Meanwhile, sales of companion animal products grew 1% operationally primarily due to the introduction of Apoquel. EuAfME segment earnings decreased 2% operationally primarily due to the revenue decline which was mitigated by strong expense discipline.

Turning to our Canada and Latin America segment, or CLAR, first quarter revenue was $168 million, an increase of 10% operationally. This segment saw significant negative impact on revenue of 12 percentage points due to foreign exchange. The FX impact was primarily due to shifts in Brazil as well as Argentina and Canada. Sales of livestock products grew 9% operationally driven largely by poultry in Brazil and cattle and swine product sales across other Latin American markets. Livestock sales in Canada were relatively flat.

Sales in companion animal products grew 15% operationally largely due to increased sales in Brazil, Mexico and Argentina. CLAR segment earnings increased 11% on an operational basis, driven by strong revenue growth as well as gross margin and operating expense levels that stayed in line with revenues. Reported growth of 23% is higher than the operational growth, which was primarily driven by the unfavorable impact of the currency devaluation in Venezuela in the first quarter of 2013 which we discussed earlier.

In Asia Pacific, or APAC, first quarter sales were $169 million, an increase of 4% operationally. Our APAC segment also felt the significant impact from foreign exchange with the Australian dollar, Japanese yen and Indian rupee all contributing to a negative 7 percentage point impact on revenue. Sales of livestock products grew 75 operationally driven primarily by sales of swine products in China and Japan, poultry products in India, and cattle products in China. This growth was slightly offset by a decline in cattle product sales in Japan, New Zealand and Australia.

Sales of companion animal products declined 2% operationally largely due to declines in Australia driven by competitive pressures in parasiticides and declines in customer inventory levels related to the timing of price increases versus the prior year. APAC segment operating earnings decreased 2% operationally due to unfavorable mix as well as the timing of promotional investments.

Now let me turn to guidance for the full-year 2014. We have now reported one quarter of the fiscal year and remain confident in our ability to deliver on our full-year financial guidance. As a result, we are reaffirming all aspects of our financial guidance for full-year 2014. We continue to expect reported revenue of approximately $4.65 billion to $4.75 billion for the full year. This guidance also reflects an unfavorable impact of approximately 1.5 percentage points related to the year-over-year impact from foreign exchange. You would typically expect the foreign exchange impact on the bottom line to be relatively consistent with our overall margins; however, there are mitigating items in other P&L line items this year that largely offset this impact. Please note that our guidance does not include any further currency devaluations in Venezuela.

Our guidance on adjusted cost of goods sold for full-year 2014 remains approximately 35.5% of revenue, roughly flat year-over-year. This reflects the anticipated benefit of price, volume and ongoing cost saving efforts which is forecasted to be offset by the full-year impact of cost incurred to build global manufacturing and supply functions as well as unfavorable mix. The incremental costs will be reflected primarily in the second half of 2014.

Adjusted SG&A expenses are expected to be between $1.43 billion and $1.48 billion for the full year. We expect between 1% to 2% of operational growth in this line item to come from the unfavorable comparison in our corporate functions. Adjusted R&D expenses are expected to be between $390 million and $405 million for the full year. We continue to expect our effective tax rate on adjusted income to be approximately 29% for the full year. This guidance does not reflect the potential extension of the U.S. R&D tax credit in 2014.

Finally, we continue to expect adjusted EPS of between $1.48 and $1.54 per share. This guidance reflects our ability to achieve our profitability targets as we absorb multiple headwinds in 2014, including the incremental cost of standing up our global manufacturing and supply operations, unfavorable comparisons in corporate function expense, and an additional month of higher interest expense. Separately, we continue to estimate pre-tax charges for 2014 of between $165 million and $185 million primarily related to stand-up and acquisition-related costs which are excluded from our adjusted earnings guidance. Including the impact of these items, as well as purchase accounting adjustments, our guidance for reported diluted EPS for full-year 2014 remains between $1.15 and $1.21 per share.

This 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 products this year. Our long-term value proposition remains anchored in three objectives: to grow revenue in line with or faster than the market, to grow adjusted net income faster than revenue, and to find investment opportunities with strong returns to our business and return excess capital to shareholders.

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

John O’Connor

Thank you, Glenn. Operator, first question, please.

Question and Answer Session

Operator

Thank you. [Operator instructions]

Our first question is coming from Chris Schott with JP Morgan. Please go ahead.

Jessica Fye – JP Morgan

Hey there, it’s Jessica Fye on for Chris. Two questions – one, can you just elaborate on the cattle trends in the U.S. this quarter. What inning are we in in terms of recovery from the drought, and maybe mention feed lot and positive herd size trends. And then secondly, recognizing that there are going to be some quarter-to-quarter variability in your business, are there any trends you’re seeing in the second quarter thus far that we should be aware of?

Juan Ramon Alaix

Thank you, Jessica. Let me answer the comment on cattle and then also the recovery that we can see on the second quarter. So on cattle, definitely the drought impact has been already solved, and the drought mainly impacted the price of the corn. The price of the corn now, it’s at a level which is in line with what we had before the drought impact. But we have seen in the U.S. is that the cattle has been declining in 2013. According to information that we have from external sources, the cattle herd declined by 2%, which compares the number of animals at the beginning of January of 2014 compared to the same period in 2013. We expect that now that the price of beef is very high, it’s really reaching record highs in terms of price, there will be an incentive for cattle producers to rebuild the herd; but this will take some years, as we expressed previously, because it takes two to three years really to have these rebuilt. We expect that at the end of 2014, the herd will have a small increase of a little bit less than 1%. Also, because of some of the cows will be kept to rebuild the herd, there will be less placement during 2014. We saw a significant increase in the first quarter in the number of placements by 5%. We expect that in the following quarters, this will have some moderated placement and at the end of the year will be in line with 2013 or slightly below.

In terms of what we expect for the following quarter, I think we have some unique items in the first quarter. In the U.K., Australia, also the cold weather in the U.S., we expect these items not affecting our performance in the quarter, and if you see our guidance, we are maintaining the guidance which means we expect higher growth in the remaining quarters. Additionally, we have a significant impact on foreign exchange in the first quarter. Based on current exchange rates, we expect that in the second quarter the impact will be much lower.

John O’Connor

Operator, next question, please.

Operator

We’ll go next to Kevin Ellich with Piper Jaffray. Please go ahead.

Kevin Ellich – Piper Jaffray

Good morning. Two questions for you guys. First, Juan Ramon, could you give us your thoughts on the pig virus, what the impact was this quarter, and I think you guys had a new product, ractopomine Engain that was expected to launch in Q1. I’m wondering if it did and how it’s doing. And then the second question I had, had to do with the weather impact in the U.S. on the companion animal business. Could you quantify that for us, and what sort of growth have you seen coming out into the second quarter? Thanks.

Juan Ramon Alaix

Thank you, Kevin. So let’s start with PEDv. The PEDv, it’s affecting significantly the swine industry. The estimate of the total impact is 50% of sows have been affected by the virus, and this is translating into something like a 10% reduction on the herd in swine. The impact on the first quarter as well as the rest of the quarters is something that we are incorporating in our guidance, and we are also managing this situation because again, the price of pork is very high and this is also incentivating producers to use products that will protect better the animal that will have more value. So we have in one side, the negative impact of PEDv affecting a number of animals, but at the same time the high value of these animals which is increasing the use of premium price, which is the space where we mostly compete. So there are two elements that are in some way balancing, although the impact on PEDv will be higher.

In terms of ractopomine, we launched Engain. This product is specifically for swine. The product has been introduced already and it’s—the results are in line with our expectations, and we expect Engain to compensate partially the negative impact of PEDv.

In terms of companion animals that you also asked what was the impact of the cold weather in the U.S., the impact was mainly related to two factors: one, it was a reduced number of visits to veterinarian clinics, and second there was a delay in terms of growing tics and fleas. Now the situation, it’s normalized and we expect that this temporary impact will be compensated in the second quarter. Definitely we have some revenues that will be lost because of these pet owners not visiting the clinics, but on the total year we don’t think that this will represent a significant impact. In any case, it is already incorporated in our guidance.

John O’Connor

Operator, next question, please.

Operator

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

David Redford – BMO Capital Markets

Good morning, this is David Redford on behalf of Alex Arfaei. I was wondering if you could add a bit more color to the discrete item that increased your tax rate this quarter and whether or not you’re open to a transaction that would lower your tax rate, such as a merger or tax inversion.

Juan Ramon Alaix

I will ask Glenn to answer this question, David.

Glenn David

Sure, so thanks for the question, David. Related to the higher ETR in the quarter, it’s driven by a non-recurring discrete item, as we discussed, and it’s related to an intercompany inventory adjustment. While the impact is fairly significant for the quarter, over the course of the year we believe it’s very manageable within the overall tax rate that we reaffirmed today of approximately 29%.

In terms of our view of entering into any further transactions, we continue to evaluate all options to increase the value of our business. At this point in time, we do not see ourselves entering into a transaction like you mentioned, and I also want to mention that we are subject to certain provisions under the Tax Matters Agreement which might limit our ability to do that.

John O’Connor

Operator, next question, please.

Operator

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

Wesley Nurss – ISI Group

Hi, this (indiscernible) sitting in for Mark today. I have one quick follow-up on the gross margins. Was there any impact to the gross margin related to geographic or species mix, and could that affect kind of the trend for the remainder of the year? I also had a question about Apoquel. You mentioned that supply was outpacing demand. Can you quantify that to any extent? And then also, I believe I heard for Apoquel there were some manufacturing issues related to that product. Isn’t Apoquel just a small molecule? Can you describe a little bit further some of the challenges there and why it will take until the first quarter of ’15 to resolve those issues? Thank you.

Juan Ramon Alaix

Thank you, Wes. I will answer on Apoquel and then Glenn will cover the question on the gross margin. Apoquel is still having big sales over time, reaching the status of (indiscernible), so more than $100 million, and we remain confident that this product will significantly exceed this $100 million. What we estimated for 2014 was a switch from current therapies, mainly steroids, to Apoquel at a different rate than we have seen after the introduction of the product, so this has created a higher demand than expected, and because of manufacturing it’s complex, we need to really produce all this product, which is a small molecule, but it takes something like 12 months from the raw materials through API – active pharma ingredient – and then finished good. We have the limitations of this lengthy manufacturing period to ramp up production and to meet all the demand of the market. As I said, we expect that the manufacturing will be normalized in 2015 and at that time we’ll be able really to supply all the demand for the product.

And now, Glenn will answer the question on gross margin.

Glenn David

Sure. So in relation to the question on gross margin and specifically to geographic mix, emerging markets did outpace revenue growth of the developed markets this quarter, so that was a negative driver on mix for the quarter; however, in terms of the favorable impacts of gross margin, we referenced the impact of foreign exchange providing about a 50 basis point benefit. That’s driven by the fact that FX at revenue had a negative impact of 3% but at adjusted cost of sales it had a favorable impact of 4%, so that drove the 50 basis point improvement.

The other thing in terms of cost of sales is we do expect the cost of goods sold in the second half of the year to increase as the cost of building up our global manufacturing and supply organization will be most evident in the second half, and that will bring us in line with the 35.5% guidance we confirmed today.

John O’Connor

Operator, next question, please.

Operator

We’ll go next to John Krieger with William Blair. Please go ahead.

John Krieger – William Blair

Hi, thanks very much. Can you talk about any changes that you might be seeing among your customers in anti-infective usage? I think you mentioned in your prepared remarks that you saw some reduction in swine. Are you seeing any signs that that might be broadening out to other regions or other species?

Juan Ramon Alaix

Thank you for the question. Definitely the pressure to reduce the use of antibiotics in regions like Europe and more specifically in western Europe continues affecting industry revenues. In 2013, the use of anti-infectives in Europe declined by 7%. This was not only because of the pressure but also the introduction of some generic products into this space. If you will compare the 7% of the industry decline to our 2% decline, it indicates that we have been managing very well the challenge on antibiotics in western Europe and we have been able really, thanks to the breadth of our portfolio and the direct interaction with our customers, to maintain a strong position in antibiotics. The antibiotic pressure was mainly focused on northern Europe while in southern Europe or eastern Europe or Africa-Middle East, we don’t see a significant restriction on the use of anti-infectives. If I move to other regions, I would say that in the U.S., for instance, the focus has been on restrictions related to the use of anti-infectives in growth promotion. We agree with the FDA to remove this indication from our label to those products have this growth promotion indication, and overall we think that despite this pressure that definitely will continue in Europe, and we have seen new regulations in countries like Belgium or France. We expect the antibiotic to continue growing at a lower basis, although a lower pace than the growth of animal health.

John O’Connor

Operator, next question, please.

Operator

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

Erin Wilson – Bank of America

Great, this is Erin Wilson in for Willoughby. On Apoquel, will there be significant incremental cost associated with normalizing supply by 2015, and can you speak to also the recent industry consolidation based on your experience following the Wyeth and Pfizer merger and other mergers as well? Could you benefit potentially from divestitures in specific product lines from some of your competitors? Does that represent an opportunity for you to benefit from sales force defections or other changes?

Juan Ramon Alaix

Thank you, Erin, and I will ask Glenn to comment on this question on the cost.

Glenn David

So Erin, specific to your question on Apoquel, we don’t see a significant increase in cost related to ramping up production. In general, increased volumes relate to additional efficiencies and should be a beneficial factor to cost in the long term.

Juan Ramon Alaix

Okay, and you also asked about M&A and the consolidation of—the impact in terms of the consolidation. So first, I think the recent news on this consolidation, in my opinion, are positive for the animal health industry because they are showing the high value of the assets in this industry. At the same time, I don’t see that this is changing significantly the competitive landscape, so in our opinion the model that we have, which is going to the market that we have a direct force, direct sales force, also supporting our revenue with innovation in terms of R&D, and high quality manufacturing is a model that has been showing significant strength. As a reference, in 2013 the market grew by 7%--4%, sorry, and Zoetis grew by 7%. This indicates that despite the challenge or despite consolidation and even the time that we were involved in the separation from Pfizer, so we were able to grow much faster than the market.

John O’Connor

Operator, next question, please.

Operator

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

Chris Caponetti – Morgan Stanley

Hi, thanks very much. It’s Chris Caponetti for Dave. I was hoping you could tell me what operating cash flow was during the quarter, and then separately if you could just prioritize your uses of cash given what appears to be, I guess, a more limited interest in transformative M&A, at least over the near term. Thank you.

Juan Ramon Alaix

I will ask Glenn to go into the details of this cash plan, but let me have some general comments on our cash philosophy. Definitely Zoetis will generate predictable and steady cash flow. We will identify opportunities that will increase the value of our company, and one of the areas that we think that we can increase value is also accessing opportunities in terms of M&A. We will assess opportunities based on (indiscernible) and also the return on the investment, and definitely we have integrated many companies in the past. We have the knowledge and the capabilities to make these integrations successful and we will continue assessing any opportunity that the market will offer.

And now, Glenn can provide some additional comments on cash.

Glenn David

Sure. So in terms of the cash flow statement for the quarter, as part of our earnings release process we don’t provide balance sheet or cash flow information. That information will be available in the 10-Q to be filed next week.

John O’Connor

Operator, next question, please.

Operator

We’ll go next to Louise Chin with Guggenheim. Please go ahead.

Louise Chin – Guggenheim

Hi, thanks for taking my question. So first question I had was on your pricing power. I know you’ve historically been able to drive a lot of pricing power, and I’m curious is that is particular to Zoetis or it’s sort of an industry-wide figure. And then secondly on cash flow, based on my modeling, it looks like you’ll be generating a lot of strong cash flow over the next several years, and I was wondering if you could comment if that is a correct assumption or not. Then lastly, we’ve gotten some pushback on your operating cost – you know, that you’re going to have to separate from Pfizer and that cost is higher than expected. I’m just curious how you’re going to meet your gross margin and operating margin expansion targets despite the near-term increase in costs. Thank you.

Juan Ramon Alaix

Thank you, Louise, for the questions. Definitely we have pricing power and then we have increasing prices in most of the countries. Definitely in countries which are more developed, we have more opportunities to increase prices while in emerging markets, because of local competition, we see the opportunity in terms of volume higher than prices. In general in the industry, it’s also increasing prices, and according to external sources (indiscernible), they are indicating that on the total growth anticipated for 2014, this 5% will be balanced between price and volume. We are confident that because of our model and the strength of our portfolio, we’ll be able really to implement the price increases in most of the geographies.

In terms of the question on separating costs, maybe Glenn can provide some comments on that.

Glenn David

Sure. So the guidance that we reaffirmed today does include some certain significant items and acquisition-related costs primarily related to standing up the organization that we’ll experience in 2014. In terms of the operating costs, the guidance also reflects some of the dyssynergies that we may experience this year related to being an independent company, and we highlighted some of those in terms of the incremental costs related to our corporate functions and some of the incremental costs in terms of building up our global manufacturing and supply organization, but we still believe in the long-term ability to be able to grow expenses at the rate of inflation.

Juan Ramon Alaix

And let me finish with your question on cash flow. Definitely this company will generate cash in a way that will be strong and also predictable and steady, and we will use the cash in a way that will maximize the value of Zoetis and also the value for the shareholders.

John O’Connor

Operator, next question, please.

Operator

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

Liav Abraham – Citi

Good morning. Just a follow-up question on your tax rate. I understand from your commentary that you’re not focused on a tax inversion at this point, at least not in a material way. Can you talk to the opportunities that you have for potential reduction of your tax rate on a standalone basis over the medium term? Thanks very much.

Glenn David

Sure. So in reaffirming our tax rate of 29%, we also indicated that that does not include the benefit of the R&D tax credit, which could provide an additional benefit of about 50 basis points. I’ll just reaffirm what the company has said in the past, that the rate of approximately 29% is generally the long range rate in which we think we could operate.

John O’Connor

Operator, next question, please.

Operator

We’ll go next to Jamie Rubin with Goldman Sachs. Please go ahead.

Ariel Herman – Goldman Sachs

Hi, this is Ariel Herman in for Jamie. So just a couple quick ones. Regarding Apoquel, how much did this contribute to your overall growth, so another way of asking this is what would the growth be ex-Apoquel? And then when you think about new products versus the current or base business, how should we think about the growth in each of the segments, so how fast are new products growing versus potentially the base business declining? Then separately just to follow up on the industry consolidation question, I believe you stated previously that scale is one of the strengths of Zoetis, so if competitors are getting bigger and consolidating, how could this potentially affect you? Thanks.

Juan Ramon Alaix

Thank you, Ariel. On Apoquel, Apoquel will represent in 2014 approximately 1% of our total revenues, so it means that in terms of revenue growth, it will represent also about this 1%. Our model is not based on bringing new products to compensate the loss of exclusivity or the duration of the old portfolio, but our model is to continue investing in our current portfolio in a way which is a balance with the investment that we make in generating new products. So because of generic competition has a different impact in our industry, we are able really to continue supporting our product with (indiscernible) life cycle management. We can continue investing in indications, we can continue investing in the current portfolio, moving a product from different species. We can also work on combining producers to maintain these products fresh and generating growth, and also we can invest in expanding our portfolio geographically. Definitely new products will represent a portion of our growth, and if you take our total growth, a portion will come from price- we mentioned that this will be approximately 50% of our revenue growth will be coming from price, and then in terms of volume two-thirds will be coming from our current portfolio and the way that we are maintaining our current portfolio life, and one-third will be coming from new products. These are general statements that can be different depending on the years and depending on the new product introductions or the success of being in also innovation to our current portfolio.

In terms of what will be the impact of the consolidation since some of our competitors will increase scale, we are already competing with large companies, companies that already generate more than $3 billion, and we have been proving that our business model is extremely effective and efficient, and we based our model, as I mentioned, in our great introductions, bringing innovation in both new products and supporting our existing portfolio, and the quality and reliable supply. The combination of all these elements and the way that we are executing our strategies is what is making our differentiation in the market, and we are convinced that despite this consolidation we remain very competitive and growing in line or slightly faster than the market, despite having a market share of 20%. And very important, also our plan is to increase our earnings faster than revenues with the right focus on expenses and also the right focus on improving gross margin.

John O’Connor

Operator, we have time for one more question.

Operator

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

David Krempa – Morningstar

Great, thanks for taking the question. If we look at the significant differences in margin compared to the international markets versus the U.S., would you say the biggest driving factor there is solely the pricing or are there still scale benefits you can realize there that should improve as you grow, or at nearly a billion dollars in these regions are you already taking advantage of all the scale opportunities there and we shouldn’t expect any significant increases in these margins going forward?

Juan Ramon Alaix

Well, margins are definitely affected by the product mix and also affected by species mix and geography mix. In smaller markets, we don’t have the same economies of scale that we can generate in the U.S. As these markets are growing, we’ll see also that the margin will improve because they will increase the absorption of all the expense infrastructure that we have been building to maximize the opportunities in these markets. I’m convinced that our margin will continue growing. As I mentioned, we’ll be growing revenues in line or faster than market, but margins or earnings will be growing faster than revenues. This will increase our margin opportunities.

I don’t know, Glenn, if you want to add any additional comment on that?

Glenn David

No, the only thing I’ll add is to Juan Ramon’s point about the expectation to grow revenue—to grow income faster than revenue. We expect that across all of our regions, both the developed and the emerging.

Operator

I’d like to turn the conference back over to Juan Ramon for any closing or additional remarks.

Juan Ramon Alaix

So thank you, all of you for joining us on today’s call, and thank you for your interest in Zoetis and our first quarter performance. 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 1-800-677-6124 for U.S. listeners, and 402-220-0664 for international. Please disconnect your lines at this time and have a wonderful day.

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