Zoetis Inc. — Q3 2016 Form 10-Q
Reporting period: Third quarter ended October 2, 2016; comparisons are with the quarter ended September 27, 2015. Nine-month figures include six additional calendar days in 2016. Amounts are in U.S. dollars, millions unless noted.
Business context and results
Zoetis is a global animal-health medicines and vaccines company serving livestock and companion-animal markets. It reports U.S. and International operating segments and sells products in more than 100 countries.
- Q3 revenue: $1,241, up 2% reported and 4% operationally; foreign exchange reduced growth by 2%. U.S. revenue was $640 (+1%); International revenue was $585 (+3% reported, +6% operationally).
- Nine-month revenue: $3,611, up 3% reported and 7% operationally; foreign exchange reduced growth by 4%. U.S. revenue rose 7% to $1,816; International revenue was $1,754, flat reported and up 7% operationally.
- Product mix: Q3 companion-animal revenue rose 9% to $490, led by dogs and cats; livestock revenue declined 2% to $735. For nine months, companion-animal revenue rose 14% to $1,479, while livestock revenue declined 3% to $2,091. Apoquel and new launches supported growth; portfolio rationalization weighed on sales.
- Profit: Q3 net income attributable to Zoetis was $239 (+26%); diluted EPS was $0.48 versus $0.38. Nine-month net income was $667 versus $317; diluted EPS was $1.34 versus $0.63. Prior-year nine-month results included substantially higher restructuring and other significant charges.
- Adjusted results (non-GAAP): Q3 adjusted net income was $258 (+2%) and adjusted diluted EPS $0.52 (+4%). Nine-month adjusted net income was $743 (+10%) and adjusted diluted EPS $1.49 (+11%).
- Margins and costs: Cost of sales was 33% of revenue in Q3 versus 35% a year earlier, and 33% for nine months versus 36%. U.S. gross margin was 78.6% for Q3 and 77.9% for nine months; International gross margin was 65.6% and 65.9%, respectively, both above comparable 2015 levels.
- Cash flow: Nine-month operating cash flow was $427 (versus $386); capital expenditures were $156. Investing cash outflow was $155 and financing cash outflow $775. Cash declined $503 to $651, primarily reflecting debt repayment, repurchases, dividends, and acquisition-related payments.
Financial position and material changes
- At October 2, cash was $651; working capital was $2,325 and the current ratio 3.24:1. Current liabilities declined to $1,039 from $1,781 at year-end, including repayment of $400 of debt due in 2016 and payment of dividends payable.
- Long-term debt was $4,467, compared with $4,463 at December 31, 2015; total principal debt was $4,501. No short-term borrowings or revolving-facility borrowings were outstanding. The company was in compliance with debt covenants.
- Q3 interest expense rose to $41 from $29; nine-month interest expense rose to $125 from $86, mainly reflecting the $1.25 billion senior-note issuance in November 2015. The $400 million notes due in 2016 were repaid.
- Inventory increased to $1,563 from $1,467, primarily supporting launches and seasonal safety stock. Share repurchases totaled approximately five million shares in the first nine months; $75 million remained under the authorization.
- Q3 reported earnings benefited from lower operating costs and stronger segment performance. The nine-month comparison also benefited from much lower restructuring charges: the 2016 period recorded a $15 net benefit versus $280 of charges in 2015. Divestiture gains and tax items also affected comparability.
Outlook, commentary, risks, and unusual items
- The filing provides no specific numerical revenue or earnings guidance. Management stated it believes cash, operating cash flow, and available financing are sufficient for foreseeable needs, while noting that economic conditions could affect future liquidity or financing access.
- Management cited Apoquel, new product launches, acquisitions, favorable product mix, and efficiency initiatives as growth or margin contributors. Product and market rationalization reduced revenue growth by approximately 5% in both the Q3 and nine-month operational-growth discussions.
- Foreign exchange remained a headwind: it reduced nine-month revenue growth by 4%; approximately 46% of nine-month revenue was denominated in foreign currencies. The company reported using operational measures and derivatives to manage exposures.
- The Belgian excess-profits ruling dispute resulted in a $38 net tax expense in the first half of 2016. The company reported $87 of uncertain-tax-position liabilities, excluding interest and penalties, and considered a further approximately $22 decrease in reserves reasonably possible within 12 months, related to an expected remaining payment.
- Restructuring and efficiency efforts include plans to eliminate approximately 2,000–2,500 positions; about 1,800 had been eliminated by October 2. The company had divested three U.S. manufacturing sites, one international site, and its Taiwan joint-venture interest, and warned that site changes may cause supply disruption or fail to deliver planned savings.
- Other risks include disease outbreaks, manufacturing or supply interruptions, competition and generic products, regulatory changes, foreign exchange and currency controls, tax disputes, and product-liability, patent, environmental, and commercial litigation. Zoetis said it could not estimate reasonably possible losses in excess of legal accruals.
- Specified legal matters include approximately 255 PregSure-related claims, three consolidated lawsuits concerning lascadoil contamination in animal feed, and a remaining contract-based suit related to recalled poultry-vaccine lots in Mexico. The company stated it believed its defenses were strong; outcomes remain uncertain.
- Other notable items: the Denmark veterinary-diagnostics acquisition cost $80, including contingent consideration; a South American livestock acquisition had $22 of milestone payments outstanding. The independent accountant performed an interim review, not an audit, and reported no material modifications needed to the interim statements.
Key facts investors should verify
- Whether reported and adjusted earnings growth is sustainable after accounting for restructuring, acquisition-related amortization, divestiture gains, and discrete tax effects.
- How companion-animal growth, especially Apoquel and new launches, compares with livestock declines and the effects of portfolio rationalization.
- Whether foreign-exchange pressures, inventory growth, and lower cash balances affect future cash generation and liquidity.
- Progress and execution costs of the workforce and manufacturing-footprint changes, including any supply interruptions or realized savings.
- Resolution and cash impact of the Belgian tax matter and disclosed legal contingencies.
- Debt refinancing needs, including the $750 million 1.875% note due in 2018, and the company’s financing and interest-cost outlook.