Zoetis Inc. quarterly report, Q3 FY2015

Business context and reporting period

Zoetis Inc. is a global animal-health medicines and vaccines company serving livestock and companion-animal markets. This unaudited Form 10-Q covers the quarter ended September 27, 2015, and the nine months then ended; comparisons are with the periods ended September 28, 2014. The company reports two geographic segments: U.S. and International.

Financial performance and condition

• Revenue and growth: Reported Q3 revenue was nearly flat, while operational revenue growth (excluding foreign exchange) was 9%, comprising 6% volume and 3% price growth. Nine-month operational growth was also 9%; foreign exchange reduced reported growth by 8%.
• Profit and margins: Q3 pretax income was $273 million versus $238 million. Nine-month pretax income was $476 million versus $665 million, chiefly reflecting $280 million of restructuring and acquisition-related charges, compared with $10 million a year earlier. The effective tax rate was 30.4% for Q3 and 33.0% for the nine-month period. Calculated from reported revenue and cost of sales, gross margin was approximately 65.3% in Q3 versus 64.1%, and 64.4% for nine months versus 64.6%.
• Cash flow: Nine-month operating cash flow was $386 million, up from $239 million. Investing used $378 million, including $229 million cash paid for Abbott Animal Health assets; financing used $271 million, including $150 million of share repurchases and $127 million of dividends. Cash declined $290 million to $592 million.
• Debt and liquidity: At September 27, cash was $592 million; reported debt included $400 million current and $3,226 million long-term debt, plus $8 million short-term borrowings. Working capital was $1.792 billion and the current ratio 2.08:1, versus $2.379 billion and 3.19:1 at year-end 2014. The company reported compliance with debt covenants and no borrowings under its $1 billion revolving facility at quarter-end.

Material changes versus prior comparable periods

• U.S. Q3 revenue rose 19% to $632 million, while International revenue fell 15% to $569 million as reported, largely due to currency translation; International operational revenue grew 2%. For nine months, U.S. revenue rose 15% and International reported revenue declined 10%, despite 4% operational growth.
• Companion-animal sales were a growth driver: Q3 operational sales rose 18%, supported by Apoquel and the Abbott acquisition. Livestock sales rose 5% operationally in Q3. For nine months, companion-animal and livestock sales grew 12% and 7% operationally, respectively.
• Q3 GAAP net income increased 14%, while nine-month GAAP net income fell 31%. Adjusted net income increased 22% for Q3 and 15% for nine months. Adjusted results exclude purchase accounting adjustments, acquisition-related costs, and certain significant items; they are non-GAAP and not directly comparable across companies.
• Cash increased from operating activities, but acquisition spending, repurchases, dividends, and currency translation contributed to a lower cash balance. Accounts receivable and inventories increased from year-end; the company cited delayed collections partly related to U.S. ERP billing disruptions.

Outlook, commentary, risks and unusual items

• 2015 guidance: Revenue of $4.7–$4.75 billion, operational growth of 6.5%–7.5%, adjusted diluted EPS of $1.70–$1.74, adjusted net income of $855–$875 million, and reported diluted EPS of $0.82–$0.89. Guidance included $470–$490 million of certain significant items and acquisition-related costs. These are management estimates subject to stated risks.
• Efficiency program: Announced in May 2015, the program targets elimination of about 5,000 product SKUs, sale or exit of ten manufacturing sites over the long term, and reduction of approximately 2,000–2,500 positions. Management estimated approximately $300 million annual cost savings by 2017, alongside expected reductions of about $280 million in revenue and $100 million in gross profit by 2017. Expected pre-tax charges were $420–$480 million, excluding non-cash items; $280 million of restructuring and certain acquisition-related costs had been recorded in the nine-month period.
• Acquisitions: The company acquired certain Abbott Animal Health assets for a stated purchase price of $254 million, including $229 million cash and contingent consideration. Subsequent to quarter-end, Zoetis announced an agreement to acquire PHARMAQ for $765 million, expected to close in Q4 2015 and intended to be financed with its revolving credit facility. It also amended the facility’s leverage covenant for a qualifying material acquisition.
• Key exposures: Management cited foreign exchange and currency controls, particularly Venezuela; changes in regulation of antibacterials used in food-producing animals; animal disease outbreaks, weather and demand variability; manufacturing capacity and product-supply challenges; competition and R&D execution; and ERP implementation risks. The company reported that earlier FDA Form 483 observations had been resolved to the FDA’s satisfaction; USDA follow-up on certain biological-product compliance matters continued.
• Contingencies: Legal matters include PregSure-related claims, environmental litigation in Brazil, lascadoil-related claims, and remaining contract claims concerning recalled poultry vaccines in Mexico. Management stated it did not believe these matters would materially affect financial position, but said outcomes are uncertain and it could not estimate reasonably possible losses above accrued amounts. Uncertain tax positions were $60 million, excluding $8 million of related interest and penalties.
• The independent accountant performed an interim review, not an audit, and reported no material modifications were needed to the interim financial statements for U.S. GAAP conformity.

Important facts for investors to verify

1. Whether operational revenue growth and expected savings from the efficiency program offset planned product, site, and workforce reductions, and whether costs remain within the $420–$480 million estimate.
2. The extent to which currency movements, Venezuela exchange-rate assumptions and collections restrictions affect reported revenue, cash conversion, and asset recoverability.
3. Whether receivables and inventories normalize after ERP-related billing disruptions and production transfers, and how working capital affects future operating cash flow.
4. Funding and leverage implications of the PHARMAQ acquisition, the $400 million 2016 note maturity, and the amended revolving-credit covenant.
5. Developments in manufacturing capacity and Apoquel supply, regulatory matters, antibacterials policy, and the identified legal and tax contingencies.
6. The assumptions and exclusions behind adjusted earnings and full-year guidance, including the substantial gap between adjusted and reported EPS.