Zoetis Inc. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; comparisons are with periods ended October 1, 2017. Zoetis develops, manufactures and sells animal health medicines, vaccines and diagnostics across U.S. and International segments. The filing notes a 2018 change to quarterly reporting dates for certain non-U.S. subsidiaries; prior periods were not adjusted because the impact was not material.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $1.480 billion | $1.347 billion | $4.261 billion | $3.847 billion |
| GAAP net income attributable to Zoetis | $347 million | $298 million | $1.083 billion | $783 million |
| Diluted EPS | $0.71 | $0.61 | $2.22 | $1.59 |
| Adjusted net income, non-GAAP | $403 million | $322 million | $1.143 billion | $844 million |
| Operating cash flow | Not provided for the quarter | Not provided for the quarter | $1.206 billion | $738 million |
- Reported revenue grew 10% in Q3 and 11% year to date. Operational growth, excluding foreign exchange, was 12% and 9%, respectively. Q3 foreign exchange reduced reported growth by about 2%; year-to-date exchange effects added about 2%.
- Consolidated gross margin, calculated from reported revenue and cost of sales, was approximately 68.0% in Q3 versus 67.7%; for nine months it was approximately 67.9% versus 65.7%. Management cited manufacturing efficiencies as a primary contributor.
- Operating cash flow of $1.206 billion was offset by $2.185 billion of investing outflows, principally the $1.884 billion net cash payment for Abaxis and $200 million of capital expenditures. Financing provided $730 million. Cash and cash equivalents ended at $1.286 billion, down from $1.564 billion at year-end 2017.
- Long-term debt, net, was $6.441 billion, up from $4.953 billion at year-end; total principal debt was $6.5 billion. Cash less reported net debt implies net debt of about $5.155 billion. Current assets were $4.076 billion and current liabilities $1.003 billion; working capital was $3.073 billion and the current ratio 4.06:1.
Changes and operating drivers
- Growth was strongest in companion animals: Q3 revenue rose 19% globally, while livestock revenue rose 3%. Dermatology products and newer products, including Simparica, supported growth. Abaxis contributed after its July 31 acquisition.
- Q3 U.S. segment revenue rose 11%; International revenue rose 8% reported and 12% operationally. International Q3 results faced currency headwinds, including depreciation of the Brazilian real, Argentine peso and Turkish lira. Year-to-date International revenue rose 14% reported and 11% operationally.
- Abaxis was acquired for approximately $1.962 billion of consideration. It contributed $42 million of post-acquisition revenue and a $32 million net loss for the period, including purchase-accounting amortization, inventory fair-value expense and acquisition-related severance. The purchase price allocation remains preliminary.
- Q3 restructuring and certain acquisition-related costs rose to $47 million from $8 million; nine-month costs were $54 million versus $7 million. Q3 interest expense increased 26% to $54 million, primarily following new debt issuance.
- GAAP net income increased 16% in Q3 and 38% year to date. Lower effective tax rates—17.0% for Q3 and 15.2% year to date, versus 28.3% and 28.6%—reflected the U.S. tax-rate reduction and Tax Act measurement-period benefits, including $23 million in Q3 and $58 million year to date.
Outlook, risks and unusual items
- The filing discusses 2018 financial guidance as a forward-looking topic, but the supplied filing text does not provide a clear numerical guidance range or update. Management said cash, operating cash flow and financing arrangements should meet foreseeable funding needs, while cautioning that economic conditions could affect liquidity or future financing access.
- In September, Zoetis received approximately $44 million from a divestiture of certain International agribusiness products and recorded an approximately $40 million pre-tax gain in Q4 2018; this is a subsequent event, not Q3 income.
- Key risks include foreign exchange volatility, disease outbreaks, competition and generic products, product safety or quality concerns, regulatory changes, trade tariffs, customer and distributor consolidation, and the success of R&D and acquisitions. The company reported approximately 49% of nine-month revenue denominated in foreign currencies.
- Zoetis reported $184 million of liabilities for uncertain tax positions, plus $11 million of related interest and penalties. It said it could not estimate the range of reasonably possible losses in excess of accruals for its legal contingencies. Disclosed matters include environmental proceedings in Brazil and an EU competition-law appeal; Pfizer is obligated to indemnify Zoetis for the identified EU fine under the separation agreement.
- Debt is substantial. The $1.0 billion revolving facility was undrawn and the company reported covenant compliance at September 30, 2018. A $300 million floating-rate note exposes the company to interest-rate changes. The company also repurchased about 7 million shares year to date for $548 million, with about $451 million remaining under its authorization.
- The interim financial statements received an independent accountant’s review, not a full audit. Management stated disclosure controls were effective; Abaxis integration was ongoing and its related controls continued to be evaluated.
Investor verification points
- Confirm current full-year guidance and how much of reported growth is organic versus Abaxis-related, foreign exchange and pricing.
- Track Abaxis integration, profitability, preliminary purchase accounting, goodwill and intangible-asset amortization.
- Assess debt-service capacity, refinancing and interest-rate exposure, and the effect of continued buybacks and dividends on cash.
- Separate recurring earnings and cash generation from Tax Act benefits, acquisition/restructuring costs and the China site relocation gain; review the Q4 agribusiness divestiture gain separately.
- Monitor tax-position resolutions, legal contingencies, currency movements, tariffs, disease and product/regulatory risks.