Zoetis Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter ended June 30, 2013; six-month results are compared with the six months ended July 1, 2012. Zoetis, a global animal-health medicines and vaccines company operating in more than 120 countries, completed its full separation from Pfizer on June 24, 2013. This is its first quarter-end as a fully independent public company.
Financial performance
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Revenue | $1.114 billion | $1.094 billion | $2.204 billion | $2.141 billion |
| Net income attributable to Zoetis | $128 million | $173 million | $268 million | $284 million |
| Diluted EPS | $0.26 | $0.35 | $0.54 | $0.57 |
| Adjusted net income (non-GAAP) | $178 million | $176 million | $357 million | $328 million |
| Operating cash flow | Not provided for the quarter | $269 million | $70 million |
Q2 revenue increased 2% as 4% operational growth was partly offset by $19 million of unfavorable foreign exchange. First-half revenue rose 3% (4% operational growth, offset by a 1% FX headwind). Q2 GAAP net income fell 26%; first-half net income fell 6%, while adjusted net income rose 1% and 9%, respectively. Management attributed the GAAP decline chiefly to standalone-company costs, higher interest expense after the debt offering, and prior-year favorable legal and reserve items that did not recur.
Gross margin was approximately 62.7% in Q2 versus 65.4% a year earlier, and 62.9% for the first half versus 64.0%. Q2 cost of sales rose 10% to $416 million and SG&A rose 16% to $399 million; first-half increases were 6% and 11%, respectively. R&D was $95 million in Q2 and $185 million for the first half.
By region, U.S. revenue increased 4% in Q2 and 5% for the first half; APAC increased 4% and 2%. EuAfME declined 2% in Q2 but grew 2% for the first half; CLAR grew 1% in Q2 and was flat for the first half. Companion-animal revenue grew faster than livestock revenue in both periods. Dogs and cats, vaccines, and U.S. sales were notable growth contributors.
Cash, debt and liquidity
- Cash and cash equivalents were $369 million at June 30, 2013, versus $317 million at December 31, 2012. Working capital was $1.761 billion; the current ratio was 2.33:1.
- First-half operating cash flow was $269 million, compared with $70 million in the prior-year period. Investing cash outflow was $74 million, including $80 million of capital expenditures; financing cash outflow was $140 million. Ending cash increased by $52 million.
- Long-term debt was $3.640 billion net of discount, representing $3.650 billion principal across notes due 2016, 2018, 2023 and 2043. Short-term borrowings were $12 million. The $1.0 billion revolving credit facility and $1.0 billion commercial-paper program had no borrowings outstanding.
- The company declared a quarterly dividend of $0.065 per share; $33 million was payable at quarter-end. The filing says cash, operating cash flow and available financing are expected to support future needs, while noting macroeconomic and financing-market uncertainty.
Material changes and unusual items
- Zoetis issued $3.65 billion of senior notes in January 2013 and used substantially all net proceeds, together with other separation consideration, in connection with its separation from Pfizer. Pfizer completed the exchange offer in June and no longer owns Zoetis shares.
- The balance sheet at June 30 is on a different presentation basis from the December 31, 2012 combined balance sheet; debt, cash, tax balances and equity were affected by separation adjustments. Prior-year operating results also include Pfizer cost allocations and are not necessarily representative of standalone costs.
- Standalone-company and separation costs were $77 million in Q2 and $111 million for the first half, included among significant items. Zoetis reaffirmed expected 2013 nonrecurring costs of approximately $200–$240 million, with a further $100–$140 million expected in 2014.
- A previously recorded $27 million European employee-termination reserve was reversed in Q2 after Zoetis decided not to implement that plan as originally designed. Management expected a revised, significantly smaller charge to be estimable before year-end.
- Other notable items included a $9 million first-half foreign-currency loss associated primarily with Venezuela’s devaluation and a $6 million gain on a government-mandated sale of Brazilian product rights.
- The interim financial statements received an independent accountant’s review, not an audit. The accountant reported no material modifications needed for conformity with U.S. GAAP.
Guidance, commentary and risks
Management reaffirmed full-year 2013 guidance: revenue of $4.425–$4.525 billion; reported diluted EPS of $1.00–$1.06; and adjusted diluted EPS of $1.36–$1.42. Adjusted cost of sales was forecast at 35%–36% of revenue, adjusted SG&A at $1.385–$1.435 billion, adjusted R&D at $385–$415 million, adjusted interest expense at approximately $115 million, and an adjusted effective tax rate of approximately 29.5%. These are forward-looking estimates, not results.
- Risks include new restrictions on antibacterials used in food-producing animals; product safety, quality or efficacy concerns; competition and generic products; adverse weather and drought; animal disease outbreaks; foreign-exchange movements; macroeconomic weakness; and the success of R&D and product launches.
- The filing notes a European Commission procedure concerning Suvaxyn PCV after a recall of two batches following higher-than-expected adverse reactions. The regulator was reviewing proposed manufacturing changes and possible action on the product authorization.
- Legal matters include Roxarsone-related claims, PregSure-related claims, patent litigation concerning Advocin, and environmental and labor claims in Brazil. Management states it cannot estimate reasonably possible legal losses in excess of recorded accruals. A €11 million European Commission fine relating to former human-health activity is indemnified by Pfizer; Zoetis recorded a matching receivable and liability and was preparing an appeal.
- Separation-related uncertainties include reliance on Pfizer transitional services and manufacturing arrangements, standalone operating costs, tax-related restrictions and indemnities, and the risk that separation benefits may not be achieved. Management cited drought effects on cattle products and said H7N9 and PEDV were not then expected to have significant 2013 revenue impacts.
Key facts for investors to verify
- Track whether revenue growth converts into margin and GAAP earnings as standalone costs and debt interest continue.
- Compare reported and adjusted results, including the size, timing and classification of separation and other excluded costs.
- Monitor delivery against 2013 revenue and EPS guidance, and the estimated $200–$240 million of 2013 nonrecurring costs.
- Review debt service, credit-facility covenant headroom, cash generation and the sustainability of dividends.
- Follow Suvaxyn PCV regulatory developments, other product-safety matters, and legal exposures for which potential losses beyond accruals are not estimable.
- Assess standalone financial comparability carefully: 2012 results include Pfizer allocations, and the June 2013 balance sheet is not directly comparable with the December 2012 combined balance sheet.