Zoetis Inc. — Q1 2018 Form 10-Q
Business context and period. Zoetis is a global animal-health medicines and vaccines company serving livestock and companion-animal markets. This unaudited report covers the three months ended March 31, 2018, compared with the three months ended April 2, 2017. International subsidiaries report on periods ending in February; the filing states results were not adjusted for this timing difference because the impact was not material.
Financial performance and liquidity
| Metric | Q1 2018 | Prior period | Change |
|---|---|---|---|
| Revenue | $1.366 billion | $1.231 billion | +11% reported; +7% operational |
| Gross profit / gross margin | $919 million / 67.3% | $788 million / 64.0% | Margin +3.3 percentage points |
| Income before taxes | $417 million | $337 million | +24% |
| Net income attributable to Zoetis | $352 million | $238 million | +48% |
| Diluted EPS | $0.72 | $0.48 | +50% |
| Adjusted net income (non-GAAP) | $365 million | $261 million | +40% |
| Adjusted diluted EPS (non-GAAP) | $0.75 | $0.53 | +42% |
| Operating cash flow | $389 million | $119 million | Increased $270 million |
- Revenue growth included approximately 7% operational growth and a 4% favorable foreign-exchange contribution. In-line product volume, new products, and pricing contributed approximately 3%, 2%, and 2%, respectively.
- International revenue was $726 million, up 18% reported and 11% operationally; U.S. revenue was $634 million, up 5%. Companion-animal revenue grew 14% globally, and livestock revenue grew 10%.
- Cost of sales rose just 1% while revenue increased 11%; cost of sales declined to 32.7% of revenue from 36.0%, reflecting manufacturing efficiencies, partly offset by unfavorable foreign exchange. SG&A rose 9% to $338 million and R&D rose 8% to $97 million.
- The effective tax rate fell to 16.1% from 29.1%, primarily reflecting the lower U.S. federal tax rate under the Tax Act and changes in earnings mix. This lower rate materially supported reported earnings growth.
- Cash and cash equivalents were $1.654 billion at March 31, up from $1.564 billion at year-end. Working capital was $3.267 billion and the current ratio was 4.27:1.
- Long-term debt, net of discount and issuance costs, was $4.954 billion; cash less this debt implies net debt of approximately $3.3 billion. No amounts were drawn under the $1.0 billion revolving facility, and the company reported compliance with its financial covenants.
- Investing cash outflow was $45 million, including $53 million of capital expenditures. Financing cash outflow was $262 million, including $190 million of share repurchases and $62 million of dividends paid. The declared quarterly dividend was $0.126 per share.
Material changes and management commentary
- International segment earnings increased 23% reported (15% operationally), supported by revenue growth and improved gross margin. U.S. segment earnings rose 7%, with growth and improved gross margin. Management cited dermatology and new products among growth drivers; U.S. livestock growth was partly offset by weak dairy conditions and competition affecting certain products.
- Management attributed higher SG&A to compensation, foreign exchange, professional services, and new-product promotion. R&D spending rose with project investment, compensation, foreign exchange, and inclusion of an acquired Irish biologics business.
- Operating cash flow improved substantially, but management attributed the increase both to higher income and to the timing of ordinary-course receipts and payments. Tax-account movements were also significant in the cash-flow reconciliation; the filing does not identify the full amount of the increase as recurring.
- The company repurchased approximately 2.4 million shares under its authorization during the quarter; approximately $810 million remained available at quarter-end.
- Zoetis adopted the new revenue-recognition standard on January 1, 2018, using the modified retrospective method; no opening retained-earnings adjustment was required. The company recorded approximately $4 million of contract liabilities at March 31.
Outlook, risks, contingencies, and unusual items
- The filing refers to 2018 financial guidance but the supplied filing text does not provide clear quantitative guidance. Management said cash, operating cash flow, and available financing were expected to meet foreseeable funding needs, while noting that economic conditions could affect future liquidity or financing access.
- The Tax Act’s one-time mandatory deemed-repatriation tax was initially recorded as a provisional $212 million net tax expense in 2017, payable over eight years. Zoetis recorded a $2 million first-quarter tax benefit adjustment and said its accounting remained incomplete within the permitted measurement period. The company had not yet selected an accounting policy for GILTI tax effects.
- Uncertain tax-position liabilities were $191 million, excluding $12 million of related interest and penalties. Management said outcomes of tax audits and disputes could affect results, but did not expect a significant decrease in uncertain positions within the next 12 months.
- Legal matters include environmental proceedings in Brazil, an appeal relating to animal-feed contamination litigation (claims against Zoetis had been dismissed, with appeal proceedings pending), and an appeal of a European Commission competition decision. Management said it could not estimate reasonably possible losses above amounts accrued; it did not believe the matters would materially affect financial position, although results or cash flows could be affected when resolved.
- Key business risks include animal disease outbreaks, product safety or quality concerns, regulation of products used in food-producing animals, generic and other competition, customer or distributor consolidation, foreign-exchange volatility, weather, R&D execution, and tax-law changes. Approximately 51% of revenue was denominated in foreign currencies; currency movements increased reported year-over-year revenue growth by approximately 4%.
- The company expects to complete its supply-network strategy over several years. Most of its operational-efficiency program was substantially completed by year-end 2017. Adoption of the lease accounting standard in 2019 was not expected to significantly affect income statements, but could materially affect balance-sheet assets and liabilities.
Most important facts for investors to verify
- Whether operational revenue growth and margin improvement persist, particularly in International markets, companion-animal products, and key dermatology lines.
- How much of earnings growth reflects sustainable operating performance versus the lower Tax Act-driven tax rate, and how the provisional tax accounting is finalized.
- Whether the strong operating cash flow is repeatable, given management’s emphasis on timing of receipts and payments and movements in tax accounts.
- Debt-service capacity, use of cash for repurchases and dividends, and compliance with credit-facility covenants.
- Developments in the disclosed legal and tax contingencies, foreign-exchange exposure, competitive pressure, and animal-health regulatory risks.