Zoetis Inc. — Q2 2014 Form 10-Q
Business context and period. Zoetis is a global animal-health medicines and vaccines company serving livestock and companion-animal markets in more than 120 countries. This unaudited report covers the three and six months ended June 29, 2014; comparisons are to periods ended June 30, 2013. The 2013 six-month comparison includes pre-separation results and Pfizer cost allocations, so it may not be directly comparable with Zoetis as a standalone company.
Financial performance
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $1,158 million | $1,114 million | $2,255 million | $2,204 million |
| Income before taxes | $200 million | $187 million | $427 million | $379 million |
| Net income attributable to Zoetis | $136 million | $128 million | $291 million | $268 million |
| Diluted EPS | $0.27 | $0.26 | $0.58 | $0.54 |
| Operating cash flow | Not stated for quarter | Not stated for quarter | $136 million | $269 million |
Margins and expenses. Gross margin was approximately 64.3% in Q2 and 64.9% for the first half, versus 62.7% and 62.9%, respectively, in 2013. Pretax margin was 17.3% in Q2 and 18.9% for the first half; net margin attributable to Zoetis was 11.7% and 12.9%, respectively. First-half effective tax rate rose to 31.1% from 29.3%; Q2 rate declined to 30.5% from 31.6%.
Revenue drivers. Reported revenue grew 4% in Q2 and 2% in the first half. Excluding foreign exchange, operational revenue grew 6% and 5%, respectively, from volume and pricing; currency reduced reported growth by about 2 percentage points in Q2 and 3 points in the first half. Livestock operational sales increased 9% in Q2 and 6% year to date; companion-animal sales rose 2% in both periods. Q2 operational growth was led by the U.S. and CLAR; first-half segment operational revenue increased in the U.S., CLAR and APAC, while EuAfME was flat. PEDv tempered swine growth.
Cash flow, liquidity and debt. First-half operating cash flow fell to $136 million, primarily due to changes in operating assets and liabilities, including timing of receipts and payments and lower accrued compensation. Investing cash outflow was $95 million, including $87 million of capital spending and a $15 million milestone payment; financing cash outflow was $74 million, mainly dividends. Cash declined $32 million to $578 million. Working capital was $2.266 billion and the current ratio was 3.14:1. Long-term debt was $3.642 billion and short-term borrowings were $12 million; the $1.0 billion revolving facility was undrawn and all financial covenants were met. Senior notes mature in 2016, 2018, 2023 and 2043. Dividends declared were $0.072 per share for the first half; none were declared in Q2.
Material changes and unusual items
- GAAP net income attributable to Zoetis rose 6% in Q2 and 9% in the first half; adjusted net income, a non-GAAP measure, rose 6% in each period to $189 million and $380 million. Adjusted diluted EPS was $0.38 for Q2 and $0.76 for the first half.
- Costs of sales, SG&A and R&D declined year over year in the first half. Cost of sales as a share of revenue improved to 35.1% from 37.1%; SG&A was 33% versus 34%, while R&D was 8% in both periods.
- Q2 included a $13 million charge for a commercial settlement and recall involving specific poultry-vaccine lots in Mexico. The filing says there were no manufacturing quality or efficacy issues identified, but a third-party storage issue may have affected efficacy; the lots were recalled and the product was unavailable in Mexico. Management did not expect significant additional charges.
- First-half significant items included $74 million of standalone-company “stand-up” costs, restructuring and pension-settlement charges, partly offset by gains and an insurance recovery. Q2 stand-up costs were $41 million. These items and purchase-accounting and acquisition costs are excluded from adjusted results.
- Zoetis updated 2014 guidance: revenue of $4.675–$4.750 billion; adjusted diluted EPS of $1.50–$1.54; reported diluted EPS of $1.16–$1.20; adjusted cost of sales about 35.5% of revenue; adjusted SG&A of $1.440–$1.480 billion; adjusted R&D of $390–$405 million; and an adjusted effective tax rate of about 29%. Estimated significant items and acquisition-related costs were $175–$195 million. Guidance depends on exchange rates and other uncertainties.
Outlook, risks and contingencies
- Management cited foreign exchange, competition, weather, herd and flock economics, disease outbreaks, regulation and product demand as factors that can affect results. It expected no significant 2014 revenue impact from PEDv or H7N9 at the time of filing, while continuing to monitor developments. Zoetis expected to seek a conditional USDA license for a PEDv vaccine in the second half of 2014.
- Key disclosed risks include restrictions on livestock antibacterials, animal-disease outbreaks, manufacturing interruptions or capacity imbalances, product recalls, foreign-currency and repatriation restrictions, and successful execution of multi-year financial-system and ERP implementations.
- Legal matters include product-related claims, patent litigation and environmental proceedings. Management stated it did not believe the matters would materially adversely affect financial position, but could not estimate reasonably possible losses above recorded accruals. PregSure-related claims remained ongoing; certain Roxarsone cases had been dismissed with prejudice.
- Tax liabilities for uncertain tax positions were $51 million, plus $9 million of related interest and penalties. Management did not expect a significant decrease within the next 12 months, but noted uncertainty in outcomes and timing.
- The interim statements received an independent accountant’s review, not an audit; the accountant reported no material modifications needed for conformity with U.S. GAAP.
Most important facts for investors to verify
- Whether operational revenue growth and margin improvement persist after the effects of foreign exchange and prior-year Pfizer separation costs.
- Whether the sharp first-half operating-cash-flow decline reverses, and how working capital, inventory build and customer collections develop.
- Progress against 2014 guidance, including the level and nature of excluded standalone, restructuring and other significant costs.
- Any further consequences or costs from the Mexico vaccine recall, and whether product availability and customer demand recover.
- Developments in PEDv, antibacterial regulation, manufacturing continuity, foreign-exchange exposure and ERP implementation, as well as material changes in litigation or tax contingencies.