碩騰 (ZTS) 2014 Q1 法說會逐字稿

Welcome to the first-quarter 2014 financial results conference call and webcast for Zoetis. Hosting the call today is John O'Connor, head of Investor Relations for Zoetis.

The presentation materials and additional financial tables are currently posted on the Investor Relations section of Zoetis.com. The presentation slides can be managed by you, the viewer, and will not be forwarded automatically. In addition, a replay of this call will be available approximately two hours after the conclusion of this call, via dial in, or on the Investor Relations section of Zoetis.com.

(Operator Instructions)

It is now my pleasure to turn the floor over to John O'Connor. John, you may begin.

Thank you. Good morning, and welcome to the Zoetis first-quarter 2014 earnings call. I am joined today by Juan Ramon Alaix, our Chief Executive Officer, and Glenn David, our Senior Vice President of Finance Operations and acting Chief Financial Officer. Juan Ramon and Glenn will provide an overview of our quarterly results, and then we will open the call for your questions.

Before we begin, let me remind you that the earnings press release and financial tables can be found on the Investor Relations section of Zoetis.com. We are also providing a simultaneous webcast of this morning's call, which can be accessed on the website as well. A PDF version of today's slides and a transcript of the call will be available on the website later today.

Our remarks today will include forward-looking statements and actual results could differ materially from those projections. For a list and description of certain factors that could cause results to differ, I refer you to the forward-looking statement in today's press release and our SEC filings, including but not limited to our 2013 10-K and 10-Qs.

Our remarks today will also include references to certain financial measures, which were not prepared in accordance with generally accepted accounting principles, or US GAAP. These non-GAAP adjusted figures exclude the impact of purchase accounting adjustments, acquisition-related costs, and certain significant items, such as the nonrecurring cost of becoming a standalone public company. A reconciliation of these non-GAAP financial measures to the most directly comparable US GAAP measures is included in the financial tables that accompany our press release and in the Company's 8-K filing, dated today, May 6, 2014.

We also cite operational results, which exclude the impact of foreign exchange. Prior to the completion of our IPO last year, Zoetis was not an independent public company, and the first quarter of 2013 includes results from periods that were derived from the consolidated financial statements and records of Pfizer, which can make comparisons difficult in certain instances. With that, I will turn the call over to Juan Ramon.

Thank you, John, and hello, everyone. Before moving into some of the details of our call today, I would first like to address a recent change in the Company's executive team. On April 22, we announced that Glenn David, Senior Vice President for Finance Operations, was named the Company's acting Chief Financial Officer. I am delighted that Glenn is here with me on today's call, and he will speak with you as we move through the details of our first-quarter performance.

First, let me share some of the highlights from the quarter, beginning with our high-level financials. We concluded the first quarter with revenue growth of 1%, or 4% operational. Adjusted net income for the first quarter was $191 million, or $0.38 per diluted share, increases of 7% and 6% compared to the first quarter of 2013. As a result, and due to our ability to successfully navigate multiple headwinds in the first quarter, we are reaffirming our guidance for revenue and adjusted net income for the full year 2014.

At the species level, we delivered 3% operational growth in companion animal and 4% operational growth in net livestock. The 3% growth in companion animal was driven by a strong performance in Latin American countries, due to the continued increase in the medicalization rates and the positive impact of our new canine product APOQUEL in the US, UK, and Germany. Companion animal sales in the quarter were affected by the cold weather in the US, which reduced the number of pet owner visits to veterinarian clinics.

In livestock, sales of our swine portfolio grew by 6%. This growth was tempered by the continued spread of Porcine Epidemic Diarrhea virus, or PEDv, especially in the United States.

Our poultry portfolio performed well, also growing by 6%. In the US, our Rotecc program, which enhances our ability to deliver solutions, focused on sound rotation principles for coccidiosis management, has been an important driver of this performance. Avian flu, in some markets, continues to impact the poultry industry.

In cattle, we delivered operational growth of 3%. Performance in the US and in Latin America was strong, while performance in Australia and some European markets declined.

I would now like to share with you some of the performance headlines for our four regions. In Asia-Pacific, we delivered operational revenue growth of 4%. Revenue for the region's emerging markets grew by 14%, offsetting a decline in the more developed markets. We remain confident that for the full year, operational growth for the region will be faster than the average of Zoetis.

Despite positive performance in Japan, New Zealand, and China, sales of companion animal products declined by 2%. It was mainly due to the timing on price and promotional activities in Australia, a market that represents 36% of our companion animal revenue in the Asia-Pacific region.

In livestock, our business grew by 7%. The strong revenue growth in countries like China and India was partially offset by the negative growth in Japan, New Zealand, and Australia. In Australia, it was due to the ongoing conditions of the weather in the market.

Our business in Canada/Latin America delivered operational growth of 10%, with companion animal and livestock growing at 15% and 9%. Companion animal growth in the region was driven by the continued increase in the medicalization rates in the majority of the Latin American countries and the positive results in Canada.

In livestock, we delivered strong performance in our poultry business in Brazil, Mexico, Venezuela, and Peru. Here, demand for our medicated feed additives was particularly strong. We saw positive performance of our cattle business, with strong contributions from Venezuela, Mexico, Brazil, Argentina, and Uruguay.

Our business in Europe/Africa/Middle East declined by 4% operationally. This performance was primarily associated with declines of our livestock product sales, which Glenn will cover in his remarks. During the first quarter of 2014, the companion animal business in EuAfME grew by 1%, thanks to the successful launch of APOQUEL in the UK, Germany, and certain other markets.

In Asia, we saw a positive response to our promotional activity for our parasiticide portfolio in France, Italy, and several emerging markets in the region. We also saw additional competition for our vaccines and RIMADYL. Livestock sales in the region declined 6% operationally. Despite this decline, we saw positive performance of the cattle business in southern Europe and in some emerging markets in the region.

Now, to the US, where the business grew by 6%. This result was driven by a number of factors. First, in companion animal, the business grew by 3%. Here, we saw the positive impact of the launch of APOQUEL, which partially offset the impact of cold-weather conditions that reduced the number of visits by pet owners to veterinarian clinics.

Then, in livestock, the US, we delivered 7% growth. This was positively impacted by the performance of our cattle business, which was due in part to a higher number of feedlot placements, the higher price of calves, and the cold weather that increased the demand of respiratory vaccines and antibiotics. We are encouraged by signs of the US cattle being rebuilt after drought conditions have eased.

Poultry in the US continued its strong performance. Many factors have contributed to this growth. These include our Rotecc program, mentioning that previously, and the successful introduction of our conditionally licensed Georgia 08 vaccine. In addition, we have seen growth in our core poultry vaccine line.

Our swine business in the US continued to be impacted by the ongoing spread of PEDv. As a result of the virus, the USDA forecast a reduction in the size of the US swine herd of approximately 10%. In spite of this, we delivered growth due to the positive performance of the products that we introduced in 2013, such as DRAXXIN 25 and ENGAIN.

As in previous quarters, the business of both our producers and veterinarian customers continue to feel the impact of a number of external factors, such as weather and disease outbreaks. These factors have a degree of impact on our own performance, given the nature of the direct relationships that we have with our customers.

On climate, customers in markets in the Southern Hemisphere, such as Australia and New Zealand, have continued to be adversely affected by the drought conditions. These conditions negatively impact our livestock business due to the pressure they place on our producers to feed and maintain larger herds.

In the Northern Hemisphere, a very cold winter has negatively impacted our customers. In our livestock business, these conditions created an increased need for anti-infectives and vaccines. In our companion animal business, it has reduced the number of visits being made to vet clinics in the quarters. While these conditions have been particularly harsh and extreme in some markets, they are the reality that our customers face on an ongoing basis.

Moving now to disease outbreaks, the spread of PEDv that we have talked about previously continues. During the last quarter, the PEDv has continued to spread into the US as well as in Mexico and Canada. In the US, 30 states have now confirmed at least one case of PEDv, and reports suggest that approximately half of the US sow population has been infected.

In Mexico, the virus has reported infected nearly a third of swine herds. The virus has also continued to be active in Asia-Pacific, with active cases present in a range of new markets, including Japan, South Korea, and Taiwan. These add to instances of the virus having been reported in China, Thailand, and the Philippines.

Herds are being hit hard by the outbreak and fewer piglets are surviving. With higher prices being paid for swine herds when they go to the market, we believe that producers may now be investing more in keeping those still in their herds healthy. This means that they will likely turn to premium products to achieve a greater return of investment from growing pigs, especially as market prices for pork products continue to increase.

At Zoetis, we have advanced our research efforts to understand the safety, efficacy, and manufacturing of an effective vaccine candidate. This is in partnership with Iowa State University, and we continue to make progress in pursuit of a diagnostic tool in collaboration with the University of Minnesota. We are actively monitoring the continued evolution of the PEDv outbreak on the swine industry as well as any impact in our revenues.

One of the core characteristics of our business is the depth and diversity of our product portfolio. These enable us to actively minimize the challenge created by any given species, geography, therapeutic area, or product. As we have shared with you previously, our R&D effort is focused not only on the development of new products, but also the lifecycle development and continuous improvement of all our brand assets. During the first quarter of 2014, we continued to secure regulatory approvals for existing products that are being introduced into new geographies or that have their indications or claim extended.

Furthermore, during the first quarter, we launched a number of new products. These include BOVI-SHIELD GOLD ONESHOT, Fostera PCV, Fostera PRRS in Canada, Latin America, and Thailand.

Also on the topic of new products, I will provide a brief update on APOQUEL. APOQUEL is an historic product for Zoetis and also for the industry. It joins our portfolio of already gold-standard products and industry-leading brands across the species and will have a positive impact on our business moving forward.

In the first quarter, we continued to see high levels of customer acceptance for this innovative new treatment. The product was launched in the US, UK, Germany, and certain other markets. The strong demand we have seen for the product has exceeded our initial expectation and has been generated by customers switching faster than anticipated from existing treatment options to APOQUEL.

The manufacturing process for APOQUEL is complex and lengthy. This means that our ability to significantly ramp up production quickly to meet the high level of demand is limited. As a result, there are some restrictions on stock availability.

To ensure that dogs currently on APOQUEL continue to receive their treatment, we are allocating current product availability to those patients. Based on current predictions, we expect the situation to be normalized by the end of the first quarter 2015, and for APOQUEL to represent approximately 1% of Zoetis' revenue by the end of 2014.

So, moving now to the close of my remarks. First, let me say that I see our overall performance for the first quarter of 2014 as positive. This is because we delivered operational growth in revenue of 4% and an adjusted net income of 8% while absorbing multiple headwinds.

Second, Zoetis remains committed to its full-year guidance number on revenues and EPS previously provided. Our revenue growth for the year is in line of faster-than-expected market growth, now that the nurseries have reduced their industry outlook for 2014. They now expect growth to be at the rate of around 2%, in nominal US dollar terms, and around 5%, in constant currency terms.

With that, thank you for your attention, and I will now ask Glenn to walk us through the financial results. Glenn?

Thank you, Juan Ramon. It's a pleasure to be here today and to join you as acting Chief Financial Officer. As some of you know, I have been working with Juan Ramon since 2011, when I joined the Pfizer Animal Health business, and I have been part of the Zoetis earnings process for the last year in my role as Senior Vice President of Finance Operations. Let me start today with a review of the first-quarter results, and then discuss our guidance for full year 2014.

Turning to the income statement slide, for the first quarter, revenue was approximately $1.1 billion, an increase of 1% year over year, including a negative impact of 3 percentage points from foreign exchange. So, operational growth, excluding currency, was 4%.

Reported net income was $155 million, or $0.31 per diluted share, and adjusted net income was $191 million, or $0.38 per diluted share, representing growth of 7% and 6%, respectively. Adjusted net income for the quarter excludes the after-tax impact of $36 million, or $0.07 per diluted share, for purchase-accounting adjustments, acquisition-related costs, and certain significant items.

Let's now turn to our adjusted net income statement slide, which I will discuss primarily on an operational basis. Again, operational revenue growth was 4%. Companion animal sales were 35% of sales in the quarter and grew $12 million, or 3%. Livestock sales were 64% of sales in the quarter and grew $28 million, or 4%. And, the remaining 1% of sales is attributed to Client Supply Services, which was realigned this quarter. I will explain more about that in a minute.

Adjusted cost of sales declined operationally by about 2%, due to the impact of unfavorable items in the prior year's quarter. Adjusted cost of sales was 34.2% of revenue, versus 36.5% in the year-ago quarter, reflecting the operational decline in cost of sales, as well as a 50-basis-point benefit in the current quarter from foreign exchange.

We expect our cost of sales to increase as a percent of revenue in the remaining quarters, particularly in the second half of the year, and bring us in line with the full-year guidance we are reaffirming today. This reflects the recognition of additional costs from building our global manufacturing and supply organization, which will be most evident in the second half of the year, as well as our expectation that foreign exchange will not have as favorable an impact on gross margin.

Meanwhile, adjusted SG&A increased by 4% operationally in the first quarter. In the first two quarters of 2013, we were still building out many of the corporate functions needed to support Zoetis as an independent public company. We largely completed this process in the third quarter of last year, and this unfavorable comparison is the primary driver of SG&A growth in the first quarter of 2014, accounting for approximately half of the increase in this expense. Adjusted R&D expense decreased 2% operationally.

Interest expense is up $7 million in the quarter, due to the completion of our debt offering at the end of January 2013. This reflects the impact of an additional month of interest expense versus the prior year, which is greater than the one month of interest allocation we received from Pfizer in our carve-out financials.

Overall, we did a good job on expense management in the first quarter. Our operating expenses grew at a slower pace than revenue, even when including the unfavorable comparison in SG&A that I mentioned. Adjusted other income and deductions was negatively impacted by $5 million in FX losses related to the Argentine peso.

In the year-ago quarter, we reflected the impact of the currency devaluation in Venezuela. In our segment reporting, you will find the impact from the Argentine peso in our corporate line item, while the impact of the devaluation in Venezuela in 2013 is reported as part of our Canada/Latin America segment.

Our effective adjusted tax rate for the first quarter was approximately 31%. This rate is elevated versus prior periods due to the impact of a discrete item in the quarter, but we continue to expect an effective tax rate for the year of approximately 29%. And again, our adjusted net income was $191 million, representing reported growth of 7% and operational growth of 8%. This performance demonstrates our ability to grow adjusted earnings faster than revenue, despite the challenges we have outlined.

Now, on to our segment results. I will discuss these on an operational basis, but it should be noted that segment earnings are pre-tax numbers and reported on an adjusted basis. I will also highlight some of the more significant foreign-exchange impacts in the regional results.

I want to mention that effective this quarter, we have realigned our segment reporting with respect to our Client Supply Services organization, or CSS, which provides contract manufacturing services for third parties. The revenue and earnings associated with CSS are now reported within other business activities, separate from the four reportable segments. In 2013, CSS results were reported in the EuAfME segment. First-quarter results for 2014 and 2013 reflect the new segment structure.

Beginning with the US, first-quarter revenue was $479 million, an increase of 6%. As Juan Ramon discussed earlier, sales of livestock products grew 7%, with contributions across cattle, poultry, and swine. Sales of companion animal products grew 3%. This was driven by the introduction of APOQUEL, which was partially offset by the effects of cold-weather conditions in the first quarter. Meanwhile, US segment earnings increased 19% due to revenue growth, improvement in cost of goods, and the delayed timing of promotional investments based on the unfavorable weather impact in the quarter.

Now, turning to our Europe, Africa, and Middle East region, or EuAfME. In EuAfME, first-quarter revenue was $270 million, a decrease of 4% operationally. Sales of livestock products decreased 6% operationally. This decline was largely driven by the UK and is the result of two major factors.

First, an unfavorable comparison to the year-ago quarter regarding rebates, which should normalize throughout the year. Second, in 2014, we have taken actions to more tightly monitor and manage customer inventory buildups that normally occur in advance of price increases. These efforts negatively impacted our livestock product growth in the quarter.

Meanwhile, poultry products were negatively impacted by regulatory issues, which have since been resolved. And, swine products were impacted by competitive pricing issues and a reduction in the use of anti-infectives. All of these items were tempered by the growth of cattle product sales in emerging markets. Meanwhile, sales of companion animal products grew 1% operationally, primarily due to the introduction of APOQUEL. Europe-AfME segment earnings decreased 2% operationally, primarily due to the revenue decline, which was mitigated by strong expense discipline.

Turning to our Canada and Latin America segment, or CLAR, first-quarter revenue was $168 million, an increase of 10% operationally. This segment saw a significant negative impact on revenue of 12 percentage points due to foreign exchange. The FX impact was primarily due to shifts in Brazil as well as Argentina and Canada.

Sales of livestock products grew 9% operationally, driven largely by poultry in Brazil and cattle and swine product sales across other Latin American markets. Livestock sales in Canada were relatively flat. Sales of companion animal products grew 15% operationally, largely due to increased sales in Brazil, Mexico, and Argentina.

CLAR segment earnings increased 11% on an operational basis, driven by strong revenue growth as well as gross margin and operating expense levels that stayed in line with revenues. Reported growth of 23% is higher than the operational growth, which was primarily driven by the unfavorable impact of the currency devaluation in Venezuela in the first quarter of 2013, which we discussed earlier.

In Asia-Pacific, or APAC, first-quarter sales were $169 million, an increase of 4% operationally. Our APAC segment also felt a significant impact from foreign exchange, with the Australian dollar, Japanese yen, and Indian rupee all contributing to a negative 7 percentage-point impact on revenue. Sales of livestock products grew 7% operationally, driven primarily by sales of swine products in China and Japan, poultry products in India, and cattle products in China. This growth was slightly offset by a decline in cattle product sales in Japan, New Zealand, and Australia.

Sales of companion animal products declined 2% operationally, largely due to declines in Australia, driven by competitive pressures in parasiticides and declines in customer inventory levels related to the timing of price increases versus the prior year. APAC segment operating earnings decreased 2% operationally, due to unfavorable mix, as well as the timing of promotional investments.

Now, let me turn to guidance for the full year 2014. We have now reported one quarter of the fiscal year and remain confident in our ability to deliver on our full-year financial guidance. As a result, we are reaffirming all aspects of our financial guidance for full year 2014. We continue to expect reported revenue of approximately $4.65 billion to $4.75 billion for the full year.

This guidance also reflects an unfavorable impact of approximately 1.5 percentage points related to the year-over-year impact from foreign exchange. You would typically expect the foreign-exchange impact on the bottom line to be relatively consistent with our overall margins; however, there are mitigating items in other P&L line items this year that largely offset this impact. Please note that our guidance does not include any further currency devaluations in Venezuela.

Our guidance on adjusted cost of goods sold for full year 2014 remains approximately 35.5% of revenue, roughly flat year over year. This reflects the anticipated benefit of price, volume, and ongoing cost-saving efforts, which is forecasted to be offset by the full-year impact of costs incurred to build our global manufacturing and supply functions as well as unfavorable mix. The incremental costs will be reflected primarily in the second half of 2014.

Adjusted SG&A expenses are expected to be between $1.43 billion and $1.48 billion for the full year. We expect between 1% to 2% of operational growth in this line item to come from the unfavorable comparison in our corporate functions. Adjusted R&D expenses are expected to be between $390 million and $405 million for the full year.

We continue to expect our effective tax rate on adjusted income to be approximately 29% for the full year. This guidance does not reflect the potential extension of the US R&D tax credit in 2014.

And finally, we continue to expect adjusted EPS of between $1.48 and $1.54 per share. This guidance reflects our ability to achieve our profitability targets as we absorb multiple headwinds in 2014, including the incremental costs of standing up our global manufacturing and supply operations, unfavorable comparisons in corporate function expense, and an additional month of higher interest expense.

Separately, we continue to estimate pre-tax charges for 2014 of between $165 million and $185 million, primarily related to stand-up and acquisition-related costs, which are excluded from our adjusted earnings guidance. Including the impact of these items, as well as purchase-accounting adjustments, our guidance for reported diluted EPS for full year 2014 remains between $1.15 and $1.21 per share. This annual guidance reflects our confidence in the diversity of our portfolio, the strength of our business model, and our view of the evolving market conditions for animal health products this year.

Our long-term value proposition remains anchored in three objectives: to grow revenue in line with or faster than the market; to grow adjusted net income faster than revenue; and to find investment opportunities with strong returns to our business and return excess capital to shareholders. That concludes my prepared remarks, and now we will open the line for your questions. John?

Thank you, Glenn. Operator, first question please?

(Operator Instructions)

Chris Schott with JPMorgan.

Hey there, it's Jessica Fye on for Chris. Two questions -- one, can you elaborate on the cattle trends in the US this quarter? What inning are we in, in terms of recovery from the drought -- I know you mentioned feedlot and positive herd size trends. And then, secondly, recognizing that there can be some quarter-to-quarter variability in your business, are there any trends you're seeing in the second quarter, thus far, that we should be aware of?

Thank you, Jessica. Let me answer the comment on cattle, and then also the recovery that we can see in the second quarter. In cattle, definitely the drought impact, it has been already solved, and the drought mainly impacted the price of the corn. The price of the corn, now -- it's in that level which is in line with what we had before the drought impact. But what we have seen in the US is that the cattle has been declining in 2013. According to information that we have from external sources, the cattle herd declined by 2%. We compare the number of animals at the beginning of January of 2014 compared to the same period in 2013.

We expect that now the price of beef -- it's very high. It is really reaching a record high in terms of price. There will be an incentive for cattle producers to rebuild the herd, but this will take some years, as we expressed previously, because it takes two to three years really to have these rebuilt.

We expect that at the end of 2014 the herd will have a small increase of a little bit less of 1%. Also, because of some of the cows will be kept to rebuild the herd, there will be less placement during 2014. We saw significant increase in the first quarter in number of herd placements by 5%. We expect in the following quarters these will have some moderated placement, and at the end of the year, will be in line with 2013 or slightly below.

In terms of what we expect for the following quarter, we have some unique items in the first quarter in UK, Australia, also the cold weather in the US. We expect these items not affecting our performance in the quarter. And, you see our guidance, we are maintaining the guidance, what it means is we expect higher growth in the remaining quarters. Additionally, we have a significant impact on foreign exchange in the first quarter. Based on the current exchange rate, we expect that, in the second quarter, the impact will be much lower.

Operator, next question please.

Kevin Ellich with Piper Jaffray.

Good morning. Two questions for you guys. First, Juan Ramon, could you give us your thoughts on the pig virus, what the impact was this quarter? And, I think you guys had a new product, a ractopamine, ENGAIN, that was expected to launch in Q1 -- wondering if it did and how it is doing?

And then, the second question I had had to do with the weather impact in the US on the companion animal business; could you quantify that for us? What sort of growth have you seen coming into the second quarter? Thanks.

Thank you, Kevin. Let's start with PEDv. The PEDv, it's affecting significantly the swine industry. The estimate of the total impact is 50% of the sows has been affected by the virus. And, this translating into something like a 10% reduction on the herd in swine. The impact on the first quarter, as well as rest of the quarters, is something that we are incorporating in our guidance.

We are also managing this situation, because again, the price of pork, it's very high. And, this is also incentivating producers to use products that will protect better their animals that will have more value. So, we have in one side the negative impact of PEDv affecting the number of animals, but at the same time, the high value of these animals, which is increasing the use of a premium price, which is the space in where we mostly compete. So, there are two elements that are in some ways balancing, although the impact on PEDv will be higher.

In terms of ractopamine, we launched ENGAIN. This product is specific for swine. The product has been introduced already, and the results are in line with our expectations, and we expect ENGAIN to compensate, partially, the negative impact of PEDv.

In terms of companion animals, that you also asked what was the impact of the cold weather in the US? The impact was mainly related to two factors. One, it was a reduced number of visitors to veterinarian clinics. And second, there was a delay in terms of growing ticks and fleas. Now, the situation, it has normalized, and we expect that these temporary impact will be compensated in the second quarter. Definitely, we have some revenues that will be lost because of these pet owners not visiting the clinics. But on the total year, we don't think that this will represent a significant impact. In any case, it has been already incorporated in our guidance.

Operator, next question please.

Alex Arfaei with BMO Capital Markets.

This is David Redfern on behalf of Alex Arfaei. I was wondering if you could add a bit more color to the discrete item that increased your tax rate this quarter, and whether or not you are open to a transaction that would lower your tax rate, such as a merger or a tax inversion?

I will let Glenn to answer this question, David.

Sure, thanks for the question, David. Related to the higher ETR in the quarter, it is driven by a nonrecurring discrete item, as we discussed, and it's related to an inter-company inventory adjustment. And, while the impact is fairly significant for the quarter, over the course of the year, we believe it's very manageable within the overall tax rate that we have reaffirmed today of approximately 29%.

In terms of our view into entering into further transactions, we continue to evaluate all options to increase the value of our business. At this point in time, we do not see ourselves entering into a transaction like you mentioned. And, I also want to mention that we are subject to certain provisions under the Tax Matters Agreement, which might limit our ability to do that.

Operator, next question please.

Mark Schoenebaum with ISI Group.

Hi, this is Wes Nurss sitting in for Mark today. One quick follow up on the gross margins: was there any impact to the gross margins related to geographic or species mix? And, could that affect the trend for the remainder of the year? I also had a question about APOQUEL -- you mentioned that supply was outpacing demand; can you quantify that to any extent? Then, also, I believe I heard for APOQUEL, there were some manufacturing issues related to that product. Isn't APOQUEL just a small molecule? Can you describe a little bit further some of the challenges there, and why it will take until the first quarter of 2015 to resolve those issues? Thank you.

Thank you, Wes. I will answer on APOQUEL, and then Glenn will cover the question on gross margin. APOQUEL is still having at the peak sales, it means over time reaching the status of blockbuster, so more than $100 million. And, we remain confident that this product will significantly exceed this $100 million. What we estimated for 2014 was a switch from current therapies, mainly steroids, to APOQUEL at a different rate that we have seen after introduction of the product.

This has created a significant higher demand than expected, and because manufacturing is complex, we need really to produce all these products, which is a smaller molecule, but it takes something like 12 months from the raw materials through API, active pharmaceutical ingredient, and then finished good. And, we have the limitations of these lengthy manufacturing period to ramp up our production and to meet all the demands of the market. As I said, we expect that the manufacturing will be normalized in 2015, and at that time, we will be able to supply all the demands of the product. And now, Glenn will answer the question on the gross margin.

Sure. In relation to the question on gross margin, and specifically to geographic mix, emerging markets did outpace revenue growth of the developed markets this quarter, so that was a negative driver on mix for the quarter. However, in terms of the favorable impacts of gross margin, we referenced the impact of foreign exchange providing about a 50 basis point benefit. That is driven by the that FX at revenue had a negative impact of 3%, but at adjusted cost of sales, it had a favorable impact of 4%, so that drove the 50 basis point improvement.

The other thing, in terms of cost of sales, is we do expect the cost of goods sold in the second half of the year to increase as the costs of building up our global manufacturing and supply organization will be most evident in the second half, and that will bring us in line with the 35.5% guidance we confirmed today.

Operator, next question please.

John Kreger with William Blair.

Thanks very much. Can you talk about any changes that you might be seeing among your customers in anti-infective usage? I think you mentioned in your prepared remarks that you saw some reduction in swine. Are you seeing any signs that that might be broadening out to other regions or other species?

Thank you for the question. Definitely, the pressure to reduce the use of antibiotics in regions like Europe, and more specifically in Western Europe, continue affecting industry revenues. In 2013, the use of anti-infectives in Europe reduced by or declined by 7%. This was not only because of the pressure but also the introduction of some generic products into this space. If we compare this 7% of the industry decline to our 2% decline, it indicates we have been managing very well the challenge on antibiotics in Western Europe.

And, we have been able, really, thanks to the breadth of our portfolio, the direct interaction with our customers, to maintain a strong position in antibiotics. The antibiotic pressure was mainly focused on Northern Europe, while in Southern Europe or Eastern Europe or Africa/Middle East, we don't see significant restrictions on the use of anti-infectives. And, if I move to other regions, I would say that in the US, for instance, the focus has been on restrictions related to the use of anti-infectives in growth promotion. We agree with the FDA to remove this indication from our label to those products having these growth-promotion indications.

And overall, we think that despite this pressure that definitely will continue in Europe, and we have seen new regulations in countries like Belgium or France. We expect the antibiotic to continue growing at the global basis, although a lower pace than the global growth of animal health.

Operator, next question please.

Robert Willoughby with Bank of America.

This is Erin Wilson in for Willoughby. On APOQUEL, will there be significant incremental costs associated with normalizing supply by 2015? And, can you speak to also the recent industry consolidation based on your experience following the Wyeth and Pfizer merger and other mergers as well? Could you benefit potentially from divestitures of specific product lines from some of your competitors? Does that represent an opportunity for you or could you benefit from sales force defections or other changes?

Thank you, Erin. And, I will ask Glenn to comment on these questions on the cost.

Erin, specific to your question on APOQUEL, we don't see a significant increase in cost related to ramping up production. In general, increased volumes relate to additional efficiencies and should be a beneficial factor to cost in the long term.

Okay, and you also asked about M&A and the consolidation of -- the impact in terms of the consolidation. First, I think the recent news on this consolidation, in my opinion, are positive for the animal health industry because are showing the high value of the assets in this industry. And, at the same time, I don't see that this is changing significantly the competitive landscape.

So in our opinion, the model that we have, which is going to the market with our direct field force -- also, supporting our revenue with innovation in terms of R&D and high-quality manufacturing -- is a model that has been showing significant strength. As a reference, in 2013, the market grew by 4% and Zoetis grew by 7%. This indicating that despite of a challenge or despite of consolidation -- and even the time that we were involved in the separation from Pfizer, so we were able to grow much faster than the market.

Operator, next question please.

David Risinger with Morgan Stanley.

Hi, thanks very much. It is Chris Caponetti for Dave. I was hoping you could tell me what operating cash flow was during the quarter? And then, separately, if you could just prioritize your uses of cash, given what appears to be I guess a more limited interest in transformative M&A, at least over the near term? Thank you.

I will ask to go into details of these cash -- Glenn. But let me have some general comment on our cash philosophy -- definitely, Zoetis will generate predictable and steady cash flow. We will identify opportunities that will increase the value of our Company. And, one of the areas that we think that we can increase value is also assessing opportunities in terms of M&A. We'll assess opportunities based on strategic feed and also the return on the investment. And definitely, we have integrated many companies in the past. We have the knowledge and the capabilities to make this integration successful, and we will continue assessing any opportunity that the market will offer. And now, Glenn can provide some additional comments on cash.

Sure. In terms of the cash flow statement for the quarter, as part of our earnings release process, we don't provide balance sheet or cash flow information. That information will be available in the 10-Q to be filed next week.

Operator, next question please.

Louise Chen with Guggenheim.

Hi, thanks for taking my question. First question I had was on your pricing power; I know you have historically been able to drive a lot of pricing power, and I'm curious if that is particular to Zoetis or is an industry-wide figure? And then secondly, on cash flow, based on my modeling, it looks like you will be generating a lot of strong cash flow over the next several years, and I was wondering if you could comment if that is a correct assumption or not? Then, lastly we've gotten some pushback on your operating costs, that you're going to have to separate from Pfizer, and that cost is higher than expected. And just curious, how you're going to meet your gross margin and operating margin expansion targets, despite the near-term increase in costs?

Thank you, Louise, for the questions. Definitely, we have the pricing power, and then we have increasing the prices in most of the countries. Definitely in countries which are more developed, we have more opportunities to increase prices; while in emerging markets, because of local competition, we see the opportunity, in terms of volume, higher than prices.

In general, the industry is also increasing their prices. And according to external sources with nurseries, so they are indicating that the total growth which is predicted for 2014, this 5% will be balanced between price and volume. We are confident that because of our model and the strength of our portfolio, we will be able to implement price increases in most of the geographies. And, in terms of the question on separating costs, maybe Glenn can provide some comments on that.

Sure. So, the guidance that we reaffirmed today does include some certain significant items and acquisition-related costs, primarily related to standing up the organization that we will experience in 2014. In terms of the operating costs, the guidance also reflects some of the synergies that we may experience this year related to being an independent company. We highlighted some of those in terms of the incremental costs related to our corporate functions and some of the incremental costs in terms of building up our global manufacturing and supply organization. But, we still believe in the long-term ability to be able to grow expenses at the rate of inflation.

Let me finish with your question on cash flow. Definitely this Company will generate cash in a way that will be strong and also predictable and steady. We will use the cash in a way that will maximize the value of Zoetis and also the value for shareholders.

Operator, next question please.

Liav Abraham with Citi.

Good morning, just a follow-up question on your tax rate. I understand from the commentary that you are not focused on a tax inversion, at this point, at least not in a material way. Can you talk to the opportunities that you have for potential reduction of your tax rate, on a standalone basis, over the medium term? Thanks very much.

Sure, so in reaffirming our tax rate of 29%, we also indicated that that does not include the benefit of the R&D tax credit, which could provide an additional benefit of about 50 basis points. I will just reaffirm what the Company has said in the past, that the rate of approximately 29% is generally the long-range rate in which we think we could operate.

Operator, next question please.

Jamie Rubin with Goldman Sachs.

Hi, this is Ariel Herman in for Jamie. Just a couple quick ones. Regarding APOQUEL, how much did this contribute to your overall growth? So, another way of asking this is, what would the growth be ex-APOQUEL? And then, when you think about new products versus the current or base business, how should we think about the growth in each of the segments? So, how fast are new products growing versus potentially the base business declining?

Separately, just to follow up on industry consolidation question, I believe you stated previously that scale is one of the strengths of Zoetis, so if competitors are getting bigger and consolidating, how could this potentially affect you? Thanks.

Thank you Ariel. On APOQUEL, APOQUEL will represent in 2014 approximately 1% of our total revenue. It means that, in terms of revenue growth, will represent also about this 1%. Our model is not based on bringing new products to compensate the loss of exclusivity or the duration of the portfolio. But our model is to continue investing in our current portfolio in a way which is balanced with investments that we make in generating new products. So, because of generic competition has a different impact in our industry, we are able really to continue supporting our products with the right lifecycle management.

We can continue investing in indications, we can continue in investing in the current portfolio, moving product from different species. We can also work on combining products to maintain these products fresh and generating growth. Also we can invest in expanding our portfolio geographically. Definitely, new products will represent a portion of our growth. If you take our total growth, a portion will come from price. We mentioned that this will be -- approximately 50% of our revenue growth will be coming from price.

Then, in terms of volume, two-thirds will be coming from our current portfolio, and the way that we are maintaining our current portfolio life, and one-third will be coming from new products. This general statement can be different depending on the years and depending on the new product introduction, or the success of bringing also innovation to our current portfolio.

In terms of what will be the impact of the consolidation, since some of our competitors will increase scale, we are already competing with larger companies -- companies that are already generate more than $3 billion, and we have been proven that our business model is extremely effective and efficient. And, we base our model, as I mentioned, in our direct interactions, bringing innovation in both new products and supporting our existing portfolio, and the quality and reliable supply.

The combination of all these elements, and the way we are executing our strategies, is what is making our differentiation in the market, and we are convinced that despite of this consolidation, we will remain very competitive. Growing in line or slightly faster than the market, despite of having a market share of 20%, and very important also, our plan is to increase our earnings faster than revenues with the right focus on expenses, and also the right focus on improving gross margin.

Operator, we have time for one more question.

David Krempa with Morningstar.

Great. Thanks for taking my question. If we look at the significant differences in margins, compared to the international markets versus the US, would you say the biggest driving factor there is solely the pricing? Or, are there still scale benefits you can realize there, that should improve as you grow? Or, at nearly $1 billion in these regions, are you already taking advantage of all the scale opportunities there, and we shouldn't expect any significant increases in these margins going forward?

The margins are definitely affected by the product mix and also affected by species mix and geography mix. In smaller markets, we don't have the same economies of scale that we can generate in the US. As these markets are growing, we will see also that the margins will improve because they will increase the absorption of all the expensive infrastructure that we have been building to maximize opportunities in these markets. And, I am convinced that our margins will be continue growing.

As I mentioned, we will be growing revenues in line or faster than the market, but margins or earnings will be growing faster than revenues. This will increase our margin opportunities. I don't know, Glenn, if you want to add any additional comment on that?

No, the only thing I'll add is, to Juan Ramon's point about the expectation to grow revenue -- to grow income faster than revenue, we expect that across all of our regions, both the developed and the emerging.

I would like to turn the conference back over to Juan Ramon for any closing or additional remarks.

Thank you, all of you, for joining us on today's call. Thank you for your interest in Zoetis and our first-quarter performance. Thank you very much.

Thank you. This does conclude today's teleconference. A replay of today's call will be available in two hours by dialing 1-800-677-6124 for US listeners, and 402-220-0664 for international. Please disconnect your lines at this time, and have a wonderful day.