碩騰 (ZTS) 2016 Q1 法說會逐字稿

Good day and welcome to the first-quarter 2016 financial result webcast for Zoetis. Hosting the call today is John O'Connor, Vice President 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, operator. Good morning and welcome to the Zoetis first-quarter 2016 earnings call. I'm joined today by Juan Ramon Alaix, our Chief Executive Officer, and Paul Herendeen, our Chief Financial Officer.

Before we begin, I'll remind you that 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 2015 annual report on Form 10-K and our reports on Form 10-Q.

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. A reconciliation these non-GAAP financial measures to the most directly comparable US GAAP measures is included in the financial tables that accompany our earnings press release and in the Company's 8-K filing dated today May 4, 2016. We will also cite operational results, which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramon.

Thank you, John. Good morning, everyone. We delivered another solid quarter demonstrating our steady and predictable growth and conforming the strength of Zoetis as the industry leader in animal health. The divestiture of our portfolio in terms of geographies, species and therapeutic areas, as well as our business model continues driving our performance.

In previous years, we have seen that different species leading our growth based on the changes in the market trends and the mix of products in our portfolio. For example, in 2013 our growth was driven largely by swine and poultry products. In 2014, it was driven by cattle and swine, and in 2015 companion animal and cattle led the way. This quarter, the most significant operational growth driver by far has been our portfolio of companion animal, a strength we expect to continue through 2016.

Our companion animal business is growing thanks to increasing sales of APOQUEL [division] of Abbott Animal Health products, the introduction of new vaccines in Europe and the US, and the overall positive performance of the rest of our portfolio. This important as we experience softer growth in livestock.

We continue to invest across our portfolio, and in the first quarter, our R&D investment continued to show many positive results, including the approval of SIMPARICA, our new oral parasiticide in the US, Brazil, and Canada. This quarter also marked the completion of our ERP implementation. After nearly two years, all our commercial operations, manufacturing plants, and support functions are on a single platform, enabling us to achieve greater efficiency. Overall, we have been able to accelerate our operational efficiency program with a positive impact in 2016, and we expect to exceed the initial savings target of $300 million by year 2017.

I am pleased to say that with a positive momentum in the business and the help of improved foreign-exchange rates, we are increasing our guidance for the full-year 2016 and 2017.

Coming now to more detail on our first-quarter results, operational revenue growth was at 12%, and you can find the slide on our webcast that breaks this down. This reflects 6 extra days in the quarter due to the accounting calendar, as well as the negative impact of changes in markets like Venezuela and India, and the product SKU rationalization that we communicated last year. Adjusting for these factors, the growth will be 10% operational and 6% excluding the additional impact of recent acquisitions.

In the quarter, we grew adjusted net income by 28% operationally, once again growing faster than revenue and helped by the fact that our OpEx increased only 2% operationally compared to the 12% revenue growth. We continue to deliver our long-term value proposition of growing adjusted net income faster than revenue.

In looking at the overall market, we continue to see the animal health industry performing well, despite global economic challenges. We have seen good growth in most markets, as greater consumption of [proteins] and increased medical spending on pets continues to help create customer demand for our products.

As always, while I'm very pleased with the quarterly results, I also want to emphasize the need to look at our business on a full-year basis to account for some of the seasonal situations and timing patterns in animal health. Let me now update you on our new product launches and R&D developments.

APOQUEL is showing steady growth. We have continued to launch APOQUEL in additional markets such as Canada, Australia, and New Zealand. And we plan in the coming months to introduce the product in the rest of the markets where it has been approved, including Japan, Brazil, and Mexico. And this month, the product will be available to customers without restrictions.

In the first quarter, APOQUEL sales were approximately [$50] million, an increase of about [$14] million from the year-ago quarter. As previously communicated, we expect APOQUEL to generate peak sales of more than $300 million.

As for Simparica, our new once monthly chewable tablet for the treatment of fleas and ticks, it has launched in the US and in several European markets. It is early, but we are seeing a positive response from customers, and we expect performance to ramp up in the remainder of the year. We are also developing combinations of this Saronaler molecule in Simparica with other agents. This would cover a broader spectrum of parasites, including heartworm, and we see Saronaler as a strong platform for future lifecycle innovations.

Our canine antibody therapy that targets and neutralize IL-31 to help treat atopic dermatitis in dogs has been introduced to veterinarian dermatologists in the US and there are conditional license. And we received another conditional license in Canada in the first quarter. We are seeing a very positive customer feedback, and we are gaining market experience with the product.

We continue to allocate our capital for investments in key commercial activities, R&D programs, and business development opportunities that can generate faster revenue growth. For example, vaccines and genetics are two areas we are expanding our portfolio, as we put greater R&D emphasis around disease [intervention], and in the first quarter, we have several positive developments.

We received approval of RUI LAN WEN, the second vaccine resulting from our joint venture in China, and the first combination vaccine in China to help protect ticks against certain locally prevalent illnesses. We also gained approval in China for a poultry vaccine to help prevent Marek's disease.

In the US, we have now received licenses from the USDA for our new VANGUARD B oral vaccine, and three new VANGUARD Rapid Resp intranasal vaccines. Zoetis is now the first and only manufacturer to offer oral, intranasal, and injectable options for vaccinating dogs against Bordetella bronchiseptica.

We were also granted a conditional license in the US for an avian influenza vaccine to help prevent disease caused by the avian influenza virus, H5N1. We are participating in the process to supply the USDA with a vaccine for a stockpile, should they decide a vaccination strategy is needed.

We are also seeing progress in genetic tests, as our farm animal customers want more information about traits and conditions that can help them build a healthier and more productive herd. In the quarter, in the US, we launched CLARIFIDE Plus, the first commercially available genomic test that gives dairy producers a direct way to predict risk factors for costly diseases in Holstein dairy cattle.

And just last month, in Chile, we launched the ALPHA JECT LiVac SRS vaccine for salmon, the first attenuated live vaccine against SRS. This was a significant R&D achievement by PHARMAQ, and a much-needed product to help Chilean fish farmers. Great news for the industry and terrific new opportunity for Zoetis.

In summary, we are off to a good start for 2016, based on the strength of our diverse portfolio and the continued benefits of our R&D investment. We have been able to accelerate our efficiency program and expect to achieve additional savings targets of $300 million by 2017. And finally, with improved foreign currency rates and the positive momentum of the business, we are increasing our guidance for the full-year 2016 and 2017.

With that, let me turn things over to Paul. Paul?

Thank you, Juan Ramon. I'm going to hit on many of the themes covered by Juan Ramon, because they're important to the financial review of the quarter. So let's talk about our first-quarter performance.

I'll walk you through a number of factors that you should consider to gauge how we did in Q1. There's some helpful information on the webcast slides, and of course, included in our press release. I'll then hit on a few other highlights in the quarter results and discuss our updates to guidance.

Now before I jump in the quarter, let me say that we know that the US financial markets are quarter-centric, and not to [nocify] quarterly [warnalers], but in any quarter, a lot of noise can and does creep into the comparison for the prior-year period. In our discussion and our webcast slides, our objective is to try to highlight for you the major elements of the noise in our results so that you can calibrate how our reported performance might influence your thoughts about our future prospects. The most important thing about our first-quarter performance is that the results through Q1 supported an improvement to our outlook for the full-year 2016.

So with that background, let me cover two important points to enable you to put our 12% operational revenue growth in perspective. First, we operate on a four-four-five financial week calendar, with our international operations closing one month ahead of the US. This is a carryover from our days as part of Pfizer. Under a four-four-five calendar, every handful of years you'll have a quarter in the year that has as many as six extra calendar days in it; that's what we have in Q1 2016 compared with Q1 of 2015. We estimate that the additional days account for approximately 6% of the 12% operational revenue growth for Q1 2016 versus 2015. Important safety tip for those with quarterly models out there: our fourth quarter this year will have five fewer days than the prior-year quarter and the full-year 2016 has one more calendar day than 2015, this being a leap year. So that's the extra days.

Second, our operating efficiency initiative was a drag on our operational revenue growth in the quarter. We estimate that the combination of the eliminated SKUs and the changes to our business models in Venezuela, India, and other countries reduced operational revenue growth by some 4%. So you think about it like this: 12% operational growth in the quarter, minus 6% for the extra days, plus 4% for the impact of the efficiency initiative equates to a normalized growth rate of approximately 10%. Of that 10%, roughly 4% came from acquisitions, including Abbott, PHARMAQ, and other smaller transactions. So our organic operational growth in Q1 was circa 6% and including acquisitions was 10%, so not 12%, but pretty good, right?

Now, highlights from the first quarter, very high level. We've now entered what I previously referred to as the golden age of our companion animal business. We're full supply of APOQUEL, the launch of Simparica, our refreshed companion animal vaccine line, and the conditional license for IL-31, we are positioned to deliver significant growth in our companion animal business in 2016 and beyond.

On a normalized basis, organic operational revenue growth, which adjusts for the six extra days, the impact of the operational efficiency initiative, and M&A, we had about 20% growth in companion animal in Q1 compared with Q1 of 2015. And the growth was reasonably consistent between the US and the international segments.

On the same normalized constant-currency basis, livestock was up 1%, with solid performance in the international segment offset by a decline in the US. Q1 of 2015 was a particularly strong quarter in US livestock, and there were a number of other factors that I will touch on later. Our livestock business, both in the US and international segments, are healthy and poised to contribute revenue growth in the remainder of the year.

Stepping down the P&L, our adjusted gross margin hit an all-time high of 67.4% in the quarter, a bit above the high end of our full-year guidance range. But I'll point out that from a gross margin perspective, many things fell on the favorable side of the line during the quarter: mix, level of scrap, et cetera. Our expectations for gross margin for the full year continue to be in the range of 66% to 67%.

In operating expenses, total adjusted OpEx grew 2% on an operational basis, but if you remember those extra six days, they impact our expenses as well. Our progress in reducing operating cost continues, and we're on track to deliver on the promises of our operational efficiency in this initiative in 2016 and expect to enter 2017 having taken more than the targeted $300 million of cost out of our Company.

With our gross margin expansion and active efforts to contain operating costs, our 12% reported operational revenue growth translated into 37% operational growth in adjusted operating profit and 35% operational growth in adjusted income before tax. The EC's actions last January were a key driver of the 350-basis-point rise in our adjusted effective tax rate to 30.9%, which resulted in our adjusted net income in the quarter rising 28% operationally.

Our purchase of shares, which began in Q1 of 2015 started in January 2015, helped to reduce our fully diluted share count from $503.2 million in Q1 of 2015 to $499.5 million in the current quarter. And that led to operational growth of adjusted diluted EPS of 29%. So that was a very quick walk down our P&L for the quarter.

Now here are a few more contextual details that I believe will help you think about our performance. First, FX, dare I say that we may have found the bottom of the cycle? Maybe not, but the environment has improved for sure. Foreign exchange had a negative 2 -- 700-basis-point impact on our revenue growth in the first quarter compared with Q1 of 2015. That's a big hit, but based on current rates, the FX impact on our growth will lessen over the remainder of the year. While we continue to measure our performance on an operational or constant-currency basis, it just feels better when the gap between operational and reported results narrows.

Next, the SKU reduction and the changes to our business models in countries like Venezuela and India reduced our operational revenue growth by roughly 400 basis points. You should expect the growth drag on the full-year to be roughly 500 basis points, so more of a negative factor compared with the prior year for the next nine months and particularly in Q2 and in Q3. Importantly, the impact of the SKU reduction and the changes in business models are felt more in our international segment than in the US and more in livestock than in companion animal.

Let me step through the elements of the 12% operational revenue growth in Q1. Price accounted for 3% of the growth, APOQUEL volume another 3%, 4% from acquisitions, 6% from growth of in-line products, and minus 4% from the impact of the SKU reductions and changes to business models in Venezuela, India, and other countries.

Companion animal was the star of the quarter. Revenue growth normalized for both the six extra days and the impact of the efficiency initiatives, increased 20% operationally. APOQUEL was the major driver, but other products contributed as well, including vaccines, as well as the Abbott acquisition. We also expanded US customers' access to a number of our companion animal products through third-party distributors, and that change led to a one-time and semipermanent buildup of their inventories during the quarter to establish their base level.

In livestock, we had lots of puts and takes. Normalized organic revenue growth was 1% operationally, with the international segment up 5% and the US segment down 9%. First, let's talk about international.

France livestock rebounded as anti-infective sales in the quarter were higher when compared with a very light Q1 of 2015, which was caused by new legislation last year. Australia livestock also posted a strong quarter, with better weather playing a role. In Brazil, we had benefited from above-average price increases and continued favorable conditions in the cattle segment, which were, in part, offset by the negative impact of our SKU reductions.

In US livestock, a mild winter was a major driver of lower cattle product sales in the quarter. With milder weather, there was a less risk of disease incidence and that impacted our [premium] products. We also saw a decline in swine products due to increased competition. In summary, after adjusting for the noise, we had a solid quarter from a revenue perspective and through the ongoing programs to improve efficiency, delivered an improved gross margin, contained operating costs, and posted strong growth in profits.

Switching to restructuring charges, let me quickly review this quarter's one-time charges related to certain significant items. First, the stand-up costs, which are mainly associated with our separation from Pfizer, totaled $12 million in the quarter, down about half from the prior-year. Now that work continues to wind down and will be substantially completed later this year.

In the second bucket, costs related to the efficiency initiative, we recorded $5 million of costs, which were more than offset by a $33 million gain associated with sale of four manufacturing sites and certain products as part of the efficiency initiative during the quarter. Interesting, rather than the gain, I like to think about it from a gross cash perspective. Gross pretax cash proceeds from the sale of the sites were $75 million. But we have additional assets for sale, including a transaction in Taiwan, which closed last Friday and any impacts from those sales would further affect costs in this second bucket.

Finally, we recorded $3 million of costs associated with our ongoing supply network strategy initiative. We're still in the early days of that initiative. We also did record a one-time net tax charge of approximately $35 million in the quarter relating to the nullification of our Belgian tax ruling by the European commission for periods from 2013 through 2015.

Now guidance. Turning to guidance, there are four factors that led us to narrow and raise our guidance for 2016. First, let me cover the easy one, FX rates. We refreshed our guidance for our current FX rates, and that was certainly a helper in our guidance. Second, in the first quarter, our international segment was stronger than we had expected, and we're confident that strength will carry through the balance of 2016. Third, we're more confident in our expectations for APOQUEL, as we put supply issues behind us and have launch plans in place in new markets and they're well underway. And fourth, we reduced our guidance for our 2016 effective tax rate on adjusted income by 100 basis points. This is due to changes in our projected mix of income by jurisdiction, as a result of internal restructuring of our international operations.

If you want to calibrate the various factors, at the midpoint of our guidance range for adjusted EPS, we raised guidance by approximately $0.10 per share. I'd be remiss if I didn't say it's actually $0.105, but $0.10 a share for this purpose. Roughly $0.03 comes from FX, roughly $0.04 comes from stronger operational performance, and the reduced tax rate added roughly $0.03. I hope that helps you think about the change to the guidance. For 2017, the only change we made at this point are based on changed FX rates.

So to go through it for 2016 and 2017, for the full year of 2016, we now expect revenue between $4.775 billion to $4.875 billion, reported diluted EPS of between $1.41 and $1.56 per share, and adjusted diluted EPS between $1.83 to $1 90 per share. For the full-year 2017, we now expect revenue between $5.075 billion to $5.275 billion, reported diluted EPS of between $2.01 to $2.19 per share, and adjusted diluted EPS between $2.24 and $2.38 per share.

To summarize, we enjoy a diverse product portfolio, global footprint, and productive R&D that together enable us to balance fluctuations across different species, therapies, and markets and deliver consistent revenue and profit growth over time. We are well down the road of improving the efficiency of our operating expense structure, leading to improved margins, and we are on track to achieve an adjusted EBIT margin of 34% in 2017.

With a continued focus on expense efficiency, we expect to deliver operating profit growth faster than the revenue growth. Last but certainly not least, we strive to intelligently allocate our capital and actively manage our capital structure to drive shareholder returns.

That's it for my prepared remarks. Let me turn it back to Juan Ramon before we get to Q&A

Thank you, Paul. Before we begin the Q&A, I wanted to mention a personnel development. Beginning July 1, John O'Connor will be promoted to the role of Vice President of Corporate Strategies, Business Analytics, and Enterprise Risk Management for Zoetis. And Steve Frank will now lead our Investor Relations program. John will be reporting to Alejandro Bernal, Executive Vice President and Group President of Corporate Strategy, Commercial, and Business Development.

John has done a great job as head of Investor Relations over the last two years, and I want to thank him for those contributions. He will continue to be a valuable advisor to me, to Paul and Alejandro, in his new capacity. I am pleased to say that John will leave the Investor Relations program in good hands under Steve Frank. Steve has a great knowledge of our industry and business, having worked in animal health for the last 15 years, and has been involved in our recent acquisition of PHARMAQ, Abbott, as well as our IPO. Many of you know Steve, and he has been working with John in IR since 2014 to prepare for this opportunity. I am sure we'll have a seamless transition.

With that, let me open the lines for Q&A. Operator?

(Operator Instructions)

Alex Arfaei, BMO Capital.

Good morning, folks, and congratulations on the quarter, and congratulations, John, on the promotion.

Could you -- I'm not sure if I caught the APOQUEL sales, if you don't mind repeating what the APOQUEL sales were by region? And could you also comment on some of the vaccines that you're developing on your livestock business, particularly the avian vaccine? Thank you very much, we would appreciate it.

Okay, so, the first question on APOQUEL -- total revenue for APOQUEL in the quarter were $50 million, five-zero, and US generated $35 million and international markets $15 million, one-five. This is answering your question on APOQUEL.

You also asked about new vaccines. On new vaccines, we have new vaccines for companion animal, and this has been introduced in Europe, as well as in the US.

I mentioned new vaccines that are in the US covering oral, injectable, intranasal, and I mentioned that this for a specific Bordetella issue -- Bordetella bronchiseptica disease. So it is something that definitely represents a significant upgrade on our portfolio for companion animal in vaccines.

We also launched a new vaccine in China used for swine, and is a combination of a vaccine for [PRRS] with a combination for swine fever in pigs. So, another opportunity for increasing our presence in China, and increasing our presence in the swine market in China that is a significant opportunity for Zoetis.

Next question, please.

Louise Chen, Guggenheim.

Hi, thanks for taking my question. So, you guys talked about maybe exceeding your operational efficiency target of $300 million. I was wondering if you could give more color there on the potential upside, and then how this could positively impact your 2017 guidance and margin expectations? Thanks.

Well, we already incorporated in our guidance for 2017 the potential exceeding of the $300 million. At this point, we have not provided any concrete amount of this exceeding opportunity. This is something that in the future, as we move into the programs, we will be sharing with you.

Next question, please.

Erin Wilson, Credit Suisse.

A follow-up to that question -- on the restructuring SKU rationalization and overall cost structure initiatives, how should we think about the quarterly progression throughout the year?

And then as a second question, how would you characterize the current environment in the US livestock business? You mentioned weather impacting the business in the quarter, but how should we think about the dynamics now? Thanks.

Erin, it's Paul. I'll take the -- how do you think about the OpEx rollout.

As we said, we expect to enter 2017 with the cost structure trimmed down to its new and efficient level. We have some work to go on that. And I think if you're a quarterly modeler -- I know you are -- I think you've got to think of that as continuing to show in positive impact through Q4.

It's not like we're going to finish this in Q2; we're not going to finish in Q3. There's more to come that you will see evidenced in our cost structure in Q4.

So, I don't know if that exactly answers it. But just suffice to say that the improvements will continue to occur throughout 2016, and with a good chunk in Q4 2016.

You want to take the last one?

Let me cover the question on the US livestock. Let me start with the cattle. In the cattle, there are two segments, beef and dairy.

Let's talk about beef. Beef -- we reported that there were probably milder winter conditions that impacted our premium products, but the fundamentals of the beef market of the cattle are very strong.

We have seen that the increase in placement in feedlot. We also expect that this will continue for the rest of the year. And also we expect that, at the end of the year, the number of cows in beef will be increasing by 2% to 3%.

So it's something that, even if we have seen this temporary impact in the first quarter, we want also to see this business on a yearly basis. And we are confident that, on a yearly basis, the market remains very strong.

In dairy, what we have seen is that global prices for milk has been going down. This is also resulting in some negative impact in dairy customers. And in some of the cases, we expect that there will be reducing the number of dairy cows.

Again, so, it's a cycle that we have seen also in previous years. After a cycle of low price, reduction of cows, it will be another cycle and prices will go up, and then they will be rebuilding the herd. So, we don't see that is something that is concerning on medium-, long-term profit for the Business.

In swine, we reported that we are facing some additional competition for vaccines. It's a similar case that we saw in the past with companion animal. We identified this need in companion animal.

We have been working to upgrade our vaccines now. Our vaccines in companion animal are very strong. And we are doing the same with swine.

So, we are working to upgrade our swine portfolio for vaccines. And we are confident that this also will bring asset opportunity for growing in the future. We don't expect swine to be a significant driver of growth in 2016.

And finally, poultry -- poultry in the US -- I think it's a positive segment. We expect generating positive growth in 2016.

Next question, please.

John Kreger, William Blair.

Thanks very much. Can you just talk a little bit about the strategy around dermatitis in dogs, now that you've got IL-31 out there, as well as APOQUEL? What are you learning about the market and how vets are using those two products? Thanks.

Well, it's still very early because, first, APOQUEL has been, because of the limitations in terms of supply, has been mostly used in chronic dogs with dermatitis. We expect now that in May we are opening the market without restrictions. They will be expanding the market, not only to chronic, but also to acute.

In the case of IL-31 -- IL-31 has been introduced as a conditional license. So what we are doing is to gain experience in the market by doing some activity with dermatologists -- veterinarian dermatologists. This also has the objective of collecting all the data that will support full license in terms of efficacy of the product.

But we are convinced that there are two products that they are very complementary. And one, it's oral; the other one is injectable. There are some dogs which have not managing well swallowing pills. It's something that IL-31 will cover.

They're also not everyone is responding the same way to treatments. So, we see that APOQUEL, in some cases, is working very well. IL-31 in some cases is also working very well. So the veterinarian has the option to choose what is the best treatment depending on specific cases of dogs with atopic dermatitis or with any kind of skin conditions.

Finally, APOQUEL will have broader indications, while IL-31 will have indication of atopic dermatitis.

Next question, please.

Chris Schott, JPMorgan.

Great, thanks very much for the questions, and congrats, John.

First, just update on SIMPARICA and how you're thinking about the rollout of the product. Should we think about a slower ramp here, given entrenched competition? And what type of share do you think Zoetis can ultimately capture of this obviously very large end market? Thanks.

As I mentioned, it's early -- the interaction of SIMPARICA. SIMPARICA has been to use -- in the US and in a few European markets. We plan to introduce the product in the rest of the markets where the product has been approved.

SIMPARICA has been launched with very strong [publications]. And comparing SIMPARICA against other products, oral and topical, and we have seen that SIMPARICA -- it's showing very positive comparison in terms of fast of action. So it's very fast on killing ticks and fleas, and also very important.

So, the SIMPARICA is keeping full efficacy during the [relation] of the treatment, which is also very important and much better than some of our competitors. So we are definitely convinced that SIMPARICA will have a place in the market.

I think it's -- we are not yet establishing what is the target in terms of market share. But definitely we expect that we'll gain the market share that corresponds to accompany that our strength, capabilities are more present in the market.

Yes, it's Paul. I just want to follow on, on that.

I think that the overall market size is -- for parasiticides -- is about $4 billion. The dogs portion is about $2.5 billion. The fastest growing segment are the oral parasiticides. But if you want to think about the market, it's that $2.5 billion market.

And we believe two things: one, with our footprint and the quality of our sales forces, we have the opportunity to certainly penetrate that $2.5 billion market, and participate in the fastest-growing part. The second thing I want to point out is, this is a self-developed product. And that means the economics of this product to us as compared with the economics of the product to Merial and to Merck that were in-licensed through third parties.

This is a very good product for us, and we're really excited about both the prospects of penetrating that market, but also getting the fruits of our investment in R&D. So this is a great story; let's see how it plays out.

Thank you, Paul.

Next question, please.

Jeff Holford, Jefferies.

Thanks very much for taking my question. So, Elanco licensed a new canine osteoarthritis drug just in the last quarter. I wonder if you could talk about that, in terms of why you didn't feel compelled to license that asset?

And just remind us what products you have in that area, and if you are very active in terms of R&D, late-stage [product color] in there, and how that might impact your Franchise? Thanks very much.

Thank you for the question, Jeff. We believe that we have a portfolio in pain which is very strong. We have Rimadyl in all markets. We also have in the European market another product which is also complementary to Rimadyl, which is called Trocoxil, and very important.

So, we have a lot of experience in this area. And this expertise is not only in terms of commercial, but also in terms of R&D. And in R&D, it's an area of focus, and we have programs in pain that I'm convinced will strengthen our portfolio in the future.

Next question, please.

Mark Schoenebaum, Evercore ISI.

Hello, guys. Thank you for taking my questions. It's actually Vlad Nikolenko on behalf of Mark Schoenebaum. Congrats with the strong quarter and, John, congrats on promotion.

So, I have two somewhat related questions. First, on more about market trends in general. So, your official guidance for 2016 and 2017 implies a strong operational growth in terms of revenue, like mid- to high-single digits. So I'm wondering if we can think about this revenue growth over the longer term that just will continue to grow in line with the rest of the industry -- animal health industry -- or at some point we need to expect some slow down of this trend.

And a second somewhat related question is about segments. Do you have more color about the potential long-term growth in different segments of products, antibiotics versus vaccines versus other pharmaceuticals and other segments that you report? Thank you.

Thank you, Vlad, and let me first describe the market trends. So we see that the overall market trends that maybe are slowing down the growth in some inter-markets, it's not affecting the same way to our industry. And one example, so we have seen that in Brazil, the GDP, it's declining, while the GDP for agriculture, including the livestock, is growing.

So again, so it's in the animal health industry, I think we cannot extrapolate the market trends which are affecting other sectors to our trends. And our trends are based on operation, which still continue growing; middle class, which is still increasing; and also the need to improve productivity, because there's always been a challenge with the need of more food with fewer resources. And companies like Zoetis that can bring this type of innovation, they have a significant opportunity for growth.

And the same drivers are also impacting companion animal. More people, more (inaudible) is increasing the number of pet adoptions. And also very important, the amount that pet owners are spending per pet in keeping these animals healthier and to live longer. So we are very confident that the market trends remain positive for the animal health industry.

And for Zoetis, we have been targeting that to grow in line or faster than the market. In the first [three] years as independent Company, we have been growing faster than the market. In 2016, because some one-time impact related to our operational efficiency, they reported the growth will be lower. Adjusted by this factor, we expect that we'll be growing in line of [factor] on the market.

The same for 2017. We have created for 2017 a growth that, in my opinion, it's -- at the mid-point, it is faster than the prediction of the market, and we have no reasons to believe that in the future we will continue growing in line or faster in the market.

So, one of the things that are very important is that we have already all what is needed to maximize our portfolio, and very important. Our R&D investment continue delivering very strong results, and we have been continue bring into the market new products. But also very important, bringing to the market lifecycle innovation which is also helping to protect our future growth.

And maybe Paul can talk about trends in specific areas, antibiotics, vaccines, things that are part of our efforts to ensure that we have the right balance and the right opportunities for growth.

Sure, and when you think about -- when people talk about anti-infectives or antibiotics, people look at our portfolio and they say, gee, you're a market leader in anti-infectives. I hear this, I see this in the news and, therefore, we have a lot of revenues at risk. And to put it in perspective, I think what people mostly focus on the amount of anti-infective sales that we have in livestock; they're not necessarily as concerned about whether the anti-infectives will be used in the treatment of companion animals.

But we have sold about $1.3 billion of anti-infectives into the livestock segment, but importantly -- but first I'm going to talk about our Company and our outlook. Importantly, of that $1.3 billion, about $1 billion of that are in the form of high-value injectable products that are dosed to animals when they are sick. And where the alternative is, that animal could die, and the animals around that animal could die.

And that's what I would characterize as the responsible use of anti-infectives, and that is the overwhelming majority of our portfolio, is products that fall into that category. And while there continues to be pressure or concern from folks generally about the use of anti-infectives and wanting to use less anti-infectives, what they're mainly focused on is not treating the sick animals, but really the use of anti-infectives in ways that would, for example, to promote growth.

Within our portfolio, about $300 million balance in livestock, that is mainly anti-infectives that are used in feed and in water. Our work with our customers and our own diligence strongly suggest that those products are being used in what we would call a responsible way, in other words, not in sub-therapeutic doses to promote growth, but to treat sick animals. Even still, if I were looking as an outsider, I would look at that $300 million as -- that's the piece I got to keep my eye on, and that's the piece I'd be concerned about.

Now, back to the overall trends, our anti-infectives continue to grow, but they grow slower than the balance of our portfolio. And just so we're real clear, of course that's baked into our 2016 expectations, our 2017 expectations and, frankly, is baked into folks who look at our industry generally about what the long-term growth prospects are for the industry. It's an important part of the industry, and so that's baked into the macro view of our industry able to grow mid-single digits or better for the foreseeable future.

I'll continue on, because it's a very interesting topic. We pivoted many years ago away from the development of [initial] anti-infectives to a focus on vaccines, because the best way to reduce the use of anti-infectives is to reduce the incidence of disease. That's the best way.

And we have been very successful pivoting our R&D portfolio and now our product portfolio to feature vaccines that will assist producers in maintaining the health of their herd so that they would have to use less anti-infectives. So, that's a big area for us. Now, we focused -- I'm focusing all of this on the livestock thing because I think that's where your question lies. So I'll stop there.

Next question, please.

Douglas Tsao, Barclays.

Hello, good morning. Thanks for the questions. Just on the IL-31, what is your expectation in terms of timing for going from a conditional to a full approval? And just, obviously, there's some limitations in terms of your promotion of the product right now. Just how widely is that being used in terms of that [narrative]?

Thank you, Doug, for the question. So we expect that there is something that will depend on the final approval from the USDA. We expect this approval by the end of the year. So now what we are doing to gain experience and also collecting the data in terms of efficacy, and this will be submitted to the USDA for final approval of the program -- at least related to the US.

We have a senior partner in Canada and a different one in Europe. Also we expect in Europe this product approved in the future. So, today, it's used under this conditional license, so the use, it's quite limited, because we are just going to fewer customers in the US, mostly veterinarian dermatologists. Some others customers are using the product.

And the objective is not really to generate significant revenue growth, but to gain experience of the product, and making sure that the product, it's generating the amount of data that will support full license. We are convinced that IL-31 will be an important product in our portfolio and very important. So it's developing a franchise, which is this skin conditions, itching, atopic dermatitis. And with two products in the markets, I think in my opinion we have a very strong position relate to future opportunities.

Next question, please.

Jami Rubin, Goldman Sachs.

Good morning, this is Divya Harikesh on behalf of Jami Rubin. Just wanted to get your latest thoughts on capital allocation. Are there any other assets that look more attractive at current valuations or areas that are of particular interest to you?

Also, how much leverage would you consider, given the market's increasing concern on leverage levels for companies? Thank you.

It's Paul. I'll take that on the capital allocation front. Of course, we continue to, I think like most companies, and we focus first on what kind of capital can we allocate within our Company to drive incremental revenue and profit growth. That is always going to be very high return activity.

So the first thing we do is try to max out programs inside that can drive revenue. And that falls in a bunch of categories. That could be incremental sales force; it could be investment in DTC advertising to grow markets; it could be incremental investment in R&D to develop new products; it could be incremental CapEx to create a technology platform for us. So it's all those things. So we do that first.

The second piece, which is I think what you were asking about is outside. So we look outside and what sorts of opportunities do we see?

We see a very consistent flow of what I'll call smaller deals that we do every single year that, none of which I think on an individual basis is going to be exciting to the markets at large. But in the aggregate, help us, one, feed our R&D effort because we can acquire technologies and things that feed R&D. Second is small add-ons that we just continually do, and that can be anywhere from $40 million to $75 million a year in activity, and it's relatively consistent.

The next bucket would be the mid-sized M&A. I think last year, I guess I'd put PHARMAQ in that category, and maybe even Abbott in that category as well.

Last year, we were fortunate enough to close two deals. I wish we could do that every year. The challenge is not our desire -- would you do this deal? We'll do those deals 100 out of 100 times if they present themselves.

As we used to always love to say, we're tanned, rested and ready to do those deals when they present themselves. And we're spring-loaded to go after them when they present themselves, but predicting when they're going to be available is a challenge.

On the larger scale, M&A, really I guess what you think of as potentially transformative, we've said many times over, a transaction with one of the top five companies is very difficult for reasons of anti-trust -- you can think of it as FTC type issues, because there's a lot of concentration now amongst the top, say five companies. So the prospects for large transaction, I'd say, never say never; it's not zero, but it would be pretty hard.

And then next down the list, there are opportunities there. We continue to look. We're very active, and I should say we're very proactive in [targeting] assets that we think would be interesting and valuable to add to our Company. But of course, we're not going to disclose what our list of targets might be at any moment in time.

And then the last bucket is the one that is the one that I think is important, and I referenced it in the tail end of my prepared remarks. And that is returning capital to shareholders. As we enter 2017, when we have lots of stand-up costs and the operational efficiency cost and all those things behind us, not just from a P&L perspective, but also from paying out the accruals, et cetera, and we put that cash flow behind us, that negative cash flow behind us, and we enter 2017, we still have to throw off a fair amount of cash.

And the question is -- well, gee, if you don't have anything to do with it, what are you going to do? Well, a couple of things. One, we have a dividend. It's circa a commitment this year of, call it, circa $190 million or thereabouts in 2016.

We have a share repurchase program. We are currently repurchasing shares at the rate of $75 million a quarter under a program that we announced way back in November of 2014. And so, long-winded, but we intend, to the extent that we can't deploy that capital in our Business or outside our Business, to return to shareholders in the form of dividends and share repurchases over time.

We think that's appropriate. Cash is a non-productive asset for us to have around. But this also dovetails nicely into the discussion of capital structure, which you inquired about as well.

So, we have articulated that we expect to operate in the normal course of business in the range of 2.5 to 3.5 times trailing EBITDA for a debt level for our Company. Operating in that range will enable us to maintain an investment-grade rating -- we believe will enable us to maintain an investment-grade rating, and that's important. As you pointed out, the market is taking a different look at leverage levels today than they might have two or maybe three years ago, and we're cognizant of that.

I've said, because we get this question a lot, and I'll restate it. People say -- well, would you ever do a deal that would cause you to be above that range? The answer is yes, we would go above the top end of that range to pursue what we felt was value-generative M&A.

Would we go above that range to buy back stock? Probably not. In fact, I'll say definitely not. But we would, in the context of making an acquisition.

So, we get below 2.5, we probably put some leverage on; we get above or up to the top end of the range at 3.5, you'd expect us to manage that leverage down. The objective is to try to operate in that range. And I'll stop there. I think the high end of the range, I don't know what it is.

Next question, please.

David Risinger, Morgan Stanley.

Great, thank you very much. So I was a little bit on and off the call. I just have a couple of questions on the guidance changes. So for the 2016 guidance, Paul, what percentage of the EPS guidance increase was due to operations? And what percentage was due to FX?

And then for 2017, obviously, you haven't updated that guidance for operating performance; you've only updated it for FX. When do you expect to update it for operating performance? Could we expect that after the second-quarter results or do we have to wait until the Company goes through its full-year annual planning in the fall? Any color on that would be helpful. Thank you.

Yes, sure. Thanks for the question, David. It's Paul. I'll take that.

I'll go through -- the factors, again, mid-point of the range, $0.10 up -- $0.03 from FX, $0.04 from stronger operational performance, and then the tax rate was a $0.03 helper as well. And that gets you to the $0.10 raise at the mid-point of our range in 2016.

Yes, you're quite right, 2017, we said we updated our 2017 guidance solely for the favorable change in FX rates. It's 2017 guidance. We're one quarter into 2016. We have a pretty broad range there. You can surmise that our outlook continues to be in that range or we would have adjusted that range.

So there's no set time at which we would change 2017 based on an operational -- change our operational view of 2017. But to the extent that we were outside the range for 2017, we'd change it.

I'll stop there. Next question, please.

Kathy Miner, Cowen and Company.

Thank you, good morning. First, I just had a follow-up on the sarolaner. Could you confirm that you're at -- you do have full supply now, so you're ready for full global launch? And was there any stocking in the first quarter of sarolaner?

Second question has to just do on the SKU reduction; you've targeted 5,000 or roughly in total. Can you give us a sense of where that's at right now? And is that something that just goes away slowly as the year unfolds, or is it more dramatic that they're there until year end? And also a sense of what therapeutic categories those SKU reductions are coming from, so as we look at that, we can get a sense of where some of those reductions will be coming. Thank you.

Let me start with sarolaner, SIMPARICA now, which -- the name in the market is SIMPARICA. And we have no restriction for this product. We have enough product to use the product in all markets.

And the regulatory authorities approve, and in the US all new markets. And we also have operations for Canada and some other countries. So it's something that we don't see any restrictions.

So at the time of the launch in the US and also in Europe, there is no any insignificant loading of the product on the country. So, most of the product was related to samples that we provided to (inaudible) to get familiar with the product. So we have not generated significant revenues in the first quarter, but we expect that this revenue will be ramping up during the rest of the year. So we have very good expectation for the product.

As I mentioned in some of the other comments, we have very strong publications supporting the efficacy of the product. As I said, this product is working very fast and also it's showing that during the duration of the treatment, it's having very strong efficacy. So it's not dropping efficacy at the last day of the duration of the treatment or [the countries] maintaining the efficacy.

And in terms of SKU, I think we have made significant progress on SKUs. So most of the SKUs have been already eliminated from our portfolio. And maybe there are some few SKUs that will be eliminated from now until the third quarter, which are related to SKUs that will be replaced by other products that we are introducing to market. But the large majority of SKUs have been already eliminated from our portfolio.

Let me continue on, on that, because I think you asked a question about how it plays out over the course of 2016, and also important. When we eliminate an SKU from the portfolio, if we sell it, like as we did, we sold some plants, as I'd said in my remarks, during the quarter, and we sold it with some product. Obviously, that product is gone.

When we eliminate an SKU and we stop producing, we may still have inventory and we may still sell it. And so that's why you're seeing it play out over the course of 2016. But let me frame it.

Q1, we said the impact of SKU reductions was about 4%. We said that we expect it to be about 5%. This is growth versus prior year.

For the full year, which it says that during the nine months, Q2, Q3 and Q4, it will be greater than 5% impact from a growth perspective versus the same period -- in the same period in the prior year. And I further said that it's mostly in Q2 and Q3, so middle part of the year, as we sell out these products and they're gone. And what you're going to see is a moderation of that in Q4, because we did start to see an impact in Q4 of last year.

And as we enter 2017, there's still going to be a drag, because you still sold them at the beginning -- some of these products at the beginning of 2016. But if you look at the kind of run rate, when we enter Q1 of 2017, that will be fully reflective of all of those SKUs being gone.

And again, impact versus prior year heavier in Q2, Q3 of this year, moderates in Q4. There's still an impact in Q1 next year and Q2 next year, but it diminishes pretty substantially. The key part is we will have this activity behind us entering 2017.

Next question, please.

(Operator Instructions)

Erin Wilson, Credit Suisse.

Thanks so much. Also, I still don't see a balance sheet in the release. My bigger question here is: What can you accomplish in the way of working capital improvements near term to address the high inventory days?

And then also, how much was the distributor stocking contribution in the quarter? I assume that's related to the vaccine business. Was that material?

It's Paul. Let me take the balance sheet and working capital questions. We are working very hard to shrink and then eliminate the gap between when we report our earnings and when we release the balance sheet. We're expecting to file our Q Friday of this week, so we've shrunk it to a couple of days; it had been substantially more than that.

That's just a -- we could not shrink those days in the context of also changing all of our ERP systems, et cetera. So, we're working on that, and our goal is to be like most other companies, to have our balance sheet on the same day we report earnings. So just know that's a priority for us and we will get there.

With respect to working capital, you pointed out to the days sales of inventory that were on hand at the end of the year. We expect that we can have some pretty sizable improvements in our investment in working capital or our working capital efficiency. Now, with the -- thank some higher power -- the completion of our SAP implementation where we have every part of our Company up on one instance of SAP, we now have the opportunity to activate the tools that will enable us to much more tightly manage our investment in inventory, while at the same time having a high service level to our customers.

That's not something that is instantaneous; that is something that we've started. And I think I've said in public forums before, we expect to make progress against that in 2016. We'd expect to make much more substantive progress on that in 2017. And that is the focus of our opportunity in being more efficient in working capital.

We're pretty good in accounts receivable. I say pretty good -- we're good in accounts receivable, and we're also good on accounts payable.

So it's really inventory that we are focused on. Expect a modest improvement in 2016, and a more significant improvement beginning in 2017, as we get the tools up that will enable us to better manage our supply chain.

Your question regarding the distributor stocking, again, that was in the US. That was with respect to some companion animal products to increase. So the amount that went in was approximately $18 million in the quarter, and so it's something you should take into consideration

Next question, please.

It appears we have no further questions. I'll return the floor to Juan Ramon for final comments.

Thank you very much for your attention, and looking forward for following quarters and also the interaction with all of you. Thank you.

This does conclude today's teleconference. A replay of today's call will be available in two hours by dialing 800-757-4761 for US listeners, and 402-220-7215 for international. Please disconnect your lines at this time, and have a wonderful day.