John O'Connor - Juan Ramón Alaix - Chief Executive Officer and Director Glenn David - Acting Chief Financial Officer and Senior Vice President.

Alex Arfaei - BMO Capital Markets U.S. Mark J. Schoenebaum - ISI Group Inc., Research Division Jessica M. Fye - JP Morgan Chase & Co, Research Division Kevin K. Ellich - Piper Jaffray Companies, Research Division Louise Alesandra Chen - Guggenheim Securities, LLC, Research Division John Kreger - William Blair & Company L.L.C., Research Division Erin E.

Wilson - BofA Merrill Lynch, Research Division Christopher J. Benassi - Goldman Sachs Group Inc., Research Division Ross Taylor - CL King & Associates, Inc., Research Division.

Welcome to the Second Quarter 2014 Financial Results Conference Call and Webcast for Zoetis. Hosting the call today is John O'Connor, acting 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 2 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 Second Quarter 2014 Earnings Call. I'm joined today by Juan Ramón Alaix, our Chief Executive Officer; and Glenn David, our Senior Vice President of Finance Operations and Acting Chief Financial Officer.

Juan Ramón 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 our recent 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 U.S. 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 U.S.

GAAP measures is included in the financial tables that accompany our earnings press release and in the company's 8-K filing dated today August 5, 2014. We also cite operational results, which exclude the impact of foreign exchange.

I also want to remind you that beginning last quarter, we 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 4 reportable segments. In 2013, CSS results were reported in the EuAfME segment. With that, I will turn the call over to Juan Ramón..

Thank you, John, and thank you to those joining us for today's call. I would like to start by sharing high-level details of our performance for the second quarter. During this period, we delivered operational growth of 6% in revenues and 11% in adjusted net income or adjusted diluted EPS of $0.38.

We also delivered operational revenue growth across each of our geographical segments in the quarter, reflecting the strength and balance of our diverse portfolio.

This illustrates that our continued focus on building strong customer relationships, bringing new products to the market, while managing the product lifecycles and producing high-quality products and reliable supply, all remain fundamental strengths of our business and model. Let me now comment on the performance of our business by species.

The performance of our livestock segment grew by 9%. Here, we see more favorable market conditions for many of our customers across the globe. Overall, worldwide demand for meat protein continues increasing, especially in emerging markets. In these markets, their objective is to increase their local production.

But to meet their needs, they still depend on key export markets, such as the U.S. and Brazil, where we also have a significant presence. Additionally, feed costs continue to moderate for our customers. Nevertheless, conditions will remain difficult for some producers in certain markets in Asia Pacific and in Europe.

And factors such as disease outbreaks and climate conditions are placing some limitations on how quickly our customers can expand protein production. These conditions reinforce the value of our medicines and technology for more efficient production.

As producers work to supply greater volumes of meat protein by increasing cattle and swine slaughter weights, we expect to see continued strong demand for our products. Our global presence and breadth of portfolio positions -- so it is well to capitalize on these positive trends.

Let me take a deeper dive into some of these individual species, starting with cattle, which grew 10% operationally. We delivered strong growth in all regions, most notably in the Canada/Latin American region, where we implemented new pricing strategies in a number of Latin American countries. Poultry delivered operational growth of 11%.

All regions contributed to these, but particular in the U.S., where sales of our medicated feed additives and also vaccines delivered double-digit growth. In swine, PEDv has continued to spread, not only in the U.S., but also in Canada, Mexico, Japan, and a number of other countries.

The virus is reducing the size of swine herds, and producers are working to offset these reductions by raising higher-weight animals. Additionally, our business has felt the impact of antibiotic regulations in Europe. In spite of these conditions, Zoetis is still the leader, based on growth of 5% in swine, thanks to introduction of new products.

Moving now on to companion animal. We delivered 2% operational growth in the quarter. Sales of our canine product APOQUEL contributed to the growth in this sector, even as we continue to address our levels of supply for this product. I will talk a little bit more about APOQUEL later on this call.

Overall, while growth fundamentals for companion animal remains strong in all countries, and particularly in emerging markets, we have seen an increase in competition in many of our larger developed markets. This is primarily from new product introductions in parasiticides and in vaccines.

We are confident that the breadth of our portfolio, including new product launches, as well as the strength of our field force and our world-class capabilities in R&D, will enable us to stay competitive in this market.

Across our business, we continue to see that the depth and the diversity of our portfolio plays a critical role in the overall performance of our company and also sustain our competitive advantage.

The depth and diversity is demonstrated by our portfolio for multiple species across 5 therapeutic areas and by the 300 products marketed in 120 countries. As a result of this quarter's performance, and our forecast for the rest of the year, we are increasing the lower end of our guidance range for revenue, adjusted EPS and SG&A for the full year.

Now, I would like to provide an update on our portfolio, and in particular, highlight our R&D progress and the latest for APOQUEL. Earlier, I spoke about the impact of PEDv on our business. Now, let me share with you some details of the progress that we are making on developing a vaccine for this disease, where we have 2 programs.

Our most advanced program is for an inactivated or kill vaccine. On this, we are working closely with the USDA and expect to request approval for a conditional license in 2014. Following any approval, we anticipate that we will be able to supply the markets soon after.

We also continued our work with Iowa State University on an additional vaccine approach. We are making good progress and will provide updates of this program as the research evolves.

Finally, we continue working with the University of Minnesota for a PEDv diagnostic test and this type of test will help producers to rapidly identify potential infections in their herds. The result from these research programs will also have applicability outside of the U.S.

We are exploring regulatory approaches to enhance the reach of these potential products in all the affected markets. This quarter, we secured regulatory approval and launched ACTOGAIN. This ractopamine product for the use in cattle, alone or in combination with other commonly used medicated feed additives.

This in addition to our already-strong cattle portfolio. The approval of ACTOGAIN builds on the success of the launch of ENGAIN, also a ractopamine product, which was approved and recently launched for use in swine. Both ACTOGAIN and ENGAIN are performing better than expected.

This performance is in part driven by the removal of a competing product from the market. And finally, to our progress with APOQUEL. As you will remember, this is an innovative medicine designed to relieve dogs from pruritus. We launched the product in the U.S.

and in a number of European markets early this year and have seen significant levels of customer demand for the product. This has resulted in a supply shortage.

Our priorities at this point are to ensure that dogs currently being treated with APOQUEL continue to receive their product without interruption and to normalize the product supply as soon as possible. As noted on our last call, the process to produce APOQUEL is complex.

We are working to reduce the length of time it takes to manufacture the product and to add manufacturing capacity. By April, next year, we expect to significantly increase the supply of APOQUEL, and as a result, we'll be able to begin offering APOQUEL to new customers.

Based on our current market demand, the introduction of the product in new markets, and our plans to increase supply, we now expect the product to generate in excess of $100 million in revenues next year. And before I ask Glenn to walk us through the financials, I would like to highlight our coming Investor Day.

This will take place on November 18 at The New York Stock Exchange. We're very excited to be able to host this event and look forward to having the opportunity to share with you more details of our strategy, capabilities and value propositions, as well as the overall animal healthcare industry.

And with that, Glenn?.

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 our 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] Our first question comes from Alex Arfaei with BMO Capital Markets..

First, on your vaccine -- on your PED vaccine. Will you have a competitive advantage in getting this vaccine to the market? If you could just give us a better sense as to where the competitors are and what kind of commercial opportunity are we looking at? And a quick follow-up, if I may, I'm not sure if I understand it, Ramón, correctly on APOQUEL.

Did I hear you correctly in saying that you expect to have supply to the market, increased supply to the market, later this year? Or is it still a 2015 expectation?.

Alex, it's Juan Ramón Alaix. So let me start confirming that for APOQUEL, we expect that to normalize supply next year in April. And at that time, I will be able to supply more product to new customers.

On the first question, on the PEDv, so we have a program now that we expect to complete soon and to submit that to the FDA, a conditional -- license for conditional approval. And there is one vaccine already in the market covering this disease.

And we expect that our vaccine also will cover the needs of swine producers to protect animals against this outbreak and its high significant impact on their herds..

Operator, next question, please?.

Certainly. We'll next go to Mark Schoenebaum with ISI Group..

My question on the business is maybe on use of cash, if I may. In your last slide, where you kind of summed up the 3 big priorities, I suppose, for the next 5 years. The last one is to find profitable investment opportunities and return excess capital to shareholders. So I was wondering, we haven't seen a lot of M&A yet at Zoetis.

So I'm wondering why that is? And if we should expect the pace to pick up? And then the follow-up on that is the dividend. I don't think we've seen much of a dividend raise since you guys have spun out of Pfizer.

So I was wondering if just philosophically, you could talk to us and maybe help set expectations, what we should expect about the rate of dividend increases..

Mark, on the first question on M&A, so in 2013, that it was the first year of Zoetis as an independent company. We were focused on standing up our operations and then, we decided that maybe it was not the right time for us to consider on M&A activity.

We are now that -- we have, in most of the cases, completed our infrastructure, with the exception of IT. We think that we can now consider M&A opportunity that the market brings to us. And we'll be active pursuing these opportunities. We know that because of our size and our market share, we may face some challenge in terms of antitrust.

This will incorporate it in our analysis, but definitely, we will consider any opportunity that will match our strategic objective, and also will provide the return on the investment..

Mark, related to your question on dividends. So today, we have increased our dividend. And subject to board approval, we do expect to grow the dividend at a rate that is equal to or faster than our growth in adjusted net income..

Operator, next question please?.

Certainly. We'll take a question now from Chris Schott with JPMorgan..

It's Jessica Fye on for Chris. A question on gross margin, just as we're starting to think about next year.

Can you just remind us how much of your manufacturing Pfizer still does? And how we should think about the impact of that, I think there's some manufacturing royalty kicking in for the product they supply you with next year? And then maybe also just following up on Mark's question on M&A.

We're seeing a number of tax inversion transactions across the space and just would like to hear your views on whether that will be of interest to Zoetis..

So in terms of M&A, also, this tax inversion opportunity, we will continue to exploring any opportunity that will provide reduction in terms of effective tax rate, something that definitely we will see the opportunities the market -- that exist in the market. And we will decide based on these opportunities.

On the gross margin, I will ask Glenn to respond to your question..

So in terms of gross margin for 2015 and specifically to the impact of the Pfizer MSA. So when we looked at the potential impact of the Pfizer MSA, that it might have in 2015. Based on 2013 costs and volumes, we expected it to have about a $30 million negative impact on cost of goods going into 2015.

We've taken a lot of actions to minimize that impact, and those actions have resulted in reducing that exposure by about 1/2. However, since then, a number of those products, APOQUEL being one of them, have had growth in volume. So it will limit our ability to bring the $30 million down fully, but we have taken many actions to minimize the impact..

Operator, next question, please?.

Certainly. Our next question comes from Kevin Ellich from Piper Jaffray..

First off, we've seen some pretty strong livestock trends, especially in the U.S. Just wondering if you can keep up kind of the high single-digit, low double-digit growth in the U.S.? And then second, regarding your operating cost, and you have a direct sales model, especially in the U.S.

Just wondering if there's any ability for you guys to leverage the operating cost by maybe laying on distributors and using some of the national distributors more to minimize or drive some more leverage in the model..

On the performance on livestock, definitely on the second quarter, we reported very strong growth. We see that the demand for animal proteins remained very strong in the worldwide market. We also see that the profitability of livestock producers -- it's now very high.

They have high price of the meat, low prices for input, which increases significantly the profitability. And this is also driving the willingness of livestock producers to increase the herd, to supply all the market demand. We don't see any change in the near future, so we expect that the livestock market will continue growing in the future.

In terms of our direct sales model, so we are convinced that the demand generation model that we have, which means that our own field force and also our own group of veterinarians are interacting directly with customers. And this interaction is generating very strong demand and very strong support to our portfolio.

In the U.S., we combined our direct efforts with partnership with distributors, for those customers that we don't have the reach because of economical conditions.

And we see that this model is working very well, and we'll continue supporting our product portfolio through this direct interaction, and also with the combination and partnership with some of our distributors that will reach these smaller customers..

Operator, next question, please?.

Certainly. Our next question comes from Louise Chen with Guggenheim..

So first question I had was on SG&A leverage. What is your ideal level of SG&A leverage and when do you expect to get there after you finish this Pfizer separation? And then second question I had was, we've seen a number of development-stage, companion animal health companies starting up.

I'm just curious, your thoughts on the unmet needs these companies address and if there's potential partnership opportunities here?.

So this is Glenn. I'll address the SG&A question. In terms of the SG&A leverage, so the way we think about this is, in 2014 in particular, we have indicated that we do have incremental expenses related to building up our corporate functions, and that is increasing the level of growth we expect in SG&A this year.

However, over the long term, we do expect to grow SG&A in line with inflation, while being able to grow our revenue at a pace faster than the market, which will continue to improve our margins going forward..

Okay, the other question was about these biopharma companies and potential partnerships. Well, I think it's -- we have already the infrastructure, also the reach to customers. And we have developed, over time, a very strong model in terms of direct sales to customers.

And we are convinced that this model also can benefit smaller companies that will have maybe problems that will be covering and managing [ph] the market, but without the infrastructure to reach customers. So we will consider this kind of partnership with these companies..

Operator, next question, please?.

Our next question comes from John Kreger with William Blair..

I think you mentioned on the call that your parasiticide class within companion animal saw some pressure in the quarter.

Can you just expand on that a little bit? Did it actually decline? And if so, maybe you could quantify it? And do you have anything in your pipeline that might cause this trend to be able to reverse in the coming year or so?.

Well, our parasiticide franchise in companion animal didn't decline in the quarter, but the growth was affected by the entrance of new competitors.

There have been 2 new competitors launching new parasiticides, oral parasiticides, and we have seen that the market dynamics in parasiticides are changing, and moving from the traditional parasiticides that there were topical to more attention to oral parasiticides.

We also have programs in this area and we expect to launch these products, oral parasiticides for companion animals, in the future..

Operator, next question please?.

Our next question comes from Robert Willoughby with Bank of America..

This is Erin Wilson in for Bob. Follow up to the SG&A expense question and the leverage of that metric going forward.

What can be addressed or corrected near term or can be considered one-time in nature? And outside of some of those items, can you call out where you have made progress on this line as it relates to your separation from Pfizer? And I guess the second question then, similar would be -- can you just speak to the competition in U.S.

companion animal in light of the increased promotional spending that you've called out.

Why is it such a light trend in companion animal?.

Sure. So in terms of the SG&A and items that might be considered one-time in nature, I think the key item is what we've been highlighting in terms of the buildup of our corporate enabling functions and the timing of which that ramped up and when those costs were most debited in the P&L.

So in 2013, in the first half of the year, we were not running at our full cost base for our enabling functions and that corrected in the second half, and that's driving the difficulty in comparison year-over-year.

Some of the areas that you have seen have significant improvement though year-over-year, I think when you look at the growth in our regions and our segments, you've seen very strong IBT growth or income growth in those regions, demonstrating continued focus on managing -- or on our expenses..

Maybe a comment on the competition in the U.S. and also details on the promotional activities that we conducted in the second quarter.

Definitely, as I said during my remarks and also the remarks of Glenn, we have seen introduction of new parasiticides, also introduction of new vaccines and the introduction of generic competition to a product which is important in our portfolio, which is RIMADYL.

And in terms of the additional investment in promotional activities in the quarter, I think it's only a question of pacing. If you take year-to-date, you would see that the investment in the year has been in line with our projections of growing promotional activities below the growth in terms of revenues..

Operator, next question, please?.

Our next question comes from Jami Rubin with Goldman Sachs..

This is Christopher Benassi on behalf of Jami Rubin with Goldman Sachs. Since the IPO, investors have believed in the story of continued improvement in Zoetis' margins. However, we are curious as to where you might see room for further margin improvement, possibly in SG&A, R&D or maybe even across the board..

In terms of where we see continued improvement. So R&D, I think, is one item that you've highlighted. We've seen growth in R&D that's been sort of in the low-single digits, while we still continue to be very effective with our R&D productivity.

From an SG&A perspective, as well as a cost of goods perspective, we do continue to see areas for improvement. So as I mentioned, SG&A, we do expect to grow in line with inflation. And cost of goods, we're clearly focused on continuing to find areas to improve our cost of goods and expect incremental improvements in COGS going forward..

Operator, next question, please?.

Our next question comes from Ross Taylor with CL King..

I just had a couple of questions related to the PEDv vaccine you have in development.

But for a conditional approval, what kind of efficacy data do you have to present to the regulators to receive a conditional approval? And I also wondered how much does a conditional approval limit appeal or uptake of this product once it does reach the market?.

So in terms of the regulatory requirements for conditional approval for a vaccine, so we need to demonstrate safety of the vaccine and also efficacy in certain conditions. And the requirements for efficacy for a conditional license are lower than the efficacy requirements for a full license.

In terms of the selling opportunities of a vaccine under conditional approval, I think it's something that, since the vaccine, in this case, will be responding to a real market need, we don't see that this will create any limitations.

There will be some limitations in terms of promotional activities, but not limitations in terms of selling the product to the market..

Operator, next question, please?.

We now have a follow-up from Kevin Ellich with Piper Jaffray..

Following up on the PEDv comments, I'm just wondering, Juan Ramón, in your prepared remarks, you talked about how hog farmers are growing larger animals, even though we've seen, I guess, some pressure on the herd sizes.

And I'm just wondering if your new product, ENGAIN, is helping to -- if you've seen some good uptake because of this? And if you could quantify that also? And then Glenn David, the tax rate was lower on a year-over-year basis.

Just wondering what we could expect? And I also wanted to clarify, did you say your tax guidance does not include the R&D tax credits?.

The follow-up question on PEDv, so definitely, ENGAIN, it's helping producers to have a more efficiency in terms of food. So they are reaching feed efficiencies because of this product. This product is also a product that already exists in the market, it's ractopamine.

And we think that the product that are released [ph] in the market, together with ENGAIN, is helping the producers to achieve the targeted weight, with lowered cost in terms of food..

And in terms of the tax rates. So the tax rate was lower in the quarter at 28.4%. We have reaffirmed our guidance of approximately 29% for the year, and we still believe the full year is the best view of our overall tax rate.

And just to emphasize it, that does not include the R&D tax credit, which would lower our rate by approximately 50 basis points..

Operator, next question, please?.

Next we have a follow-up from Robert Willoughby with Bank of America..

This is Erin again. A quick follow-up. There has been some recent changes, or recently announced upcoming changes, in the companion animal diagnostics market in the U.S., with IDEXX Laboratories moving to a direct distribution model.

Do you see this as an opportunity for you? What -- and just generally speaking, what is your underlying growth rate for your diagnostics business?.

So we remain committed to diagnostics. We see diagnostics as very complementary to our current business, in both R&D and also commercial. And we are trying to build our portfolio in terms of diagnostics.

And the change on IDEXX in terms of direct model, it's something that we will not comment on the strategy of our competitors, but definitely, we'll explore any opportunity that will further penetrate our diagnostic depth into the market..

Operator, next question, please?.

[Operator Instructions] We'll now go to a follow-up from Alex Arfaei with BMO Capital Markets..

Sorry if you addressed this earlier, had to hop off for a minute. But what can we expect for your November Investor Day? If you could just frame that for us. Can we look for something like a 5-year outlook? If you could just give us more color as to what we can see from you..

So we're working on the details of the agenda that we will communicate to you in the near future. So one of the objectives that we have during this day is to provide much more details on our strategy.

Also have the opportunity to provide this information in terms of commercial, in terms of manufacturing, in terms of R&D, from members of my leadership team, that will go into some detail that may have not been provided until now.

And in terms of the outlook, we are considering what should be the details that we will provide in terms of the outlook, and we are still considering different timeframes that will be information that we'll be sharing with you at that time.

The other objective is also to go into some additional details on the animal healthcare market, to have much more clarity in terms of projections of the market and also the opportunities for both livestock and companion animals..

Operator, are there any other questions?.

At this time, there are no additional phone questions..

Well with that, thank you very much for joining us today. Thank you very much for your interest in Zoetis, and we -- I look forward for more interactions with you. I definitely hope to see you at our Investor Day in November 18. Thank you very much..

Thank you. This does conclude today's teleconference. The replay of today's call will be available in 2 hours by dialing 1 (800) 374-1216 for U.S. listeners; and (402) 220-0681 for international. Please disconnect your lines at this time, and have a wonderful day..