John O'Connor - Juan Ramón Alaix - Chief Executive Officer and Director Paul S. Herendeen - Chief Financial Officer and Executive Vice President.

Christopher T. Schott - JP Morgan Chase & Co, Research Division Kevin K. Ellich - Piper Jaffray Companies, Research Division Jami Rubin - Goldman Sachs Group Inc., Research Division Alex Arfaei - BMO Capital Markets U.S.

John Kreger - William Blair & Company L.L.C., Research Division Louise Alesandra Chen - Guggenheim Securities, LLC, Research Division Douglas D. Tsao - Barclays Capital, Research Division Vlad Nikolenko David Risinger - Morgan Stanley, Research Division Jeffrey Holford - Jefferies LLC, Research Division Erin E.

Wilson - BofA Merrill Lynch, Research Division.

Welcome to the Third 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 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 Third Quarter 2014 Earnings Call. I'm joined today by Juan Ramón Alaix, our Chief Executive Officer; and Paul Herendeen, our Chief Financial Officer. Juan Ramón and Paul 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 the slides used today will also be available on the website following the call. 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 statements in today's press release and our SEC filings, including, but not limited to, our 2013 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 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 costs of becoming a standalone public company. A reconciliation of these non-GAAP financial measures to 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, November 4, 2014. We also cite operational results, which exclude the impact of foreign exchange.

I also want to remind you that beginning with the first 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 today's call. Before beginning my comments on our third quarter performance, I would like to introduce Paul Herendeen. Paul joined Zoetis as our new CFO this past September to lead the company's finance and information technology organizations, in addition to being part of the Zoetis executive team.

I'm delighted that Paul has joined Zoetis and is on the call today. Later, he will speak with you as we review the details of our third quarter performance. A key element of our long-term value proposition is our ability to grow in line or faster than the market.

Based on most recent data, Zoetis continues to grow faster than the animal health industry. Over the trailing 12 months ending with the second quarter, the animal health market grew by 3% according to industry sources, while Zoetis grew by 5% with both percentages, including the negative impact of foreign exchange.

Our ability to grow faster than the animal health market illustrates the fundamental strength of our business model. With the broadest product portfolio in the industry, the steady introduction of new products and our top-ranked field force, we are able to bring value solutions to veterinarians and livestock producers around the world.

Now, let's turn to our operational performance during the most recent quarter. During the third quarter, we generated operational growth of 10% in revenue and 21% in adjusted net income, delivering adjusted diluted EPS of $0.41.

Revenue growth during the quarter was strong in all regions and in both developed and emerging markets, with emerging markets delivering double-digit growth. These are result of favorable market conditions, the strength of our diverse product portfolio and the diversity of our global presence. Let me now comment on our livestock performance.

In livestock, we grew 13% and growth was strong across all geographic segments. Producers are enjoying favorable market conditions in many parts of the world with high meat and milk prices, together with lower feed cost. On a global basis, the outlook for meat and daily proteins remains strong.

A growing middle-class in China, India and other emerging markets continues to drive growth in worldwide demand for meat, eggs and daily proteins. Let's now take a closer look at our third quarter performance by species, starting with cattle. Cattle is our largest species and it grew 13% with all regions delivering strong growth.

In the United States, we saw strong demand for our premium products, while we also generated gains gains in market share. Swine revenues grew 17% despite the challenge of porcine epidemic diarrhea virus or PEDv in a number of countries.

All regions contributed to this growth and we continue to expand our swine product portfolio through the introduction of vaccines with new antigen combinations as well as registering and commercializing products in new markets.

Poultry revenue grew 7% with strong contributions from the emerging markets within the European, Africa and Middle East region. Now, turning to companion animal. Companion animal grew by 5%, aided by sales of APOQUEL in the U.S. and several European countries. Strong growth of key brands in the U.S.

and Europe was offset by the introduction of new products from competitors and the impact of the solution changes in Japan. While competition has affected our results in parasiticides and vaccines, we are confident in our ability to participate in this and other growing market segments as we introduce innovative products to the market.

For example, we are preparing for European launch in 2015 of Versican Plus, a new line of canine vaccines. We will cover -- I will cover Versican Plus in more details when I discuss new products and milestones. We can also confirm that in April 2015, we expect to significantly increase APOQUEL supply.

With greater supply, we expect to begin offering APOQUEL to new customers. We continue to receive very positive feedback from customers about this product.

And based on current market conditions, we believe APOQUEL can achieve annual sales of approximately $200 million to $300 million at peak sales, which normally is 5 years after product introduction.

Now, I would like to share with you several products and milestones that illustrate how our singular focus on animal health and our core capabilities allow us to put our customers first and bring our solutions to their most pressing animal health needs.

Earlier in the quarter, we announced that we obtained a conditional license in the United states for our vaccine to help fight PEDv in pigs. Under a conditional license, we demonstrate safety in a field study and provide reasonable expectations of efficacy.

We are now conducting additional studies to demonstrate efficacy and to obtain a full license from the USDA. The PEDv vaccine has been received very positively by swine customers and is available to them ahead of the cold weather when the virus is more likely to spread.

We were able to bring this vaccine to market in only 14 months by leveraging our 3 interconnected capabilities. Our R&D capability and the expertise in biologics allow us to fast-track the development of PEDv vaccine. Manufacturing and scale-up capability enable us to produce enough of the vaccine to meet projected customer demand.

And now that the product has been launched, Zoetis representatives and our field veterinarians are partnering with our customers on how to incorporate the new vaccine into their protocols and biosecurity programs. The development of these vaccine is an example of how we leverage our capabilities to bring solutions to our customers.

This past quarter, Zoetis also received a full license for the first poultry vaccine targeting Georgia 08 type IBV. The full license followed the USDA conditional license that Zoetis received in late 2013. These are the first commercially vaccine to help reduce disease cause by the virus strain.

In our companion animal business, we received European approval for Versican Plus. This is a combination canine vaccine that provides unmatched leptospira protection as well as a greater convenience and flexibility for veterinarians. It provides protection against obtained bacterial and viral infections in one vaccine dose.

By offering multiple vaccine combinations, Versican Plus provides a comprehensive solution for European markets that accommodates a broad range of vaccination protocols. We are now preparing the launch of Versican Plus in the European Union in 2015.

Also, we announced the formation of a new collaboration with Easter Bush Research Consortium that is focused on combating emerging infectious diseases in Europe. Zoetis will partner with others in this consortium to detect and identify emerging infectious diseases early and to develop medicines and vaccines to treat and control them.

Zoetis is the only animal health company in this consortium. Collaboration like this one contributes to our ability to be first to know about emerging infectious diseases and aspires to be first to market with new products to diagnose and prevent diseases.

And before I ask Paul to walk us through the financials and provide details on our 2014 guidance, I would like to remind you of our upcoming Investor Day. We are very pleased to be hosting an investor meeting on November 18 at the New York Stock Exchange.

The goal of the meeting is to enhance understanding of the animal health industry, the key drivers of Zoetis market leadership and the strategies for future growth. I will be joined by the Zoetis executive team for a discussion of our regional businesses, R&D approach, manufacturing and supply chain operations and financial goals.

And with that, Paul?.

Thank you, Juan Ramón, and good morning. It's been a very busy and productive first 2 months and I'd like to say that the more I learn, the more confident I am that the fundamentals of our industry, our team here at Zoetis and the strengths of our capabilities provide us with the opportunity to create value for our stakeholders.

I'll speak more about all this in 2 weeks at our Investor Day, but now let me dive in and review the third quarter a little more deeply and to discuss our guidance for 2014. Turning first to the interest income statement slide.

For the third quarter, revenue was approximately $1.2 billion, an increase of 10% year-over-year on both a reported and operational basis. Reported net income was $166 million or $0.33 per diluted share in the third quarter, an increase of 27%.

And adjusted net income was $207 million or $0.41 per diluted share, representing reported growth of 20% and 21%, respectively.

Adjusted net income from the quarter excludes the after-tax impact of $41 million or $0.08 per diluted share for purchase accounting adjustments, acquisition-related costs and certain significant items, the majority of which were related to standup costs. Now, let's take a minute to discuss currencies.

In the third quarter, foreign exchange did not have a material impact on our revenue or income growth. It's important to remember that our 3 international business segments have an earlier quarter close than the U.S. segment. The third quarter for the international segments closed at the end of August with the U.S.

segment closing at the end of September. Looking ahead, we expect to see a negative impact on revenue growth in the range of 250 to 300 basis points in the fourth quarter based on current rates and we expect to see similar magnitude of impact in 2015. Now let's turn to our adjusted income statement slide, which I'll discuss on an operational basis.

Again, because FX was not a significant factor in the third quarter, operational revenue growth was 10%, the same as reported. Livestock comprised 65% of sales in the quarter and grew $88 million or 13% operationally. Companion animal comprised 34% of sales in the quarter and grew $20 million or 5% operationally.

Adjusted cost of sales was 35.5% of revenue versus 34.7% in the year-ago quarter. And that's due to the buildup of central manufacturing supply chain operations. This buildup was completed by the end of 2013 and those higher costs are now flowing through our cost of goods sold.

Adjusted SG&A, meanwhile, increased by 2% operationally in the third quarter. In other items, adjusted R&D expense was flat operationally and interest expense was flat at $29 million in the quarter. Our effective adjusted tax rate for the third quarter was 28.3%. I would not read too much into our tax rate in the quarter.

What's important is that we expect our rate for the full year 2014 to be consistent with our guidance, which is approximately 29%. And again, our adjusted net income was $207 million, representing a growth of 20% or 21% operationally. Now let me talk for a minute about how we're tracking year-to-date on a few elements.

This was a great quarter, but we always want to keep in mind the full year and that's because of the nature of our business, the cycles in the animal health industry and fluctuations in currencies in any given year. In looking at any quarter relative to the prior year, lot of noise can creep in.

The longer the time period you look at, the more that noise cancels itself out and you can see a clearer picture of the underlying trends in our business. We focus on full calendar years and do not guide or manage to quarterly results.

While it feels great to put a quarter on the board with such strong revenue and profit growth, the bigger picture is that we are on track to deliver on our guidance for the full year. That said, let's take a quick look at the 9 months year-to-date and compare that back to 2013.

We're tracking in line with our revenue expectations for the first 9 months, growing revenue 6% on an operational basis. Our guidance range implies full year 2014 operational growth of 5% to 6%. Our adjusted cost of sales is at 34.9% of revenue on a year-to-date basis.

As I said earlier, we continue to expect our cost of sales to increase as a percent of revenue for the year, bringing us in line with the full year guidance of approximately 35.5% of revenue. And finally, adjusted net income is also performing in line with our expectations growing at 13% on an operational basis year-to-date.

This year-to-date performances are in ranges that are consistent with our expectations, and I'll discuss the implications on our full year guidance in a moment. Now let's turn to our operating segment results.

Again, I'll discuss these on an operational basis, but I -- but it should be noted that the segment earnings are on a pretax basis and are presented on an adjusted basis. Beginning with the U.S. Third quarter revenue was $532 million, an increase of 7%. Sales of livestock products grew 12% with cattle and swine as the main contributors.

Growth in cattle products benefited from higher demand for our premium product as producers continue to see strong market conditions. With higher prices for beef and lower input costs, producers are moving lighter animals into feed lots sooner to meet the market opportunity.

These cattle can be more vulnerable to illness and disease, given their age and weight, and require more use of medicines and vaccines to maintain their health. These market conditions also mean our customers place more importance on using our premium products to protect animals and investments.

Meanwhile, swine products sales were driven primarily by the success of several recent new product introductions such as our Fostera PCV M. hyo combination vaccine. The DRAXXIN 25 anti-infective product for swine and our ENGAIN ractopamine product for use in feed.

This growth in swine was slightly offset by the continuing impact of PEDv, which Juan Ramón mentioned. In companion animal products, we generated an operational growth of 2%, driven by APOQUEL and other key brands such as ProHeart 6, Cerenia and Convenia.

This growth was offset, however, by increased competition in vaccines, pain products and parasiticides. In summary, the U.S. segment earnings increased by 10% based on the quarter's strong sales and lower expenses. Now turning to our Europe, Africa and Middle East region or EuAfME.

Revenue in EuAfME was $293 million, an increase of 12% operationally compared to the third quarter of 2013. The growth was a combination of double-digit growth in both developed and emerging markets.

Sales of our livestock products increased 13% operationally as the region delivered positive results in France and the U.K., as well as in emerging markets. The livestock growth was driven by increased sales across all species with particular advances coming from cattle and poultry products.

In France for example, we saw an increase in the sales of the anti-infectives as customers sought to buy product ahead of more restrictive legislative changes. And in the U.K., we saw strong demand for cattle products.

Meanwhile, sales of companion animal products increased 11% operationally, primarily driven by sales of APOQUEL in Germany and the U.K. as well as growth in parasiticides such as the Stronghold brand.

EuAfME segment earnings increased 28% operationally, primarily due to the revenue increase, improved gross margins and lower operating expenses in the quarter. Turning to our Canada and Latin America segment or CLAR. Third quarter revenue was $194 million, an increase of 17% operationally compared to the third quarter 2013.

In this region, we saw a significant growth in emerging markets such as Venezuela, Brazil and Argentina and also in Canada. Overall for the segment, sales of livestock products grew 16% operationally and sales of companion animal products grew 19% operationally. Sales in Venezuela and Argentina grew significantly across all species.

In Brazil, there was significant growth driven primarily by sales of cattle products, including new product launches and growth in key companion animal brands such as Vanguard, Cerenia, Revolution and Convenia, as this market continues to expand at a high rate. Meanwhile, growth in Canada was primarily driven by sales of companion animal products.

This was the result of a later spring season than last year, which had a positive impact on parasiticides sales -- the growth of parasiticides sales for this quarter as compared to last year quarter. Strong volumes in cattle and swine products also contributed to growth in Canada.

CLAR segment earnings increased 19% on an operational basis, driven by revenue growth, limited growth in operating expenses and partially offset by a decline in gross margin. In Asia Pacific or APAC, third quarter sales were $179 million, an increase of 7% operationally compared to the third quarter 2013.

Sales of our livestock products grew 9% operationally, driven primarily by sales of cattle products in Australia and growth in Southeast Asia from recently launched swine products. In Australia, we are seeing more cattle moving into feed lots and requiring more treatment as Australia continues see the impact of drought on its cattle businesses.

In the swine, we continue to see strong sales driven primarily by an increase in sales of our vaccine portfolio. Sales of companion animal products, however, were flat operationally due to an inventory buyback related to the termination of a distributor agreement in Japan.

Excluding this event, operational growth would have been 8% driven by sales of parasiticides, equine vaccines in Australia and increased sales of vaccines in China. APAC segment operating earnings increased 24% due to revenue growth, improvements in gross margin and a decline in operating expenses. That's on an operational basis.

Now let me turn to guidance for the full year 2014. As I mentioned earlier, we think about and manage our business in an annual basis and not quarterly. There can be a lot of variability in any individual quarter.

For example, in revenue, the variability can be to due to changes in weather patterns or seasonality be associated with certain product lines. In R&D expenses, for example, the quarter -- quarterly variability may be based on project schedules and conditions needed to complete field trials.

Our R&D expense, for example, tends to be heaviest in the fourth quarter. Over a full year, that variability, which you have seen in pockets this year, historically evens out, and we are able to deliver a steady and predictable performance when measured on an annual basis.

We remain confident on our ability to deliver on our full year guidance for 2014 and we are reaffirming our adjusted earnings per share for the full year and narrowing our revenue guidance towards the high end of the range. We now expect reported revenue of approximately $4.7 billion to $4.75 billion for the full year.

This guidance would imply full year reported growth of 3% to 4% for revenue and includes a negative impact of 2 percentage points from foreign currency. This also implies an operational growth of 1% to 5% in the fourth quarter, and that's when compared with a strong fourth quarter in 2013.

After taking into consideration the current FX environment, reported revenue growth could be 250 to 300 basis points below the operational growth rate in Q4. Our guidance on adjusted cost of goods sold for the 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 savings efforts, which is forecast to be offset by the full year impact of costs incurred to build our central manufacturing and supply functions as well as unfavorable mix.

We understand this implies our fourth quarter cost of goods sold as a percentage of revenue will be higher than what you've seen to date. However, we believe our 2014 full year guidance of approximately 35.5% of revenue is a better reflection of our underlying cost of goods sold.

Adjusted SG&A expenses are now expected to be between $1.46 billion and $1.48 billion. We continue to see good OpEx discipline in the regions, which is helping to mitigate increased spending in our general and administrative functions, where we continue to build out the infrastructure to support our business on a fully standalone basis.

Adjusted R&D expenses are expected to be between $385 million and $395 million. We continue to deploy resources responsibly in R&D as this investment is fundamental to the enhancement and protection of our existing portfolio through life cycle developments and the development of innovative new products to help fuel additional growth.

We continue to expect our effective tax rate on adjusted income to be approximately 29%. This guidance does not reflect the potential extension of the U.S. R&D tax credit. And we continue to expect adjusted EPS of between $1.50 and $1.54 per share for the full year.

This guidance would imply full year reported growth of 6% to 9% for adjusted EPS and reflects a negative impact of approximately 200 basis points coming from foreign currencies. Please note that our guidance does not reflect any further currency devaluation in Venezuela.

Separately, we now estimate pretax charges for 2014 of between $180 million and $195 million, primarily related to standup costs and acquisition-related costs. These charges are excluded from our adjusted earnings guidance.

Including the impact of these items as well as purchase accounting adjustments, our guidance for our reported diluted EPS for the full year 2014 remains between $1.16 and $1.20 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 animal health market for the remainder of the year. To sum up the quarter, we had a very strong revenue and earnings growth quarter in all regions, demonstrating the strength of our business model.

We demonstrated an ability to drive gross margin improvements and operating expense containment in our regional segments while continuing to absorb some of the impact of the buildup costs associated with our corporate functions.

We saw no material impact from foreign currency on our growth this quarter, but anticipate more significant effects on our future results. And we are reaffirming our guidance for the year despite the expected currency headwinds in Q4. That concludes my prepared remarks. And now we will open the line for questions.

John?.

Thank you Paul. Operator, we are ready to take the first question..

[Operator Instructions] We'll take our first question from Chris Schott of JPMorgan..

And then, Paul, congrats on the new role. Two questions here. First, can you elaborate on the U.S. companion business and competitive dynamics there? I think last quarter you mentioned you were increasing some of your promotional investments.

I guess, any sign that those investments are having any impact? Or just when should we think about that business starting to maybe turn around a little bit more? And then a question for Paul, just as you're stepping into the CFO role, can you just elaborate a little bit more on your priorities? I guess, specifically, what are the biggest opportunities you see at Zoetis when you look at the company's margins, tax rate and capital structure?.

It appears that the -- we're experiencing technical difficulties at this time. Please standby. [Technical Difficulty].

I hope now the line is fine and I will be able to answer your questions, Chris..

Sir, you may now proceed with your answer..

Okay. So Chris, it's Juan Ramón and I will answer the question on U.S. companion animal dynamics. So there are different factors driving the market in the U.S. in companion animal. The introduction of new products, mainly in parasiticides.

The market is moving more to oral parasiticides compared to the previous, more topical ones with the introduction of 2 main competitors in this market. And we are participating in the market in the topical, but not on the oral. The other change that we have seen is that the introduction of new vaccines in the U.S.

that also they are impacting our performance. And finally, in the pain market in where we participate with RIMADYL a very strong brand, there are also new factors affecting our performance. One, it's a competitor that was out of the market in 2012.

It was back in '13 and now it's full revenues and also made it part of the shares that we gained when this competitor was not participating in this market. It's now back to the more normal situation.

And also, the introduction of generic competition for RIMADYL on the chewable formulation, although this have not been representing a significant impact so far. Now, I will ask Paul to answer your question..

Yes, thanks, Juan Ramón, and Chris, thanks for the questions. Yes, I've been here about 60 days now. I'll tell you that my -- the first thing I see is an opportunity or I say, more as a priority for me is to help us to get complete with the standup process.

Until we get through that, I think that it's going to somewhat mask our company's cash flow generation capabilities because it, obviously, while it doesn't affect adjusted net income, it obviously is a cash flow item.

And so in terms of priority, both getting us past those -- that standup activity and getting the G&A infrastructure built to the point where it can support this global business has kind of been very, very high on my list.

Now that said, I mean walking down through the income statement, there are opportunities for us to continue to drive operating margin improvements over time, and I think these are themes that you've heard from the other members of the team as we go -- as you go back. I mean, we've got very good expense control in our commercial groups.

That's been a little bit masked by the buildup of cost in G&A. And again, once we get through that, we'll get to more of a normalized run rate for our OpEx. There are opportunities in the gross profit margin when we look at ability to continually benefit from price increases. Second, from improvements in efficiency in our plant network structure.

And those are things that although they will happen here in the near term, I think that it will take us some time to generate the most meaningful portion of those margin expansion opportunities. Part of your question was around the tax rate.

We -- when we spun out from Pfizer, we started with a tax rate kind of -- or we could have had a tax rate sort of in the 40% range. We were able to put together a structure or put in place a structure that enables us to have that tax rate down in the neighborhood of about 29%.

So good from the perspective of a structure that allows us to have a much lower tax rate. Thinking ahead, I think that our ability to manage that tax rate is based on opportunities to present themselves to us that fit within our structure.

I would not expect to see revolutionary changes in our tax rate, although we will do our level best to manage that tax rate down over time. And I think your last question was around capital structure. In this company, we are -- we have expressed that we wanted to maintain a level of debt in our cap structure.

I think you certainly know me from my prior employer and -- I like debt, we like debt. There's a role for debt in our capital structure. We've expressed a target of 2.5x trailing 12 months' EBITDA. That's an appropriate debt load, but I will say that's a target.

It's a target, where if there were an opportunity in the call -- we were called upon to lever up a little bit, we would do that, and then we would endeavor to reduce our debt over time back towards the target. And I'll stop there.

Can I get the next question please?.

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

First one, Ramón, could you give us a little update on the competitive landscape. Sentinel Spectrum went to a competitor, wondering what your thoughts are? And also you talked about oral parasiticides, just wondering what's on the horizon for your product portfolio? And then for Paul, you've been with the company now for only a couple of months.

Congratulations again. I'm sure it's been like drinking from a firehose, but just wondering if you could give us your puts and takes from when you decided to join the company until now. And also an update on the inventory issue in Japan with the distributor..

Thank you, Kevin. And I will answer the questions on Sentinel and oral parasiticides. Well, definitely as a leader in this industry, we see any transaction or any potential transaction in the market and also we are active assessing any opportunity. And definitely, Sentinel was an opportunity that we explored.

And what -- as you see, we decided not to participate in this transaction. And we talked about what our programs or plan on oral parasiticides. Definitely, we see oral parasiticides an important part of preventing animals, dogs and cats against ticks and fleas and also heartworm.

And we -- I would like to postpone the details of my answer to the Investor Day in -- when we have the opportunity to provide, to investors and to analysts, a more comprehensive view of our R&D approach and also some of the areas in where we are investing..

And I'll pick -- Kevin, pick up from there. It's Paul. Your question was around puts and takes from prior to joining. So I've here, it's almost exactly 60 days, I think. As of today, it's 61 days.

When I first looked at the opportunity, I think the thing that attracted me to it was, first looking at the industry, an industry that -- a global industry that grows consistently over time. So solid underlying macro trends. And then you look at the company, Zoetis.

Here's the company that's a market leader with a broad portfolio, very durable revenue streams and remember, from my experience at Warner Chilcott, we sort of had the opposite of the durable revenue streams. Everybody was always concerned.

And I looked at this and said, "Here's a company that has the opportunity to put consistent, revenue growth on the board by levering its broad portfolio and driving growth of those assets through application of sales force." It's very similar to what I was used to at Warner Chilcott, and also supporting those brands through productive R&D, both in terms of extending product life cycles, in terms of providing fuel to allow the sales forces to grow the overall revenue base and lastly, to add those truly innovative products that give you the opportunity to step up and accelerate your growth.

So I look at this as being kind of a similar economic model to the pharma business, but with those important differences of longer duration, revenue streams, less reliance on IP. It's about the brands.

Same levers to drive the business that's using your field sales resources, face-to-face with your customers to go out and drive revenue and then lastly, supporting that portfolio through productive investment in R&D. And I'd say that, that was my analysis coming in and 61 days later, I think this is a terrific company.

And what I've been most impressed with is the ability of the company to execute consistently and drive revenue that exceeds the overall market growth. It's been quite an interesting couple of months here. And again, the most important thing was we've got a great team here that knows how to drive this business. I'll stop there.

I'm sorry, you had a question about inventory in Japan. That was related to the termination of a distributor agreement. It's kind of a normal course. It came to the end and we were called upon to buy back some inventory, and that's what's going on there..

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

Just a couple of questions. Specifically on the outlook for gross margins. I mean, Paul, you talked about gross margins getting hit in the fourth quarter. I imagine that's largely due to FX. But in light of global pricing pressure, maybe, Juan, you can touch upon that in terms of what you are seeing across all your different geographies.

But in light of that competitive dynamic, how do you see the outlook for gross margins? Do you think that gross margins can expand in 2015, in 2016? Or should we assume that pricing pressures would offset volume growth and cost cutting or slimming down the manufacturing.

But if you could just talk to, number one, pricing, global pricing pressures; and number two, impact on gross margins? And the other question was -- to Paul, was there any channel loading in front of the new vaccine launches? And Paul, congratulations on what sounds like a terrific opportunity for you..

Thank you, Jami. And we see -- we continue seeing opportunities of applying price increases across all geographies in where we operate. Definitely in 2014, we had been increasing prices in the U.S., also in Europe, in Canada, Latin America and Asia Pacific.

We also apply quite an aggressive approach in some markets with high inflation rates, and this is something that we have seeing a positive impact in our revenues also because of these price [indiscernible].

In terms of the expansion of gross margin, definitely, we'll have the opportunity to cover that in our Investor Day and we'll provide more details on what can be our objective for the future. And maybe I would like to delay this -- well, the details until this Investor Day. And maybe -- and the last comment on the channel loading.

So we're not loading the channel and this is something that -- the vaccine launches will be next year. And normally, we apply a very strict procedures to avoid -- that we are increasing inventory that is not needed to meet customer demands..

Jami, it's Paul. I think you had a question regarding Q4 margin and so I want to make sure I address that because it's an important point. It's an FX impact. Yes, there's FX impact in -- across all of our line items through our P&L.

However, it's -- the main reason for the expected increase in cost of goods sold as a percentage of revenue in Q4 is related to the timing of increased headquarters cost, which are flowing through our cost of goods sold in the second half of 2014.

And I wasn't here when the folks articulated that, but I think that they provided some guidance that you should expect the cost of goods sold as a percentage of revenue to rise as the year went on.

But that the guidance range, which is -- well, actually the guidance level, which is I think the important statistic is, we do expect to be in line with our guidance for the full year, which was 35.5%.

I think broadly, looking ahead without providing guidance, I think we have the opportunity to absorb those increased HQ costs in 2015 and beyond without having it have a deleterious effect on our margin..

Our next question comes from Alex Arfaei of BMO Capital Markets..

Regarding your Investor Day, you said that we're going to see some financial targets. I just want to clarify, are we going to -- are you going to provide some sort of medium to long-range guidance or targets beyond 2015? And the follow-up, there had been a lot of reports about potential buyers for your business.

Obviously, in 2015 -- after June 2015, this will become more of a factor. Just could you comment on your overall strategic view about how relevant is that for you? How would you evaluate such opportunity? And just give us an overall sense of how you would think about that.

Obviously, in the second half of next year, there's going to be a lot of focus on that.

So how should we think about your position on potential -- on being a target of a potential acquisition?.

Okay. Let me ask Paul to answer this question..

Sure. I'll start with the Investor Day. We will provide a look, of course, what I'll call our normal sort of guidance look at 2015.

And in addition, we will provide our thoughts around 2016 and 2017, not in the same level of detail, but in a way that would enable the market in large to get their arms around what our expectations are for the next several years.

With respect to the second question?.

And I think it's -- we cannot really respond on other company's strategy. We think we have a solid business that we can provide significant value to our shareholders. We are showing that we are meeting our objective in terms of revenues, in terms of adjusted net income and we are also, very important, growing faster than the market.

So all this, in my opinion, is showing that this company is well managed. We also have a significant generation of cash over time, and then this will be additional opportunity for investors..

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

Paul, I think you said your first priority was to kind of focus on the stand-up activities. Can you just elaborate on what's still left to do on that front? And second question, I believe you guys have said previously that you expect about maybe 20 basis points of manufacturing cost headwind as we move into '15.

Is that still a decent expectation?.

We have the opportunity to pull the price lever; we have the opportunity to manage our global supply chain and drive better efficiency; and there's always a favorable mix to the extent that our higher-margin product lines provide more of our overall revenue base.

So I would say, yes, we're always facing headwinds -- or we are facing some headwinds looking into '15, but those are challenges that we have a solid opportunity to overcome..

Our next question comes from Louise Chen of Guggenheim..

I have a few.

So first question for Paul is since you've joined Zoetis, what are some new initiatives that you plan to implement at the company that could help drive earnings well above the sort of the $2 per share mark? And then secondly, as a company, do you have any interest in companion animal oncology or biologic drugs? As you know, a lot of smaller companies develop these products.

I'm just wondering if that's true -- truly good opportunity or not.

And then lastly just on APOQUEL, is there any way you can quantify what sales would've been in '14 had you had enough supply? And then in '15, how should we think about the sales ramp? I know you had said $200 million to $300 million in peak sales over, normally, a 5-year time frame, but could you get there faster?.

Yes, thanks, Louise. It's Paul. I'll take the first part of that. New initiatives to drive growth.

Let's say the new initiatives, I get to step behind others who are already activating those sorts of strategies in order to drive longer-term growth, but as -- just referencing back to my past life, the similar sorts of levers that you would expect me to pull, and those include focus on value-generative business development activity.

That would include using our existing tax structure to manage that tax rate in a downward direction.

I think the things that I focus on also are the active management of our capital structure and thinking about ways that we can deliver value to our stakeholders really across-the-board, both from operations and from the management of our cap structure. So those are the initiatives that I've had.

And then the second question was in companion animal?.

Yes, just curious if you think the oncology or biologics opportunities that some of the smaller companies are pursuing are actually real opportunities. Because I haven't seen the larger companies go after that, so just kind of curious..

I would take this question and let me say that in oncology, Zoetis was the first company launching a product that was fully developed to treat cancer for dogs. And this product was Palladia that we launched 2 or 3 years ago. So within that oncology, it's important in companion animal.

It's, today, in many cases, veterinarians are still using products developed for human to treat cancer in dogs or cats. But we think that in the future, maybe there will be new products that will be better targeted for treating these kind of diseases in companion animal.

And definitely, we will be assessing these opportunity and considering the internal or external opportunities to complement our portfolio. In terms of bios, I think it has been a key area for Zoetis.

We have a very strong portfolio in both companion animal and livestock and we'll continue investing in bringing new products to our portfolio and also to strengthening our offer to our customers.

And then finally on APOQUEL, so in 2014, we have communicated that our revenues will be around 1% of our total revenues and this has been because of the limitations in terms of product supply. Speculating how much will be the sales of APOQUEL with -- under restricted supply probably is not adding too much value.

So what I think, in my opinion, it's -- important is that for 2015, we expect to generate more than $100 million in revenues and we expect definitely to generate these revenues, basically on that 9 months of full supply because we expect to have this product available to more customers from April.

So you can -- that's why we are now communicating that we expect that this product has the potential of $200 million to $300 million at peak sales..

We'll take our next question from Douglas Tsao of Barclays..

Just to start, I think I'm trying to understand and I've got some questions trying to understand sort of the sequential guidance in terms of revenue. Obviously, they were really strong this last quarter. If I look at your historical seasonality, 4Q seems to be up a little -- to be up pretty meaningfully from 3Q.

So just understanding some of those dynamics, as we move into the fourth quarter, that we should be aware of. And certainly the FX guidance seems to be a little bit more extreme than I would've expected. And then the other question is on terms of the PEDv vaccine.

Just perhaps you can provide some perspective on how big an opportunity that can be for you and sort of the timing of that sort of coming -- or sort of the revenue sort of building on that product line because, obviously, very impressive how quickly you were able to get a product approved and to market..

Yes, it's Paul. I'll take the fourth quarter. And how do you get there? I mean, we have 3 quarters on the board. So the year-to-date number is on the board. We have guidance. You can do the math and see what it implies with respect to revenue growth in the fourth quarter that's implied by that.

Midpoint of the range, it's -- from a reported basis, it's sort of flattish and we did state that there's about a 250- to 300-basis-point negative impact to our revenues in Q4 versus Q4 of 2013. So fairly significant FX headwinds.

And it does give me the opportunity to say, look, we feel like, from an operational perspective, we have a very strong quarter here and very strong guidance for the full year and that's pretty good when you're facing those sorts of FX headwinds that will -- almost certainly, in fact, I would say certainly will hit us in Q4 '14 compared back to '13.

And frankly, as you think ahead to 2015 v '14 you have got to take this into account. For perspective, 45% of our revenue comes from our U.S. So we're U.S. dollar denominated, we're exposed to the euro, the real, Canadian dollar, Aussie dollar, sterling, yen. From the perspective of a U.S.

dollar-denominated P&L, all those currencies I mentioned, there's not a lot of good news. There's a lot of headwind there. So we feel like our guidance for the full year and our guidance for Q4 is pretty strong, given that we're facing those headwinds going into -- or going into Q4.

I think I'll leave it at that and Juan Ramón?.

And I will answer the question on PEDv. And so just to provide a little bit of understanding of the market's potential. So first, this vaccine, it's targeting sows. And then by vaccinating the sows, it's transmitting the immunity to the piglet. So the number of sows in the U.S.

is a little bit less of 6 million compared to 100 million of pigs of the total market. You see that the potential is related to the number of animals that will get this vaccine. That will be less than 6 million. The second fact that is also important is that we obtained a conditional license.

Under the conditional license, we have some limitations in terms of the promotions. Actually, we can go to the customers and work with them to ensure protection for the sow, but there are some limitations in terms of promotion. What is important here is not the size of the revenues, but the confirmation that our business model is working very well.

We have very strong capabilities in terms of R&D. Also, we have very strong capabilities in terms of our manufacturing to produce vaccine in a way that it's going to the market very fast.

So in our opinion, we are bringing with this vaccine significant value to our customers, that they are facing a significant challenge with this disease, and we are confirming that Zoetis has all the capabilities that are needed to succeed in this industry..

Sorry, it's Paul. I just do want to follow up. The one thing that I didn't say in my remarks about Q4 is also take a look at the quarter you're comparing to back in 2013. Our Q4 was quite strong.

If you look at Q -- if you go back to '13 and you look sequentially, Q3 of '13 like $1.1 billion, Q4 '13 $1.254 billion, I think it was -- I've got -- yes, it was a little over $1.2 billion. And so, one is comparing back to last year's Q3, that certainly helped us in putting our good quarter on the board here in Q3 of '14.

But that's a tough comparison quarter, Q4 of '13..

And so, Paul, just to clarify, so you don't think that necessarily that step-up of $115 million sequentially is sort of like a normal seasonal trend that we should think about?.

From '13 -- what I'd say is, I want to make this point over and over and over again, is because of the nature of our business and seasonality and how things can shift from September to October or across the month, the best way to look at it is the longest time period that you're comfortable with whether that's a year, a half year, whatever.

If you look at the second half of 2014 versus '13, it's a good, solid second half of '14..

Our next question comes from Mark Schoenebaum of Evercore ISI..

It's actually Vlad Nikolenko sitting in for Mark Schoenebaum. And so the question -- sorry for maybe beating a dead horse. But the question about the Q4, the current full year guidance implies that from Q3 to Q4 of this year, so year -- quarter-by-quarter growth, it's probably going to be a down quarter for revenue and for EPS.

So I'm wondering if you can explain that in terms of expenses, what happens in Q4.

Is it just seasonal stuff or something else? And in terms of revenue, I understand there will be a huge FX impact, but also just for FX, just to understand how it works for our models, I'm wondering if you can give more color about the type of hedging Zoetis is using for -- both for revenue, for the plan, as well as for EPS..

Okay. Let me -- stay with me here because I want to make sure I understand your question. I think you started by asking about sequentially from Q3 of '14 into Q4 of '14. If you take the midpoint of our range, it would be up in Q4 versus Q3. Okay.

So sequentially, I mean, at the midpoint of our range, you would have an increase in revenue Q3 '14 into Q4 '14.

The other thing to point out is we talked about the impact in the quarter of the increased cost of goods sold as a percentage of revenue, the implied is in the -- is going to be a high percentage and we called that out even in my prepared remarks. So you've got that. Then within SG&A, we typically do spend more towards the back half of the year.

That's been a historically observed phenomenon within our business. And certainly within R&D, there is seasonality in our spend there and we talk about sort of the timing of trials that we can do in the field.

You need the right conditions in order to be able to do that and the timing of projects, generally, ours have seemed to cluster and have us with more expense in R&D in Q4.

You put all of those things together, yes, and then looking at Q4 on a stand-alone basis, yes, you could say, "Well, gee, the -- against whatever comparator you want to have, whether it's Q3 of '14 or Q4 of '13, it's a tough comparison." Again, strong full year expectation for the company.

You were looking for reported growth in the neighborhood of 3% to 4% at the top line and that's on an operating basis taking FX out of the mix. Now this is revenue, expecting 5% to 6%. Think of that reported 3% to 4% range as -- but for FX, that's 5% to 6%, which is a very solid full year revenue growth '14 v '13.

And I'm sorry, the second question?.

And the second question about the hedging. What type of hedging do you guys use to hedge top line and bottom line, if you do. Hedging instruments, if you're using specific instruments or rely on sort of natural hedging.

And if there is natural hedging between regions, what is the delay between -- when the dollar moves or currencies move and the impact that we can see?.

Yes, a couple of things. I mean, we have natural hedges built in to markets where we have a significant presence because, of course, our costs are denominated in the same currency as our revenue streams. We do not hedge our top line nor our bottom line results. Like most companies, we don't. We are subject to, what they -- the changes in exchange rates.

And frankly, if you look at them, again, my favorite phrase, over a long enough period of time, you'll see that those things sort of set -- sort themselves out. Where we do hedge is our net asset exposures in our subsidiaries.

So that to the extent that we have risk when those balance sheets are translated, that we can hedge that and keep those costs within a relatively narrow band. We do, do that. Those costs as well as the FX gains or losses, would show up in our other income and deductions line within our P&L..

Our next question comes from David Risinger of Morgan Stanley..

So I have, first, some questions for Juan Ramón and then for Paul. So Juan Ramón, first, could you just talk about animals moving into feed lots sooner in a little bit more detail on -- specifically what I'm hoping for you to address is how durable that is.

So for how many quarters will that be benefiting Zoetis? Second, you've mentioned the APOQUEL revenue for '15 being over $100 million. Could you just help us benchmark that by providing a framework for what revenue you're going to be booking in 2014 for APOQUEL? And then third, for the PEDv vaccine. You mentioned 6 million sows is the opportunity.

Could you just tell us the price of the vaccine? And I think it's given twice a year, but just remind us about that as well..

Thank you, Dave. And you are correct, it's 2x per year, maybe the first time, it's -- it can be an opportunity of 3 vaccines, but then the following years would be 2x. And the price of the PEDv vaccine, it's $7 -- about $7. The treatment choice, 3.5 each vaccine. In terms of APOQUEL for 2014, so we communicated that will be around 1% of our revenue.

Our revenue, it's $4.5 billion or $4.7 billion. So we expect that we'll be around $40 million in terms of revenues. And this is only limited because of the supply availability. And then talking about the movement of animals and how long this movement will stay? Well, it depends on the price of the grain.

So if the price of the grains are low, so the incentive of moving animals and keeping these animals in the feed lot with significant gains in terms of weight, I think, it will be an opportunity for maintaining this current situation.

What we saw in 2014 is even the number of animals moving to the feed lot, maybe it will be slightly lower than the 2013 because they are less animals because they are keeping animals. Also to rebuild the herd, they have been moving animals at a younger age, which are lighter, more vulnerable to infections, more needs of vaccinations.

And this has been having a positive impact in our revenues. We expect this situation of younger animals move to the feed lots will stay in the future, in 2015, because the price of feeding the animals remains very low and the profitability and the value of these animals is very high..

That's great. And Paul, congrats again.

My couple of questions for you are, first, when do you expect to get through the standup costs? Second, what is the FX hit to EPS that you're expecting in the fourth quarter? And then third, if the R&D tax credit is passed, what will the benefit be in the fourth quarter?.

Okay. In -- 2 out of the 3, I can answer. Thanks, David. Well, that question about when we'll be through the standup cost, I would expect to be substantially complete towards the latter part of 2015. Let's say, the end of 2015.

We will continue to be flipping switches on our ERP implementation into 2016, but the lion share of the costs should be behind us after the year end 2015. The FX impact on -- at the net income line implied for Q4 is in the range of 100 to 150 basis points negative.

And then the last question about the R&D credit in Q4, if it were to be passed, it will have an impact of approximately 50 basis points to the full year rate..

Our next question comes from Jeff Holford of Jefferies..

I've got 2 for Paul, please. Firstly just on APOQUEL, just trying to think about contribution margins of this product as it gets towards the peak of $200 million to $300 million, which you just guided.

I would assume that this is a very high margin product relative to the rest of the business, something more like a pharmaceutical contribution margin, probably -- possibly 50%, 60% or higher in terms of the operating level, if you can comment around that.

And then just secondly, could you tell us if Zoetis has any kind of poison pill type measures as bid defenses? And if not, is the company intending to introduce these into 2015?.

I couldn't get the second question. So it's....

I'll get the second..

So let me answer the APOQUEL. So our gross margin, has risen to 65%. And we communicated that companion animal has the highest margins in our total portfolio, followed by cattle, then swine and the lowest is poultry.

So even if we have not provided details of each species, you can extrapolate that with the 65% that companion animal, being the highest, it's -- APOQUEL has a good margin. And in terms of how much we need to invest to support these product launches.

So what we said is that we have the infrastructure to support the promotional activities of any new products. And maybe in some cases, we need also to support this approach probably some additional advertising and promotion.

But in our opinion, in the case of APOQUEL, the reaction of the market has been so positive that we don't think that we'll require any significant additional investment to support the objective that we have set for 2015 and also the long-term objective of $200 million to $300 million peak sales.

And then Paul will answer the question on the poison pill..

Yes. Yes, I'll answer the question by saying, with respect to your specific question around poison pill, no comment on that specifically. However, what I would say is, we're a public company.

We're for sale every day and to the extend that someone were to come in and be interested and think they could do a better job with our collection of assets, there's certainly the opportunity for them to express that. What I would report back though is, we think we're the team to run this company. We're driving value for our shareholders.

We're doing that by pulling all of the levers at our disposal which includes being maniacal about deploying capital both inside and, hopefully, outside of our business. And at the end of the day, if we deliver value, that's what we rely on to continue to be the fellows and ladies that run this company..

Our next question comes from Erin Wilson of Bank of America..

Livestock growth was impressive. Can you break out what was attributable to volume, price and new products, such as the beta agonists? How sustainable kind of is that growth? And also with consolidating competitors, there could also be some opportunities to potentially fill some holes in your portfolio.

What are areas that you would find particularly interesting for you, any specific therapeutic category?.

Well, we, in my opinion -- thank you, Erin, for the question. I think, in my opinion, we have a very strong portfolio. I believe that, that is the strongest portfolio in the animal health industry.

We have always opportunities to fill some gaps, but we don't have a strategic need to really cover areas, which are important for animal health, which are not part of our portfolio. We are very strong in vaccines. We are very strong in parasiticide.

We are strong in also other therapeutic areas and definitely we'll be always assessing opportunities to add more products to our portfolio.

But because we think that we have the infrastructure and we have the opportunity to achieve synergies in both revenues and also in terms of costs, by adding products or adding assets of our company, but not because we have a strategic need to fill any area where we feel that we are -- or represent a significant gap in our business.

And in terms of the livestock growth, definitely it has been very strong growth. Volume has been the most important part of the growth. And price, we also mentioned that the price is in line with the industry. The industry in terms of price is growing around 3% and this is consistent with our growth in terms of price.

So all the rest has been volume, so very strong performance in terms of volume. That is also the result of excellent portfolio and also excellent execution from our teams to bring this as well to the market..

Okay.

And as it relates to QUEL and the competing drug for Rimadyl, are there relationships with distributors that you could establish there and -- that would potentially help to win the competition there? And how big is opportunity for Versican? And is there an opportunity for that in the U.S.?.

So we definitely partner with distributors that are also helping us to reach customers that we are not calling directly to our field force. And this partnership is working very well and I think it's something we are happy with the declaration that we are having with distributors.

And we will continue really providing to them the products and also the kind of support that they need also to promote the products to customers that we are not directly targeting through our direct model..

And there are no further questions at this time. I would like to turn the floor back over to Juan Ramón for any additional or closing remarks..

So thank you very much for joining today's call. And I'm looking forward to see you on November 18 in New York at the New York Stock Exchange, in where we'll have the opportunity to go into more details of our business model and also more details on our guidance for 2015 and also for the period of '15, '17. Thank you very much..

Thank you. This does conclude today's teleconference. A replay of today's call will be available in 2 hours by dialing 1 (800) 723-2156, for U.S. listeners and area code (402) 220-2660 for international. Please disconnect your lines at this time, and have a wonderful day..