Steve Frank - Zoetis, Inc. Juan Ramón Alaix - Zoetis, Inc. Glenn David - Zoetis, Inc..

Louise Chen - Guggenheim Securities LLC Jonathan Block - Stifel, Nicolaus & Co., Inc. Jeffrey Holford - Jefferies LLC Derik de Bruin - Bank of America Merrill Lynch John Scotti - Evercore ISI John C. Kreger - William Blair & Co. LLC Frank DiLorenzo - BMO Capital Markets Kathy M. Miner - Cowen & Co. LLC.

Good day, and welcome to the Third Quarter 2016 Financial Results Conference Call and Webcast for Zoetis. Hosting the call today is Steve Frank, Vice President of Investor Relations for Zoetis. The presentation materials and additional financial tables are currently posted on the Investor Relations section of zoetis.com.

The presentation slides can be managed by you, the viewer, and will not be forwarded automatically. In addition, a replay of this call will be available approximately two hours after the conclusion of this call via dial-in on the Investor Relations section of zoetis.com.

At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. It is now my pleasure to turn the floor over to Steve Frank. Steve, you may begin..

Thank you, operator. Good morning and welcome to the Zoetis third quarter 2016 earnings call. I am joined today by Juan Ramón Alaix, our Chief Executive Officer; and Glenn David, our Chief Financial Officer.

Before we begin, I'll remind you that the slides presented on this call are available on the Investor Relations section of our website and that our remarks today will include forward-looking statements, and that actual results could differ materially from those projections.

For a list and description of certain factors that could cause results to differ, I refer you to the forward-looking statement in today's press release and our SEC filings, including but not limited to, our 2015 annual report on Form 10-K and our reports on Form 10-Q.

Our remarks today will also include references to certain financial measures, which were not prepared in accordance with Generally Accepted Accounting Principles or U.S. GAAP. 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, November 2, 2016. We also cite operational results, which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramón..

Thank you, Steve. Good morning, everyone. There's been a lot written lately about the animal health industry, livestock, in particular, and the cycles we face as a part of the global food supply chain.

Let me start by saying that I'm very pleased with the positive result we have reported in the third quarter because it reaffirms that we understand the cycles of our customers' businesses. And as in the past, we continue to be resilient in our ability to adapt and steadily grow our business, despite the broader agricultural market changes.

At Zoetis, we have regularly grown faster than the market, and we are very well positioned to achieve predictable growth during these cycles because of our diverse portfolio and global scope. We remain focused on the long-term full-year review of our business since quarterly results can be misleading about the cycles in our customers' markets.

Our strength in all relevant geographies, species, and therapeutic areas help us offset many of the economic and business challenges that can affect part of the animal health industry in the near term.

We're also making improvements in our cost structure and reallocating resources to the most important growth opportunities in animal health from a therapeutic area and geographical perspective.

I'm pleased to say, we have nearly completed our operational efficiency initiative, and we can confirm that we expect to achieve the target of $300 million in cost savings by the end of 2017.

We also now expect to achieve an adjusted EBIT margin of 34% to 35% in 2017, higher than our original projection, and we expect to grow our revenues faster than the market again in 2017. This quarter, we delivered strong results. We grew our revenue 4% operationally, with particular strength in our companion animal portfolio.

When you exclude the impact of our operational efficiency initiative, foreign exchange, and acquisitions, or what we call normalized organic operational growth, our growth in the third quarter was 6%. On the same normalized basis, our companion animal products grew 11% and our livestock products grew 2%.

The companion animal growth was driven by a full supply of APOQUEL and the introduction of other new products. And in livestock, the main driver of growth was strength in our international markets, which were able to offset the impact of product rationalization changes across the livestock portfolio.

Moving forward, we expect companion animal to be the main contributor to growth in the fourth quarter and in 2017. And in terms of livestock, we expect improved growth as we get beyond the product rationalization impacts this year.

Moving on to earnings, we grew adjusted earnings 6% operationally, reflecting the negative impact of higher adjusted effective tax rate. Glenn will discuss this in more detail. But, excluding tax and interest, our EBIT growth was 17%.

As we finish up 2016, we are increasing our 2016 earnings guidance to reflect the strong performance we have achieved through the first nine months of the year.

And based on the monthly (sic) [continued] trends we see and the confidence in our business, we are also improving our guidance for 2017, despite the recent negative evolution of currencies compared to the U.S. dollar. Let me provide additional business updates on some key products and discuss the investments we are making to support that growth.

For the first nine months of 2016, we have generated approximately $180 million in revenue for APOQUEL, with about $70 million coming in the third quarter. We have here an excellent response from veterinarians and pet owners using APOQUEL, as we increase our penetration in new markets.

Our research indicates that we are achieving great awareness and satisfaction among veterinarians, as well as more frequent proactive requests from pet owners. APOQUEL has now been launched with unrestricted supply in all approved markets. And we are working on further expanding its market share.

In the U.S., we have seen growth of new patients since achieving full supply in May. APOQUEL has been doing very well in treating dogs with chronic allergies. And we are increasingly seeing it used for more seasonal and acute allergy causes, an important part of our expansion plans.

As we look ahead with APOQUEL, we are trying additional ways to support this product growth. For example, in the U.S., we are developing and testing direct-to-consumer, or DTC, advertising and we expect to launch a national advertising campaign for APOQUEL in 2017.

Also to support the growth of our companion animal business, we have also been expanding our product portfolios and field force in China and Brazil. These are great examples on how our efficiency initiative is ultimately about better allocating resources to generate sales growth.

Meanwhile, Simparica, our new oral parasiticide for dogs, is available in the U.S. and most of the EU countries, and is being further deployed in markets like Canada and Brazil. In 2017, Simparica will be available for the full flea and tick season in the U.S. and EU.

We are planning to support Simparica with additional promotional investment to ensure it has a positive impact in our revenue growth in 2017. We are also getting ready for the broader launch of our canine antibody therapy, targeting IL-31. This therapy is currently only available in the U.S. under conditional license.

And in October, we expanded our efforts beyond dermatology specialists and made it available to all veterinarians in the U.S. We'll broaden distribution in the weeks ahead and we expect to achieve a full USDA license by the end of the year, with Europe to follow next year.

We are also seeing good progress with the PHARMAQ acquisition that we made one year ago. We have posted $64 million in fish revenue through the first nine months of the year, despite the toxic algae bloom that has been impacting fish farmers in Chile. PHARMAQ has achieved rapid adoption of its ALPHA JECT LiVac SRS vaccine for farmers in Chile.

Fish farmers who needed a more predictable and reliable means of protection have responded very favorably to recent information that LiVac SRS has already demonstrated protection up to 11 months after vaccination, and we continue testing for longer duration of efficacy.

Fish farmers also view this vaccine as an important way to reduce the use of antibiotics in their operations. Now, let me turn to the R&D innovations that continue supporting our future growth and value creation. New product introductions like APOQUEL, the IL-31 antibody therapy, Simparica and the ALPHA JECT LiVac SRS vaccine are very important.

And continuous innovation over the lifecycle of our products is also critical to our long-term success. In the third quarter, we had several approvals of new indications and formulations for key livestock products. In swine, we obtained approvals in the U.S. for new combinations of our FLUSURE XP vaccine.

This now helps guard against additional flu strains that threaten swine herd health. We also expanded our FOSTERA swine vaccine with additional indications and approvals in markets like Brazil, Mexico and Korea. Our premium injectable anti-infective DRAXXIN received additional indications and approvals in Japan and Canada.

We also obtained approval in Japan for BOPRIVA, a unique vaccine that temporarily reduce testosterone in bulls, providing farmers with a highly-effective way to manage aggressive behavior. We're also making investment and showing progress in our diagnostic portfolio. In August, we acquired Scandinavian Micro Biodevices or SMB.

They are pioneers in developing the manufacturing microfluidic lab on a chip diagnostic products, which are used for veterinary point-of-care services. SMB's promising product line has helped our existing diagnostic business, which obtained approval for values and test kits in the third quarter in new markets such as Mexico, Japan and Korea.

Lots of good news to share about our new products, lifecycle innovation and business development activities. In summary, we have continued to demonstrate the strength of our diverse portfolio across geographies and species. And this time, we see particular strength in our companion animal portfolio.

We are realizing the benefits of a disciplined approach to R&D and business development, which is strengthening our business for the long term. And we expect to achieve our operational efficiency initiative target in 2017 and set ourselves on a path to increase profitability, cash generation and value creation, while maintaining our revenue growth.

With that, let me turn things over to Glenn.

Glenn?.

Thank you, Juan Ramón. Before I get into the financials, I wanted to thank many of you for reaching out and speaking with me since I became CFO in August. I'm very excited to take on this role and work with the rest of Zoetis' leaders to continue driving the performance of our company.

As CFO, I am committed to maintaining our reputation for financial integrity and transparency and continuing an ongoing dialogue with the investment community.

We remain focused on achieving our updated financial guidance for 2016 and 2017, building our capacity for long-term revenue and earnings growth, and delivering the innovations and financial performance that people have come to expect from Zoetis.

I am pleased to say that in my first quarter as CFO that we are making excellent progress on all those fronts, and we are raising our earnings guidance for 2016 and improving our earnings guidance for 2017, despite the negative impact of foreign currency, which was approximately $0.03.

The consistent performance we've delivered over time through recent periods of major efficiency initiatives and change is a testament to the quality and commitment of our Zoetis colleagues.

So, what are the key takeaways for the third quarter results? Continued strong operational revenue growth from our diverse portfolio, continued improvement in our adjusted EBIT growth and margin, a meaningful contribution from several new product launches, lifecycle innovations and targeted business development activities, and finally, an updated guidance for 2016 and 2017 that reflects our recent performance and confidence in the future.

Now, let me walk you through the major pieces of our third quarter income statement and provide some color. We generally talk to operational growth, which excludes the impacts of foreign currency.

You can also see, once again, in the tables on our website that we are providing additional detail on impacts related to our operational efficiency initiatives, M&A, and in the case of the year-to-date charts, the extra days in our first quarter relative to the prior year.

We refer to the revenue growth excluding these items as normalized organic operational growth. For the third quarter, operational revenue growth was 4%, which excludes the 2% negative impact of foreign exchange. Now, let me take you through the key elements of our performance and bridge that to our normalized growth.

First, APOQUEL and a number of other new products contributed 5% of our revenue growth. The in-line portfolio grew 1%, with price contributing 2% and volume declining 1%.

Recent M&A contributed 3% to our growth, while our operational efficiency initiative reduced our growth by 5%, due to product rationalizations and changes to our business in markets like Venezuela and India. Accounting for all of these factors, we delivered normalized organic operational growth of 6% in the quarter.

And for the first nine months of the year, our revenue growth on this basis was 7%, in line with our view of 7% to 8% growth for the full year. Turning now to our segment performance; in terms of the U.S., we generated 1% operational growth compared to a very strong third quarter in the previous year. Just a reminder, the U.S.

grew 19% in Q3 2015, with livestock growing 13% and companion animal growing 27%. In the third quarter of 2016, U.S. companion animal products grew 5%, driven by APOQUEL, Simparica and other new product launches like our new vaccines. This growth was partially offset by a decline in surgical fluid products. In U.S.

livestock, we declined by 2% against the very strong year-ago quarter when we grew 13%. The decline was primarily due to the impact of SKU eliminations, lower sales of our swine products, where we continue to see increased competition, as well as the impact of a challenging market environment, especially for our cattle and swine customers.

We partially offset this decline with growth in our cattle business, where successful promotional activity drove increased volumes. Shifting back to a normalized organic operational growth basis, U.S. grew 3% with companion animal growing 6% and livestock growing 1%. Turning to International, revenue grew 6% operationally.

We delivered very strong operational growth of 15% in companion animal and 2% in livestock. Our International business saw a significant impact from our operational efficiency initiatives, which reduced growth by 8%. By species group, the impact was 9% in livestock and 6% in companion animal.

M&A activity, primarily PHARMAQ, contributed 5% to our International revenue growth. Based on these factors, our normalized organic operational growth for International was 9%, with companion animal growth of 21% and livestock growth of 4%. You can see the full results for our top 11 markets in the table, so let me highlight a few items.

Growth in markets like Japan, Brazil, Germany and Australia was primarily from companion animal products and launches of APOQUEL. In Japan, we saw a significant benefit from the initial stocking of APOQUEL with wholesalers in the quarter.

France and Canada both saw a mix of companion animal and livestock sales driving their growth, including sales of APOQUEL and a more stable environment in France around antibiotic usage and prior regulatory changes.

Meanwhile, we continue to see livestock supported with growth in cattle in Brazil and swine in China, where we currently have favorable market conditions, as well as growth in companion animal in China, where we are seeing positive trends in medicalization rates for pets.

Overall, we have been very pleased with the strong growth we have seen in emerging markets, particularly China and Brazil, where we have invested in expanding our field force and product portfolios to effectively capitalize on the fast-growing trends in these countries.

We'll continue to deploy selling resources in these and other markets where we see significant and sustainable growth drivers, combined with high returns on our investments. Wrapping up the revenue picture, there are five key takeaways for the third quarter.

Our diversified model continues to deliver steady, predictable and meaningful revenue growth, with strong product lines and geographies balancing the effect of certain market challenges and cycles. Product rationalization continues to impact revenue growth. However, we continue to deliver strong growth on a normalized basis.

APOQUEL once again was a significant growth driver, with launches in new markets and continued expansion of the customer base in existing markets. Other companion animal products, like Simparica and recent additions to our vaccine portfolio, are contributing to growth.

And finally, when it comes to revenue, we are improving the base business in various emerging markets by expanding our product portfolio and adding to our direct sales capability.

Turning to the rest of the P&L, adjusted gross margin improved 120 basis points, primarily due to a more profitable mix of products, while foreign exchange had a negative impact of 70 basis points this quarter.

Adjusted operating expense also declined, reflecting the continued realization of our operational efficiency changes and continued discipline around SG&A, which includes the addition of PHARMAQ expenses this year.

Improved gross margin and a reduction in operating expenses enabled us to grow our adjusted EBIT by 17% operationally, versus the 4% operational revenue growth. Our adjusted effective tax rate in the third quarter was 31.6% versus 25.1% in the year-ago quarter.

This difference was primarily driven by the impact of the European Commission tax ruling earlier this year, and the benefit of certain discrete items in the year-ago quarter.

As a result, adjusted net income grew 6% operationally, reflecting the change to our adjusted tax rate and higher interest expense, which offset much of our adjusted EBIT growth.

For the quarter, GAAP net income grew 26% on a reported basis, aided by a reduction in stand-up costs and restructuring charges, as well as the revaluation of deferred tax assets related to the establishment of our new International operating model.

Moving to guidance for full-year 2016, we are narrowing to the high end of our revenue range, and increasing our adjusted diluted EPS to reflect our ongoing confidence in the momentum of our new products and the sustainable cost benefits of our operational efficiency initiative.

As you model out the remainder of 2016, remember that we have five fewer days in Q4 2016 than Q4 2015. And this is usually our highest quarter in terms of operating expenses as a percent of revenue, and our lowest quarter for gross margin, due to the seasonal nature of our product mix.

For the year, we expect to achieve operational revenue growth, including the impact from product rationalization, of 4% to 5%, and adjusted EBIT margin of approximately 32%, and operational growth and adjusted net income of 12% to 15%.

The significant increase in our guidance for reported diluted EPS is due to our increased outlook for the business and the favorable tax items realized in Q3. Moving to 2017; since our last update in August, changes in FX rates have lowered our views for revenue by $50 million and adjusted diluted EPS by $0.03.

However, the overall evolution in our business over the past year has been positive on balance, as our companion animal dermatology portfolio continues to grow and several livestock markets in our International business are strengthening.

These changes are allowing us to increase the lower end of our revenue range and maintaining the high end, while absorbing the negative impact of foreign exchange. Cost of goods remains the same at 32% to 33% as we have been successful in our cost reduction efforts, as well as our SKU rationalization that has brought an improved mix.

On SG&A, FX changes were slightly in our favor.

However, we are increasing the lower end of our range and maintaining the high end as we allocate a portion of our cost savings to promising investment opportunities, such as, advertising and promotion investments in key companion animal franchises like APOQUEL and Simparica that will drive revenue starting in 2017 and over the next several years.

Field force expansions in Brazil and China where we see sustainable growth drivers and opportunities for increased market share, and enhancements to our diagnostics commercial capabilities following the acquisition of SMB.

We're also taking on the necessary R&D investments to develop SMB's pipeline, as well as investing additional R&D dollars to some of our key international growth markets.

When you take all of these changes together, we are increasing the lower end of our adjusted EPS range, maintaining the high end of $2.38, despite the negative impact of foreign currency, while also improving our view for adjusted EBIT margin to be between 34% and 35%.

While we don't provide quarterly guidance, we do want to point out that we are currently expecting the delivery of full-year 2017 adjusted diluted EPS growth to be more heavily weighted to the second half of the year for a few reasons.

First, we will have some lingering effects from the operational efficiency initiative in the first two quarters as we continue to sell out remaining inventory in Q1 and Q2 of 2016. Second, a portion of our revenue growth is dependent upon the ramping up of new product launches, which we expect to build throughout the year.

Finally, many of the incremental investments we are making on the SG&A line are weighted towards the first half of the year and begin to deliver results on the revenue line as the year goes on. A final point on capital allocation; we are continuing to repurchase shares at a steady rate of $75 million per quarter.

At this rate, we'd exhaust our current plan at the end of this year. Share repurchases will continue to be an important element of our capital allocation framework and we will provide a more specific update later this year. So wrapping up; we've improved our outlook for revenue. We've achieved our targeted cost structure.

We're prudently taking on investments in long-term growth. We've improved our outlook for adjusted EBIT margin and we've improved our view for EPS. There's been a tremendous effort to get where we are. We're proud of what we've achieved to-date and we are excited to continue to move the business to new heights.

With that, I'll hand it over to the operator to open the line for your questions.

Operator?.

And we'll take our first question from Louise Chen with Guggenheim Securities. Please go ahead..

Hi. Thanks for taking my question. My question here is on livestock. How should we think about Zoetis' ability to grow livestock sales through pricing pressures in the U.S. for cattle? And can you provide more details on the herd size, U.S. feed lot sales, and producer profitability and the puts and takes here? Thanks..

Thank you, Louise. It's Juan Ramón. Well, on the question on the livestock and how we plan to grow this business in price or other volume growth, definitely, we'll continue applying the same strategy in terms of pricing that can be justified through outcome and providing the value to our customers.

We continue having these prices vary constantly over the years, and we also plan to continue increasing these prices in the future. In the U.S., as we reported, livestock in this quarter grew by 1% in terms of normalized growth, so excluding the impact of SKU or currency or M&A.

If we go to the sales of – in light of this growth, cattle grew by low-single digit, swine declined and poultry have double-digit growth. So, talking about the cattle and also the situation on the feed lots and all different drivers that are affecting this segment, so let me describe the factors that are impacting the cattle business in the U.S.

So, one, it's more animals, which is positive. We have seen also in this quarter higher placement of animals in feed lots, another positive element. But there are other elements, which are negative and we have seen that in the quarter. So, first, the producers are losing money. Animals are entering heavier into the feed lots.

And also, we have experiencing mild weather conditions in the U.S. that are driving a lower-disease incident. So, net-net, compared to one year ago, we think that the situation is less positive.

But still, with this situation, we have been able to grow the business and the reason why we are growing is because of our portfolio, the ability also to increase prices and also the team, which is interacting with customers. The last comment I want to make here is that this is a business, livestock, which is affected by cycles.

Cycles that have been affecting in the past, and will continue affecting in the future. Despite these cycles, the animal health industry has been very resilient and they're showing very steady growth. In the past, that's 5% to 6% and we expect also in the future despite of those cycles we will continue growing at the same rate.

And definitely, we see Zoetis also growing in 2017 in livestock in line with the market..

Thank you. We'll take our next question with Jon Block with Stifel. Please go ahead. Your line is open..

Great. Thanks, guys. Good morning. And maybe I'll just try to ask both questions upfront, so the first one on APOQUEL. I think it's now $280 million run rate before the DTC.

So, how do you feel about that north of $300 million goal? Is that now possibly $400 million? And maybe if you can talk about what prior DTCs have done to other Zoetis products, like Rimadyl. And then just a follow-up on the U.S. livestock; you mentioned you're up 1% after the adjustments in the SKU rationalization.

In the comments, I think you called out some promotions in the quarter. So just wondering, is the thought of positive U.S. livestock growth for the year still intact? Just trying to get the fluctuations between 3Q and 4Q. Thanks, guys..

Thank you, Jon for the question. On APOQUEL, we expect definitely to exceed that $300 million. We want to make sure that we have full understanding of the market reaction not only in the U.S., but also in all the rest of the markets in the product has been now made available that – with full availability.

We also need to have a full understanding of what will be the impact not only in chronic, but also in seasonal and acute.

And we said that DTC campaign, definitely, we expect to broaden the access of – or expanding the access of the product to more patients and also bring pet owners to the clinics then the veterinarians then can prescribe the product. In terms of other DTC investments, we mentioned also that we are considering also DTC for Simparica.

It's something that we will consider in the U.S. when we have the right level of penetration in the market. In terms of cattle; so cattle in the U.S., we expect that at the end of the year, we'll be growing and we insisted many times that it's important not to look at our business on a quarterly basis, but on a full-year basis.

And in full-year basis, we still expect the cattle business showing positive growth. And we know that some cycles that can be negative at certain point will turn into positive in the following phases or the following quarters or months. So, we are confident also that the cattle business in the U.S. will be showing growth in 2017..

And this is Glenn. And just to add on to APOQUEL in terms of the DTC. Since we don't have a lot of experience with DTC with a lot of our other products, we did run specific pilots for APOQUEL that give us strong confidence in the return that we're going to get that investment in the future.

And then the other thing in terms of the peak sale, we really do want to stress to look at that from a dermatology portfolio perspective. We're very excited about IL-31 in the future that that's going to bring for us..

Okay. Our next question comes from Jeff Holford with Jefferies. Please go ahead..

Thanks very much for taking my question. Just for Glenn, I wonder if you can just tell us around some of the inventory management you have. You have the SKU focus. You quite clearly guided for that in 2017.

Could you just tell us if there could be further inventory movements from the integration of SAP and is that included in the 2017 guide? And then just quick add-on of you noticed – you mentioned an update on the share repurchase, would that be part of our Capital Markets Day later this year? Thank you..

So from an inventory perspective, we definitely still do see significant opportunity to reduce our inventory moving forward. We currently sit at 10 plus months of inventory on the balance sheet and that's definitely an area of opportunity that we see. And we'll start to see benefits from the additional visibility we have in SAP.

We'll start to see those benefits in 2017 and beyond, so definitely an area of opportunity for us to increase our cash generation. The other question in terms of share repurchase, so we have a $500 million share repurchase program in place that started last year.

We'll be complete with that program by the end of the year, and we'll come back to the market later in the year with our intentions for that moving forward. But share repurchase does remain a very important part of our capital allocation priorities..

And the next question comes from Derik de Bruin with Bank of America. Please go ahead..

Hi. Good morning..

Good morning..

Could you talk a little bit about the swine business, and how much of a headwind has that been to organic revenue growth the last year or so? And I guess, when can we think about new product timing and concentrations of that? I mean just talk a little bit more about how you are thinking about rebuilding that business, or expanding that business..

Yes. And let me describe the swine business, not only in the U.S., but also International. Internationally, the swine business has been showing double-digit growth, which is very strong growth. While in the U.S., we saw in this quarter, a decline.

The main reason of this decline was some challenge in terms of one important vaccine that is used in the swine industry, which is the PCV2 vaccine. We expect to update this vaccine, and having a positive impact in terms of growth in 2017.

The rest of the markets outside of the U.S., the performance has been very strong, especially in China, where we continue seeing the benefits of more sophistication of the swine production (39:16). And we are very well positioned to maximize the opportunities in this (39:21) market.

We also – after we explain that, we are expanding our portfolio and field force in the country, in China. And definitely, we see swine generating net growth in 2017..

And our next question comes from John Scotti with Evercore ISI. Please go ahead..

Hi. Thanks for taking my question.

So I wanted to ask on operating margin, because given the increase in 2017 guidance; Glenn, in your new seat, would appreciate any thoughts on where you see operating margin growth beyond 35%? And specifically, where do you think the upper bound of operating margin expansion is? Is above 40% realistic here? And then also, can you comment specifically on the contribution of the manufacturing initiative in future years? And then really fast, sorry, just a follow-up on APOQUEL.

You mentioned you plan to exceed $300 million, can you provide any detail on timelines for that? Is that a 2017 event? Thank you..

So, in terms of the $300 million, I'll take that question first, that is a 2017 event. Exceeding the $300 million is baked in to our projection for 2017. In terms of operating margin, so we're not targeting a specific operating margin going forward. We're really focused on income generation and cash generation, and that is our focus.

However, when you look at what we articulate as our long-term strategy, the ability to grow revenue at a faster pace than our costs, that definitely does lead to increased margins as we move forward.

And in terms of the benefit that we expect to get from the supply network strategy moving forward, so we have articulated and we're still committed to, by 2020, we do expect to achieve an extra 200 basis points improvement in our margin from that strategy. So, when you take all of those factors together, that definitely leads to improved margin.

But again, our focus is on cash generation..

And the next question comes from Jami Rubin with Goldman Sachs. Please go ahead..

Good morning. This is Jonathan (41:21) on the call for Jami.

So, if protein prices continue to fall and are sustained at lower levels as a result of your cyclical factors, would that potentially cause you to revise your expectations, particularly in cattle and swine? And a second question, some of your competitors have cited challenges in their dairy segment, and given that you discuss cattle as a consolidated figure, I was hoping that you could comment on trends seen in that particular group? And further, can you elaborate on the progress of the SKU rationalization program and when that will begin tapering off, and whether you will see operational growth in U.S.

livestock remain positive, net of these rationalizations? Thank you..

Thank you for your questions. Hi, Jonathan (42:02). Let me start with the comment on the protein pricing and how this can be affecting our business. So, we have seen that these prices are going up and down, it is part of cycles that has been affecting our industry for decades. And we have been managing that very well, this situation.

We saw prices going down for poultry, and then the next cycle, going up. It always depend on the supply. The demand continue growing, and it is something that will help the industry to continue generating more revenues. We don't think that the current situation is specifically negative.

It's something that we expect that there will be a reverse in the near future. And we will see that this is not having a negative impact in our projections.

And, again, so this industry (43:11) has been very predictable and showing steady growth, even in situations with significant negative factors, including the drought or even including the economic crisis in 2008, the animal health industry was probably one of the few industries showing growth in this negative environment.

Dairy, we have seen that the prices of dairy has been down significantly at the beginning of the year.

Now these prices are recovering, and very important is that we have not seen any reduction of a herd in terms of cows, which is an indication that producers are still keeping the animals to ensure that they will be able to supply market demands in the next cycle. So, we expect also dairy having a positive trend in 2017.

And then, Glenn will talk about the SKU rationalization..

In terms of the SKU rationalization, we are essentially complete with that program. However, we did have some sales of these products in Q1 and Q2 of 2016. That does pose a challenge in the comparative for 2017. We estimate that impact to be about 1% for 2017 and more disproportionately weighted to the first half of the year..

The next question comes from John Kreger with William Blair. Please go ahead..

Hi. Thanks very much.

Glenn, can you expand a bit more on the supply chain optimization plan? You've talked in the past about a couple hundred basis points goal, but could you maybe just lay out a little more specifically, the timeline and the strategy to get there? And then secondly can you give us an update on how the livestock antibiotic portfolio did in the quarter? Thanks..

So, in terms of the supply chain optimization, there are a number of sites that we're still in the process of divesting or changing our strategy in three sites essentially that will need to ship product from one site to another. That occurs over time.

So the progression of that 200 basis points improvement that we talked about through 2020 will come over a number of years. You'll see that in 2018, 2019, and 2020. It won't be an automatic shift. It's based on the timing of shifting the products of the – from those three plants.

In terms of livestock antibiotic growth year-to-date, we are seeing positive growth year-to-date in those products. There are some shifts with M&A – within MFA. But overall, our antibiotics are growing year-to-date..

And we'll take the next question from Alex Arfaei with BMO Capital Markets. Please go ahead..

Good morning. This is Frank DiLorenzo on behalf of Alex. Thanks for taking my call. Regarding business development, will management continue to look towards small opportunities such as the recent Scandinavian Micro Biodevices deal, or are you willing to consider larger deals.

Also along those lines, are there any particular areas of interest that you are focusing on? Thanks..

So, we are not limiting our target in terms of M&A to small acquisitions. What we are targeting is a business that will support our strategy and also will create value. And I think we have significant experience in integrating companies.

We think that any acquisition that is supported by the strategy and the value creation will generate synergies in terms of costs and also revenues. We are also defining what are the areas of interest for M&A. We will continue assessing opportunities in our core business.

But also, we will consider in diagnostics also in genetics, and in devices, as a way to complement our portfolio and maximize the already existing infrastructure that we have that we will be using these products also to deliver even higher value to our customers..

We'll go next to Kathy Miner with Cowen & Company. Please go ahead. Your line is open..

Thank you, good morning. Two questions, first on APOQUEL, I think you've talked in the past that the APOQUEL sales have been largely three-quarters U.S. and one quarter O-U.S. How has that shifted and how do you see that trending going forward? And also on APOQUEL, are you able to tell us how many dogs in the U.S.

have been treated with APOQUEL so far? And then secondly just a broader question on pricing trends, as you look into 2017, can you remind us what you're pricing expectations are, both U.S. and O-U.S. and whether there's been any change from 2016? Thank you..

Let me start with the comment on prices. So, on prices, we are consistent also with the animal health projections. And the animal health projections is growing prices 2% to 3%. And this has been always very consistent in the past, and we'll continue applying this 2% to 3% in our projections.

And we expect that 2017 also will be in line with these percentages. Not too big difference in terms of U.S. or international. The only difference in some international markets with high inflation rates, the price increases can be higher and in line with this inflation. You also asked about the use of APOQUEL in the U.S. mainly.

And well, so far, until very recently, the use of APOQUEL has been mostly focused on chronic. We have seen already in this quarter that it's already APOQUEL in the U.S., which is where we have more recent market research. The use has been also extended to seasonal and chronic and acute.

And we expect also this to continue not only in the U.S., but also in the international markets. And we are very confident that the expansion of the products will be driven by the use in all the different categories; chronic, acute and seasonal. You also asked about what is the division of APOQUEL U.S.-international.

Well, this quarter, on the $70 million, $40 million came from the U.S. and $30 million international. This is something that is probably not representative of the full potential of international and the U.S.

What we can also show in the market through market research is that the new patients is growing constantly in the U.S., which is very positive, and we expect that this will continue.

And if the results of the pilot is showing positive for the DTC that we are testing in the U.S., then we expect that this will be also accelerating the use of APOQUEL in the U.S.

As you know, not in all markets that DTC is available because there are some restrictions in terms of regulatory for direct-to-consumer advertising in many markets in the world..

And we'll take a follow-up from Derik de Bruin with Bank of America. Please go ahead..

Hi. Thanks. This is Mike (51:10) on for Derik just with a quick follow up. In the last couple of months there's been a lot of movements in the competitive landscape with companies moving ahead with proposed asset swaps, some divestitures.

Can you talk a little bit about how have you seen any change in the competitive landscape, if you've been able to gain any share, and especially in the last quarter there was a lot of mixed results from competitors, particularly in companion animal in the U.S.

Some promotional changes with flea and tick; can you just talk about if you've been able to capitalize on any of those disruptions in the market?.

Well, let me start saying that we believe that we have the best portfolio in animal health industry in both companion animal and livestock. We have significant new products launch recently, and also very important our R&D investment in our current portfolio is also showing very positive results.

So, we don't think that the consolidation of the industry that will be taking place from now until the end of the year will change that significantly the competitive landscape. We compete not on a global basis, but also on a country basis and also on species basis. And there are not too significant difference because of this consolidation.

So, we are very confident that we remain very competitive, and the products that we are introducing and also this report in terms of promotional activities and R&D and even manufacturing quality and delay of supply will help us to maintain and expand our market share..

And it does appear we have no further questions at this time. I will return the floor to you, Juan Ramón for any additional or closing remarks..

So, thank you very much for joining us today. And as we said, we reported very strong results in the quarter. We are very confident on the projections that we are making for 2016 and 2017. And we'll connect again in the next earnings release. So, thank you very much..

Thank you. And this will conclude today's teleconference. A replay of today's call will be available in two hours by dialing 800-839-1320 for U.S. listeners and 402-220-0488 for international. Please disconnect your lines at this time, and have a wonderful day..