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

Derik de Bruin - Bank of America Merrill Lynch John C. Kreger - William Blair & Co. LLC Jonathan Block - Stifel, Nicolaus & Co., Inc. Jami Rubin - Goldman Sachs & Co. LLC Louise Chen - Cantor Fitzgerald Securities Erin Wilson Wright - Credit Suisse Kevin Ellich - Craig-Hallum Capital Group LLC Kathy M. Miner - Cowen & Co.

LLC Alex Arfaei - BMO Capital Markets (United States) Brett W. S. Wong - Piper Jaffray & Co..

Welcome to the second quarter 2017 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, or 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 Zoetis' second quarter 2017 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 statements in today's press release and our SEC filings, including but not limited to our 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, August 8, 2017. 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. As in previous quarters, the innovation we bring to the market and the diversity of our portfolio across the geographies, the species, and the therapeutic areas are all supporting in the consistency of our financial results.

Our innovations include the recent introduction of new products like Cytopoint, Simparica, and Stronghold Plus, and lifecycle innovations that are developed across our approximately 300 product lines.

Our diverse portfolio helps us overcome economic cycles and deal with all the political situations and weather conditions that affect the markets, the species, or the product categories. We are seeing this diversity once again in the second quarter.

And along with the excellent execution of our Zoetis team and our singular focus on animal health, all these factors helped deliver excellent results. In the second quarter, our revenue grew 6% operationally, and excluding the impact of product rationalizations that we have discussed before, our operational growth would have been 7%.

We expect this will be the last quarter that we see any significant impact from the product rationalization, as those efforts and comparisons are largely complete.

The main driver of our second quarter revenue growth remains companion animal products, which grew 10% operationally, driven largely by sales of our industry-leading dermatology portfolio consisting of Apoquel and Cytopoint and our new oral parasiticide, Simparica.

In the U.S., companion animal products grew 7%, and in international markets, they grew 15% operationally. We continue to see further penetration of new products in key countries outside of the U.S. such as Japan, Brazil, and Canada.

We have been supporting growth for Simparica and Apoquel with direct-to-consumer advertising that we have started in the second quarter in the U.S. We have made similar efforts in Brazil. Initial reports on DTC in the U.S. are positive, and we look forward to analyzing more data as we evaluate the full-year impact.

Our total dermatology portfolio has shown significant growth, achieving our first-ever quarter of more than $100 million in sales. We continue to build disease awareness through our DTC campaign and expect to expand the market. Our latest data shows that 55% of dogs with dermatology problems in the U.S.

are treated with Apoquel or Cytopoint, up from 52% in the first quarter. Cytopoint has gotten good traction in the U.S. this year. And in EU countries we are conducting an early experience program and expect to fully launch in September. We believe the early adoption and stable reaction in the U.S.

is a good indication of the success we can achieve in the European markets. Although Simparica sales were lower than in the first quarter, we continue to track well with our expectation for the year in this highly competitive market. In the U.S., we have seen net sales from clinics to pet owners growing market share since the beginning of the year.

Meanwhile, our livestock portfolio grew 3% operationally, with increases in cattle and poultry products being partially offset by a decline in fish products. Our swine product sales in the quarter were flat. In the cattle market, we posted 4% operational growth. Export demand for U.S. beef has been increasing due the lower average retail prices.

And we continue to see positive signs in other major beef-producing markets, like Brazil, Argentina, Mexico, Australia, and Canada. In the case of poultry products, we grew 4% operationally.

We are seeing strong growth in the U.S., driven mostly for our broad portfolio and expertise to help customers address a range of consumer and retailer preferences. Combining our vaccines with product such as Zoamix, Robenz, and Deccox, we are helping certain producers shift to No Antibiotics Ever production.

In swine products, although we have taken actions to strengthen our vaccine portfolio in the U.S., we are still showing a decline in U.S. sales. In international, however, our swine business is growing very strongly, led by China, the world's largest pork market.

In fish products in the second quarter, we have seen a decline of 5% operationally, mainly due to a slower uptake of our SRS vaccine in Chile. Nevertheless, we still expect double-digit growth for fish products this year, and we remain confident in the long-term prospects for this business.

We posted 11% operational growth in adjusted net income, once again faster than revenue growth of 6% and in line with our value proposition to shareholders to grow adjusted net income faster than revenue.

And the full implementation of our efficiency initiative is enabling us to invest in additional promotional activities like DTC, while showing only a modest 1% operational growth in operating expenses. With our increasing cash flow, we continue to look at other investments we can make to support our future growth.

One key area is ensuring reliable, high-quality supply to drive our growth. As part of our supply network strategy, we expect to complete the sales of our Guarulhos plant in Brazil in the fourth quarter. At the same time, we are planning to expand our vaccine plant and invest in manufacturing capacity for other innovative products.

We'll share more details as plans move farther along. While new products like Simparica and Cytopoint may get well-deserved headlines, we also focus on lifecycle innovation to keep established brands delivering value to customers over decades. For example, Zoetis received approval in May from the FDA for Clavamox Chewable for dogs.

This leading anti-infective was first approved in the U.S. in 1984, and it provides a broad spectrum of treatment for various infections in dogs and cats. Clavamox Chewables join the original tablet and liquid drop formulations, which we'll continue to market. And our internal innovation is complemented by M&A opportunities.

Last week, we completed the acquisition of Nexvet Biopharma, an innovator in monoclonal antibody therapies for companion animals in management of chronic pain and other therapeutic area. This acquisition demonstrates how we use external innovation in key technologies and therapeutic areas to support future growth.

Nexvet strengthens our R&D pipeline in monoclonal antibodies to help us to sustain our leadership in chronic pain management for companion animals, an area valued at an estimated $400 million a year, and which is poised for innovation with new monoclonal antibody therapies.

We are moving ahead with the work of integrating Nexvet into our existing research and manufacturing operations in order to advance with their promising product candidates. With the first half of the year now behind us, we are tracking to our expectations.

We are pleased with the strong start to the year, and we are increasing our full-year 2017 guidance for revenue and net income, based on foreign currency changes and our continued confidence. With that, let me hand things over to Glenn, who will provide more details on our second quarter results and full-year guidance.

Glenn?.

Thank you, Juan Ramón, and good morning, everyone. We had another solid quarter based on the strong growth of our dermatology portfolio and other recently launched companion animal products, as well as growth in our global livestock portfolio, which was balanced across our U.S. and international business segments.

Total company revenue grew 6% operationally, which excludes the negative 1% impact from foreign exchange. Breaking down that 6% growth, 6% came from dermatology and other new products, and 1% came from our inline portfolio, with the product rationalization having a negative 1% impact on operational growth.

As Juan Ramón mentioned, our dermatology portfolio reached a considerable milestone with sales in the quarter of $102 million. As we have said in the past, Q2 and Q3 are the peak seasons for dermatitis in the U.S., with a softer Q1 and Q4. As expected, Simparica sales were lower sequentially at $20 million. This was driven primarily by the U.S.

and the timing of distributor purchases in Q1, in anticipation of the flea and tick season. Internationally, we saw strong growth sequentially in Simparica, with additional penetration in most major markets. In terms of the bottom line, we delivered 11% operational growth in adjusted net income, and 12% operational growth in adjusted diluted EPS.

Overall, we had another quarter of solid top line performance, and we again grew our bottom line faster than our sales. We continue to deliver steady, long-term growth in an attractive and stable industry.

Our ability to bring innovative and differentiated products to market, combined with our diverse portfolio and leading commercial capabilities, gives us a stable foundation for future long-term growth. Now let's discuss segment revenues. Our International segment generated operational revenue growth of 7%, while the U.S. grew 5%.

In the International segment, product rationalization had a negative 1% impact on growth. So let me highlight a few markets. China has delivered another strong quarter, growing 14% operationally, with growth coming from both our livestock and companion animal businesses.

In livestock in China, we benefited from solid market dynamics in swine, including favorable pork prices through the first half of the year. We expect some softening in this trend during the second half of the year.

However, the continued modernization of production will drive greater long-term growth based on the use of vaccines and medicines to ensure a safe, high-quality food supply. In companion animal, our recently expanded field force continues to partner with local veterinarians to improve medicalization rates and increase routine care for pets in China.

In Brazil, we grew 8% operationally in the quarter behind the strength of our cattle and companion animal businesses. Investments in field force expansion and favorable market condition contributed to growth in cattle, despite recent industry and government headlines.

And companion animal growth in Brazil was driven by new product introductions, including Simparica and Apoquel. Japan also made a significant contribution in the quarter, growing 17% operationally over the same quarter last year. Apoquel sales begin to normalize with distributors and better reflect the strong underlying demand in the local market.

As a reminder, there was significant distributor stocking in Q3 of 2016, when we initially launched Apoquel. Key markets in Europe performed well in the quarter, as the U.K., Germany, France, Spain, and Italy all exhibited operational growth. The U.K. and Germany led the way at 12% and 8% operational growth respectively. Growth in the U.K.

was driven primarily by Apoquel, while Germany's performance was due to strength in both Apoquel and Simparica. To summarize, very strong growth in our International business coming from a number of sources, including strong market trends, strategic investments, and our success in bringing new value-added products to market.

Turning to the U.S., revenue grew 5% in the second quarter, companion animal grew 7%, and livestock grew 3%. Companion animal sales in the quarter were driven primarily by our dermatology portfolio, Simparica, and a number of other new product launches. U.S.

dermatology sales were $74 million for the quarter, with Cytopoint sales reaching $15 million, exhibiting nice sequential growth as clinic penetration and dosing accelerate. As Juan Ramón said, patient share also continues to grow for Apoquel and Cytopoint.

As I mentioned earlier, Simparica sales were lower this quarter than last, but still in line with expectations. Our increased selling and promotional activity will lay the groundwork for continued revenue growth in this highly competitive market.

We will continue to evaluate the performance of our direct-to-consumer promotional campaign for Apoquel and Simparica, with early indications suggesting that we are on track to meet our business objectives.

Additional contributions to companion animal growth came from new products including Diroban, which recently received approval for the treatment of dogs with heartworm. With the introduction of Diroban, Zoetis now offers veterinarians a full canine heartworm product portfolio, including prevention, detection, and treatment. Moving to U.S.

livestock, sales grew 3% in the quarter, due primarily to our cattle and poultry businesses. Our cattle business returned to growth this quarter due to the success of products such as Actogain and Synovex, while sales of our premium injectable antibiotics continue to be impacted by healthier animals moving into the feedlots.

As certain poultry producers expand their no-antibiotics-ever labels, our portfolio of medicated feed additives for these criteria are doing well and contributed to poultry growth in the U.S. We work closely with our customers to provide the necessary products and technical assistance to help them switch over when they choose.

Our swine business declined again this quarter in the U.S., primarily due to competition for our Fostera PCV/M. hyo vaccine. Our updated vaccine product is seeing modest uptake with medium and smaller producers, and we will continue to work with customers to gain acceptance.

Finally, both our cattle and swine businesses were impacted by the implementation of the Veterinary Feed Directive, or VFD, which negatively impacted our medicated feed additive performance, as producers are adjusting to the new regulation in how to adopt their protocols. Now turning to the rest of the P&L.

Adjusted gross margin of 65.6% decreased approximately 230 basis points year over year on a reported basis and, on a sequential quarter basis, improved 120 basis points from the first quarter of this year. As I had mentioned during last quarter's earnings call, in 2017, we have made additional cost improvements in our manufacturing network.

As a result, in the first quarter of 2017, we recognized higher costs associated with previously produced inventory, which depressed our gross margin. This change also had a negative impact on our second quarter margin, which we had previously indicated.

The second quarter results for adjusted gross margin, while showing improvement over the first quarter, are slightly below our initial expectations. We have been working to improve our inventory management, including reductions in the level of inventory write-offs we incur.

While we still expect to improve in this area for 2017, the magnitude of improvement is less than we had expected and will continue to be an area of focus in the future. Gross margin was also impacted by unfavorable foreign exchange in the quarter.

Adjusted SG&A grew by 1% in the quarter, with higher investment in our DTC advertising campaign offsetting the expense reductions in other areas. Adjusted R&D declined 1% operationally for the quarter due to the timing of project spending and fixed expense reductions from our operational efficiency initiative.

The adjusted effective tax rate for the quarter was approximately 29%. The tax rate in the quarter is significantly improved from the prior year, primarily due to the impact of operational changes implemented in the third quarter of last year.

Taking all these factors into consideration, we generated 11% operational growth in adjusted net income for the quarter. Moving to guidance for full year 2017. This year, we continue to perform in line with our expectations, with certain upsides and downsides, particularly with tax and cost of goods sold.

For the year, we still except to achieve operational revenue growth of 5.5% to 7.5% and an adjusted EBIT margin of 34% to 35%. Since our last update in May, changes in FX rates in several markets are favorable to revenue, and we are increasing both the lower end and higher end of the range as a result.

We have also narrowed the range for revenue towards the high end of our guidance by $25 million to reflect our performance to date and our confidence in the remainder of the year. Our guidance for the range of cost of goods sold for the year has moved from 32% to 33% of revenue to approximately 33%.

As we progress into the second half of the year, our results will more fully reflect the impact of our manufacturing cost improvements. Our updated view, however, also reflects the higher expense for inventory charges that I discussed earlier, as well as unfavorable mix and foreign exchange.

For SG&A, we're increasing the low end of our range and maintaining the high end, consistent with the change in our revenue guidance. We have increased both the low end and high end of our R&D expense range to reflect additional investments, primarily as a result of the Nexvet acquisition and the impact of foreign exchange.

Our guidance for an adjusted effective tax rate has been lowered to approximately 29% from our pervious guidance of 30%. The favorable change is primarily due to jurisdictional mix and certain discrete item that have been realized in the first half of the year and does not take into account any potential tax changes being discussed in Washington.

With more than half of our adjusted pre-tax income in the U.S., a lowering of the U.S. corporate tax rate would have a meaningful benefit to us. As a result of the aforementioned changes, we've increased the low and high end of the range for adjusted net income for the year.

In the second quarter, we also repurchased another $125 million in shares, and our guidance for reported and adjusted earnings per share reflects the share repurchases completed through Q2.

We expect our operating cash flow to grow through the year, allowing us to fund incremental investment in our business, including the including the $85 million used to purchase Nexvet last week. Just to summarize before we go to Q&A, we have delivered consistent operational revenue growth of 6% in the first half of the year.

We expect positive trends in the uptake of new products and growth in international livestock to continue. Our earnings growth will accelerate meaningfully in the second half of the year, and cash flow generation will continue to improve, giving us greater flexibility to invest in our business.

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

Operator?.

We'll take our first question from Derik de Bruin with Bank of America Merrill Lynch. Please go ahead..

Hi, good morning..

Good morning..

Good morning..

Hello? Oh, great. So just a couple of questions. So the first on – now that you've closed Nexvet, could you give a little bit more timing on the pipeline? How can we think about some of the products coming through? I believe they've got one canine and one feline drug coming in the research development pipeline right now.

Could you just give us some tiny update there? And also, on the gross margin, could you sort of back out what the different headwinds were this quarter and sort of what the underlying growth rate was? Thanks..

Thank you, Derik. And I will take the first question, and then Glenn will answer the question on the gross margin. So, Nexvet, we completed the acquisition last week, on Monday last week. Our team, R&D team, it's now interacting with the R&D team of Nexvet, getting a getting full understanding of all the programs.

When we have completed this analysis, then we will define when we expect to launch the product for both dogs and cats in both the U.S. and the European end markets. So it's a little bit too early now.

But, again, so one thing that we need to remember is that we are in a market in where our competitors are not providing any detail in terms of R&D products, and providing too many details, and especially in an area that we think that can be also of high interest, will have a negative impact in our programs and maybe in the opportunity to generate future revenue growth..

And in terms of gross margin, the cost of goods sold, so for Q1, our cost of goods sold was about 35.6% of revenue. In Q2 that improved to 34.4%.

The key drivers of that were the costing methodology and the fact that we did recognize a disproportionate amount of the higher costs associated with previously produced inventory in the first half of the year.

When you look at our guidance for the full year of approximately 33%, that definitely implies a significant improvement in the second half of the year after we're outside the costs associated with that previously produced inventory.

Next question?.

We'll take our next question from John Kreger with William Blair. Please go ahead..

Hi. Thanks very much. Can you talk a bit more about your swine product performance? It seems like the vaccines have been under pressure for the last two or three quarter. Should we expect that to persist in the second half, or do you expect that to turn? Thank you..

Thank you, John. Well, we mentioned that we have been working on our vaccine portfolio in both U.S. and international markets. We have seen good growth in international markets, but in the U.S. despite of – our portfolio now being much more competitive, we have not yet gained share as we expected.

We remain confident that we have now a very strong portfolio. And very important, we also have products in our pipeline that will be reaching the market in 2018 that will bring this segment also to growth in the U.S. In the second half in the U.S.

– that is also a question that you raised, I think – we'll be improving, but probably not improving as fast as we expected initially. On the other hand, in international, we expect continued growth and positive evolution of our portfolio in swine. Next question, please..

Our next question comes from Jon Block with Stifel. Please go ahead..

Great. Thanks, guys. Good morning. Two questions, and I'll try to ask them both upfront. First off, the PHARMAQ number was a bit light and, Juan Ramón, curious if you think it's market or market share, and is there a revised figure for the year, which I believe stood at $125 million? And then sort of for the guidance and just looking forward, Glenn.

The gross margin will obviously be better in 2H relative to 1H.

So do we take that 2H 2017 and sort of use it as our runway for 2018? And then, finally, I know you don't guide quarterly, but just how do we think about the cadence behind revenue growth? Believe we should think about it greater – the revenue growth – greater in 4Q relative to 3Q just from a comp and days adjustment perspective. Thanks, guys..

Thank you, Jon. And – well, the PHARMAQ was the main driver of our light performance in the quarter. SRS vaccine, that – it was a significant growth driver, and it's a vaccine for salmon in Chile – it's still showing significant result in terms efficacy and safety, and it's helping fish farmers in Chile to reduce their use of antibiotics.

In the second quarter, we saw a reduction of the use of the vaccine, mainly because of pricing discussions. At the end of quarter, we reached price agreement with fish customers in Chile, and we have seen already in the first two months of the third quarter, the vaccine showing very good revenues and very good growth.

We remain very confident that this segment will deliver long-term growth. In the quarter, as I mentioned in my comments, we expect double-digit growth, but you mentioned the $125 million will be below this amount. But, nevertheless, we expect that in the future years, the correction will be in line with our expectations..

And, Jon, in terms of gross margin in the first half/second half, so as indicated with the guidance that we provided, we do expect a significant improvement in gross margin in the second half.

Regarding the impact of that, and how you look at that for 2018, there are a numbers of factors that will impact the gross margin for 2018, including mix, foreign exchange, as well as the goals that we have in place from an inventory reduction perspective, which mainly just make some decisions that would have some impact on our ability to utilize overhead.

While that would be the right impact from a cash flow perspective, it may have some negative impact from a P&L perspective. So there are a number of factors that'll impact gross margin for 2018, and when we provide guidance for 2018, you'll get better clarity on that.

In terms of the guidance for the second half of the year from a revenue perspective, days has a minimal impact in the second half. We do have one more day in Q4, but other than that there's really nothing that would lead to a significant changes in growth between Q3 and Q4.

Next question?.

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

Thank you. Just following up on the question related to gross margins, are you still comfortable with your 200 basis point improvement after the 2017 initiative by 2020? Is that still on track? And also with respect to U.S.

livestock, can you update us on the impact of meat prices this quarter and your expectations for the rest of the year? Thanks very much..

Thank you for the question. So we are still seeing the opportunity of improving by 200 basis points in gross margin by 2020, and plans are moving ahead as expected. In terms of comments on the cattle business in the U.S., well, there are some positive factors that are really helping the cattle business in the U.S. One is the number of cows.

It's expected to grow in 2017 and 2018. We also expect that the number of placements in feedlots will be higher than in 2016. And we also saw that the feedlot producers are generating profits in 2017, and we expect also the same in the second half.

The price of the beef, it's also helping exporters to increase exportations to markets like Japan, markets like Mexico, and many other markets in where the beef it's – in the U.S. it's being exported. Also the prices of milk are positive. It is not related to beef, but we have seen an increase on the price of milk.

It's still below prices that we saw in 2016, but this is also helping to rise the market. And at the same time, we have seen some headwinds in the U.S. market for our cattle. One was the mild weather in the first quarter that reduced the risk profile of animals and also had a negative impact in our premium antibiotics.

The implementation of the Veterinarian (sic) [Veterinary] Feed Directive also had an impact in the first quarter, and we expect also having an impact in the remaining of the year. And finally, we have seen in the first half of the year that animals moving to the feedlots were heavier, again with a lower risk profile.

In the second half, we expect that these animals will be medium size; that also will increase the opportunity for the cattle business. But in general we have seen that the prices in the different parts of the chain of production has been more positive than in 2016.

Next question?.

The next question comes from Louise Chen with Cantor Fitzgerald. Please go ahead..

Hi. Thanks for taking my questions.

First question I have is, I was wondering if you could talk a little bit more about some of your near- and long-term growth drivers, that being PHARMAQ, the Nexvet acquisition, and also the triple combo product, and how we should think about the peak sales potential for these products, and when we'll see some sort of meaningful accretion to earnings from these different products? And then the second question I have was just on diagnostics.

Do you want a bigger footprint in diagnostics, and will you have to make additional investments to get there? Thank you..

chemistry, immunology, molecular, also specialty. And we'll be working on developing all of these programs to bring products into the market. It will be a phasing of introduction of products, and we are confident that end of 2017 or early 2018, we'll start introducing new products into the market.

Next question?.

Your next question is from Erin Wright with Credit Suisse. Please go ahead..

Great, thanks.

Can you speak to some of the initiatives you alluded to in you prepared remarks in terms of the manufacturing footprint and also the potential for further rationalization? It sounds like you continue to expect the 200 basis points in gross margin expansion associated with those initiatives, I guess starting in 2018, but could that process be expedited at all? And then my second question.

You mentioned building cash flow, which I think that statement is still absent from the press release disclosure. But can you speak to capital deployment priorities, how is the M&A pipeline shaping up, and is Nexvet fully incorporated into your guidance at this point from an expense perspective? Thanks..

Okay, thank you, Erin. We'll mention the comments on manufacturing initiative. So, first, we are – the manufacturing is always a continuous work in design opportunities for being more efficient. Reducing cost, it's a priority, but it's not the only priority that we have in design and manufacturing.

We also want to make sure that we are improving the cost, at the same time ensuring that we have reliable supply. And at the same time that we are also working on reliable supply that we'll reduce our inventory levels. So this is something that is a target for the company.

We identified a target for 2017, and we'll continue targeting inventory improvements over time. In terms of the initiatives that we already communicated is the 200 basis points by 2020. And you're asking if we can accelerate that.

I think it's something that – we always try to do things as fast as we can, but at this point, what we are really targeting is to ensure that, by 2020, we generate these 200 basis points.

And we also need to understand that, in some cases, these savings as a result of transferring the products from one plant to another plant or different plants, is something that it takes time, because it's a complex process to move products from different plants, and we need to make sure that when the product is in the final destination, it really delivers in terms of cost and also in terms of supply to the market.

We also expect that, because of all the product rationalization, all the manufacturing plant rationalization, also we have opportunity for impact in terms of volumes and improving our allocation of overheads.

In terms of cash flow and the priorities for our cash, we remain committed to invest internally, investing in commercial, and we have examples this year to invest in DTC campaigns to support new product launches.

We also continue committed to bring innovation to the market internally with our R&D expertise and capabilities, and we see opportunities also for further expansion of some of the areas in where we think that we can improve our operations in terms of manufacturing, with special attention on ensuring that we have the right capabilities and capacity for vaccines in developed and also in emerging markets that also will be equally important.

And we also mentioned that we, as a second priority, it's identified opportunities that will complement our internal efforts and will support further revenue growth and further profitability.

And it's something that we are committed to identify these opportunities and bring these opportunities – to keep these opportunities – can bring values to our operations. And finally, you also asked in terms of Nexvet guidance. At this point, we are not yet providing any guidance in terms of Nexvet. It's too early.

So we need first to have full control of all the programs that Nexvet has been – developed. We have access to some of these programs, but now that our R&D colleagues are really working together with Nexvet R&D colleagues, then we'll have a full understanding of the opportunity. So, Glenn will add some comments..

Yeah, Erin, just to clarify on the Nexvet. So for 2017, you'll notice that we did raise our R&D guidance, and that was to reflect the costs the we see for 2017 for Nexvet. Juan Ramón comment was more in terms of long-term guidance for Nexvet. The other thing I just wanted to comment on was the manufacturing initiatives.

There are certain investments that we are contemplating that will lead to some increased capital expenses that'll keep our capital expense as we move to 2018 probably more aligned with previous years.

However, those initiatives we do believe will shore up supply for some of our newer products, some of our key products, as well as key products in key markets. And they'll also have the right return from a financial perspective, bringing our costs down on those products as well.

Next question?.

Your next question is from Kevin Ellich with Craig-Hallum. Please go ahead..

Good morning, guys. Just, Juan Ramón, could you maybe give us an update on what you're seeing in the companion animal market? You guys gave some good detail on Simparica. Wanted to see why we saw the sequential decrease in Q2 and what your outlook is for distributor increases who are purchasing in the back half of the year.

And do you plan on expanding your relationship with those distributors? And then secondly, on the production animal side, you've talked about the premium line of antibiotics like Draxxin.

Did you say you expect the trend to reverse in the second half, where – kind of the midsize cattle being in the feed lots, and that could lead to increased sales?.

Well, thank you, Kevin, for the two questions. So first on the companion animals. So on companion animal, we expect that we'll continue generating very positive growth in the second half, and we expect that the differential between companion animal and the livestock will remain in the second half of the year.

We have seen in the second quarter growth in the U.S. of companion animal, 7%, while international market was 15%. I think it was in line with our expectations. The U.S.

in the second quarter in companion animal, we had some additional promotional activities that also had a temporary impact in terms of prices, but the growth in the different parts of the companion animal portfolio have been in line with our expectations. Simparica also had additional revenues in the U.S. in the first quarter.

That had an impact in the second quarter. But we don't see any situation that is different than what we expected, very pleased with the performance of new products, Apoquel, Cytopoint, and Simparica. All indicators are showing our progression in terms of market share improvement in both – for dermatology and also for parasiticide segment.

And in the other inline portfolio, again, so we have not seen any change in the generic assumption, so I think it's something that – it's in line with the plan that we have seen in previous quarters, maybe occurring on Rimadyl that's has been affected by the interaction of Galliprant.

Galliprant is another product for treating pain, and we know that in this market, new products, they get significant attention and growth. And this growth is maintained depending on the results that are showing in the mid and long term in terms of efficacy and safety.

But we are very pleased with our overperformance in companion animal, and definitely it's a significant driver of our growth in the first half, and we expect also a significant driver of our growth in the second half. In terms of the trends for the cattle in the U.S., you mentioned the Draxxin impact.

I will say that maybe – well, definitely the mild winter and also the heavier animals into the feedlot had an impact in terms of the use of premium antibiotics.

The other impact that we have seen was also the implementation of the Veterinarian (sic) [Veterinary] Feed Directive that has been affecting our cattle business, especially the medicated feed additives. We saw that it was affecting temporary to smaller producers in the U.S., and they will be adjusting how to use these products in the future.

This adjustment is taking longer, and we have incorporated in our guidance a more permanent impact in our revenue. But, having said that, we expect more favorable conditions in the second half of the year for cattle, and we also have seen that in the second quarter premium antibiotics has been performing very well in the year.

Next question?.

Your next question's from David Risinger with Morgan Stanley. Please go ahead.

David, can you check the mute function on your phone?.

Maybe we can try the next one?.

Yes. We'll go next to Kathy Miner with Cowen & Company. Please go ahead..

Thank you. Good morning. Just a follow-up on the dermatology sector.

Can you give us a little bit more color on Cytopoint, and how you characterize its use? Is it being used more every four weeks or every eight weeks? And are you seeing it used in more Apoquel-treated dogs or non-Apoquel dogs? And also just on Apoquel, can you talk about whether you're starting to see – getting any more traction in the acute and shorter-term settings as opposed to the chronic use? Thank you..

Thank you, Kathy, and I will start with Cytopoint. And, first, I think Cytopoint has been – well, the indication of the label in the U.S., it's four to eight weeks. And we see that it's more used on the mid of this four to eight weeks than at four weeks.

And we have seen also seen that Cytopoint in its infancy also having a 28% cannibalization to Apoquel. But combining both together, I think we are growing very nicely.

And now I think we see the opportunity also to extend these experience to the European markets, in where we started the early experience program, and we expect a full launch in September in the European market. And in the European markets, the label, it will be different.

It will be 1 milligram on four weeks, compared to 2 milligrams on four to eight weeks in the U.S. But still the products are very consistent in terms of efficacy and also in terms of safety.

For Apoquel, we have seen now that Apoquel use has been extended or increased in terms of acute, but also in terms of seasonalized conditions for dogs, and this is the result of now full availability of the product in the market, and we believe also the effort that we are making in terms of direct-to-consumer advertising.

Chronic use will remain the main generator of revenues because the use will be very prolonged, but the acute or the seasonalized use of the product also will add significant opportunity.

Next question?.

We'll go next to Alex Arfaei with BMO Capital Markets. Please go ahead..

Okay. Good morning, folks. Thank you for taking the questions. Juan Ramón, just want to clarify your comments on Rimadyl. So I guess the pain franchise was lower, because of new product competition and not cheaper generics from the distributors. And then a follow-up on Brazil. Very good performance there given everything that's going on.

My understanding is that the USDA has banned fresh beef imports from Brazil because of safety concerns. Obviously we know there's other concerns there as well in Brazil. So what impact could all of this have longer term on your business? And is there an opportunity for U.S. livestock to do better as a result and gain share? Thank you very much..

Thank you, Alex. So for the question on Rimadyl, So we are not saying that generic competition is not gaining share. It's gaining share in line with previous comments. And there – well, the message I wanted to convey was that we have not seen significant changes in the trends of the generic penetration.

What we saw is that product, which is Galliprant, which is a new product that has been introduced recently, it's a product developed by Aratana and commercialized by Elanco, it has been gaining share in this pain market.

We have seen also in the past that new products in this market are having rapid penetration, because it's still some level of dissatisfaction in terms of safety. And products coming into the market may have some opportunity, and definitely the opportunity will be maintained if it can really deliver on the expectations in the medium and long term.

But we don't think that will be something that – we are confident that Rimadyl, with so many years in the market, with a very well-established profile in terms of efficacy and also in terms of safety, will remain a key player in terms of managing pain for dogs.

At the same time, so moving into the acquisition of Nexvet, it's very strategic for us to maintain our leadership in this area. We are convinced that there is still unmet needs in this market in terms of safety and efficacy.

And monoclonal antibodies can really fill this gap in terms of providing an alternative to current products in the market, and we are convinced that in both in dogs and cats, monoclonal antibodies will play a significant role. In Brazil, definitely the scandals are not helping, but we have been managing quite well.

Our growth in Brazil despite of this political and scandals situation and we – the investments that we made in terms of expanding our field force are having a very positive favor. We are growing sales in Brazil very rapidly in cattle, but also in some other areas. Areas like companion animal is also driving significant growth.

And Brazil in general has been a market exporting in most of the cases processed beef rather than fresh beef to some of the markets, and this is not really changing. And Brazil, they had a temporary challenge when they had the scandal in terms of the meat quality with China, but this has been already managed.

And I think the prospects for Brazil are very positive, and definitely Brazil will be continue competing with the U.S., although today they are competing with a different quality of meat. U.S. is much more focused on quality, while in Brazil at this point they are much more focused on process, which has – not so important in terms of quality.

So very positive in terms of future growth in Brazil, and also we see some additional opportunities in terms of export in the U.S.

Next question please?.

And our last question will come from Brett Wong with Piper Jaffray. Please go ahead..

Hey, guys. Thanks for taking my question and fitting me in here. Just wanted to see if you could talk a little more on the U.S. livestock fundamentals. You already talked about the beef cattle outlook into 2018, expecting expansion.

But how long are you expecting expansion in the other species like chicken? And when we see contraction in any of those markets including cattle, what is the expected impact to the business, given that the animal health products are a lot less discretionary in nature? Thanks..

Thank you, Brett. And so we think that the fundamentals of the U.S. livestock are very strong. So, in terms of cattle, I described that in our opinion, cattle will continue being an important part of the production of quality meat in the U.S. and also export to many other markets.

We expect also that the growth in terms of number of heads in cattle will moderate in 2018, but still growing, which is positive. And we also think that in both in poultry and swine, the production in the U.S. is very efficient. They are very competitive. The consumption of animal proteins worldwide will continue growing, and the U.S.

will continue playing a significant role in terms of producing the meat that will be reaching their customers around the world. The poultry and the swine, they are two areas in where they can manage very well the additional volumes. And we expect that in 2018, poultry and swine also will remain positive.

If we move – I was making comments in general to the market. If we move to our specific business, so we expect both poultry and swine in the U.S., showing positive growth in 2018. So we expect to bring new products.

And also we have seen that even for producers that are moving to No Antibiotics Ever, we can offer to these producers a very good portfolio that will meet their demand. At the same time, also we generate also a very positive growth in our company.

Next question?.

It appears we have no further questions. I'll return the floor to you, Juan Ramón, for any closing comments..

Thank you very much for joining us today. And we mentioned during the call, we are very pleased with the results. We are also very confident on the guidance for 2017. And, as I mentioned, companion animals will continue driving growth. But we see also positive growth in terms of livestock.

We expect in the second half also maintaining the differential of growth that we have seen with the companion animal and livestock in the first half. With that, thank you very much for joining, and looking forward for meeting you again in the third quarter earnings call..

And this will conclude today's program. Thanks for your participation. You may now disconnect. Have a great day..