Good day, and welcome to the Fourth Quarter and Full Year 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 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 Steve Frank. Steve, you may begin. .

Thank you, operator. Good morning, and welcome to the Zoetis Fourth Quarter and Full Year 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 statement 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, February 15, 2018. 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. .

Two weeks ago, we celebrated our fifth anniversary as a public company. And since our IPO in 2015, we have been able to improve the ways we innovate and serve our customers, grow as a profitable stand-alone business and build a track record of delivering results.

Over the last 5 years, we have maintained a high level of R&D productivity and developed new and enhanced products that address the more relevant needs of our customers. New innovative products like Apoquel, Cytopoint and Simparica as well as lifecycle innovation for our existing portfolio has supported our leadership in the animal health industry..

On an operational basis, Zoetis' revenue has grown an average of approximately 7% over the last 5 years compared with the 5% to 6% for the animal health industry. And our adjusted net income for the same period has grown operationally an average of approximately 21%.

Over the last 5 years, we have been able to deliver on our commitment of growing our revenue in line or faster than the market and growing our adjusted net income faster than sales while also targeting value-added investment opportunities and returning excess capital to our shareholders.

And for the next 5 years, we remain committed to achieving these elements of our value proposition for shareholders. .

In 2017, Zoetis became the first animal health company to deliver more than $5 billion in revenue as we continue to demonstrate the strength of our business model and the growth opportunities in animal health. We achieved operational revenue growth for 2017 of 8% based on the diversity of our total portfolio and balanced performance across the U.S.

and major international markets. And once again, we grew our adjusted net income 5% sales at 21% operationally as we continue to realize the benefits of our operational efficiency initiatives and deliver our long-term value proposition..

The strength of our diverse portfolio of approximately 300 product lines helped to absorb economic challenge in certain market and to offset all issues like the implementation of the Veterinary Feed Directive, or VFD, in the U.S. Our companion animal business led the way again in 2017.

It grew 14% operationally based on the continued penetration of Apoquel and ramp-up of Cytopoint and other new products like Simparica, which has gained share in the large and highly competitive parasiticide market..

We believe 2018 will be another year of above-market growth for our companion animal business. We see further opportunities for gaining share and expanding the market for dermatology products with our innovative treatment options. We expect to achieve more than $500 million in combined sales from Apoquel and Cytopoint in 2018..

We'll also continue to support these products, as well as our oral parasiticide, Simparica with direct-to-consumer campaigns in the U.S. and other markets. Simparica has been able to gain market share in the U.S. in 2017, and we expect further growth there and internationally in 2018. .

Meanwhile, we delivered 5% operational growth in our livestock business there for the year. International markets grew faster than the U.S. where we felt the impact of the VFD implementation in our cattle and swine anti-infective products. For 2018, we see more favorable market conditions for livestock, particularly in the U.S.

Glenn will discuss the details of our fourth quarter results and guidance in a minute. But I would like to say that we feel very confident about our prospect for 2018. .

In addition to revenue growth, we have also been focused on improving our operational efficiency and margins. And in 2017, we achieved an adjusted EBIT margin of 34.1%. This was an improvement of 900 basis points in the last 3 years.

With our improved cost structure, margin expansion and revenue growth, we have been able to almost double our operating cash flow for the year in 2017 compared to the previous year. That improved cash flow, along with the long-term benefit of the recent U.S. tax reform, is providing us the flexibility to invest for long-term growth..

In terms of long-term growth, we'll continue investing significantly in R&D for our core species and geographies, look to strengthen our cattle, fishing areas, livestock monoclonal antibodies, vector vaccines, genetics, diagnostics, devices and automation and define new technologies in areas like data analytics and sensors.

We'll continue supporting our key products like Apoquel and Simparica with direct-to-consumer advertising and other marketing campaigns. We'll also increase our field force in diagnostics to better support the interaction of new products in the future growth expected in this area.

We'll be allocating capital to support many of the manufacturing and supply improvements I have discussed recently in places like China, Ireland and the United States.

And as always, we'll continue to look at external partnership and business development that could accelerate our ability to grow in our core business and in complementary spaces like genetics and data analytics.

All these investments will support our goal of more integrated solution, which cover the entire life cycle of animal care that our customers need. .

In conclusion, as we mark our fifth anniversary as an independent company, I'm grateful for the colleagues at Zoetis who have delivered our strong performance and will support our future of profitable growth. We continue to drive innovation, believe in customer excellence, simplify our operations and increase our cash flow.

And as we look to the future, we'll remain committed to strengthening our interconnected capabilities in direct sales, R&D, manufacturing and look for additional investment opportunities to enhance our growth..

With that, let me hand things over to Glenn, who will provide more details on our fourth quarter results and full year guidance for 2018. .

Thank you, Juan Ramón, and good morning, everyone. .

Before I get into the details on our fourth quarter performance and guidance for 2018, I will provide a few comments on the results for full year 2017. This year, we delivered operational revenue growth above the market, grew adjusted net income faster than revenue and almost doubled our operating cash flow.

Reported revenue for full year 2017 was $5.3 billion with operational revenue growth of 8%. Of this 8%, 3.5% came from our dermatology portfolio, 3.5% came from Simparica and other new products and the remainder of growth came from price and volume. Our product rationalization initiative had an unfavorable impact of 1% on volume for the year..

Adjusted net income for full year 2017 was $1.2 billion and grew 21% operationally. Adjusted net income continues to grow faster than revenue driven by the continued impact of our operational efficiency initiative and a lower adjusted effective tax rate.

Our performance this year, again, reaffirms our ability to execute on the financial targets that we said in May of 2015 when we provided long-term guidance through to 2017..

With the results that we are reporting today, both our top and bottom line in 2017, beat the goal outlined nearly 3 years ago. For the full year, we've performed well across all the species and key markets where we compete.

The diversity and durability of our existing portfolio, our market-leading commercial and manufacturing capabilities and the innovations we bring to the marketplace have allowed us to outpace the animal health industry market growth for the last 5 years..

Our income growth and our increased discipline on the balance sheet have enabled us to almost double our operating cash flow in 2017. This was the result of lower cash outlays for termination benefits and stand-up costs, increased profitability and inventory improvements. In 2017, we reduced our months on hand of inventory by more than a month.

We have more work to do in this area but are pleased with the progress in 2017..

Turning now to quarterly results. Q4 2017 was an exceptional quarter, with top line growth coming from new products in our companion animal portfolio and strong livestock performance in our U.S. and International businesses.

Our product rationalization initiative had no material impact on our growth this quarter and will not have an impact on our revenue growth going forward. Total company revenue in the fourth quarter grew 13% operationally, excluding the favorable 1% impact from foreign exchange.

Our key dermatology products, Apoquel and Cytopoint, once again surpassed the $100 million marketing revenue with sales in the quarter reaching $125 million and $428 million for the full year 2017. Sales of Simparica were $18 million in the quarter, growing 102% over the same period in the prior year.

Fish products also contributed to growth with sales of $39 million, growing 44% operationally versus the same quarter last year. Our recently introduced PD vaccine in Norway was the primary driver of growth as it continues to gain share and help increase the penetration of other related vaccines in our portfolio..

Now let's discuss segment revenue. Our International revenue grew 13% operationally in the fourth quarter, with companion animal operational growth of 18% and livestock growth of 11%.

The International segment continues to drive growth across multiple dimensions with growth coming from our dermatology portfolio; new products, such as Simparica, our PCV combo vaccine and our PD vaccine; and volume and price from our in-line portfolio..

Turning to some key market highlights in the quarter. In Brazil, we grew 13% operationally, driven by the strength of both our livestock and companion animal businesses.

In cattle, investments in our field force have led to increased penetration and coverage in key regions within the market while favorable export market conditions also continued to contribute to growth. In swine, increased sales of IMPROVAC, or Vivax as it's called in Brazil, were driven by higher usage and greater penetration with larger customers.

The higher companion animal revenue in Brazil benefited from the continued growth of Simparic through the increased promotional activity and higher veterinary clinic penetration..

In Japan, we experienced operational revenue growth of 27% in the quarter. Growth came from Apoquel as a result of the timing of distributor purchases last year and the additional market penetration we achieved as well as the launch of premium injectable products for livestock..

France grew 23% operationally over the same period last year due to a timing impact related to our price changes and new products to both -- across both companion animal and livestock..

China grew 13% operationally on a continuing strength of the companion animal business, driven by increasing medicalization of pets. Our swine business once again showed modest growth this quarter due to softening pork prices, which we have expected and discussed on recent earnings calls.

Our optimistic outlook and long-term view of the market remain unchanged as we continue to invest in our local operations there. .

To summarize, a very strong quarter for our International segment with growth across the diversified portfolio, including all of our core species and key markets, favorable market conditions, strategic investments in our portfolio and a focus on execution, are all helping to drive consistent commercial results..

Turning to the U.S. Revenue grew 13% in the fourth quarter. Companion animal grew 15% while livestock grew 11%. Companion animal sales in the quarter were driven primarily by key dermatology products, Simparica and a number of other recently launched products. U.S.

dermatology sales for Apoquel and Cytopoint were $86 million for the quarter and exhibited substantial growth over the same quarter in the prior year. While we did see a small decline on a sequential quarter basis, Q1 and Q4 are impacted by seasonality with the warmer spring and summer months experiencing peak activity.

Simparica grew over the same quarter last year as DTC investment and field force efforts led to higher clinic penetration in both key corporate accounts and smaller clinics.

Additional contributions to companion animal growth came from a number of line extensions to our Vanguard vaccine franchise, DIROBAN, a recently launched product for the treatment of heartworm and CLAVAMOX chewable, a trusted antibiotic in a new easy-to-administer tablet. .

Our U.S. livestock business saw a return to growth in the fourth quarter, with sales increasing 11%, thanks to the performance of our cattle and poultry businesses.

During the fourth quarter, growth in cattle products was driven by increased sales of premium products, which was supported by a greater risk of disease outbreak and incidents due to the weather as well as the timing of promotional activities in 2016.

Our beef cattle business also benefited from higher numbers of animals moving through feedlots than in the comparable 2016 period. Our livestock business continued to be impacted by the Veterinary Feed Directive, or VFD, with another $10 million hit to revenue in the quarter. For the full year 2017, the VFD had about a $40 million impact on revenue.

In poultry, there's a weather's portfolio of alternatives to antibiotics and medicated feed additives continue to be the primary driver of growth as certain producers expand their "No Antibiotics Ever" labels.

The weather works with customers to provide the necessary product and technical assistance that can help them switch over whenever they choose..

Now moving on to the rest of the P&L. I will quickly cover a few key line items and then move on to our guidance for 2018.

Adjusted gross margin of 68.9% increased 450 basis points in the quarter on a reported basis and reflects the benefit of cost improvements in our manufacturing network as well as the reduction of inventory waste charges versus the same quarter last year.

Operating expenses in total grew at 2% operationally versus the same period last year, which was significantly lower than the operational revenue growth of 13% as we benefited from the final stages of our operational efficiency initiatives. The adjusted effective tax rate for the quarter was approximately 27.6%.

This is higher than the rate in the comparable 2016 period due to the favorable impact of certain one-time discrete items that we experienced in the same quarter last year.

Our reported effective tax rate of 43.5% reflects the provisional net tax charge of $212 million in the fourth quarter, which is the result of the recently enacted tax legislation in the U.S.

Adjusted net income for the quarter grew 37% operationally through a combination of strong revenue growth and margin expansion and cost improvements in manufacturing and leveraging our global scale and infrastructure. Adjusted diluted EPS grew 39% operationally in the quarter versus the same period in 2016..

Turning now to guidance for the full year 2018. A table of our guidance is included in both our press release and the presentation slides provided for this earnings call. Please note that our guidance for 2018 reflects foreign exchange rates as of early February..

Building off a strong 2017, we see another year of operational revenue growth above the long-term trend we see in the industry overall. Our projected reported revenue range for 2018 is $5.675 billion to $5.8 billion. This represents operational revenue growth of between 5% and 7% over our full year results in 2017.

Foreign exchange is expected to add an additional 2% for this revenue growth..

We continue to expect more balanced performance across companion animal and livestock in 2018. Livestock growth is expected to reflect improved conditions in the U.S. and a relatively similar performance in 2017 in our International segment.

While companion animal continue to grow faster than livestock, its growth rate will moderate as our dermatology portfolio and other new products grow off a larger base in 2018..

Our adjusted cost of sales as a percentage of revenue is expected to be approximately 32% in 2018, an improvement of around 100 basis points over 2017 and driven by manufacturing cost reductions, price increases and favorable product mix. We expect SG&A for the year to be between $1.37 billion and $1.42 billion.

Similar to revenue, foreign exchange is expected to increase these expenses approximately 2% on a reported basis. We will continue to fund our DTC programs for Apoquel and Simparica in the U.S.

These programs have been successful, and we expect they will continue to help our sales teams drive market expansion in dermatology and market share in parasiticide..

As our diagnostics pipeline continues to advance, we are beginning to fund additional investments in commercial capabilities in both the U.S. and International to be prepared to offer our customers these products with the level of service and support we offer them on our other portfolios..

We expect R&D expenses to be between $400 million and $420 million, a step-up in the level of spending we have had in prior year. Over the course of 2017, we made a number of decisions to either expand investments or accelerate investments where we saw the opportunity to do so in areas such as monoclonal antibodies and key emerging markets..

The increase in adjusted interest expense and other income deductions reflects the incremental interest expense associated with our recent debt offering. .

For the full year 2018, the company expects its adjusted effective tax rate to be in the range of 21% to 22%. The decrease versus prior year is primarily the result of the tax changes enacted in the U.S. in December.

The target range for adjusted net income for the full year 2018 is between $1.45 billion and $1.52 billion, representing an operational growth rate of 20% to 26%. Growth here includes the favorable impact of continued operating margin expansion and a lower adjusted effective tax rate.

Our guidance for adjusted diluted EPS is between $2.96 and $3.10 for the full year..

Turning to capital allocation. Our priorities remain the same, investment in our own business and internal R&D programs, then external business development opportunity and finally, returning excess capital to the shareholders. With the impact of the recent tax law changes, we'll have greater flexibility to execute on these priorities.

I would also point out that given the level of investments we have discussed in manufacturing facility, you should expense capital expenditures in 2018 to be approximately $100 million higher than the $224 million we reported in 2017.

In terms of returning excess capital to shareholders, we increased our dividend by 20% for Q1 2018 and had share repurchases of $500 million in 2017. It's worth mentioning that we still have $1 billion left on our current share repurchase program..

To wrap up, we had strong performance in 2017 and see those fundamental business and market drivers continuing into 2018. We have the capital and cash flow generation to invest in growth opportunities across the animal health industry.

And we have the talent and capabilities to maintain our market leadership in this attractive market and create more value for our customers and shareholders..

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

Operator?.

[Operator Instructions] We'll take our first question from Louise Chen with Cantor. .

My question is just on R&D. We always get a lot of questions on this since you don't disclose a lot of detail.

I'm just wondering, where are your greatest unmet needs in animal health? How are you addressing these? And will we hear more about these products in 2018? And also can you provide any measures by which you can measure your R&D productivity?.

Thank you, Louise, for the question. We still see unmet needs in our animal health industry. One of the unmet needs there is related to pain in dogs and cats and bring some of them in the solutions for the current treatments.

And this is why we are focused on a number of [ current treatments ] that we'll be providing alternative to the current treatments for dogs and cats. We also see opportunities of combination of oral parasiticide for internal and external parasiticides.

And definitely, we see the opportunity of enhancing productivity in livestock with the new technologies that will replace existing ones. So there are areas that definitely we have internal problems. And we mentioned many times, our competitors because they are part of pharma companies, we are not disclosing any details.

For us, providing this information will create a negative impact in our ability to compete successfully in the future. In terms of how we measure productivity, I like Glenn that will provide some details. .

So in terms of measuring the productivity for R&D, a, as we prioritize the projects across the portfolio, we use [ EMPV ] and EROI to make sure that we're appropriately prioritizing across the portfolio. We'll also look retrospectively from a return on invested capital perspective to see the return that we get from our investments.

And based on the productivity we've had over the last number of years, we've been very pleased with our return on our R&D spend. .

And we'll go to -- next question to Kevin Ellich with Craig-Hallum. .

So very, very strong results this quarter, guys. And it's great to see the rapid growth in companion animal as well, the recovery at livestock that you expect. Glenn, you made a comment about more balanced growth between livestock and companion animal in 2018 and even moderating growth in dermatology.

Can you just give us a little bit more detail behind what you expect in companion animal? Should we be thinking about 10% companion animal growth versus 8% livestock? Or any help on that front?.

Yes. In terms of the growth that we expect for 2018, I'm not going to give specific numbers, obviously, between livestock and companion. But I think when you look at 2017 for the full year, we had 5% growth in livestock and 14% growth in companion, so there was a big differential in the growth.

As we move into 2018, with a very strong performance that we had in our companion animal portfolio in 2017, we've established a new base to grow off of, particularly in our derm portfolio as well as Simparica.

So while we still expect those products to grow in 2018, the overall contribution that we'll have for the total companion animal growth will be smaller just as they're off of a much larger base. So that's going to cause our companion animal growth to decelerate as we move into 2018. .

And we'll take the next question from Erin Wright with Crédit Suisse. .

In terms of the development pipeline, a follow-up here. I guess can you speak to some of the focus areas outside of traditional therapeutics? So for instance there, you launched a new diagnostic offering at VMX, you also have SMB opportunities and you mentioned some sales force investments there.

Is that going to be a focus area for you in terms of new product launches near term? Will it be a more organic or inorganic initiative? And then, just could you speak to some of the -- you mentioned data and analytics but some of the other areas or ancillary areas outside of traditional therapeutics where you see growth opportunity?.

Thank you, Erin on that. We see Zoetis as a much more integrated offer to our customers, including the products in medicines, the change there, but also diagnostics, genetics. What we have to describe as a -- the health care cycle of intention also prediction, prevention and treatment. And definitely, we'll continue focus on our core business.

In the core business we'll continue generating the majority of our revenues and profit. But we see opportunities to accelerate our growth by investing in some of these complementary spaces. Definitely, in genetics, diagnostics, data analytics are part of these efforts.

We have now in diagnostics arranged on the pipeline that definitely we'll be focused on delivering in the next coming years. We also presented in the last congress of VMX, a new Carysta, high-volume chemistry that -- it's part of our efforts really to become a key player in diagnostics.

But in a way, that will be integrated -- or we'll be integrating more all these portfolio in our offer to our customers. As well, we will be investing in data analytics essentials that will complement our offer to our customers. .

The next question comes from Michael Ryskin with Bank of America Merrill Lynch. .

A couple of questions on the quarter and then just a longer-term follow-up. Really strong results in U.S. livestock this quarter. I know it's a bit of surprise relative to what we are looking for. And particularly, U.S. cattle had a great number. You mentioned some of the disease conditions, but you also talked about feedlots and cattle herd size.

I recognize that the weather and the [ days, months ] is more transient, but the feedlot data you should have pretty good visibility in. And I was just wondering if you could talk a little bit how the outlook there is sort of the first part of 2018.

Is the feedlot strength sustainable? Is that something that you think it will continue for several quarters? And then broader on the '18 guide, you talked about a pretty sizable gross margin improvement, 120 bps year-over-year.

Is the longer-term targets are still what you talked about, 200 bps by 2020? Or is there upside opportunity there, given how much improvement you're looking for this year?.

Thank you, Mike. I will respond about the U.S. livestock results. And then Glenn will provide the details of our gross margin improvement and also targets for the future. Well, in the U.S., definitely, we had a strong fourth quarter in the U.S. And this was just the result of several factors, including the weather conditions and movement of animals.

Also the fact that we decided not to implement promotional activities in the third quarter and then views the -- for some more movement of sales from the third quarter to the fourth quarter of 2017. But the results are in some way, what we were expecting there and we also communicated in the previous quarter.

So we saw that in the first part of the year, we have some limited growth in the U.S. cattle, but we were also expecting that at the end of the year, we will be reporting a revenue growth in the U.S. cattle. And this quarter is just confirming our projections for the year. This has been movement of animals, as I had mentioned, to the feedlots.

And we are pleased with the performance of the entire portfolio in our cattle business in the U.S. Moving forward, for 2018, we see positive elements in our beef segment in the U.S. We see that the number of animals that we -- are continue growing, probably at a lower rate than what we have seen in previous year, but still growing.

Placements are expected also to continue being positive. And we expect also that the weather conditions in 2018 will be more favorable for animal health than in '17. So overall, we see that the beef segment will grow and [ as prices ] will be growing in line with the market.

We also see that unleashing the first half, half, the dairy segment will be facing some challenge because of the price of the milk is lower than in previous quarter, and then maybe they will have an impact on the first half of the year. We expect that the second half will be a more positive.

But overall, the cattle will be showing a positive growth in 2018. And as I said, we expect that to grow in line with the market.

Then Glenn, please, do you mind to cover the question from gross margin?.

Yes. Mike, in terms of the gross margin, when you look at the 2018 guidance of approximately 32%, that's more in line with the second half of 2017, which is more reflective of our underlying cost structure as we've discussed on some of the previous calls. In terms of the 200-basis-point improvement by 2020, we remain committed to that improvement.

And as we've said all along, that improvement is driven by the supply network strategy efforts, to the extent that there's additional opportunity based on price, based on volume, based on mix, which can grow on either direction, that can either have an incremental impact or an incremental improvement over the margin over that time or take away a little bit.

But the 200 basis points was always based on the supply network strategy, and to the extent that we have favorable movement in price and mix, that would add additional margin improvement. .

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

Congratulations on the product performance and all the progress during the past 5 years, it's really remarkable. On the U.S. livestock business. Clearly, much better than expected. The difference is particularly striking, given what we are hearing from some of your competitors, particularly Elanco.

So I'm just wondering, if you could highlight what are some of the differences that's driving better performance for your portfolio versus what we are seeing from some of your competitors? And then on the companion animal business, could you comment on the base business, excluding dermatology and Simparica? Is that stable? Or is it under pressure as some of those franchises mature?.

Thank you, Alex. And well, I -- probably I should focus on the drivers of our growth and it's basically because of our portfolio. We have a portfolio, which is extremely well-balanced on many different therapeutic carriers, talking about livestock.

And these are also helping us -- as I said many times, the diversity is helping us really to manage different cycles, different opportunities, different challenge and really deliver results, which are very consistent and, in some cases, we're growing as faster than our competitors. And we don't see that the livestock business in the U.S.

is showing any negative fundamentals. As I said, for '18, we expect the cattle business, beef and dairy combined, showing positive growth. We also expect that the swine and poultry will continue growing. In the case of swine, we expect that Zoetis will be growing faster on the market because we are introducing new products.

And also we have seen that some of the challenges that we faced in '17 related to the PCV2 vaccine now are over. And at the same time, we are introducing new PCV2 vaccines covering more strength, but also will help us structurally with the growth in 2018. Poultry, also we expect a positive growth in the U.S. and will be growing in line with the market.

So overall, very pleased with our performance and also positive about the prospects for livestock in the U.S. In terms of -- you also asked about companion animal and what has been the drivers of growth in '17 and also how we see the growth moving forward.

Maybe, Glenn, you can provide the details of new products, price and also volume of growth for the price of the portfolio. .

In terms of companion animals in 2017, obviously, a lot of the growth was driven by our new products, and we had new products in a number of categories. So the ones that get the most attention, obviously, are Apoquel and Cytopoint and Simparica. But we also have significant growth coming from our vaccines as well.

And these products were the focus of our field force in 2017. In terms of the rest of the portfolio, what you then called the in-line portfolio, performance in those categories was relatively flat as we did experience some pressures from generic competition in line with what our expectations would have been, particularly in the U.S.

And that was offset by some strong performance, though, in our emerging markets that continue to grow as increasing medicalization rates in markets, such as China and Brazil continue to benefit us.

So overall, relatively flat performance of our in-line portfolio, but a really strong performance from our new products as that was the focus of our field force with the tremendous products that we had to launch and continue growth in. .

We'll go next to Jon Block with Stifel. .

Two questions. Glenn, I've OpEx as a percent of revenue, that improved by the 270 basis points in '17. It was just huge. And the guide for '18, I believe, implies about a 70 bp improvement, OpEx as a percent of revenue with a rate of revenue growth, that really isn't too dissimilar in '18 versus '17.

So I want to be clear, the 70 bps is nothing to sneeze at, but maybe if you can talk to the increased investments that you guys are pursuing and when those will yield the return or they just a function of sort of moving further away from the operational efficiency program.

And then just to pivot, Juan Ramón, I really don't expect specifics, but any thoughts if you believe you will have it, call, a new blockbuster companion animal product in '19 and maybe that's from the triple or something out of the pain portfolio from Nexvet. Any details you guys can give there. .

Jon, in terms of the OpEx improvement that we experienced in '17 versus what the expectation may be for 2018, it was really the latter of your comments. 2017, we continued to benefit from the remainder of our operational efficiency initiative and we were able to grow revenue significantly faster than OpEx in 2017.

Now as we move into 2018, we still expect to grow revenue faster than OpEx but not to the same magnitude as we don't have the same level of improvement coming from our operational efficiency initiative.

The other thing I'll point out for 2018 is there are investments that we're making in SG&A to support the continued development of our diagnostic portfolio and to make sure that we have the right commercial support behind those products as they become ready for launch. .

And answering about the potential opportunity of launching a future blockbuster. Definitely, we'll continue seeing opportunities of launching our products that generate significant growth. And I discussed about monoclonal antibodies for pain.

I also talked about combination of products in parasiticide segment for internal and external enhancement of our productivity for livestock. At this point, commenting when these products will be launched, I think it's too premature.

But we think that we can continue generating growth, which is in line [indiscernible] the market with existing portfolio and also the addition of a -- maybe a blockbuster, but also multiple products that will support our revenue growth.

In our industry, as I mentioned many times, we are not dependent on bringing these blockbusters to generate consistent growth because we don't have the same impact that we see in pharma sales because of generic deceleration. So we are pleased with our pipeline. We are pleased with the return of our investment in R&D.

And we'll continue our focus on generating internal value growth. And at the same time, as I see an opportunity that -- external opportunity that will enhance our opportunity to grow. .

The next question is from John Kreger with William Blair. .

Can you just expand a bit more on the diagnostic strategy? Not talked about it this much in the past.

Should we think about that as more focused in companion animal or livestock and more sort of centralized or sort of point-of-care type of products?.

Thank you, John. Let me say that we see diagnostics as an area that is growing faster than the average of animal health. And we see diagnostics also as a very complementary to our offer to customers and also an opportunity to leverage our existing relationship and infrastructure in many markets.

The focus today is developing our internal pipeline, to bring these products into the market. We see that it's a significant competition in companion animal, especially in the U.S., much more opportunities to offer penetration in International market in companion animals.

And because also our expertise and our presence in livestock, we see this area as a significant potential opportunity for Zoetis. And this should be in areas like rapid test point of care but also equipment. So this is where we are focused today in Zoetis.

These type of point-of-care diagnostic tools that will help veterinarians in companion animal and livestock to make decisions at the point of care. .

The next question is from David Risinger with Morgan Stanley. .

I have two questions. The first is, could you provide a little bit more color on the ramp of new products, and specifically new companion animal products ex U.S.

in 2018? And then second, with respect to cash flow for 2018, could you please discuss the outlook for operating cash flow and free cash flow in 2018 relative to 2017?.

I will provide some comments on the companion animal products outside of the U.S. Glenn also will maybe expanding in some of the details for International markets and definitely, will be commenting on the operating free cash flow. That's the question that you raised and also the outlook for 2018.

We have seen in International markets a very high growth in companion animal. International markets are combination of the new product launches, Apoquel, to a lesser extent, Cytopoint, Simparica. But also the growth that we have seen in some of the major markets in companion animal in where the rates of medicalization has been growing very fast.

And we have seen in countries like Brazil, China, significant growth. And in countries like China, we started new product launches. So we still see the opportunity of growth in the future once we introduce Apoquel, Cytopoint and Simparica in the Chinese market.

We still see significant opportunities for growth in International markets because the level of penetration of Apoquel, Cytopoint and Simparica compared to the U.S. is much lower. So we expect in 2018 that we'll be -- continue enjoying growth in international markets in companion animal.

Maybe, Glenn, you can maybe expand some details on this question and also on the free cash flow one. .

In terms of our free cash flow and the cash flow that we expect for 2018. So our operating cash flow, we expect to grow pretty much in line with our growth in adjusted net income.

As I also mentioned in my prepared remarks, with the increased expenditures we have for CapEx, free cash flow will grow slightly lower than what we expect to grow for operating cash flow. .

The next will be Kathy Miner with Cowen. .

Just wanted to follow up on the dermatology area a little bit more. Juan Ramón, I think you -- it sounds like you increased your guidance for the Cytopoint and Apoquel franchise to $500 million in 2018.

Can you tell us if this is being driven more by Apoquel and/or Cytopoint? And what the penetration is in dogs now for the -- for dermatology conditions?.

Thank you, Kathy. And I think definitely, we have seen that the option of Apoquel and Cytopoint has been growing in 2017 very fast. And that's why we are now projecting for 2018 already to generate $500 million of -- in sales or more. Both products are -- performance is still well.

And now I think it's something that we feel that pet owners when they go to clinics and they have dermatology issues, they are leaving the clinics with either Apoquel or Cytopoint. Definitely, the direct-to-consumer advertising has been helping to accelerate their option and also to expand the market.

In terms of penetration, definitely, the penetration in the U.S. and in international market is different. In the U.S., we reported last quarter that we have a penetration of -- in terms of patients of about 59%. We have seen in the fourth quarter this penetration is stable.

And it's something that, in some ways, was suspected because it's a quarter in where most of the use in -- it's in acute while -- I am sorry, chronic while we have seen increase in the penetration because of the use of acute and seasonal.

Seasonal and acute is mainly in the second and third quarter, and we expect in 2018 continue growing in these acute and seasonal and also helping also to -- with the increase of awareness in terms of dermatology issues with our continued DTC campaign in 2018. We have not seen too much cannibalization of Apoquel because of Cytopoint.

It's about 26%, which is what we were expecting. But I think it's something that we are offering -- both solutions to the veterinarians, and we are very pleased with the performance of these 2 products. .

We'll go next to Liav Abraham with Citigroup. .

Just a quick question on the tax rate. You've guided to a tax rate of 21% to 22% for 2018.

Can you comment on your outlook for tax beyond 2018 and the opportunity for this to be reduced further over time?.

Thank you, Liav. And we'll be -- Glenn, answering this question. .

In terms of the tax rate. As you mentioned, for 2018, we've guided to 21% to 22%. We haven't provided guidance for beyond 2018. There are additional cost of that kicking beyond 2018 for us then -- as coming into effect for 2019. We need to fully understand the impact of that.

But again, the guidance for 2018, based on current understanding, we're comfortable with the 21% to 22% for 2018. .

Thank you, Glenn. And maybe some clarification on the dermatology penetration. I mentioned data for the U.S., International markets there, definitely, we have a lower patient share. And we still see a lot of the room for growing in terms of patient share and also in terms of expanding the market. .

We'll go next to Chris Schott with JPMorgan. .

Just two quick ones here. First, anything -- I know you don't give quarterly guidance, but anything we should be keeping in mind as we think about quarterly progression of both top line and earnings if we think about 2018 relative to '17? And a second was just maybe following up on those comments on Apoquel and Cytopoint.

Just a little bit more color, just how much more room for growth is there in this franchise beyond '18? And I guess, what I'm really trying to get is there any more color of how -- what -- or could -- what could peak sales look like for this franchise? I guess, as you start getting through '18 this $500-million-plus number.

Is there still significant room for growth? Or are we starting to a point where we're seeing peak sales for these assets?.

Thank you, Chris. And let me cover the question on dermatology portfolio, and then Glenn will discuss about the quarterly projections for 2018. We still see growth not only in 2018 but in future years for dermatology portfolio. And maybe the growth in the market that the products has been introduced [indiscernible] like in the U.S.

This growth will be moderated in the future. But there's still -- in many international markets, we are just introducing Cytopoint. Apoquel, definitely have a -- still a lot of opportunity to continue growing. I mentioned China as a country where we don't have yet Apoquel, and we expect also China generating growth in the future.

So we don't see that 2018 will be our peak sales in terms of Apoquel. Cytopoint, on the contrary, will continue growing. Definitely, the growth will be moderated, but we expect also continue growing. And definitely, we'll see growth coming from volume but also growth are coming from prices. .

In terms of the 2018 quarterly production, as you mentioned, we don't give 2018 guidance by quarter. But just a couple of things to think about. And we do expect more balanced growth in 2018 than we saw in 2017 and a more steady performance in terms of cost of goods as a percent of revenue than we saw in 2017, in particular.

The other thing I'll point out is, we are moving from a 4-4-5 accounting calendar to a month-end accounting calendar, and that will have some small impact per quarter. The greatest impact that you'll see will probably be in Q4, where it could negatively impact our growth in Q4 2018 by almost 2%. So those are the only things that I would point out. .

The next question is from Gregg Gilbert with Deutsche Bank. .

Curious whether you saw any headwinds or benefits tied to the consolidation of vet clinics in the U.S. I realized there wouldn't be material effect for the whole year, for the whole company, but curious on that team as it continues to build. And my other question is about the environment overall in some of your competition.

And one of the elephants in the room this year is Lilly will explore options for Elanco. And I know Juan Ramón, you've commented in the past that mergers among the larger players in the industry would be difficult from an antitrust perspective.

But how would you view a spinoff of Elanco if that's what they decide to do? I'm curious on your thoughts there sort of operationally and otherwise as it relates to any effects, good or bad for Zoetis. .

Thank you, Gregg. And definitely, we have seen a consolidation of vet clinics in the U.S. Also, we have seen not too much consolidation of clinics outside of the U.S. but there may be buy-in groups that also are having an impact. So far, we are managing very well the relationship with these clinics.

In some cases, we have been able, really, to reach exclusive agreements for Simparica on one of these larger groups that -- it's something that we see as a very positive. We understand that, in some cases, we may tap some pressure in terms of prices, which is part of also our projections in our model.

But at the same time, where we see the opportunity also of expanding the health care because of better services to veterinarians. So we see also that in the case of Zoetis, we have a portfolio of specialty care. That is also providing significant benefits to this change of clinics and definitely, we are managing extremely well.

It was a very positive collaboration with [ man field ] in the future -- in the past. We also have good collaboration with the VCA, and we expect that the combination of the 2 groups also will continue positive for Zoetis. In terms of the decisions of Elanco. I think it's something that -- I prefer not to comment on other companies' strategic reviews.

We went through our process 5 years ago. It was the right decision for Pfizer and also for, as what you said, very pleased with our performance. And definitely, we have seen the benefits of being at Zoetis, having a single focus on animal health and a singular focus on providing value to our customers and to our shareholders. .

And we'll go next to Jami Rubin with Goldman Sachs. .

This is Candace Richardson on for Jami Rubin. I have two quick questions. Tempered growth in the U.S. companion this quarter appears to be related to tougher comps from certain products that launched last year. When should we expect this to annualize? And then secondly, your recent dividend increase of nearly 20% is among the highest in the industry.

We're wondering if there's a specific payout ratio you're looking to achieve.

And given that you're the only stand-alone public animal health company, what comps do you look at when you evaluate your dividend policy?.

Thank you for your question.

Please, Glenn, do you mind answering the question?.

Yes. So in terms of U.S. companion animal growth for 2017. For the full year, we had 13% operational growth in U.S. companion animal. In the quarter, we had 15% growth. So we saw another continued quarter of very strong growth in U.S. companion animals. So not necessarily tempered growth for Q4. In terms of our dividend policy.

We generally grow our dividend at or pace faster than our growth in adjusted net income. And that is our commitment moving forward is that we'll continue to grow our dividend at or faster than income and have a focus on dividend growth. We're also focused on share repurchase as another way to return excess capital to our shareholders.

And we currently prefer share repurchase as a -- gives us a little more flexibility to manage the other priorities we have for capital allocation, being our internal investments as well as business development. .

We'll go next to Douglas Tsao with Barclays. .

Just focusing on the companion business. You referenced some greater amount of competition for the in-line products. Just curious if that is a trend that you expect to continue.

And then just when you think about the growth for the dermatology franchise going forward, should we -- it'd be safe to assume that a lot of the growth going forward will come from the ex U.S. And if you think about that peak potential, I know people sort of hinted at this question, but do you think that the ex U.S.

opportunity could be ultimately as big as what we've seen in the United States?.

Thank you, Doug. We don't see that the competition has been increasing in companion animal for our in-line portfolio. Definitely, we have seen the impact of generics in line with previous years and also in line with our predictions.

Definitely, vaccines, which have been growing very fast in our opinion, growing faster than the market for companion animals. So in general, we understand that there has been new problems in the pain market in 2017 that has an impact on RIMADYL. But this is not something we see as greater competition in our in-line.

Maybe our in-line portfolio has been affected because of so many products, new products that have been launched in period year. And as you can imagine, the level of attention of our field force during this period has been intentionally in these new products. But we are very pleased also with the performance of our in-line.

And definitely, we see that this in-line will be performing according to our projections. In terms of the dermatology portfolio opportunity outside of the U.S., so there is probably a couple of years or 18 months difference in terms of the interaction of Apoquel in international markets. Cytopoint, that it was introduced in U.S.

at the end of '16 or mid-'16, has been introduced at the end of '17 in Europe, still not introduced in many international markets. I mentioned that even Apoquel is not yet approved in China, and we expect approval in the future. So definitely, it's a significant opportunity of growing our dermatology portfolio outside of the U.S.

But still, we see opportunities of continue growing in the U.S. And definitely, we'll be supporting this growth with a DTC campaign in 2018 in our U.S. markets. .

And we'll go next to Brett Wong with Piper Jaffray. .

You talked a bit about your positive expectations for U.S. livestock.

But can you comment on kind of the International livestock business, specifically in your key markets, like cattle Brazil, hogs in China, et cetera? And if you expect the strength that you saw in 2017 to continue in '18?.

We see livestock in international markets also continue positive. China show companion animal, 20% growth in '17. This was the combination of companion animal and livestock. There are always, as we mentioned many times, in current cycle prices of pork in China and some of our markets there, they kind of affect temporary some of the growth drivers.

But one of the advantages of Zoetis that we explained many times is the diversity of our business in all the geographies. In terms of Brazil, we don't see any change in the fundamentals of our business in Brazil. The cattle business is doing very well, swine doing very well. We have some challenge in 2017 in our poultry business in Brazil.

But overall, we see also projections for livestock International as a positive for 2018. And again, so -- we may see some quarterly fluctuations in some of the markets. But these are not indicative of the fundamentals of the markets, that should be a rise on a longer period of time.

And we don't see any significant or any headwind in terms of the projections for 2018 in international markets for livestock. .

We'll go next to David Westenberg with CL King. .

So my question is, some of our research is suggesting that veterinarians do tend to like order in bulk and from one vendor for additional discounts. So with the derm portfolio now approaching $500 million in sales, what's the opportunity to add to the product bag of the veterinarian.

There's Simparica and vaccines and -- what's the cross-selling opportunity on derm becomes a $500 million drug?.

So -- this is Glenn. We do think there are definitely opportunities to leverage our portfolio and in many of our markets, we have programs that do provide additional incentives with the more products that you buy from Zoetis.

So we're definitely able to leverage the scale that we have with Apoquel, with Cytopoint, with Simparica with many other vaccines to provide additional discounts for buying our total portfolio versus just buying one of our individual products. .

And when we are talking about the total portfolio, so we include products looks like rapid test and diagnostics or, in the future, equipments. So that's why we see the advantage of integrating a larger portfolio and offer this portfolio to our customers. .

And it appears we have no further questions. I'll return the floor to you, Juan Ramón, for closing remarks. .

Well, thank you very much for joining us. And thank you for your questions and looking forward to have another discussion for the first quarter of 2018. Thank you very much. .

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