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

John C. Kreger - William Blair & Co. LLC Kevin Ellich - Craig-Hallum Capital Group LLC Louise Chen - Cantor Fitzgerald Securities Michael Ryskin - Bank of America Merrill Lynch David R. Risinger - Morgan Stanley & Co. LLC Gregg Gilbert - Deutsche Bank Securities, Inc. Jonathan David Block - Stifel, Nicolaus & Co., Inc.

Christopher Schott - JPMorgan Securities LLC Jami Rubin - Goldman Sachs & Co. LLC Douglas D. Tsao - Barclays Capital, Inc. Alex Arfaei - BMO Capital Markets (United States) Kathy M. Miner - Cowen & Co. LLC Liav Abraham - Citigroup Global Markets, Inc. David Westenberg - C.L. King & Associates, Inc..

Good day, and welcome to the First Quarter 2018 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.

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..

Good morning, everyone, and welcome to the Zoetis first quarter 2018 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 the company's 8-K filing dated today, May 2, 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. Let me start by saying that the fundamental drivers of the animal health industry remain strong. The adoption of pets and focus on their health and their wellness are leading to a steady increase in medicalization rates, as well as more interest in specialty care products.

A growing world population continues to require more efficient production of meat, eggs, fish and dairy products. Our livestock customers may face economic cycles, weather conditions, as well as fluctuations in their input cost and prices.

These type of cycles will always exist, but the underlying need for healthy animals to produce safe and affordable food is essential. As a leader in animal health, Zoetis has stayed well positioned to support our customers.

We have been able to discover, develop and deliver valuable products and services to them, based on our best-in-class combination of direct sales, R&D and manufacturing capabilities. This has been our formula for success, and it remains that way in 2018.

In the first quarter, we continued generating profitable revenue growth, thanks to the quality and the diversity of our portfolio; also the innovations we bring to the market and the value we deliver to our customers.

We achieved 7% operational growth in revenue, driven by the performance of our dermatology portfolio, as well as new products including vaccines. We generated growth in the U.S.

and across our major international markets, based on the sustained effort of our field force and targeted investments for the launch of new products and the support of our in-line portfolio.

We also grew our adjusted net income by 34% operationally, based on revenue growth, improvement to our gross margin and the benefits from the recently enacted U.S. tax reform. In terms of more revenue return, our Companion Animal products grew 11% operationally, and we expect another year of above-market growth in this part of our business.

We see further opportunities for gaining share and expanding the market for our innovative dermatology products. We are extending our derm portfolio into new markets internationally, and putting our sales and marketing efforts behind them. In the U.S.

and in other select markets, we are continuing digital and direct-to-consumer campaign to expand awareness around atopic dermatitis and also to increase the overall category spend on canine itch.

Our new parasiticide products based on the sarolaner molecule, Simparica, a chewable tablet for dogs, and Stronghold Plus, a topical formulation for cats, are also contributing to growth in Companion Animal products in the first quarter, along with our new canine influenza bivalent vaccine.

All of this was developed internally at Zoetis and illustrates a positive return on our R&D investment. On the Livestock side of our business, we generated 6% operational growth, led by stronger performance in our poultry products and growth in cattle and swine products as well.

The conditions in the livestock market are stable and we expect to grow our cattle, poultry, swine and fish products in line with or faster than the overall market. There are excellent growth opportunities in animal health across the cycle of healthcare, from prediction and prevention to protection and treatment.

And we are using our stronger financial position to support investment for growth. The investment in R&D is a top priority for Zoetis, and we see opportunities to enhance our product line with new lifecycle innovation and to make new breakthrough discoveries.

In the first quarter, for example, we expanded our Fostera swine vaccine franchise with the approval in the U.S. of Fostera Gold PCV and Hyo. This is the first ever vaccine to contain both genotypes of PCV2 – 2a and 2b and a study show it provide cross protection against the leading 2d genotype.

It also provide the long duration for commercial PCV2 combination vaccines at 23 weeks. As I said, we'll maintain DTC advertising and other digital marketing campaigns similar to last year, and we have started increasing our field force support in diagnostics in key markets.

We are also executing our plans in manufacturing investments, which I have discussed recently. In fact, last week we held a groundbreaking ceremony in Suzhou, China for a new facility that will enable us to expand our vaccine manufacturing and R&D in that country.

As always, we'll identify and scrutinize external acquisitions and partnerships in areas where we have our gaps or where we can achieve more value from an existing business or asset. In closing, we remain confident in the strength of our company and the opportunities to offer customers more integrated solutions across the entire cycle of healthcare.

With this approach and our proven business model, we can generate long term growth for Zoetis and value for our shareholders. With that, let me hand things over to Glenn, who will provide more details on our first quarter results and full year 2018 guidance..

Thank you, Juan Ramón, and good morning, everyone. As Juan Ramón indicated, we performed well again in the first quarter, delivering operational revenue growth above historical trends for the market and we grew adjusted net income at a faster rate than revenue.

Total company revenue in the first quarter grew 7% operationally excluding a favorable 4% impact from foreign exchange. Revenue growth in the quarter was driven by our in line portfolio which includes our key dermatology products. We also saw growth in new products, price and a strong Livestock performance across both our international and U.S.

segments. The breakdown of our 7% growth was 2% from price and 5% from volume. Of the 5% volume, 2% was from new products and 3% was from in line products including 2% from our key dermatology products. We experienced balanced growth again this quarter as virtually all therapeutic areas, key markets and core species contributed to revenue growth.

Adjusted net income grew 34% operationally, driven by revenue growth, gross margin improvement and a lower effective tax rate. Our key dermatology portfolio, comprised of APOQUEL and CYTOPOINT, once again surpassed the $100 million mark in revenue with sales in the quarter reaching $122 million.

As we indicated on our earnings call last quarter, we expect to achieve more than $500 million in combined sales from APOQUEL and CYTOPOINT for the full year 2018. Now let's discuss segment revenue. International revenue grew 11% operationally in the first quarter with Companion Animal operational growth of 19%, and Livestock operational growth of 7%.

Companion Animal growth was largely driven by our key dermatology products APOQUEL and CYTOPOINT, new products such as Simparica and Stronghold Plus and increased medicalization rates in key emerging markets such as China and Brazil.

Livestock benefited from growing demand for animal protein, new product introductions and the success of our field force. Turning to some notable market performances in the quarter. In China, we grew 14% operationally, largely due to strength in Companion Animal, which increasingly represents a larger portion of our business there.

An increasing companion animal population and medicalization of pets contributed to this growth. And our Fel-O-Vax vaccine continues to perform well as the only registered vaccine available for cats on the market. In Brazil, sales grew 7% operationally with contributions from both the Companion Animal and Livestock businesses.

Higher Companion Animal revenue in Brazil benefited from the continued growth of Simparic due to a strong return on the direct to consumer investment, co-promotion with key in line products such as Revolution and higher vet clinic penetration.

In cattle, investments in our field force have led to increased penetration and coverage in key regions within the market and we continue to see favorable export market conditions. In swine, increased sales of Vivax, or Improvac as it's known elsewhere, were driven by higher usage and greater penetration with larger customers.

These increases were tempered by a decline in poultry. Other markets also contributed to growth. Japan experienced operational revenue growth of 17% in the quarter with positive performance across all species.

Growth came from APOQUEL as a result of the timing of distributor purchases last year and the additional market penetration we achieved in the first quarter. Australia grew 14% operationally with strength across all species, particularly poultry and cattle.

In poultry, the growth was driven by an installation of hatchery devices related to KL Products, which was acquired in 2015. In cattle, our vaccine business grew due to strong beef prices and the rebuilding of the herd and the market. Other emerging markets, particularly Russia and Poland, performed well.

Russia had increased sales of medicated feed additives in poultry. And in Poland, we had the benefit of milk price stabilization and a cattle sector recovery based on producer consolidation. To summarize, a very strong quarter for our international segment with growth across a diversified portfolio.

Favorable market conditions, a return on strategic investments in our portfolio and field force and a focus on execution are all helping to consistently drive commercial results. Turning to the U.S., revenue grew 5% in the first quarter with all species contributing to growth. Companion Animal grew 6% while Livestock grew 4%.

Companion Animal sales in the quarter were driven primarily by our dermatology portfolio and a number of recently launched products. These gains were partially offset by decreases in certain in line products and Simparica. U.S.

dermatology sales were $83 million for the quarter with both APOQUEL and CYTOPOINT exhibiting strong growth over the same quarter in the prior year. As anticipated, Q1 revenue was in line with Q4 and we expect higher sales in Q2 and Q3 with the warmer weather driving seasonal activity.

Simparica declined over the same quarter of 2017 due to the timing of customer purchases in Q1 and Q2 of last year. We expect this product to grow in Q2 as we continue to gain clinic penetration and market share and realize the benefit of our direct to consumer investments which we are maintaining in 2018.

Additional contributions to Companion Animal growth came from new product launches including our VANGUARD canine bivalent flu vaccine and DIROBAN for the treatment of heartworm. Partially offsetting growth in our Companion Animal business was the continued impact of expected competition on REVOLUTION, RIMADYL and CLAVAMOX. Our U.S.

Livestock business continued to grow in the first quarter, building off a strong fourth quarter with sales increasing 4%, thanks to the positive performance across all species. Colder and more volatile weather conditions across parts of the continental U.S.

led to a greater risk of disease outbreak and incidence and this supported the sales of premium products. Our beef cattle business also benefited from higher numbers of animals moving through feedlots than in the comparable period in 2017.

The positive performance in beef was partially offset by dairy where reduction in herds due to lower dairy prices led to declines in sales of our anti-infectives and intramammaries. In poultry, the Zoetis portfolio of alternatives to antibiotics in medicated feed additives continues to be the primary driver of growth.

Swine returned to growth in the first quarter. We are starting to see the benefits of our investments in our Fostera vaccine line including the launch of Fostera Gold PCV M. hyo and we expect further contribution in future quarters. Now moving on to the rest of the P&L. I will cover a few key line items and then discuss guidance for 2018.

Adjusted gross margin of 67.5% increased approximately 300 basis points in the quarter on a reported basis and reflects the benefit of continued cost improvements and efficiencies in our manufacturing network. Operating expenses in total grew 6% operationally versus the same period last year.

This reflects an increased investment in R&D in areas such as diagnostics and monoclonal antibodies for chronic pain. We also realized higher spend in SG&A, primarily due to increased compensation related costs. The adjusted effective tax rate for the quarter was 18.2%.

The tax rate in the quarter is significantly lower than the rate from the comparable 2017 period due to the favorable impact of recently enacted U.S. tax reform and the benefit of certain discrete items such as the vesting of employee equity awards.

We do, however, anticipate a higher effective tax rate for the remainder of the year in line with our guidance. Adjusted net income for the quarter grew 34% operationally through a combination of strong revenue growth, cost improvements in manufacturing and a lower effective tax rate.

Adjusted diluted EPS grew 36% operationally in the quarter versus the same period in 2017. Now moving to guidance for full year 2018. The year is off to a solid start, as expected. We are therefore reaffirming our 2018 guidance provided during our February earnings call. Please note that this is shown representing foreign exchange rates as of mid-April.

For the year, we continue to expect to achieve operational revenue growth of 5% to 7% and operational growth in adjusted net income of 20% to 26%. In the fourth quarter, we will have comparisons to a strong U.S. Livestock performance and less calendar days due to a change in our accounting calendar.

Finally, we repurchased nearly $200 million of our shares in the first quarter and our guidance for reported and adjusted earnings per share reflects the shares repurchased through Q1. Just to summarize, before we go to Q&A. We're off to a good start with balanced growth across our portfolio including markets, therapeutic areas and species.

We're seeing a balance contribution to growth across our in line portfolio, price and new products from our pipeline of novel innovation and lifecycle management. Our diversity, geographic presence and ability to innovate will continue to provide a platform for growth that is in line with or faster than the market.

And we will continue to invest both internally and externally to support sound investments in our business and return excess capital to shareholders. With that, I'll hand things over to the operator to open the line for your questions.

Operator?.

Thank you. We'll take our first question from John Kreger with William Blair. Please go ahead. Your line is open..

Hi. Thanks very much. Juan Ramón, can you talk a little bit about all the discussion about tariffs in recent months? Have you seen that impact your Livestock business at all? And maybe related to that, if we see changes in NAFTA, do you see any exposure to your U.S. Livestock business? Thanks..

Thank you, John. We have not seen any impact on price in our Livestock business. Definitely, yeah, that is something that can have an impact on some of the U.S. producers. Same time, because of our international presence and because the consumption of animal proteins will remain the same, we expect that anything which is not produced in the U.S.

because of the implementation of a tariff will be supplied by other markets where we also have activity. But maybe talking to two areas that represent the biggest concerns, one is China and the tariff on the importation of pork. Our swine business in the U.S. represent 3% of our total revenue. 80% of the production in the U.S.

is for local consumption and about 20% is for export. But in the case of exports, China only represent about 10% of these 20% of exports. So for our total revenues, this is something that would not have any impact. Definitely, we want to support our U.S.

customers and I think it's something that we'll continue working to ensure that they manage any impact. What percent of bigger impact is the NAFTA discussions. Definitely the export to Canada, the export to Mexico are significant and hopefully the U.S.

government will achieve a good agreement with these two countries and they will continue supporting agriculture and livestock in the U.S. So next question, please..

We'll take our next question from Kevin Ellich with Craig-Hallum. Please go ahead..

Good morning. Thanks for taking the questions. I guess Juan Ramón and Glenn, could you give us a little bit more detail on your capital allocation priorities and capital structure? You increased the dividend 20%. You bought back more stock this quarter than you had in the past.

I guess, how do you prioritize things and what's your outlook for strategic M&A? Thanks..

Thank you, Kevin. And our capital allocation priorities remain the same. So we'll continue investing internally. We have been showing that these investments are having a high return. This year we are increasing our capital expenditure in manufacturing to ensure that we have the capacity and the capabilities that will be needed to support future growth.

We'll continue investing in DTC to support key programs and we are expanding our field force to support diagnostic portfolio in the future. We'll continue also assessing external opportunities at divisions.

We'll remain focused on anything that will meet the criterias of a strategic asset, and also value creation, and it is something that we are regulating the cash really to contemplate this type of acquisition, but at the same time will remain very disciplined on ensuring that the return generated is through any type of external position.

And we'll continue paying dividends and also buying share backs in line with what we have been communicated in previous discussions..

Yeah, and the only thing I'll add, Kevin, as Juan Ramón said, our priorities haven't changed. However, we continue to have additional capacity and flexibility to execute on those priorities. And as we mentioned, our cash flow generation continues to increase also with tax reform.

We have more flexibility and access to that cash and as you indicated in terms of your question around dividends versus share repurchase, we continue to prefer share repurchase as it does give us flexibility to execute on our other capital allocation priorities..

Next question, please..

And we'll go next to Louise Chen with Cantor Fitzgerald. Please go ahead..

Hi. Thanks for taking my question. I'll try to ask Kevin's question a little bit differently.

Maybe in terms of the acceleration in your cash flow generation, could you just give us a little more color, metric behind how we should think about that? Maybe the magnitude of increase? And then also the earnings potential of that cash, that's not really reflected in your earnings per share as it is today.

So how should we think about how that magnitude could improve over the next several years? Thanks..

Okay. So then, since you are asking a similar question, I will ask Glenn this time to answer to provide a different type of comments..

In terms of the magnitude of the cash generation and how we expect that to increase particularly for 2018, I think as we look at that, while we don't provide specific guidance on cash generation, for 2018, you could pretty much expect it to increase at the pace of our adjusted net income.

So again we'll see continued expense in cash generation, continued flexibility to execute on our capital allocation priorities. Right? Our current guidance for 2018 includes the investments that we have internally.

We've also referenced that we expect capital investments to be up in 2018 and then we'll continue to look for business development opportunities that have both the strategic and right financial rationale. To the extent that those materialize, we'll adjust our share repurchases either up or down depending on the magnitude of business development..

Next question, please..

And we'll go next to Erin Wright with Credit Suisse. Please go ahead..

Hi. This is actually (27:37) on for Erin today. Thanks for taking our question. We would like to ask a question about, how do you think about the quarterly progression of growth in product metrics and where do you think there are potential elements of conservatism in your guide relative to sort of the profit metrics? Thanks..

So as we indicated, we don't provide necessarily quarterly guidance. A couple things though that we will point out related to the quarter, as we referenced on the call, a change in our accounting calendar. That does provide a slight benefit to growth in revenue, particularly in Q1 and Q3 to the tune of about a half point to a point of growth.

That reverses in Q4 where we'll see negative impact to growth from a number of calendar days by about 1% to 2%. The other thing, just to point out from a growth perspective, obviously we face tough comparison in Q4, particularly based on the strength of the U.S. Livestock performance in Q4 2017..

Next question, please..

We'll go next to Derik de Bruin with Bank of America. Please go ahead..

Thanks. This is Mike Ryskin on for Derik. You talked about the competition in the U.S. on the in line products, the REVOLUTION, RIMADYL and then you also mentioned the strength in price for the portfolio overall.

In the areas where you're seeing competition, is it more – specifically with those products, is it more in terms of volume? Or are you having a cut price there to sort of adjust for the market? And can you talk about what your expectations are for those products going forward, what levers you can pull to sort of strengthen that? And then also, if actually I can squeeze one more in, on the diagnostics products, you mentioned it's been a few months since you launched that and you talked on it briefly in the prepared remarks.

Can you talk about, give us an update on the build-out there with the sales force? Thanks..

Thank you for the questions, Mike. So we reported this quarter in Companion Animal U.S. 6% growth. When we say that we expect that, you say, growth in Companion Animal U.S.

will be higher for the total year, we saw some impacts in the first quarter that Glenn will describe, but as I said many times, one of the advantages of Zoetis is the diversity of our portfolio and this diversity in terms of species, in terms of therapeutic areas, geographies. It's helping us to be consistent in terms of generating revenue growth.

But maybe Glenn will talk about the impact or some of the problems in line portfolio in the U.S. volume, price and what are expectations that we have moving forward..

Yeah, in terms of the impact of competition in the U.S., there were three products that especially faced the competition. It was CLAVAMOX, RIMADYL and REVOLUTION. CLAVAMOX, competition was really coming from generic sellers, primarily volume, but some price expense as well.

And with CLAVAMOX, we have launched CLAVAMOX Chewables which we do expect will minimize this impact as we move forward. RIMADYL was really impacted by Galliprant and continued penetration of Galliprant and it's really a factor of the comparison year-over-year as the growth in the competition expanded throughout last year.

So, we're in the toughest quarter in terms of comparison growth year-over-year. And then REVOLUTION, really Bravecto for cats was the biggest challenge from a competition perspective. And again, more volume competition there..

And maybe adding that also the parasiticide portfolio including REVOLUTION was affected by a cold March. This is something that we have seen also affecting the overall parasiticide portfolio not only for Zoetis, but also from our competitor. So you also asked about diagnostics.

Well, in diagnostics, we continue investing internally to develop our portfolio and we are making progress in this area.

We already have products that we are offering to veterinarians, mainly Companion Animal, and what we started it's building our field support and the field support in (32:03) is field forces in all locations (32:06) that will be supporting our current and future portfolio. We started in the U.S.

We are now also expanding in key international markets and we'll continue until we complete what we think will be the needs of field support for our diagnostic portfolio. Next question, please..

We'll go next to David Risinger with Morgan Stanley. Please go ahead..

Thanks very much. I have two questions, please. First with respect to U.S. Companion Animal, the growth of 6% was marginally below what we had expected, but I wanted to ask about the outlook. I know that the comps may be getting a little bit tougher over the course of the year. I just don't have a sense for how to think about U.S.

Companion Animal growth prospects in coming quarters. And then second, you're obviously reinvesting in R&D, which has paid off in the past, and the R&D year-over-year growth is accelerating as you invest in, I guess, more expensive R&D projects and you're now past your cost efficiency initiatives in R&D.

Could you just talk about the outlook for year-over-year spending growth in R&D as well? Thanks very much..

Thank you, Dave. And we expect higher growth for Companion Animal in the U.S. for the total year. And we expect that the higher growth will be coming from, well, the strong season on parasiticides that is now starting. Also the investment in DTC that has started in the month of April, so no impact in the first quarter.

We'll be increasing our campaigns for DTC for increasing awareness on dermatology conditions and also we'll be also investing in DTC for Simparica. So all this should generate expansion of the market in dermatology and also continue grow in terms of a market share for Simparica.

So we are optimistic about generating a higher growth in Companion Animal in the U.S. for a total 2018. In terms of the R&D investment, we are increasing our allocation for R&D. We have a strategic program that we are supporting. We also added some additional products with the acquisition of Nexvet that now we are supporting.

We are also increasing our allocation for diagnostic R&D as well as increasing also investment in fish. So all this it's really increasing the level of allocation that we are – we are reallocating (35:05) that to R&D, and we are very confident that we'll maintain the same level of total activity that we show in the past.

Glenn, if you want to add some additional comments either on the U.S. or R&D, please....

Yeah. Just to add to the U. S. Companion Animal growth comment. Just one thing to consider particularly for the quarter, the quarter was negatively impacted by Simparica growth in the quarter and that was really driven by a tough comparator to Q1 of 2017. So if you go back to 2017, we had strong sales in Q1 and then a sharp decline in sales in Q2.

We're not going to see that same pattern in 2018. So while Simparica was a decliner in growth in Q1, we expect that to drive growth in Q2 to Q4 as well, which will then help accelerate growth in Companion Animal throughout the year..

Thank you, Glenn. Next question, please..

And we'll go next to Gregg Gilbert with Deutsche Bank. Please go ahead..

Thank you. I'm sorry if I missed this, Glenn, but could you give us the U.S. rest of world breakdown for APOQUEL, CYTOPOINT, and my more strategic question is about the fish business. Obviously a nice grower but small numbers overall.

I'm curious conceptually how large can that business become for you relative to the other categories and species over the very long term? And clearly there's an organic story with R&D spend that, is this an area ripe for acquisitions as well? Again just looking at how large could this business be relative to others longer term. Thanks..

Thank you, Gregg.

Glenn you want to provide the details of the derm portfolio?.

Yeah. In terms of the derm portfolio, so for the quarter, we had $122 million in sales and derm growing nicely, over 50% growth. Of that, $83 million was U.S., $39 million was international.

The break out of $122 million between APOQUEL and CYTOPOINT, there was $99 million in APOQUEL, $22 million in CYTOPOINT and obviously there's just a little bit rounding in the numbers between the two..

And I will provide some comments about fish. It is difficult to estimate what will be the long-term opportunities for fish. Today most of the revenues generated in fish are coming from salmon, and in our case we are focused on salmon. We have 70% market share in salmon for vaccines.

But the growth that will be generated in the future will be also for expanding the portfolio of vaccines for other fish species, mainly fresh fish, in where today the mortality rates are very high and most of the products that are used are antibiotics which are dropped into the water.

So we expect that in the same way that many years ago the salmon industry moved from antibiotics to vaccines and today we are not using almost antibiotics in the production of fish. We expect the same for other species in the future. We see fish in some way similar to protein many years ago.

In where there was very small revenue generated in poultry and now poultry, well, it's $16 billion revenues. So in the total animal health – no sorry – $5 billion. $6 billion (38:50), $5 billion total revenues for poultry.

So we expect that maybe not reaching this level of revenues for fish, but over time moving from an industry that today is about $600 million, $700 million to an industry that will generate more than $1 billion in terms of revenue, and we think that the greatest asset, already the expertise and also the infrastructure to generate the future products that will be delivered to the fish producers.

So next question, please?.

And we'll go next to Jon Block with Stifel. Please go ahead..

Great. Thanks. Good morning, guys. I'm actually going to try to squeeze two or three into one. And just to roll through, maybe first, last quarter you had conviction that dairy would pick up in the back half of 2018. Just curious if that's still intact as pricing seemingly remains difficult.

I guess part B would be fish up modestly year-over-year, but a big step down from the run rate that we did see in the back half of 2017.

So how do we think about the contribution from PHARMAQ this year? And then lastly, sorry, but just Simparica, is there an update in the goal? And by that I mean out of the gate I think you guys pointed to a $100 million annual product. We've seen APOQUEL and CYTOPOINT have the positive revisions.

What's the latest on Simparica? Is there a sort of an update positive or negative to the initial $100 million? Thanks, guys..

Thank you, Jon. Let me start with the question on dairy and look for 2018. In general, Livestock, it's stable in terms of the previous conversations that we had in February.

Maybe realistic (40:37) exception, it's dairy, in where we have seen that prices have been declining and we expect that in 2018 dairy farmers will face the challenge of profitability because of these prices.

We expect that as in many other occasions there are cycles that always are happening and the next cycle they will be adjusting the volume and the supply and then prices will recover and we expect that in 2019, so the dairy industry will be back to profits.

But even if the dairy, it's more negative, we'll see in some cases more positive in other species in Livestock that will compensate. So we remain confident that the total livestock will be in line with the projections that we made at the beginning of the year. In terms of fish, this quarter the fish portfolio was flat.

We are comparing with a quarter in where our vaccine for SRS in Chile was priced at much higher level. We adjusted the prices in following process and we are comparing something which is probably in terms of our volume. We have continue increasing the penetration.

Price is having a negative impact in the total revenue growth, but we expect that the growth for our fish will be growing in line of what's on the market but will be faster than the overall growth for animal health.

And maybe Glenn, you want to talk about Simparica?.

Yeah. The only other thing I'll mention on fish in terms of sequential quarters versus Q4 is the PD season, as we've indicated, really is in the second half of the year. So that's part of the step down between Q4 and Q1 performance as well.

In terms of Simparica, we have indicated that we expect that product to be a blockbuster with sales of greater than $100 million and that still is our expectation for Simparica..

Next question, please..

And we'll go next to Chris Schott with JPMorgan. Please go ahead..

Great. Thanks very much. Just two questions here.

First on the incremental investments you're making in R&D, how much of that is focused on lifecycle management versus breakthrough investments? And when we think about areas that you're focused on on the breakthrough side, what are you most excited about as you think about the R&D portfolio? My second question was just a quick one on tax.

You obviously had a lower rate in the quarter. I know you expect that to rebound the rest of the year. But we have seen a number of companies lower their tax expectations as they've had more time to digest the new rules.

So as you think about Zoetis beyond 2018, could we see improvement to the tax rate as the business trends over time? Or is 21%, 22% rate a good one to think about going forward? Thank you..

Thank you, Chris. And we are investing in lifecycle or new product innovation about the same. So we are very much balance how much these investments in our current portfolio compare to the products that will be new into the market and creating some additional growth. And in terms of what are we most excited about R&D.

Definitely, we are very excited about monoclonal antibody. We have now one monoclonal antibody which is working extremely well and generating a very positive growth and missing the demand of our customers which is CYTOPOINT which is complementing APOQUEL.

But we see monoclonal antibody as platform for many other indications including pain for dogs and cats and we see that, especially for cats, it's a significant unmet need. There's nothing specific for cats today. We state that monoclonal antibodies will cover this need and will generate very positive feedback from the market.

We are also excited and will continue investing in sarolaner which is the molecule of Simparica and combining this with other active ingredients to extend the protection of dogs and cats to other parasiticides including internal and external.

And we continue also excited about finding ways of integrating more the different aspects of healthcare, not just vaccination or treatment but also prediction with the genetic market, genetic information, and also detection with our diagnostic investment to build our portfolio also to cover from prediction, detection, prevention and treatment.

And all across that ensuring that we use digital data analytics to really increase the value of our R&D investment. So definitely we are working on all these aspects and we think that they are great opportunities in both the Companion Animal and Livestock.

And we see that integrating all these elements of healthcare will also have an impact on R&D but also an impact in our value that we'll be delivering to our customers. And let me ask Glenn to talk about tax rate for 2018 and 2019..

Yeah. In terms of the tax rate, the guidance that we had provided in February, we had spent a lot of time trying to understand the new law and providing that guidance. And we really haven't learned anything new to date that changes our expectations for the approximate 21% to 22% that we have for 2018.

Over time, we'll continue to look for ways to grind down the rate but we don't see it changing substantially from the 21% to 22%..

Thank you, Glenn. Next question, please..

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

Thank you. Just trying to – going back to the U.S. Companion Animal business that was up 6%, can you tell us, Glenn, what is a normalized growth rate if you exclude APOQUEL and CYTOPOINT? Those have been such strong drivers of growth to that business and I know there were a lot of moving pieces with Simparica this quarter.

But is that business growing excluding APOQUEL and CYTOPOINT? And then secondly, what sort of competitive intelligence have you guys done around future competition, specifically for APOQUEL? Elanco certainly has the JAK inhibitor technology.

What have you seen out there, and when do you expect competition to materialize for either of those two products? Thanks very much..

Thank you, Jami and I will answer first about the competition that we may expect for APOQUEL, CYTOPOINT and then Glenn will talk about the U.S. growth and also in line and also the rest of the portfolio. So as you know there is very little information about R&D in our industry.

Most of our competitors are part of big pharma companies and they don't have the need of disclosing the details about R&D like in human health to support the future growth. It's something that is much more complicated. We should expect that in the future we'll have competition for APOQUEL and CYTOPOINT.

There are some indications that the company was offering the monoclonal antibody that maybe have some activity in allergy, but it is information that they provided. They're still far from reaching the market because it was very early stage of development so it will take several years to reach and market.

Apart from that, maybe some competitors are also working on developing this type of portfolio. We are very confident that first we have very strong asset protection for APOQUEL, that that will go through 2029 and for CYTOPOINT it will be even longer.

And we have two products that has been demonstrated efficacy and also safety and that has been extremely well accepted by the market. So definitely competition one day will come but we're still very confident that we have very strong portfolio and very strong way to support our portfolio. And Glenn will talk about the U.S.

Companion Animal growth and the breakdown between key problems and in line portfolio..

For U.S. Companion Animal growth, when you back out the impact of derm, you especially get to flat growth for the rest of the portfolio. And that was driven by a number of factors. A, we talked about the competition that we experienced on the three products that we described.

We also had the negative impact of some of the quarterly variation with Simparica that we do expect to reverse as we move throughout the year. Offsetting that was growth in some other new product as well that contributed nicely and growth from some other in line portfolio as well. So overall, we were flat when you take out the impact of dermatology..

Next question, please..

We'll go next to Doug Tsao with Barclays. Please go ahead..

Hi. Good morning. Thanks for the taking questions. Just curious when you think about the Companion business, if you could provide some perspective on just sort of the consolidation we've seen on the customer side in terms of the vet clinics.

And does that have any impact positive or negative in terms of your business there, in the Companion business in the U.S.?.

Well, the consolidation on vet clinics, it's something that is happening and we expect that that will continue in the future. We have now Banfield and VCA, they're consolidating and representing, it's about 2,000 clinics in total. And it's a significant customer. We have excellent relationship with both VCA and also with Banfield.

There are other group that are now consolidating and we'll see that many individual clinics will be also forming and buying groups or other sorts of networks. This definitely will have pressure in terms of pricing.

But at the same time, we are very confident that the portfolio that we have which includes products which are highly differentiated also will help us to manage this situation or to manage volume and price discussions. And this is also something that we are incorporating in our projections. It's something that will happen in the U.S.

We'll see also some type of buying groups in countries like the UK or France. It's part of what we should be expect in the future, but at the same time, with this consolidation, it's also increasing the opportunity to integrate more many of the things that we can offer to these clinics. So next question, please..

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

Hey, good morning, folks. Thank you for taking the questions. Can we get your Simparica sales by U.S. and ex U.S. please? You provided some helpful comments about the U.S. performance. Would appreciate your thoughts about expectations for ex U.S. And then Glenn, stepping back and looking at your margins, you've obviously made great progress.

Just wondering what kind of operating margin is possible for your business in an optimal scenario.

I appreciate the earlier comments about gross margin getting better with mix and efficiency but as competition increases invariably in dermatology, as you recently just pointed out, I would imagine that you also need to – there's going to be some need for SG&A spend.

So if you were to look at your business optimally on an operating margin, help us figure out how much more room you have left there. Thank you very much..

I will start with a comment on Simparica. Glenn will provide more detail. But we have seen that the interaction of Simparica in international markets continue growing and continue growing there very nicely.

And we see that the opportunities of growth in international markets are in line or even higher than our expectation and we are both very confident that Simparica will reach a significant part of the revenues in the future in international markets. But maybe, Glenn, you can go into more detail..

Yeah. Just to add to that point, so Simparica internationally grew 100%, over 100% in the quarter, so very strong growth internationally. To break out, there was $31 million in sales for Simparica for the quarter; $18 million of that was in the U.S., $13 million was international.

In terms of operating margin, so as we've said in the past, we're not focused purely on generating higher operating margins. We're (55:30) both driving profitable revenue growth and improving on our overall cash flow. And that's going to continue to be our focus moving forward.

That being said, we believe our long term value proposition is very much in place in terms of our ability to grow revenue at a faster pace than OpEx and therefore drive adjusted net income growth at a faster pace than revenue.

You reference in terms of competition and global scale, we believe in the majority of the markets that we operate, we currently have the scale and infrastructure to support the anticipated revenue growth that we have moving forward.

To the extent that there are some changes needed, they'll probably be more in the incremental house (56:05) to support additional revenue growth and would not change our cost structure materially..

Next question, please..

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

Thank you. Good morning. Two questions. First on canine pain.

Given that we've seen Galliprant making some inroads, does Zoetis have an interest in small molecule canine pain meds or is your focus on monoclonals? And can you give us any update on the timing of the next monoclonals that you have in development? And the second question is on antibiotic-free proteins.

Do you see the demand for antibiotic free proteins in the U.S. increasing or do you think it's stabilized? And what are the types of products or services that Zoetis is providing to offset some of the loss of the antibiotic sales? Thank you..

Thank you for the questions, Kathy, and let me start saying that, well, we are focused on for pain for dogs mostly on monoclonal antibodies.

We think that the current treatment that exists in the market related to NSAIDs or other type of solutions are well covered, but we see the opportunity of bringing monoclonal antibodies that will provide excellent efficacy to treat the symptoms of pain and also excellent safety profile. We have seen that, well, Galliprant had a good increase in 2017.

Maybe they are reaching some level of plateau in terms of growth. And we are convinced that the portfolio we have today with RIMADYL, RIMADYL, it's a product that has been in the market for many years.

It's extremely well accepted there based on brand equity, and we'll continue supporting RIMADYL in terms of oral formulations and developing these injectable formulation with monoclonal antibodies. In terms of demand for non-antibiotic or antibiotic-free proteins, we have seen that in poultry.

It has been increasing there, the production of antibiotic-free, and the advantage of (58:39) is that we can also offer alternative to antibiotics and protein have been growing very nicely with this alternative and we have not seen the negative impact of the reduction of antibiotics in poultry.

In other species, it's much more complicated to move to antibiotic-free production because they're much more exposed to external pathogens and with this exposure, so the infections are much more complicated to achieve with biosecurity and other healthcare protocols.

In any case, we'll continue working internally to identify alternative to antibiotics that will protect the animals. One of these alternatives is where we are investing and will continue investing is vaccination.

But we know that despite of all healthcare protocols and vaccinations there, animals get sick and when they get sick, they need to use antibiotics. Otherwise the impact in animals, in the productivity, but also the potential impact to humans will be extremely negative.

So we'll work on alternative, but I don't – we don't see that antibiotics can be replaced in some of the species like beef or even pork. Next question, please..

We'll go next to Liav Abraham with Citi. Please go ahead. Your line is open..

Good morning. Thanks for squeezing me in. Just a quick follow-up question on the pipeline. Thank you for some of the color you provided.

Can you call out any specific pipeline catalysts over the next couple of years, let's say? Just want to get a sense of when some of the opportunities that you've talked about qualitatively can come to fruition and translate into revenues. Thank you..

More than providing specific timing for the launch of the product, but in some cases, as you know, first, we don't want to provide information to our competitor. That will be a negative to us, and we want to make sure that when we launch a product that we maximize revenues and profits as fast as we can.

And providing details probably will reduce the opportunity to maximize our new product launches. But definitely we'll see that we'll be launching in the next coming years combination of sarolaner with other active ingredients to cover internal and external parasiticides, as I mentioned.

You will see that we are introducing also monoclonal antibodies for pain in dogs and cats. We'll continue bringing new innovation in terms of vaccines. In 2018 we introduce an expansion of our Fostera line with the first vaccination for PCV2, combining 2a and 2b, and also providing cross protection against 2d.

So we are very pleased with the way that we are investing in our portfolio. And there will be many other things that we'll continue discussing in the future.

But we prefer at this point not to provide too many details of specific programs or time, because I said this is something that we are – we want to protect our future launches and not to provide too much information to our competitors. Next question, please..

And we'll go next to David Westenberg with C.L. King. Please go ahead..

All right. Thank you for squeezing me in. So the merger or the upcoming merger of Henry Schein and Vets First Choice, a lot of that's on the paradigm they believe they can increase compliance.

Now, for Zoetis, what opportunity do you see in encouraged compliance in your own kind of products? Is there a real potential to kind of grow the market in the companion animal market? And as a follow-up to that and the merger, what are the opportunities that you see to work with a Henry Schein, Vets First Choice combined company?.

Well, we have excellent collaboration with both and we expect that this collaboration will be maintained in the future with the combination of Henry Schein and Vets First Choice.

We see also that this JV will increase compliance, mainly on the chronic treatment and this an area that we will have a benefit for pet owners, a benefit for veterinarians and also benefits for manufacturers.

We think that this type of JV also will increase the support to veterinarians and it's an area that we are 100% aligned in terms of keeping veterinarians at the center of any healthcare decision. And we think that this type of JV will expand also the presence in international markets. Vets First Choice is mainly focused on the U.S.

today, but with their JV they maybe expand to other markets and definitely we expect to have a good collaboration with them. Next question, please..

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

My question's been asked and answered. Thanks..

Thank you..

And we will go next to Derik De Bruin with Bank of America. Please go ahead..

Thanks. Just one quick small one to squeeze in. I know it's not core business but the contract manufacturing slipped a decent amount in the quarter and by our estimates was a 25 bps to 50 bps headwind to the top line.

Can you talk about that business? It's a little lumpy but is this something that you expect to continue going forward or was this just in timing of orders?.

Yeah. That one really is just timing of orders. That business, it varies by quarter so I wouldn't read anything into the first quarter performance..

And this a business which is, as you said, is not core. It's helping us to increase the volume in some of our facilities and the absorption of overhead. But definitely is not an area that we are promoting or we are trying to increase the business through these third-party contact with in manufacturing. So our next question, please..

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

Thank you very much for joining us today. And as we said in our comments, our results in the quarter were very strong. We are very confident on the projections for the year and we'll continue having interactions with you to provide future results. So thank you very much..

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