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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, and welcome to the second quarter of 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.com.
At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation.
It's now my pleasure to turn the floor over to Steve Frank. Steve, you may begin.
Thank you. Good morning, everyone, and welcome to Zoetis second quarter 2018 earnings call. I'm joined today by Juan Ramón Alaix, our Chief Executive Officer; and Glenn David, our Chief Financial Officer.
Before we begin, I'll remind you that the slides presented on this call are available on the Investor Relations section of our website and that our remarks today will include forward-looking statements and that actual results could differ materially from those projections. For a list and description of certain factors that could cause results to differ, I refer you to the forward-looking statements in today's press release and our SEC filings including, but not limited to, our Annual Report on Form 10-K and our reports on Form 10-Q.
Our remarks today will also include references to certain financial measures, which were not prepared in accordance with Generally Accepted Accounting Principles or U.S. GAAP. A reconciliation of these non-GAAP financial measures to the most directly comparable U.S. GAAP measures is included in the financial tables that accompany our earnings press release and in the company's 8-K filing dated today, August 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 share three brief headlines for our call today. First, we continued to perform very well through the first half of 2018 with a strong second quarter results. Based on the latest external estimate, we have continued to gain market share through the last 12 months ending in March 2018. Second, we are very excited about the Abaxis acquisition that closed this week, well ahead of our expectations. And this should allow us to move quickly into the integration phase. And finally, we remain very confident in our ability to achieve our full year guidance.
When you look at our historical performance and the recent revenue growth, much of our success comes from our diverse portfolio, a portfolio that has been compiled through the long-term investments in R&D and the careful selection of external partnerships and acquisitions. We are very confident in the long-term return of this investment. And in 2018, we have had an increase in R&D expense as we continue to accelerate certain projects in key growth areas such as monoclonal antibodies that will address pain associated with osteoarthritis and other indications.
We're also progressing with the development of combination products based on the sarolaner compound, which is used in new products like Simparica, an oral parasiticide for dogs, and Stronghold Plus, a topical combination parasiticide for cats.
We have filed for approval a new three-way combination parasiticide, which if approved will be known by trade name Simparica Trio. It will combine sarolaner with two other active ingredients to focus on ectoparasiticides such as fleas, ticks and mites as well as internal parasites and the prevention of heartworm disease.
We remain very confident in the technical package that we have completed for this product. We are taking a phased filing approach in various markets around the world and subject to regulatory reviews and approvals, we would anticipate it coming to the market in 2020. We are also proud of recent launches of new swine vaccines, which includes Fostera Gold in the U.S. as well as PRRS, PCV2, PCV and M Hyo combination vaccine that are performing well in other markets. All demonstrate our continued expertise in vaccines and have us well-positioned for continued growth.
External partnerships and acquisitions are also important for innovation and providing us new capabilities to predict, prevent, detect, and treat disease in animals. We have always seen diagnostics as an important high growth space for Zoetis, an important piece of comprehensive solutions we can bring to veterinarians.
We wanted to find the right opportunity and partner. And this week, we completed our acquisition of Abaxis, a leading provider of veterinary point-of-care diagnostic instruments for approximately $2 billion.
With our growing scale and direct customer relationships in approximately 45 countries, we can help accelerate the growth of Abaxis portfolio in the U.S. and International markets. We can also combine the expertise in diagnostics with our diverse portfolio and provide customers with integrated solutions that can work across the continuum of care.
We are now moving ahead with the integration plans. While there will be cost efficiencies, the real value of this transaction is in the revenue growth opportunities, especially, International.
Another area of external investment has been in monoclonal antibodies. In addition, to our internal expertise, this June we announced a five-year agreement with Regeneron Pharmaceuticals to collaborate on additional research in antibody therapies. As part of this agreement, Zoetis will be using Regeneron technology to develop monoclonal antibodies for use in companion animals and livestock animals. Regeneron will also work with Zoetis to evaluate select Regeneron antibodies in diseases of dogs and cats. Together we'll generate data that could be used in later human trials and for proof of concept in veterinary species. This collaboration demonstrates our access to multiple sources of innovation and reinforces our reputation as the animal health partner of choice in R&D.
Finally, we are also expanding into sensors, digital platform and data analytics tools that help our customers predict and detect diseases in their animals. We recently acquired a small company based in Austria called Smartbow. They are an innovative partner. We have been working with them for more than a year on precision dairy farming technology.
Smartbow has developed a cow monitoring system that helps dairy farmers use active electronic ear tags to collect data and analytics from individual animals. This includes monitoring for reproductive data, animal locations, detecting signs of stress, behavior change and disease and paving the way for early intervention and treatment.
Moving on the second quarter results. We achieved 9% operational growth in revenue, driven by the performance of new parasiticides and new vaccines, our dermatology portfolio as well as contributions from the rest of our in-line portfolio. Our key dermatology products, Apoquel and Cytopoint, generated $143 million in sales in the second quarter. This included our first ever quarter of $100 million in the U.S. where we continued to use direct-to-consumer advertising to bring both, disease and brand awareness.
We have continued to grow patient share in both the U.S. and International segments. And over the last 12 months we have generated more than $500 million in sales for our key dermatology portfolio. Our new parasiticide products, Simparica and Stronghold Plus, saw solid growth in the second quarter, with more than $50 million in sales for Simparica, putting it well on its way to blockbuster status this year. We continue to use our digital marketing and direct-to-consumer campaigns to support these products, and we are seeing good results in the U.S. and in other markets like Brazil.
As we said last quarter, we expect to grow our cattle, poultry, swine, and fish products in line or faster than the overall market, and we expect to see positive growth in the livestock market in 2018.
We have also sustained profitable performance in the second quarter. We grew our adjusted net income by 37% operationally, based on revenue growth, improvements to our gross margin, and continued benefits from U.S. tax reform.
In closing, I'm confident that we are taking the right actions and making the right investments to deliver on our objectives for 2018 and ensure our future growth.
With that, let me hand things over to Glenn, who will provide more details on our second quarter results, the Abaxis acquisition, and full-year 2018 guidance.
Thank you, Juan Ramón, and good morning everyone.
We've had an exciting and busy second quarter, but first I would like to lay out what I will cover today. I will discuss the Zoetis Q2 results, which do not include Abaxis performance. I will mention the most recent Abaxis quarterly revenue results separately just for your reference and context going forward. And I will then review changes to our 2018 guidance, which do reflect the acquisition of Abaxis this week as well as changes to foreign exchange rates.
Beginning with Q2 performance, we had another strong quarter with 9% operational revenue growth, balanced across our U.S. and International business segments, and we continued to grow adjusted net income at a rate significantly faster than revenue. Our performance was positive across all key markets and all core species.
Total company reported revenue growth was 12% in the second quarter, including a favorable 3% impact from foreign exchange. Revenue growth in the quarter was driven by strong companion animal performance across both our International and U.S. segments.
Our in-line portfolio, including key dermatology products, continued to demonstrate solid growth, with new products also contributing strong growth across both companion animal and livestock.
Operational revenue growth of 9% was driven by 1% price and 8% volume. Of the 8% volume, 5% was from our in-line products, of which 2% came from our dermatology products and 3% from the rest of the in-line portfolio. The remaining 3% growth came from new products.
Adjusted net income grew 37% operationally, driven by revenue growth, gross margin improvements, and a lower effective tax rate. As Juan Ramón mentioned, our key dermatology portfolio, comprised of Apoquel and Cytopoint, had their best quarter yet with sales of $143 million.
We are well on our way to achieving more than $500 million combined sales target we previously communicated for these products in 2018. We're also very pleased with the uptake of Cytopoint and expect it to achieve blockbuster status this year, which is greater than $100 million of sales.
We also recognized record sales from Simparica in the quarter, generating $51 million worldwide. We continue to be very pleased with both the U. S. and international performance of this product.
Now before moving into Zoetis segment results, I would like to recognize a strong first fiscal quarter for Abaxis, which as I mentioned, is not included in Zoetis Q2 results. As a reminder, fiscal Q1 for Abaxis represents the months April to June for both U.S. and International.
Abaxis Q1 revenue was $68 million and represents 17% growth over the same period in the prior year. These results were provided to us by the Abaxis team, are unaudited, and were recognized under Abaxis accounting policies while they were an independent public company.
Now let's discuss segment revenues for Q2. International revenue grew 10% operationally in the second quarter, with positive contributions across all key markets, with companion animal operational growth of 17% and livestock operational growth of 6%.
Companion animal product 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 international markets such as China and Brazil. Livestock products benefited from growing demand for animal protein, new product introductions, and the success of our field force.
Highlighting some key markets for the quarter, in China we grew 23% operationally, largely due to strength in companion animals, which increasingly represents a larger portion of our business there. A growing companion animal population and medicalization of pets contributed to this growth, with Q2 benefiting from increased usage of our parasiticide Revolution and vaccines.
In Brazil, sales were flat operationally. However, this is primarily a result of a national truck driver strike that occurred at the end of the international quarter, impacting recognition of livestock revenue within the quarter. We expect to recover these sales in Q3, as shipping resumed early in the quarter. We anticipate stronger than normal results in Q3.
Excluding the impact of the strike, both livestock and companion animal products performed very well in Brazil in Q2. For cattle in Brazil, investments in our field force, including local commercial campaign efforts, have led to increased penetration and coverage in key regions within the market. We also continue to see favorable export conditions that will contribute to our growth. Companion animal revenue in Brazil benefited from the continued growth of Simparic due to a strong return on the direct-to-consumer investments.
Australia grew 16% operationally, primarily driven by cattle, companion animal, and sheep. In cattle, our vaccine business grew due to strong beef prices and the rebuilding of the herd in the market. Companion animal benefited from growth in Apoquel due to the return on our direct-to-consumer investments as well as strength of our in-line portfolio. Sheep products benefited from continued strength in local market conditions.
The UK contributed 23% operational growth with companion animal and cattle driving the largest increases. New products in companion animal generated strong growth with wholesale purchasing patterns in the prior year also contributing to growth for both companion animal and cattle.
Mexico grew 22% operationally, delivering growth in excess of 20% for the third consecutive quarter. And the growth was generated across all species. New products, including the recent launch of Simparica and strong demand generation by the field force is driving the positive performance.
Other emerging markets, particularly India, Poland and Turkey, performed well. India and Turkey had increased livestock product sales due to field force penetration and key account management. While Poland benefited from growth across both companion animal and livestock.
Overall, a very strong quarter for our International segment with growth across all key markets. New products, favorable market conditions and a return on strategic investments in our portfolio and field force are all helping to consistently drive positive results.
Turning to the U.S., revenue grew 9% in the second quarter, companion animal grew 15%, while livestock grew 1%. Companion animal sales in the quarter were driven by our dermatology portfolio and new products, primarily Simparica. These gains were partially offset by decreases in certain in-line products due to competitive pressure. U.S. key dermatology sales reached a new milestone of $100 million for the quarter with both Apoquel and Cytopoint exhibiting strong growth over the same quarter in the prior year. Both products also increased sales over Q1, consistent with expectations and the warmer summer months. I mentioned Simparica also had a strong quarter with the U.S. being a large contributor to the growth this quarter with more than 200% growth.
As communicated in the first quarter, we had anticipated Simparica returning to growth this quarter due to the timing of customer purchases in Q1 and Q2 of last year. Year-to-date growth of 46% also demonstrates our ability to gain clinic penetration and market share and realize the benefits of our DTC investments, which we are maintaining in 2018. Partially offsetting growth in our companion animal business was the continued impact of anticipated competition for Clavamox and Revolution. With Clavamox also impacted by the timing of promotional activities in the prior year.
The U.S. livestock business continued its strong growth in poultry and swine in the second quarter, partially offset by a decline in cattle. In poultry, there's the latest portfolio of alternatives to antibiotics and medicated feed additives continues to be the primary driver of growth. Swine continued growing in the second quarter, primarily from extended usage of Fostera Gold PCV MH, which we launched in the first quarter of this year. We expect to see continued adoption among our customers through the second of this year as it is the first and only vaccine to include two genotypes of PCV2, both 2a and 2b.
In the beef cattle business, sales of cattle products declined due to increased competition of certain medicated feed additives. As anticipated, the dairy cattle business continued to experience pressure with lower dairy prices and limited producer profitability. This led to a decline in sales of our MFAs and intramammaries.
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 68.7% increased approximately 300 basis points in the quarter on a reported basis and reflects favorable pricing, mix, reduced inventory waste and a benefit of continued cost improvements and efficiencies in our manufacturing network. Operating expenses in total grew 7% operationally versus the same period last year. The growth in operating expenses this quarter is primarily impacted by R&D growth of 16% and reflects increased investments in areas such as monoclonal antibodies, for chronic pain, and other pipeline programs.
We also realized higher spend in SG&A primarily due to increased compensation related costs. The adjusted effective tax rate for the quarter was 20.1%. The tax rate in the quarter is significantly lower than the rate from a comparable 2017 period due to the favorable impact of U.S. tax reform. Adjusted net income for the quarter grew 37% operationally through a combination of strong revenue growth, cost improvements to manufacturing and a lower effective tax rate. As previously communicated, we were able to create strong operating leverage while investing in strategic areas of future growth for Zoetis.
Now moving to guidance for the full year 2018. We continue to perform in line with our expectations. However, we are making certain adjustments to reflect the unfavorable changes in foreign exchange rates that have occurred since our last update as well as to include the partial year impact of the Abaxis acquisition based upon our preliminary estimates.
Starting with revenue, foreign exchange rates negatively impacted revenue versus prior guidance by approximately $125 million. With the addition of Abaxis as well as other operational drivers we are maintaining the high end of the range at $5.8 billion and increasing the lower end of the range to $5.7 billion. We still expect to achieve operational growth of 5% to 7% excluding any impact from Abaxis.
Including Abaxis partial year revenue, which consist of five months of domestics activity and four months of International, our operational revenue growth increases to a range of 7% to 9%. Implicit in our updated full year guidance are certain impacts in Q4 that I want to remind you as you think about the remainder of the year. Our business in Q4 2017 was very strong, so growth off its higher base will moderate. U. S. livestock is one area where we experienced an exceptionally strong Q4.
In addition, the fourth quarter of this year will also include four fewer International selling days compared to last year, resulting from the change in our accounting calendar implemented this year. Please note that from an EPS growth perspective, the second half of 2018 will be impacted by the timing of cost of sales, which were higher in the first half of 2017 when compared to the second half of 2017.
For SG&A and R&D, we're increasing both the low and high ends of the range primarily due to the impact of the Abaxis acquisition. Adjusted interest expense is increasing to approximately $200 million to reflect the financing of the Abaxis acquisition. Our guidance for the adjusted effective tax rate has been lowered to approximately 20% from our previous range of 21% to 22%, primarily due to the impact of favorable discrete, non-recurring items, resulting from the implementation of U.S. tax reform.
For adjusted diluted EPS even with the negative foreign exchange impact of $0.07 and the slightly diluted impact of the Abaxis acquisition this year, we're maintaining the high end of the range at $3.10 and increasing the low end of the range to $3. Please note that our range for reported diluted EPS includes preliminary estimates for certain significant items and purchase accounting for the Abaxis acquisition.
Finally, we repurchased nearly $400 million of our shares in the first half of the year and our guidance grew reported and adjusted earnings per share, reflects the shares repurchased through the end of Q2.
Now to summarize before we move to Q&A. We've delivered consistent operational revenue growth in the first half of the year with balanced contributions across all key markets and all four species. We are well positioned to meet our guidance for the year and anticipate continued positive trends in our key products and markets.
Our diversity, geographical presence and ability to innovate, will continue to provide a platform for growth that is in line with or faster than the market. The Abaxis integration is well underway and will allow us to unlock the value of the revenue growth opportunities in the diagnostic market and further support our customers across the full continuum of care. We will also continue to invest both internally and externally to support sound investments in our business and return excess capital to shareholders.
Now I'll hand things over to the operator to open the line for your questions. Operator?
We will take our first question from Erin Wright with Credit Suisse. Please go ahead. Your line is open.
Hi, thanks. On U.S. livestock, can you speak to the quarterly progression and your visibility there on in the second half? I guess, particularly across the cattle segment in particular, and how confident you are in sort of a better trend there? And then also maybe some of the seasonal aspect on the U.S. companion animal business? And how we should be thinking about the quarterly progression there as well? Thanks.
Thank you, Erin. And, well, we see the U.S. livestock has not changed compared to previous projections. Despite of the trade situation, we expect that the U.S. livestock will be showing positive growth in 2018.
We also mentioned at the beginning of the year that on this market growth, we expect cattle and poultry product is already growing in line with the market, and swine growing faster than the market and our forecast remain the same.
The only change compared to what we estimated at the beginning of the year was the dairy segment, where the performance is below expectations for the market, and we also expected a recovery in the second half. And now our estimate is it will be taking longer and will not be until 2019.
Just to summarize our performance in the first half. So livestock grew in the U.S. by 2%. And for total Zoetis the growth was 5%. And this confirms again that our geographical diversity is helping us to manage our economic cycles, regulatory changes or now even trade war. The fundamentals of livestock remain the same and the consumption of animal proteins to continue growing, and the needed to keep animals healthy and productive is the same as we have been communicating before.
So with all these, we expect that at end of the year, livestock in the U.S. and also the livestock worldwide will be growing and we'll be growing in line or faster than the market. Maybe also Glenn can add to my comments on the second half of the year.
Erin, just one thing to consider as you look at the quarterly progression of livestock in the second half, just a reminder that in Q4 of 2017 in the U.S. in particular, we had a particularly strong U.S. livestock performance in growth across all of its species. So that will be a challenge to growth in Q4 in particular.
Thank you, Glenn. Next question please.
And we'll go next to Kevin Ellich with Craig-Hallum. Please go ahead.
Good morning. Thanks for taking the questions. Two questions for me, Juan Ramón and Glenn. First off, clearly you guys have laid out a roadmap and strategy for your monoclonal antibodies with Nexvet, Cytopoint and now the collaboration with Regeneron. Could you talk more about, I guess how that's going to develop beyond osteoarthritis and pain? What are other indications you could look for both in companion and maybe even livestock?
And then for the second half of the year, organic growth has been really strong the first half. What factors have you considered in the guidance for the back half besides the tough comps? Have you input anything there for the potential impacts on the tariffs and other livestock headwinds that you just talked about? Thanks.
Thank you, Kevin. I will cover the monoclonal antibody question and then Glenn will respond on the organic growth in the second quarter. Definitely, monoclonal antibodies is an area of significant investment for Zoetis. We have seen first opportunities for Cytopoint and this has been something that is developing extremely well. So the reaction of the market has been exceeding the initial expectations. And we also saw opportunities on developing products, as you said, for osteoarthritis, pain, and also very important attacks (32:39). These programs are progressing very well. We are combining many different programs that came from Nexvet, but also internal programs as they were part of our R&D activity.
And beyond pain, we also see opportunities in renal, we see opportunities on oncology, and we are also developing programs for livestock. These programs are not as advanced as companion animal, but we remain confident that also monoclonal antibodies will provide opportunities in livestock, especially in feed enhancement. That is an area that also we'll be replacing existing technologies with new technologies that will be more acceptable for consumers for retailers. Glenn?
And, Kevin, in terms of your question in terms of the applied slower organic growth in the second half of the year, it is really mainly driven by the tough comps that we have, particularly in Q4, and again related to U.S. livestock.
Just a couple of other things to point out, as I mentioned in the prepared remarks, we do have four fewer calendar days in the International business in Q4 of 2018 versus Q4 2017, which also provides a tougher comp. And then there are just, as you look at some of our growth portfolio, particularly derm, the growth comes off of a higher base as we mature through the year. So those are some of the factors that would indicate slightly slower growth in the second half of the year versus the first half.
Next question, please.
We'll take the next question from John Kreger with William Blair. Please go ahead.
Hi, good morning. This is Jon Kaufman on for Kreger. So a question on poultry for you. One of the major producers recently remarked that chicken demand was a little bit sluggish, and that's end market chicken demand. I believe they cited other meats being cheaper than normal as the cause. Do you see any impact to your poultry business in the near and medium term as a result of these dynamics?
We have seen that – for us, the poultry business has been performing very well in this first half. We continue creating growth in the second half. So as we explained many times, maybe some market they will be facing some challenge. But the consumption of chicken is growing, and we have seen growth in many international markets. Maybe the only area where we saw some negative evolution was Brazil, and this was a result of also the strike, where the transportation strike was limiting the transportation of food to some of the poultry farms, and this created somewhat challenging situation for producers.
But Brazil is where we had probably the lesser penetration in terms of poultry. Overall, we remained positive about poultry. And in poultry, we have not only vaccines and pharmaceuticals, but we're also providing devices for vaccination, in-ovo vaccination. And also we have to be adding also automation with (36:08). So overall we remain positive about poultry. Next question please.
And we'll go next to Louise Chen with Cantor Fitzgerald. Please go ahead.
Hi, thanks for taking my question. I just wanted to clarify some of the points of your guidance raise. We've been getting questions on that this morning. So first thing is just on the Abaxis portion. Can you clarify if that was actually accretive or dilutive from a model line perspective, and how that's changed or has that stayed the same to what you've previously said? And then maybe a little bit more color on the tax element of the change in the guidance? And then was this upside for organic growth in the second half of 2018? Thanks.
So in terms of Abaxis and its impact to EPS, so similar to what we've indicated prior, in 2018 we do expect Abaxis to be slightly dilutive to earnings when you include the funding of the acquisition. We do expect that our first full year of operations when we're able to generate both the revenue upside and some of the expense savings that we expect to generate that it will be slightly accretive to earnings. So we do expect it to be accretive to earnings in 2019. But in 2018, it is slightly dilutive.
In terms of the tax change and the guidance, we have previously guided to an adjusted effective tax rate of 21% to 22%. Because of some favorable discrete items that we've experienced year to date and some of that we may experience in the following quarters as well, we've updated that guidance to approximately 20%. But again, those are just certain discrete items that don't necessarily carry forward into 2019 and beyond.
In terms of the organic growth for the second half of the year, again similar, I think, to some of the comments that we've made. We do have certain challenges, particularly in Q4 of 2017 (sic) [2018] from a prior-year comp perspective that will negatively impact our growth. And also we do have a four fewer calendar days in the International segment in Q4.
Next question please.
The next question comes from Derik De Bruin with Bank of America Merrill Lynch. Please go ahead.
Hi. This is Mike Ryskin on for Derik. Congrats on another strong quarter guys. A couple of quick questions. One on the Simparica Trio that you announced, just a little bit more clarity into the timing and the expectations forward and the market, any expectation for U.S. versus Europe? And I recognize, a lot of that's up to the regulatory agencies. And then on the 2020 timing is it more about – should we think about it the same way as we do all the flea and tick drugs where you want to launch 1Q to sort of be fully ramped by the mid-year summer and therefore that's why you're a little cautious with the regulatory pathways?
And then on the SG&A really quick, you've highlighted earlier throughout the year that the increased OpEx both SG&A and R&D sort of just reinvest back in the business? And then with the updated guidance today, I just want to be clear. Is the guide update for SG&A and R&D entirely just rolling Abaxis into the model, or is there any incremental spend? And you talk about the spend you're doing in the diagnostics sales force that you talked about earlier?
Thank you, Mike. On Simparica Trio, as you said, it depends on regulatory approvals. But as I said, we feel confident that the registration packets of these products is strong and we'll be able really to gain approval to launch the product in 2020.
Definitely we'll be launching the product in the first quarter. But we don't know at this point it will be in the first quarter or midyear. So definitely we'll be working to accelerate as much as possible all the approval. But it depends on third-parties approval and we don't know exactly when we'll be able to bring this product into the market. And Glenn will cover the question on OpEx.
So, Mike, in terms of SG&A and R&D, as you did mention a big part of the raise in the guidance there is related to Abaxis. But there are other operational factors driving some incremental R&D and SG&A. We mentioned the acquisition of Smartbow, while not material from upfront investment perspective. There are certain ongoing costs to developing those products and they hit both the SG&A and the R&D line. So that's another key area of growth in SG&A and R&D.
And, Mike, I don't think I responded about the timing for the U.S. and Europe. In both big market we expect approval in 2020. So, next question please.
We'll go next to David Risinger with Morgan Stanley. Please go ahead.
Yes. Thanks very much. I joined the call late, so I apologize if any of these questions were asked. But could you please comment on the key considerations for the third quarter, sequentially, relative to the second quarter of 2018 that you just reported? And then, if you could provide any updates on the triple combo? Once again I joined late, so if you're already addressed you could ignore that? Thank you.
Thank you, Dave. And that's all right. I just answered the question on the Simparica Trio. I mentioned that we expect this product to reach the market in 2020 in both U.S. and International. International will be European Union. And Glenn, do you want to answer the question on the sequential?
Sure. In terms of any sequential guidance. So, obviously, we don't necessarily guide to any particular quarter. But in terms of any major changes to growth, it really is the Q4 2018 drivers that we referenced are the things to note. In our Q3, no major changes versus the first half of the year.
Next question, please.
The next question is from Gregg Gilbert with Deutsche Bank. Please go ahead.
Just I have a couple longer term questions. One, it seems inevitable that there will be more competition in atopic dermatitis space. My question is whether you think those new (42:44) launches can come on fast enough and be large enough and profitable enough so that you can continue companion growth in revenue and profits continuously over the next three to five years? And secondly, I realize it's very early on Abaxis. But I was hoping you could talk, at least preliminarily, about the longer term opportunity to leverage that new capability across the food animal setting? Thanks.
Thank you, Gregg. Well, we mentioned usually that we expect competition for our derm portfolio. We expect competition in the future for Apoquel and also for Cytopoint. We have now very strong position in the market. We also have a product that has demonstrated very strong, safety and efficacy profile. And we are very confident that we will be able to continue defending our franchise successfully in the future. Definitely we have been growing very fast. We expect that at some point we will be reaching a level of penetration that will be difficult to continue growing. But we still have a lot of opportunities in International markets where we far off reaching this level of penetration in terms of patients.
And in some countries like China the product is not available and we expect Apoquel reaching China and also generating very positive growth. So in summary we are confident that we have very strong position, we have great two products, and definitely we expect that we will be able to protect and defend this franchise that has been created by Zoetis. In terms of Abaxis, we see both short-term and long-term opportunities. We mentioned that the short-term will be for International markets where the level of use of diagnostic tools is extremely lower than in the U.S. And now with our presence and the combination of our portfolio with diagnostics and adding the field force that we have in International market we expect to generate short-term growth.
In longer term definitely we see two opportunities. One is to continue bring innovation and we are confident that with Abaxis together with SMB and also our internal groups, we'll be able to continue bring the innovation in companion animals, but also very important now with Abaxis, we have the opportunity to reassign resources to develop a portfolio for livestock. And in livestock we see a significant opportunity in where there is no any existing diagnostic company having any penetration in this market. This market is served mainly from reference lab, farmers or veterinarians in livestock sending samples to reference labs, getting the information back in one to three days.
We see the opportunities of bringing point-of-care diagnostic tools into the farms and creating an information that will be very important to protect the animals and also may be with the opportunity also to expand the use and the compliance in livestock.
Next question, please?
We'll go next to Jami Rubin with Goldman Sachs. Please go ahead.
Good morning, this is Divya Harikesh on behalf of Jami Rubin. I have two questions. One with the Abaxis deal now closed, can you provide more color on the cost efficiencies and where we can expect that to come from? You have mentioned that you continue to expect the 200 basis points improvement in gross margins, but can you help us think about how we should think about the operating margins with respect to your accretion in 2019 and longer term as well?
The second question following-up on an earlier question on the dermatology franchise, given the momentum – and you said that the U.S. will reach a level of penetration soon – can you help frame expectations of what do you think that franchise could look like in terms of peak sales or at what level of sales do you think that they would get to maturity? Thank you so much.
So, thank you. And maybe a clarification on the level of penetration in the U.S. In the U.S. in the second quarter, we have reached 61% patient share, so we still see opportunities to continue to growing in this franchise. What I'm saying is that, well, we will be reaching in the future a level of penetration that that will be difficult to continue growing but not at this point. At this point, we still see two opportunities in the U.S. One is increasing the awareness and increasing the demand for treating dermatology issues and also increasing the penetration on patient share. Then moving to the cost efficiency in Abaxis, Glenn, do you want to cover this question?
Yeah. So, in terms of the impact of Abaxis on our margins moving forward, so from a gross margin perspective, cost of goods for Abaxis are a little higher than what we have for the remaining portfolio of Zoetis. So it will be somewhat of a negative impact but we still do expect to achieve the 200 basis points of improvement from 2017 to 2020 within our gross margins.
When you think about more to an operating margin level because of our ability to leverage our existing infrastructure, we do believe that over the next coming years we'll achieve the same operating margins that we would have without Abaxis. So we expect to be able to continue to grow our operating margin but, again, the focus continues to be on growing cash and profitable income growth.
And maybe one comment on the cost efficiencies in Abaxis. So the Abaxis acquisition is not driven by cost efficiency. We will be generating short-term cost efficiencies but the cost efficiency will be fully realized in the 2019.
You also ask about this 200 basis points of improvement in cost. Maybe, Glenn, you can cover that. Many of these costs has been already generated in 2018, so it's not that we are still targeting 200 basis points of improvement from now, so some of this has been also coming in this quarter.
So, the 200 basis point improvement, as we mentioned, was off the 2017 base where our cost of goods was approximately 33% at that period of time. We've guided for 2018 approximately 32%, so we'd expect about 100 basis point improvement year-over-year, which would then lead to about another 100 basis point improvement by the year 2020. So we're well on our way to achieving that goal and expect to be able to deliver that.
Thank you. Next question, please.
We'll go next to David Westenberg with C.L. King. Please go ahead.
Hi. Thanks for taking the questions. Some quick ones on Abaxis. Do you anticipate any product repositioning with Abaxis, particularly in context with how you're going to sell the products SMB products and CARYSTA? And then as a follow-up to that, just on – the 10-Q hasn't dropped yet, so just where in the product segmentation are you going to be putting Abaxis? Thank you very much.
Well, now we have a combined portfolio with Abaxis/SMB, but we don't think that at this point there are products which are in conflict or in competition. They are products that can be managed very well. And now we have the opportunity to combine the field force of Abaxis that has been increasing in 2018. And with our field force and the plan now – from now to the next coming months is to ensure that both field forces are fully aligned and both field forces they have their level of technical information that will be supporting this new portfolio. So we are very confident that we'll be defending Abaxis in international markets as well as in the U.S. with now stronger presence in the market.
And in terms of Abaxis reporting, Abaxis is going to be fully integrated into our operating structure, so therefore it will not be reported as a standalone segment. We will, however, provide transparency to the revenue performance of the diagnostics business moving forward. Just one point, you mentioned this quarter's 10-Q. since we did not own the business in Q2, we'll not be reporting on Abaxis revenues within the 10-Q.
Next question, please.
The next question is from Alex Arfaei with BMO Capital Markets. Please go ahead.
Great, thank you and good morning. Could you please comment on the recent announcement from the FDA about a new five-year blueprint regarding antimicrobial stewardship? How is this incrementally different relative to the prior initiatives and directives and what the impact could be for you?
And I apologize if I missed this but could you provide Apoquel and Cytopoint sales by U.S. and ex-U.S. as well as for Simparica? Thank you.
Thank you for the questions, Alex. I think that the FDA five-year blueprint, in our opinion, is consistent with previous approaches in terms of anti-infectives or antibiotics. We don't think that this will have a significant negative impact to Zoetis. We already mentioned that in antibiotics we expect that they will be growing maybe half of the growth rate of the animal health industry. This is part of our model. This is part of our prediction.
We continue also working on having a portfolio that is much more balanced and less dependent on antibiotics. If you compare the portfolio of antibiotics or the weight of our revenues in 2013 through the weight of antibiotics in 2018, this has been decreased significantly. But we are still very confident that we have a very strong portfolio of antibiotics – injectables and antibiotics that can be used by veterinarians in a way that is protecting animals and not creating additional resistance in human health. So we are confident that we'll be able really to maintain our position and support our portfolio of antibiotics.
You also asked about the breakdown between dermatology sales U.S.-International as well as Simparica. Glenn?
In terms of total derm sales for the quarter, we had $143 million in total. Of that, $100 million was the U.S., $42 million was International, so obviously some rounding there.
In terms of Apoquel for the quarter, we had total sales of $110 million, with $73 million being the U.S. and $37 million being International. And with that, you could calculate Cytopoint. From a Simparica perspective, we had total sales of $51 million, with $30 million being U.S. and $21 million International.
Next question, please.
The next question is from Kathy Miner with Cowen & Company. Please go ahead.
Thank you, good morning. I have two questions. First, on your first quarter call you provided a nice update on the potential impact of tariffs or lack thereof on your U.S. pork business – swine business. Could you give us an update as things have progressed since then, and maybe also comment whether the increased tariffs in Mexico are having any impact to your outlook?
And the second question is on aquaculture. I don't think we've talked about that today. Just give us an update. I know the second half of the year is usually stronger. Do you expect that to continue, and what kind of growth can we look for later this year and into 2019? Thank you.
Thank you, Kathy. The impact from tariffs is something that is evolving every day, because it can be a – maybe some additional tariff applied to China. But our estimate for 2018 is that there definitely will be some small impact on swine because of the exportations to China.
But to put things into perspective, so the total swine in the U.S. represent about 3% of our total revenues. 80% of the production in the U.S. is for local consumption and 20% is for export. On this 20%, 10% to 12% is exportations to China. So even if there may be some impact, the total revenues exported to China or as royalty, represent less than 0.1%.
So definitely it's an area that we are concerned because it's affecting our customers in the U.S. But at the same time, as I mentioned, before our global presence it's also protecting us for this type of economic cycles or regulatory situations or even trade wars. And we know that the consumption would remain strong, and we have a significant presence of swine activity in many other parts of the world.
You had also asked about Pharmaq performance in the second quarter. Glenn, do you want to comment on that?
Yes, so Pharmaq had sales of $24 million in Q2, which was growth of about 13% operationally, which is really driven by the increased adoption of our LiVac SRS vaccine in Chile. As we did indicate previously, 2018 we don't expect to achieve the same level of growth as we saw in 2017, as in 2017 we saw very rapid adoption of the PD vaccine in Norway, as we displaced a competitor following a legal victory. That being said there, we still expect Pharmaq to grow at a faster pace than the overall Zoetis business in 2018.
Next question, please.
The next question is from Chris Schott with JPMorgan. Please go ahead.
Great, thanks very much for the questions. Just a couple on Abaxis and the International opportunity. I think you mentioned that as a shorter-term growth opportunity, but when we think about the ramp of that business and taking advantage of your larger footprint, is that something where we just expect a significant step up in 2019, or is that a multiyear process?
And when you think longer term about the Abaxis mix, I think Zoetis right now is about 50% U.S., 50% ex-U.S. by revenue. Is it reasonable to think about Abaxis getting into that type of split over time?
And then my final question was just a quick update on capital deployment priorities post the transaction. Thank you.
Thank you, Chris. Well, first, we're penetrating International markets with the new portfolio of diagnostic equipment; we are now building the presence in this International market. When I say building the presence, we need to have the technical people that will be in charge of selling and also installing and the plan is use our existing field force to complement this effort.
This was already planned even before the acquisition of Abaxis, because when we acquired SMB, we saw the opportunity of building this infrastructure to support the future portfolio. Now with Abaxis, we are accelerating even more these plans to have the presence that we think is needed to support the growth in International markets. But it's something that we've planned to generate – well, most of this impact will be coming in 2019 and the following years.
You were asking about the long-term. It could be reaching 50%-50%. I think it's too early to say. And we still need to have a better understanding of what will be the level adoption of equipment in International markets. Again, so International markets is a combination of developed market with developing markets. And – well, definitely it will be part of our analysis – full analysis and also we'll be really targeting to maximize opportunities. But at this point, it's difficult to predict it will be 50%-50%.
In terms of capital allocation, Glenn will cover, but there is no change and we remain committed with the principles that we communicated before. Glenn?
Yes, Chris, as Juan Ramón indicated, there really is no change to our capital allocation and priorities moving forward. When you look at the current level of operating cash flow that we have and the strength of our balance sheet, we're able to fund almost the full consideration and still stay within our targeted gross debt to adjusted EBITDA range of 2.5 to 3. So that still leaves us the financial flexibility to fund future strategic investments and also return cash to shareholders through dividends and share repurchases. So really no change to our capital allocation priorities post-Abaxis.
Next question, please.
We'll go next to Kevin Ellich with Craig-Hallum. Please go ahead.
Actually all my follow up questions have been answered. Thanks.
Thank you. Next please.
And it appears we have no further questions. I'll return the floor to Juan Ramón for any closing comments.
Thank you for joining us today and thank you for your questions. And as a conclusion, we remain very positive about our performance and not the performance in the quarter but also our future performance. And we are very much on track to deliver our objectives for 2018 and we continue investing in ensuring that we'll be generating a future growth through our core portfolio but now also through the extended portfolio with diagnostics and other areas in where we are also investing. So thank you very much for your attention today.
This will conclude today's program. Thanks for your participation. You may now disconnect. Have a great day.