Zoetis Inc. (ZTS) Q4 2017 Earnings Conference Call Transcript

Zoetis, Inc. (ZTS 3.36%)
Q4 2017 Earnings Conference Call
Feb. 15, 2018, 8:30 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Fourth Quarter and Full Year 2017 Financial Results Conference Call and Webcast for Zoetis. Hosting the call today is Steve Frank, Vice President of Investor Relations for Zoetis. The presentation materials and additional financial tables are currently posted on the Investor Relations section of zoetis.com. The presentation slides can be managed by you, the viewer, and will not be forwarded automatically. In addition, a replay of this call will be available approximately 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. If you would like to ask a question at that time, please press *1 on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing #. In the interests of time, we ask that you limit yourself to one question and then queue up again with any follow-ups. Your line will be muted when you complete your question. When posing your question, please pick up your handset to allow optimal sound quality. Lastly, if you should require operator assistance, please press *0. It is now my pleasure to turn the floor over to Steve Frank. Steve, you may begin.

Steven Frank -- Vice President of Investor Relations

Thank you, operator. Good morning and welcome to the Zoetis Fourth Quarter and Full Year 2017 Earnings Call. I am joined today by Juan Ramón Alaix, our Chief Executive Officer, and Glenn Davis, 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 and 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 that accompany the 8-K filings dated today, February 15th, 2018. We also cite operational results which exclude the impact of foreign exchange. With that, I will turn the call over to Juan Ramón.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Steve. Good morning, everyone. Two weeks ago, we celebrated our fifth anniversary as a public company, and since our IPO in 2013, we have been able to improve the ways we innovate and serve our customers, grow as a formidable stand-alone business, and build a track record of delivering results. Over the last five years, we have maintained a high level of R&D productivity and developed new and enhanced drugs that address the modern needs of our customers. New, innovative products like Apoquel, Cytopoint, and Simparica as well as life-cycle innovation for our existing portfolio have supported our leadership in the animal health industry.

On an operational basis, Zoetis' revenue has grown an average of approximately 7% over the last five years, compared with the 5% to 6% of the animal health industry, and our adjusted net income for the same period has grown operationally an average of approximately 21%. Over the last five years, we have been able to deliver on our commitment to growing our revenue in line with or faster than the market and growing our adjusted net income faster than sales, while also targeting value-added investment opportunities and returning excess capital to our shareholders. For the next five years, we remain committed to achieving these elements of our value proposition for shareholders.

In 2017, Zoetis became the first animal health company to deliver more than $5 billion in revenue, and we continue to demonstrate the strength of our business model and the growth of opportunities in animal health. We achieved operational revenue growth for 2017 of 8% based on the diversity of our product portfolio and balanced performance across the U.S. and many international markets. Once again, we grew our adjusted net income faster than sales, at 21% operationally. We continue to realize the benefits of our operational efficiency initiative and deliver our long-term value proposition.

The strength of our diverse portfolio of approximately 300 total lines helped to solve economic challenge in terms of market and to offset other issues like the implementation of the Veterinary Feed Directive, or VFD, in the U.S. Our companion animal business led the way again in 2017. It grew 14% operationally based on the continued penetration of Apoquel and the ramp-up of Cytopoint and other new products like Simparica, which gained share in the large and highly competitive parasiticide market.

We believe 2018 will be another year of above-market growth for our companion animal business. We see further opportunities for gaining share and expanding the market for dermatology products with our innovative treatment options. We expect to achieve more than $500 million in combined sales from Apoquel and Cytopoint in 2018. We also continue to support these products, as well as our oral parasiticide Simparica, with direct-to-consumer campaigns in the U.S. and other markets. Simparica has been able to gain market share in the U.S. in 2017, and we expect further growth there and internationally in 2018.

Meanwhile, we delivered 5% operational growth in our livestock business for the year. International markets grew faster than the U.S., where we felt the impact of the VFD implementation in our cattle and swine anti-infective products. For 2018, we see more favorable market conditions for livestock, particularly in the U.S. Glenn will discuss the details of our fourth-quarter results and guidance in a minute, but I would like to say that we've been very confident about our prospects for 2018.

In addition to revenue growth, we have also been focused on improving our operational efficiency and margins, and in 2017, we achieved an adjusted EBIT margin of 34.1%. This was an improvement of over 900 basis points in the last few years. With our improved cost structure, margin expansion, and revenue growth, we have been able to almost double our operating cash flow for the year in 2017 compared to the previous year. That improved cash flow, along with the long-term benefit of the recent U.S. tax reform, is providing us the flexibility to invest for long-term growth.

In terms of long-term growth, we'll continue investing significantly in R&D for our core species and geographies, move to strengthen our capabilities in areas like monoclonal antibodies, better vaccines, genetics, diagnostics, devices, and automation, and refine new technologies in areas like data analytics and essentials. We'll continue supporting our key products like Apoquel and Simparica with direct-to-consumer advertising and other marketing campaigns.

We'll also increase our field force in diagnostics to better support interaction of new products and the future growth expected in this area. We'll be allocating capital to support many of the manufacturing and supply improvements I have discussed recently in places like China, Ireland, and the United States. As always, we'll continue to look at external partnerships and business development that could accelerate our ability to grow in our core business and in complementary spaces like genetics and data analytics. All these investments will support our goal of more integrated solutions, which cover the entire life cycle of animal care that our customers need.

In conclusion, as we mark our fifth anniversary as an independent company, I am grateful to my colleagues in Zoetis who have delivered strong performance and will support our future profitable growth. We continue to drive innovation, lead in customer excellence, simplify our operations, and increase our cash flow. As we look to the future, we remain committed to strengthening our interconnected capabilities in direct sales, R&D manufacturing, and look for additional investment opportunities to enhance our growth. With that, let me hand things over to Glenn, who will provide more details on our fourth-quarter results and full-year guidance for 2018.

Glenn David -- Executive Vice President and Chief Financial Officer

Thank you, Juan Ramón, and good morning, everyone. Before I get into the details on our fourth-quarter performance and guidance for 2018, I will provide a few comments on the results for full-year 2017. This year, we delivered operational revenue growth above the market, grew adjusted net income faster than revenue, and almost doubled our operating cash flow. Reported revenue for full-year 2017 was $5.3 billion with operational revenue growth of 8%. Of this 8%, 3.5% came from our dermatology portfolio, 3.5% came from Simparica and other new products, and the remainder of growth came from price and volume.

Our product rationalization initiative had an unstable impact of 1% on volume for the year. Adjusted net income for full-year 2017 was $1.2 billion and grew 21% operationally. Adjusted net income continues to grow faster than revenue, driven by the continued impact of our operational efficiency initiative and a lower adjusted effective tax rate. Our performance this year again reaffirmed our ability to execute on the financial targets that we set in May of 2015 when we provided long-term guidance through 2017.

With the results that we are reporting today, both our top and bottom line in 2017 beat the goals outlined nearly three years ago. For the full year, we performed well across all the species and key markets where we compete. The diversity and durability of our existing portfolio, our market-meeting commercial and manufacturing capabilities, and the innovations we bring to the marketplace have allowed us to outpace the animal health industry market growth for the last five years.

Our income growth and our increased discipline on the balance sheet have enabled us to almost double our operating cash flow in 2017. This was the result of lower cash outlays for termination benefits and standup costs, increased profitability, and inventory improvement. In 2017, we reduced our months on hand of inventory by more than a month. We have more work to do in this area but are pleased with the progress in 2017.

Turning now to quarterly results, Q4 2017 was an exceptional quarter, with top-line growth coming from new products in our companion animal portfolio and strong livestock performance in our U.S. and international businesses. Our product rationalization initiative had no material impact on our growth this quarter and will not have an impact on revenue growth going forward. Total company revenue in the fourth quarter grew 13% operationally, excluding the favorable 1% impact from foreign exchange.

Our key dermatology products, Apoquel and Cytopoint, once again surpassed the $100 million mark in revenue, with sales in the quarter reaching $125 million and $428 million for the full-year 2017. Sales of Simparica were $18 million in the quarter, growing 102% over the same period in the prior year. Fish products also contributed to growth with sales of $39 million, growing 44% operationally versus the same quarter last year. Our recently introduced PD vaccine in Norway was the primary driver of growth, as it continues to gain share and help increase the penetration of other related vaccines in our portfolio.

Now, let's discuss segment revenue. Our international revenue grew 13% operationally in the fourth quarter, with companion animal operational growth of 18% and livestock growth of 11%. The international segment continues to drive growth across multiple dimensions, with growth coming from our dermatology portfolio, new products such as Simparica, our new PCV combo vaccine, and our PD vaccine, and volume advice from our in-line portfolio.

Turning to some key market highlights in the quarter, in Brazil, we grew 13% operationally, driven by the strength of both our livestock and companion animal businesses. In cattle, investments in our field force have led to increased penetration and coverage in key regions within the market while favorable export market conditions also continued to contribute to growth. In swine, increased sales of Improvac -- or Vivax, as it's called in Brazil -- were driven by higher usage and greater penetration with larger customers. Higher companion animal revenue in Brazil benefited from the continued growth of Simparica due to increased promotional activity and higher veterinary clinic penetration.

In Japan, we experienced operational revenue growth of 27% in the quarter. Growth came from Apoquel as a result of the timing of distributor purchases last year and the additional market penetration we achieved as well as the launch of premium injectable products for livestock. France grew 23% operationally over the same period last year due to a timing impact related to our price changes and new products across both companion animals and livestock.

China grew 13% operationally on the continuing strength of the companion animal business, driven by increasing medicalization of pets. Our swine business once again showed modest growth this quarter due to softening pork prices, which we have expected and discussed on recent earnings calls. Our optimistic outlook and long-term view of the market remain unchanged as we continue to invest in our local operations there.

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

Turning to the U.S., revenue grew 13% in the fourth quarter. Companion animal grew 15% while livestock grew 11%. Companion animal sales in the quarter were driven primarily by key dermatology products, Simparica, and a number of other recently launched products. U.S. dermatology sales for Apoquel and Cytopoint were $86 million for the quarter and exhibited substantial growth over the same quarter in the prior year. While we did see a small decline on a sequential quarter basis, Q1 and Q4 are impacted by seasonality with the warmer spring and summer months experiencing peak activity.

Simparica grew over the same quarter last year as DTC investment and field force efforts led to higher clinic penetration in both key corporate accounts and smaller clinics. Additional contributions to companion animal growth came from a number of line extensions to our Vanguard vaccine franchise, Diroban, a recently launched product for the treatment of heartworm, and Clavamox Chewable, a trusted antibiotic in a new easy-to-administer tablet. Our U.S. livestock business saw a return to growth in the fourth quarter with sales increasing 11% thanks to the performance of our cattle and poultry businesses.

During the fourth quarter, growth in cattle products was driven by increased sales of premium product, which were supported by a greater risk of disease outbreak and incidents due to the weather as well as the timing of promotional activities in 2016. Our beef cattle business also benefited from higher numbers of animals moving through feedlots than in the comparable 2016 period. Our livestock business continues to be impacted by the Veterinary Feed Directive, or VFD, with another $10 million hit to revenue in the quarter. For the full year 2017, the VFD had about a $40 million impact on revenue.

In poultry, the Zoetis portfolio of alternatives to antibiotics and medicated feed additives continue to be the primary driver of growth as certain producers expand their "No Antibiotics Ever" labels. Zoetis works closely with our customers to provide the necessary product and technical assistance that can help them switch over whenever they choose.

Now moving on to the rest of the P&L, I will quickly cover a few key line items and then move on to our guidance for 2018. Adjusted gross margin of 16.9% increased 450 basis points in the quarter on a reported basis and reflects the benefit of cost improvements in our manufacturing network as well as the reduction of the inventory waste charges versus the same quarter last year. Operating expenses in total grew 2% operationally versus the same period last year, which was significantly lower than the operational revenue growth of 13%, as we benefited from the final stages of our operational efficiency initiative.

The adjusted effective tax rate for the quarter was approximately 27.6%. This is higher than the rate from the comparable 2016 period due to the favorable impact of certain one-time discrete items that we experienced in the same quarter last year. Our reported effective tax rate of 43.5% reflects a provisional net tax charge of $212 million in the fourth quarter, which is the result of the recently enacted tax legislation in the U.S.

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

Turning now to guidance for the full year 2018, a table of our guidance is included in both our press release and the presentation slides provided for this earnings call. Please note that our guidance for 2018 reflects foreign exchange rates as of early February. Building off a strong 2017, we see another year of operational revenue growth above the long-term trends we see in the industry overall. Our projected reported revenue range for 2018 is $5.675 billion to $5.8 billion. This represents operational revenue growth of between 5% and 7% over our full-year results in 2017. Foreign exchange is expected to add an additional 2% to this revenue growth.

We continue to expect more balanced performance across companion animals and livestock in 2018. Livestock growth is expected to reflect improved conditions in the U.S. and relatively similar performance to 2017 in our international segment. While companion animal continues to grow faster than livestock, its growth rate will moderate as our dermatology portfolio and other new products grow off a larger base in 2018.

Our adjusted cost of sales as a percentage of revenue is expected to be approximately 32% in 2018, an improvement of around 100 basis points over 2017, and driven by manufacturing cost reductions, price increases, and favorable product mix. We expect SG&A for the year to be between $1.37 billion and $1.42 billion dollars. Similar to revenue, foreign exchange is expected to increase these expenses approximately 2% on a reported basis. We will continue to fund our DTC programs for Apoquel and Simparica in the U.S. These programs have been successful, and we expect they will continue to help our sales teams drive market expansion in dermatology and market share in parasiticides.

As our diagnostics pipeline continues to advance, we are beginning to fund additional investments in commercial capabilities in both the U.S. and international to be prepared to offer our customers these products with the level of service and support we offer them on our other portfolios. We expect R&D expenses to be between $400 million and $420 million, a step up in the level of spending we have had in prior years. Over the course of 2017, we made a number of decisions to either expand investments or accelerate investments where we saw the opportunity to do so in areas such as monoclonal antibodies and key emerging markets. The increase in adjusted interest expense and other income deductions reflects the incremental interest expense associated with our recent debt offering.

For the full year 2018, the company expects its adjusted effective tax rate to be in the range of 21% to 22%. The decrease versus prior year is primarily the result of the tax changes enacted in the U.S. in December. The target range for adjusted net income for the full year 2018 is between $1.45 billion and $1.52 billion, representing an operational growth rate of 20% to 26%. Growth here includes the favorable impact of continued operating margin expansion and a lower adjusted effective tax rate. Our guidance for adjusted diluted EPS is between $2.96 and $3.10 for the full year.

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

I would also point out that given the level of investment we have discussed in manufacturing facilities, you should expect capital expenditures in 2018 to be approximately $100 million higher than the $224 million we reported in 2017. In terms of returning excess capital to shareholders, we increased our dividend by 20% for Q1 2018 and had share repurchases of $500 million in 2017. It's worth mentioning that we still have $1 billion left on our current share repurchase program.

To wrap up, we had strong performance in 2017 and see those fundamental business and market drivers continuing into 2018. We have the capital and cash flow generation to invest in growth opportunities across the animal health industry and we have the talent and capabilities to maintain our market leadership in this attractive market and create more value for our customers and shareholders. With that, I'll hand things over to the operator to open the line for your questions. Operator?

Questions and Answers:

Operator

And, at this time, if you'd like to ask a question, please press *1 on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. In the interests of time, we ask that you limit yourself to one question and queue up again with any follow-ups. Your line will be muted when you complete your question. And, when posing your question, please pick up your handset to allow optimal sound quality. Thank you. We'll take our first question from Louise Chen with Cantor. Please go ahead. Your line is open.

Louise Chen -- Cantor Fitzgerald -- Managing Director

Hi. Thanks for taking my question. My question is on R&D. We always get a lot of questions on this because you don't disclose a lot of detail. I'm just wondering where are your greatest unmet needs in animal health, how are you addressing these, and will we hear more about these products in 2018? Also, can you provide any measures by which you can measure your R&D productivity? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Louise, for the question. We still see unmet needs in the animal health industry. One of the unmet needs is related to pain in dogs and cats and bringing some of the solutions to the current treatment, and this is why we are focused on our current capabilities that will be providing alternatives to the current treatment for dogs and cats. We also see opportunities with a combination of oral parasiticides for internal and external parasiticides. Definitely, we see the opportunity of enhancing productivity and livestock with the new technologies that will replace existing ones. So, there are areas that definitely have internal problems. As we mentioned many times, our competitors -- because they are part of pharma companies, they are not disclosing any details. For us, providing this information would create a negative impact in our ability to compete successfully in the future. In terms of how we measure productivity, I'd like Glenn to provide some details.

Glenn David -- Executive Vice President and Chief Financial Officer

In terms of measuring the productivity for R&D, as we prioritize the projects across the portfolio, we use eNPV and eROI to make sure that we're appropriately prioritizing the cost of portfolio. We'll also look retrospectively from a return on invested capital perspective to the return that we get from our investments, and based on the productivity we've had over the last number of years, we've been very pleased with our return on our R&D spend.

Juan Ramón Alaix -- Chief Executive Officer

Next question.

Operator

The next question will go to Kevin Ellich with Craig Hallum. Please go ahead.

Kevin Ellich -- Craig Hallum Capital Group -- Analyst

Good morning. Thanks for taking the question. So, very strong results this quarter, and it's great to see the rapid growth in companion animal as well as the recovery in livestock that you expect. Glenn, you made a comment about more balanced growth between livestock and companion animal in 2018, and even moderating growth in dermatology. Can you guys give a little bit more detail behind what you expect in companion animal? Should we be thinking about 10% companion animal growth versus 8% livestock? Any help on that front?

Glenn David -- Executive Vice President and Chief Financial Officer

In terms of the growth that we expect for 2018, I'm not going to give specific numbers, obviously, between livestock and companion, but I think when you look at 2017 for the full year, we have 5% growth in livestock and 14% growth in companion, so there was a big differential in the growth. As we move into 2018 with the very strong performance that we had in our companion animal portfolio in 2017, we've established a new base to grow off of, particularly in our dermatology portfolio as well as Simparica. So, while we still expect those products to crew in 2018, the overall contribution that they'll have to the total companion animal growth will be smaller just because they're off of a much larger base, so that's going to cause our companion animal growth to decelerate as we move into 2018.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

We'll take the next question from Erin Wright with Credit Suisse. Please go ahead.

Erin Wright -- Credit Suisse -- Analyst

Great, thanks. In terms of the development pipeline, a follow-up here. Can you speak to some of the focus areas outside of traditional therapeutics? For instance, you launched a new diagnostic offering at VMX. You also have S&B opportunities, and you mentioned some sales force investment there. Is that going to be a focus area for you in terms of new product launches near-term? Will it be a more organic or inorganic initiative? And then, could you speak to some of the -- you mentioned data and analytics, but some of the other areas or ancillary areas outside of traditional therapeutics where you see growth opportunities? Thanks.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Erin. We see this as a much more integrated offer to our customers, including products in medicine and vaccines, but also diagnostics and genetics -- what we have to describe as the healthcare cycle of intention, also prediction, prevention, and treatment. We'll definitely continue to focus on our core business. The core business will continue generating the majority of our revenue and profits, but we see opportunities to accelerate our growth by investing in some of these complementary spaces. Definitely, genetics, diagnostics, and data analytics are part of these efforts. We have now in diagnostics a very strong pipeline that definitely will be focused on delivering in the next coming year. We also presented in the last congress of VMX our new Carysta high-volume chemistry that is part of our efforts to become a key player in diagnostics in a way that will be integrating more all these portfolios in our offers to our customers. As well, we will be investing in a data analytics center that will complement our offers to our customers. Next question, please.

Operator

The next question comes from Michael Ryskin from Bank of America Merrill Lynch. Please go ahead.

Michael Ryskin -- Bank of America Merrill Lynch -- Analyst

Hi, thanks for taking the call. Congrats on the quarter, guys. A couple questions on the quarter, and then a longer-term follow-up. Really strong results in U.S. livestock this quarter. I know it was a bit of a surprise relative to what we were looking for. In particular, U.S. cattle had a great number. You mentioned some of the disease conditions, but you also talked about feedlots and cattle herd size. I recognize that the weather and the disease might be more transient, but the feedlot data you should have pretty good visibility in.

I was just wondering if you could talk a little about how the outlook there is for the first part of 2018. Is the feedlot strength sustainable? Is that something that you think will continue for several quarters? And then, broader, on the '18 guide, you talked about a pretty sizable gross margin improvement -- 120 bps year over year. Is the longer-term target still what you had talked about, 200 bps by 2020, or is there upside opportunity there given how much improvement you're looking for this year?

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Mike. I'll respond about the U.S. livestock results, and then Glenn will provide the details of our gross margin improvement and targets for the future. In the U.S., definitely, we had a strong fourth quarter. This was the result of several factors including weather conditions, the grouping of animals, and also, the fact that we decided not to implement promotional activities in the third quarter. And then, there was some movement of sales from the third quarter to the fourth quarter of 2017.

But, the results are in some way what we were expecting, and we also communicated that in the previous quarter. We saw that in the first part of the year, we had some limited growth in the U.S. cattle, but we were also expecting that at the end of the year, we'd be reporting revenue growth in U.S. cattle, and this quarter is just confirming our projections for the year. We had movement of animals -- as I mentioned -- to the feedlot and we are pleased with the performance of the entire portfolio in our cattle business in the U.S.

Moving forward for 2018, we see positive elements in our beef segment in the U.S. We see that the number of animals will continue growing -- probably at the lower rate of what we've seen in previous years, but still growing. Placements are also expected to continue being positive. We expect also that the weather conditions in 2018 will be more favorable for animal sales than in '17. So, overall, we see that the beef segment will grow, and we expect it to grow in line with the market.

We also see that at least in the first half, the dairy segment will be a special challenge because the price of milk will be lower than in previous quarters, and maybe it will have an impact on the first half of the year. We expect that the second half will be more positive, but overall, the cattle will be showing positive growth in 2018, and as I said, we expect it to grow in line with the market. Glenn, please cover the question about gross margins.

Glenn David -- Executive Vice President and Chief Financial Officer

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

To the extent that there's additional opportunity based on price, based on volume, based on mix, this can go in either direction. That can either have an incremental impact, or an incremental improvement in margin over that time or on takeaway a little bit. But, 200 basis points was always based on the supply network strategy and to the extent that we have favorable movements in price and mix that would add additional market improvements.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

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

Alex Arfaei -- BMO Capital Markets -- Analyst

Okay, good morning, folks. Thank you very much for taking the questions and congratulations on the stellar performance and all the progress over the last five years. It's really remarkable. On the U.S. livestock business, clearly, it's much better than expected. The business is particularly striking given what we are hearing from so many of your competitors, particularly Elanco. I'm just wondering if you could highlight what are some of the differences that are driving better performance for your portfolio versus what we are seeing from some of your competitors. And then, on the companion animal business, could you comment on the base business, excluding dermatology and Simparica? Is that stable or is it under pressure as some of those show signs of maturity? Thank you very much.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Alex. I should focus on the drivers of our growth. The drivers of our growth are basically because of our portfolio. We have an extremely well-balanced portfolio on many different specific areas, talking about livestock, and this is also helping us. As I said many times, the diversity is helping us to manage different cycles, different opportunities, different challenges, and helps us deliver results which are very consistent and, in some cases, growing faster than our competitors. We don't see that the livestock business in the U.S. is showing any negative fundamentals.

As I said, for '18, we expect cattle business -- beef and dairy combined -- showing positive growth. We also expect that swine and poultry will continue growing. In the case of swine, we expect that category will be growing faster than the market because we are introducing new products, and also, we are seeing that some of the challenges we faced in '17 related to the PCV2 vaccine are over, and at the same time, we are introducing new PCV2 vaccines that cover more strength. That will help us facilitate the growth in 2018.

In poultry, we also expect positive growth in the U.S. and it will be growing in line with the market. So, overall, we're very pleased with our performance and are positive about the prospects for livestock in the U.S. In terms of -- you also asked about companion animals and what could be the drivers for growth in '17 and how we see the growth moving forward, maybe Glenn can provide the details of new products, price, and also, volume of growth for the rest of the portfolio.

Glenn David -- Executive Vice President and Chief Financial Officer

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

In terms of the rest of the portfolio -- what you would then call the in-line portfolio -- performance in those categories was relatively flat as we did experience some pressures from generic competition in line with what our expectations would have been, particularly in the U.S., and that was offset by some strong performance in our emerging markets that continue to grow as increasing medicalization rates in markets such as China and Brazil continue to benefit us. So, overall, relatively flat performance of our in-line portfolio but really strong performance from our new products, and that was the focus of our field force with the tremendous products that we had for launch and continued growth.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

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

Jonathan Block -- Stifel Financial Corp. -- Managing Director

Great, thanks, guys. Good morning. Two questions. Glenn, I have OpEx as a percent of revenue that improved by 270 basis points in '17. It was just huge. The guide for '18, I believe, implies about a 70-bps improvement in OpEx as a percent of revenue with a rate of revenue growth that really isn't too dissimilar in '18 versus '17. So, I want to be clear: The 70 bps is nothing to sneeze at, but maybe you can talk to the increased investments that you guys are pursuing and when those will yield a return, or they're just a function of moving further away from the operational efficiency program. And then, just to pivot, Juan Ramón, I really don't expect specifics, but any thoughts if you believe you will have a new blockbuster companion animal product in '19? Maybe that's from the triple or something out of the pain portfolio from Nexvet. Anything else you guys can give there? Thanks for your time.

Glenn David -- Executive Vice President and Chief Financial Officer

In terms of the OpEx improvement that we experienced in '17 versus what the expectation may be for 2018, it was really the latter of your comments. In 2017, we continued to benefit from the remainder of our operational efficiency initiative and we were able to grow revenue significantly faster than OpEx in 2017. Now, as we move into 2018, we still expect to grow revenue faster than OpEx, but not to the same magnitude, as we don't have the same level of improvements coming from our operational efficiency initiative.

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

Juan Ramón Alaix -- Chief Executive Officer

Answering about the potential opportunity of launching future blockbusters, we definitely continue seeing opportunities of launching a product that will generate significant growth. I discussed about monoclonal antibodies or pain. I also talked about combination products in the parasiticide segment for internal and external. In terms of productivity or livestock, at this point, communicating when this will probably be launched is probably too premature, but we think that we can continue generating growth which is in line or faster than the market with the triple portfolio, and also, the additions of maybe a blockbuster, but also multiple products that will support our revenue growth.

In our industry, as I mentioned many times now, we are not depending on bringing these blockbusters to generate consistent growth because we don't have the same impact that we see in human sales because of generic deterioration. So, we are pleased with our pipeline, we are pleased with the return of our investment in R&D, and we will continue to focus on generating internal value growth, and at the same time, assessing external opportunities that will enhance our opportunity to grow. Next question.

Operator

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

John Kreger -- William Blair & Co. -- Analyst

Hi. Thanks very much. Can you just expand a bit more on the diagnostic strategy? You've not talked about it this much in the past. Should we think about that as more focused in companion animal or livestock and more centralized or point-of-care type of products? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, John. Let me say that we see diagnostics as an area that is growing faster than the average of animal health, and we see diagnostics also as very complementary to our other offers to customers, and also an opportunity to leverage our existing relationships and impact factor in many markets. The focus today is developing our internal pipeline to bring these products into the market.

We see that there's significant competition in companion animals, especially in the U.S., much more opportunity for penetration in the international market in companion animals, and because of our expertise and our presence in livestock, we feel this area has significant potential opportunity for Zoetis. This should be in areas like rapid test, point-of-care, but also equipment, so these are where we are focused today in Zoetis. These are types of point-of-care diagnostic tools that will help veterinarians in the companion animal and livestock to make decisions at the point of care. Next question, please.

Operator

The next question is from David Risinger with Morgan Stanley. Please go ahead.

David Risinger -- Morgan Stanley -- Managing Director

Great. Hi, Juan Ramón and Glenn. I have two questions. The first is could you provide a little bit more color on the ramp of new products -- specifically new companion animal products -- ex-U.S. in 2018? And then, second, with respect to cash flow for 2018, could you please discuss the outlook for operating cash flow and free cash flow in 2018 relative to 2017? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

I will provide some comments on the companion animal growth outside the U.S. Glenn also will be expanding on some of the details for international markets and definitely will be commenting on the operating free cash flow. That's the question that you raised, and also, the outlook for 2018. We have seen very high growth in companion animals in international markets. International markets are a combination of new product launches, Apoquel, Cytopoint, and to a lesser extent, Simparica.

But also, the growth that we have seen in some of the international markets in companion animals where the rate of revenue has been growing very fast, and we have seen in countries like Brazil and China significant growth, and in countries like China, we saw new product launches. So, we still see the opportunity for growth in the future once we introduce Apoquel, Cytopoint, and Simparica in the Chinese market. We still see significant opportunity for growth in international markets because the level of penetration of Apoquel, Cytopoint, and Simparica compared to the U.S. is much lower, so we expect that in 2018, we will continue to enjoy growth in international markets in companion animals. Glenn, you can maybe expand some details on this question and also on the free cash flow one.

Glenn David -- Executive Vice President and Chief Financial Officer

Sure. In terms of free cash flow and the cash flow that we expect for 2018, our operating cash flow we expect to grow pretty much in line with our growth in adjusted net income. As I also mentioned in my prepared remarks, with the increased expenditures we have for CapEx, free cash flow will grow slightly lower than what we expect to grow for operating cash flow.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

Next will be Kathy Miner with Cowen. Please go ahead.

Kathy Miner -- Cowen & Co. -- Analyst

Thank you. Good morning. I just wanted to follow up on the dermatology area a little bit more. Juan Ramón, it sounds like you increased your guidance for the Cytopoint and Apoquel franchise to $500 million in 2018. Can you tell us if this is being driven more by Apoquel or Cytopoint and what the penetration is in dogs now for dermatology conditions? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Kathy. We have definitely seen that the adoption of Apoquel and Cytopoint has been growing in 2017 very fast, and that's why we are now projecting for 2018 already to generate $500 million in sales or more. Both products are performing well, and now, I think it's something that we feel that when pet owners go to clinics with dermatology issues, they are leaving the clinics with either Apoquel or Cytopoint. Definitely, the direct-to-consumer advertising has been helping to accelerate the adoption and also to expand the market. In terms of penetration, definitely, the penetration in the U.S. and international markets is different.

In the U.S., we reported last quarter that we have a penetration in terms of patients of about 59%. We have seen in the fourth quarter this penetration stable, and it is something that in some ways, was expected because it's a quarter in where most of the use is in chronic while we have seen increasing penetration because of the use of acute and seasonal. Seasonal and acute is mainly in the second and third quarter, and we expect to continue growing in 2018 in these acute and seasonal, and also helping with the increase of awareness in terms of dermatology issues with our continued PCV campaign in 2018. We have not seen too much cannibalization of Apoquel because of Cytopoint. It's about 26%, which is what we were expecting, but I think it's something that we are offering more solution sets to veterinarians, and we are very pleased with the performance of these two products. Next question.

Operator

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

Liav Abraham -- Citigroup Research -- Analyst

Good morning. Just a quick question on the tax rate. You've guided to a tax rate of 21% to 22% of 2018. Can you comment on your outlook for tax beyond 2018 and the opportunities for this to be reduced further over time? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Liav. Glenn will be answering this question.

Glenn David -- Executive Vice President and Chief Financial Officer

In terms of tax rate, as you mentioned, for 2018, we've guided to 21% to 22%. We haven't provided guidance for beyond 2018. There are additional clauses that kick in beyond 2018 for us and come into effect in 2019. We need to fully understand the impact of that, but again, the guidance for 2018 is based on current understanding. We're comfortable with the 21% to 22% for 2018.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Glenn, and maybe some clarification on the dermatology penetration. I mentioned data for the U.S. In international markets, we definitely have lower patient share, and we still see a lot of room for growth in terms of patient share and also in terms of expanding the market. Next question, please.

Operator

We'll go next to Chris Schott with JP Morgan. Please go ahead.

Chris Schott -- JP Morgan -- Managing Director

Great, thanks very much for the questions. Just two quick ones here. First, I know you don't give quarterly guidance, but anything we should be keeping in mind as we think about quarterly progression of both top-line and earnings as we think about 2018 relative to '17? And, the second was just me following up on those comments on Apoquel and Cytopoint. Just a little bit more color -- how much more room for growth is there in this franchise beyond '18? I guess I'm really trying to get at if there's any more color on what peak sales could look like for this franchise. As we start getting through '18 and this $500 million-plus number, is there still significant room for growth or are we starting to get to a point where we're reaching peak sales for these assets? Thanks so much.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Chris. Let me cover the question on the dermatology portfolio, and then Glenn will discuss about the quarterly projections for 2018. We still see growth not only in 2018 but in future years for the dermatology portfolio. Maybe the growth in markets where the product has been introduced somewhat like in the U.S., this growth will be moderated in the future. But still, in many international markets, we are adjusting to using Cytopoint. Apoquel still definitely has a lot of opportunities to continue growing. I mentioned China as a country where we don't yet have Apoquel, and we also expect China to generate growth in the future, so we don't see that 2018 will be our peak sales in Apoquel and Cytopoint, and the country will continue growth. Definitely, the growth will be moderated, but we expect also to continue growing, and definitely, we see growth coming from volume, but also, growth coming from prices.

Glenn David -- Executive Vice President and Chief Financial Officer

Chris, in terms of the 2018 quarterly progression, as you mentioned, we don't give 2018 guidance by quarter, but just a couple of things to think about. We do expect more balanced growth in 2018 than we saw in 2017 and a more steady performance in terms of cost of goods as a percent of revenue than we saw in 2017 in particular. The other thing I'll point out is we are moving from a 4-4-5 accounting calendar to a month-end accounting calendar, and that will have some small impact per quarter. The greatest impact, as you'll see, will probably be in Q4, where it could negatively impact our growth in Q4 2018 by almost 2%, but those are the only things that I would point out.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

The next question is from Gregg Gilbert with Deutsche Bank. Please go ahead.

Gregg Gilbert -- Deutsche Bank -- Managing Director

Thanks, gentlemen. I'm curious whether you saw any headwinds or benefits tied to the consolidation of vet clinics in the U.S. I realize there would be a material effect for the whole year for the whole company, but I'm curious on that, seeing as it continues to build. And, my other question is about the environment overall in some of your competition. One of the elephants in the room this year is that Lilly will explore actions for Elanco. I know that Juan Ramón has commented in the past that mergers among the larger players in the industry would be difficult from an antitrust perspective, but how would you view a spinout of Elanco if that's what they decided to do? I'm curious on your thoughts there, operationally and otherwise, as it relates to any good or bad effects for Zoetis. Thanks.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Gregg. Definitely, we have seen a consolidation of vet clinics in the U.S. Also, we have seen not too much consolidation of clinics outside the U.S., but there may be buying groups that are also having an impact. So far, we are managing very well the relationship with these clinics. In some cases, we have been able to reach exclusive agreements for Simparica on one of these larger groups. That's something that we see as very positive. We understand that in some cases, we may encounter some pressure in terms of prices, which is part of also our predictions and our model. At the same time, we see the opportunity also of expanding healthcare because of better services through governance.

So, we see also that in the case of Zoetis, we can have a portfolio of specialty care that is also providing significant benefits to this change of clinics, and definitely, we are managing extremely well. It was a very positive collaboration in the past. We also have good collaboration with the VCA, and we expect that the combination of the two groups will continue to be positive for Zoetis.

In terms of the position of Elanco, I think it's something that I prefer not to comment on other companies' strategic views. We went through our process five years ago. It was the right decision for Pfizer and also for Zoetis. We're very pleased with our performance, and definitely, we have seen the benefits of being Zoetis and having a singular focus on animal health and singular focus on providing value to our customers and to our shareholders. Next question.

Operator

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

Candace Richardson -- Goldman Sachs -- Analyst

Good morning. This is Candace Richardson on for Jami Rubin. I have two quick questions. Tempered growth in the U.S. companion this quarter appears to be related to tougher comps from certain products at launch last year. When should we expect this to annualize? Secondly, your recent dividend increase of nearly 20% is among the highest in the industry. We're wondering if there's a specific payout ratio you're looking to achieve, and given that you're the only stand-alone public animal health company, what comps do you look at when you evaluate your dividend policy? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you for the question. Glenn, do you mind answering the question?

Glenn David -- Executive Vice President and Chief Financial Officer

In terms of U.S. companion animal growth for 2017, for the full year, we had 13% operational growth in U.S. companion animal. In the quarter, we had 15% growth. So, we saw another continued quarter of very strong growth in U.S. companion animal, but not necessarily tempered growth for Q4. In terms of our dividend policy, we generally grow our dividend -- as Juan said -- faster than our growth in adjusted net income, and that is our commitment moving forward, that we'll continue to grow our dividend at or faster than income and have a focus on dividend growth. We're also focused on share repurchase as another way to return excess capital to our shareholders, and we currently prefer share repurchase, as it gives us a little more flexibility to manage the other priorities we have for capital allocation, being our internal investments as well as business development.

Juan Ramón Alaix -- Chief Executive Officer

Next question, please.

Operator

We're going next to Douglas Tsao with Barclays. Please go ahead.

Douglas Tsao -- Barclays Investment Bank -- Analyst

Hi, good morning. Thanks for taking the questions. Just focusing on the companion business, you referenced some greater amount of competition with the in-line products. Just curious if that is a trend that you expect to continue. And then, when you think about the growth for the dermatology franchise going forward, would it be safe to assume that a lot of the growth going forward will come from the ex-U.S.? If you think about that peak potential, I know people sort of hinted at this question, but do you think that the ex-U.S. opportunity could be ultimately as big as what we've seen in the United States? Thank you.

Juan Ramón Alaix -- Chief Executive Officer

Thank you, Doug. We don't see that the competition has been increasing in companion animals for our in-line portfolio. Definitely, we have seen the impact of generics in line with previous years and also in line with our projections. Definitely, vaccines have been growing very fast, and in our opinion, growing faster than the market for companion animals. So, in general, we understand that there have been new products in the pain market. Influences have an impact on Rimadyl. But, this is not something that we see as greater competition in our in-line.

Maybe our in-line portfolio has been affected because of so many new products that have been launched in the previous year, and as you can imagine, the level of attention of our field force during this period has been intentionally on these new products, but we are also very pleased with the performance of our in-line, and definitely, we see that business in-line will be performing according to our projections.

In terms of the dermatology portfolio opportunity outside of the U.S., there is probably a couple of years' or 18 months' difference in terms of the introduction of Apoquel in international markets. Cytopoint was introduced in the U.S. at the end of '16 or mid-'16. It was introduced at the end of '17 in Europe and still not introduced in many international markets. I mentioned that even Apoquel is not yet approved in China, and we expect approval in the future, so definitely, it's a significant opportunity of growing our dermatology portfolio outside of the U.S., but still, we see opportunities to continue growing in the U.S., and we'll definitely be supporting this growth with the DTC campaign in 2018 in our U.S. market. Next question.

Operator

We'll go next to Brett Wong with Piper Jaffray. Please go ahead.

Brett Wong -- Piper Jaffray -- Analyst

Hey, guys. Thanks for fitting me in here. You talked a bit about your positive expectation for U.S. livestock, but can you comment on international livestock business, specifically in your key markets like cattle Brazil, China, et cetera, and if you expect the strength that you saw in 2017 to continue in '18.

Juan Ramón Alaix -- Chief Executive Officer

We see livestock in international markets also continuing positive. China showed 20% growth in '17. This was the combination of companion animal and livestock. We mentioned many times economic cycles, prices in China and some other markets can temporarily affect some of the growth drivers, but one of the advantages of Zoetis that we've explained many times is the diversity of our business in all the categories.

In terms of Brazil, we don't see any change in the fundamentals of our business in Brazil. The cattle business is doing very well. We had some challenges in '17 in our poultry business in Brazil, but overall, we see also projections for livestock international as a positive for 2018. Again, we may see some quarterly fluctuations in some of the markets, but this is not indicative of the fundamentals of the markets. That should be analyzed on a longer period of time, and we don't see any headwinds in terms of the projections for 2018 in international markets for livestock. Next question.

Operator

We will go next to David Westenberg with C.L. King. Please go ahead.

David Westenberg -- C.L. King & Associates -- Vice President

Thanks for taking my questions and congrats on this quarter. My question is -- some of our research is suggesting that veterinarians do tend to like to order in bulk from one vendor for additional discounts, so with the dermatology portfolio now approaching $500 million in sales, what's the opportunity to add to the product bag of the veterinarian Simparica and vaccines? What's the cross-selling opportunity if dermatology becomes a $500 million drug?

Glenn David -- Executive Vice President and Chief Financial Officer

We do think there are definitely opportunities to leverage our portfolio, and in many of our markets, we have programs that do provide additional incentives with the more product that you buy from Zoetis, so we're definitely able to leverage the scale that we have with Apoquel, with Cytopoint, with Simparica, with many of our vaccines to provide additional discounts for buying our total portfolio versus buying just one of our individual products.

Juan Ramón Alaix -- Chief Executive Officer

When we're talking about the total portfolio, we include products like rapid test, diagnostics, and in the future, equipment, so that's why we see the advantage of integrating the larger portfolio and offer this portfolio to our customers. Next question.

Operator

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

Juan Ramón Alaix -- Chief Executive Officer

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

Operator

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

Duration: 69 minutes

Call participants:

Juan Ramón Alaix -- Chief Executive Officer

Glenn David -- Executive Vice President and Chief Financial Officer

Steven Frank -- Vice President of Investor Relations

Louise Chen -- Cantor Fitzgerald -- Managing Director

Kevin Ellich -- Craig Hallum Capital Group -- Analyst

Erin Wright -- Credit Suisse -- Analyst

Michael Ryskin -- Bank of America Merrill Lynch -- Analyst

Alex Arfaei -- BMO Capital Markets -- Analyst

Jonathan Block -- Stifel Financial Corp. -- Managing Director

John Kreger -- William Blair & Co. -- Analyst

David Risinger -- Morgan Stanley -- Managing Director

Kathy Miner -- Cowen & Co. -- Analyst

Liav Abraham -- Citigroup Research -- Analyst

Chris Schott -- JP Morgan -- Managing Director

Gregg Gilbert -- Deutsche Bank -- Managing Director

Candace Richardson -- Goldman Sachs -- Analyst

Douglas Tsao -- Barclays Investment Bank -- Analyst

Brett Wong -- Piper Jaffray -- Analyst

David Westenberg -- C.L. King & Associates -- Vice President

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