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EX-32.2 - EXHIBIT 32.2 - Zoetis Inc.a2016q310qex322.htm
EX-32.1 - EXHIBIT 32.1 - Zoetis Inc.a216q310qex321.htm
EX-31.2 - EXHIBIT 31.2 - Zoetis Inc.a2016q310qex312.htm
EX-31.1 - EXHIBIT 31.1 - Zoetis Inc.a2016q310qex311.htm
EX-15 - EXHIBIT 15 - Zoetis Inc.a2016q310qex15.htm
EX-12 - EXHIBIT 12 - Zoetis Inc.a2016q310-qex12.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
 
 
EXCHANGE ACT OF 1934
 
 
For the quarterly period ended October 2, 2016
 
 
or
 
 
TRANSITION REPORT PURSUANT TO SECTION 13
 
 
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
¨
For the transition period from __________ to __________
 
Commission File Number: 001-35797
Zoetis Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
46-0696167
(State or other jurisdiction of
 
(I.R.S. Employer Identification No.)
incorporation or organization)
 
 
10 Sylvan Way, Parsippany, New Jersey
 
07054
(Address of principal executive offices)
 
(Zip Code)
(973) 822-7000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
 
Accelerated filer ¨
 
Non-accelerated filer ¨
 
Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Exchange Act). ¨ Yes x No
At October 31, 2016, there were 493,832,541 shares of common stock outstanding.





TABLE OF CONTENTS
 
 
 
 
Page
 
Item 1.
 
 
 
 
Condensed Consolidated Statements of Income (Unaudited)
 
 
 
Condensed Consolidated Statements of Comprehensive Income (Unaudited)
 
 
 
Condensed Consolidated (Unaudited) Balance Sheets
 
 
 
Condensed Consolidated Statements of Equity (Unaudited)
 
 
 
Condensed Consolidated Statements of Cash Flows (Unaudited)
 
 
 
Notes to Condensed Consolidated Financial Statements (Unaudited)
 
 
 
Review Report of Independent Registered Public Accounting Firm
 
Item 2.
 
 
Item 3.
 
 
Item 4.
 
 
 
Item 1.
 
 
Item 1A.
 
 
Item 2.
 
 
Item 3.
 
Defaults Upon Senior Securities
 
Item 4.
 
Mine Safety Disclosures
 
Item 5.
 
Other Information
 
Item 6.
 
 
 





PART I – FINANCIAL INFORMATION
Item 1.
Financial Statements


ZOETIS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS AND SHARES, EXCEPT PER SHARE DATA)
 
2016

 
2015

 
2016

 
2015

Revenue
 
$
1,241

 
$
1,214

 
$
3,611

 
$
3,491

Costs and expenses:
 
 
 
 
 
 
 
 
Cost of sales(a)
 
410

 
421

 
1,198

 
1,242

Selling, general and administrative expenses(a)
 
345

 
374

 
1,003

 
1,107

Research and development expenses(a)
 
90

 
91

 
268

 
255

Amortization of intangible assets(a)
 
21

 
15

 
64

 
45

Restructuring charges/(benefits) and certain acquisition-related costs
 
4

 
13

 
(15
)
 
280

Interest expense, net of capitalized interest
 
41

 
29

 
125

 
86

Other (income)/deductions—net
 
(3
)
 
(2
)
 
(29
)
 

Income before provision for taxes on income
 
333

 
273

 
997

 
476

Provision for taxes on income
 
96

 
83

 
332

 
157

Net income before allocation to noncontrolling interests
 
237

 
190

 
665

 
319

Less: Net (loss)/income attributable to noncontrolling interests
 
(2
)
 
1

 
(2
)
 
2

Net income attributable to Zoetis Inc.
 
$
239

 
$
189

 
$
667

 
$
317

Earnings per share attributable to Zoetis Inc. stockholders:
 
 
 
 
 
 
 
 
 Basic
 
0.48

 
0.38

 
1.34

 
0.63

 Diluted
 
0.48

 
0.38

 
1.34

 
0.63

Weighted-average common shares outstanding:
 
 
 
 
 
 
 
 
 Basic
 
495.2

 
499.2

 
496.3

 
500.2

 Diluted
 
497.9

 
501.7

 
498.8

 
502.5

Dividends declared per common share
 
$

 
$
0.083

 
$
0.190

 
$
0.166

(a) 
Amortization expense related to finite-lived acquired intangible assets that contribute to our ability to sell, manufacture, research, market and distribute products, compounds and intellectual property is included in Amortization of intangible assets as these intangible assets benefit multiple business functions. Amortization expense related to finite-lived acquired intangible assets that are associated with a single function is included in Cost of sales, Selling, general and administrative expenses or Research and development expenses, as appropriate, in the condensed consolidated statements of income.

See notes to condensed consolidated financial statements.
1 |


ZOETIS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)

 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Net income before allocation to noncontrolling interests
 
$
237

 
$
190

 
$
665

 
$
319

Other comprehensive income/(loss), net of taxes and reclassification adjustments:
 
 
 
 
 
 
 
 
Unrealized gains/(losses) on derivatives, net(a)
 
1

 
(3
)
 
(2
)
 
(3
)
Foreign currency translation adjustments, net
 
49

 
(57
)
 
114

 
(200
)
Benefit plans: Actuarial (losses)/gains, net(a)
 
(1
)
 

 
2

 
1

Total other comprehensive income/(loss), net of tax
 
49

 
(60
)
 
114

 
(202
)
Comprehensive income before allocation to noncontrolling interests
 
286

 
130

 
779

 
117

Less: Comprehensive income/(loss) attributable to noncontrolling interests
 
1

 
(2
)
 

 
(1
)
Comprehensive income attributable to Zoetis Inc.
 
$
285

 
$
132

 
$
779

 
$
118

(a) 
Presented net of reclassification adjustments and tax impacts, which are not significant in any period presented. Reclassification adjustments related to benefit plans are generally reclassified, as part of net periodic pension cost, into Cost of sales, Selling, general and administrative expenses, and/or Research and development expenses, as appropriate, in the condensed consolidated statements of income.



See notes to condensed consolidated financial statements.
2 |


ZOETIS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

 
 
October 2,

 
December 31,

 
 
2016

 
2015

(MILLIONS OF DOLLARS, EXCEPT SHARE AND PER SHARE DATA)
 
(Unaudited)

 
 
Assets
 
 
 
 
Cash and cash equivalents
 
$
651

 
$
1,154

Accounts receivable, less allowance for doubtful accounts of $35 in 2016 and $34 in 2015
 
915

 
937

Inventories
 
1,563

 
1,467

Assets held for sale
 

 
71

Other current assets
 
235

 
201

Total current assets
 
3,364

 
3,830

Property, plant and equipment, less accumulated depreciation of $1,341 in 2016 and $1,208 in 2015
 
1,382

 
1,307

Goodwill
 
1,497

 
1,455

Identifiable intangible assets, less accumulated amortization
 
1,282

 
1,190

Noncurrent deferred tax assets
 
119

 
82

Other noncurrent assets
 
71

 
49

Total assets
 
$
7,715

 
$
7,913

 
 
 
 
 
Liabilities and Equity
 
 
 
 
Short-term borrowings
 
$

 
$
5

Current portion of long-term debt
 

 
400

Accounts payable
 
241

 
293

Dividends payable
 

 
47

Accrued expenses
 
457

 
676

Accrued compensation and related items
 
204

 
234

Income taxes payable
 
95

 
63

Liabilities associated with assets held for sale
 

 
4

Other current liabilities
 
42

 
59

Total current liabilities
 
1,039

 
1,781

Long-term debt, net of discount and issuance costs
 
4,467

 
4,463

Noncurrent deferred tax liabilities
 
266

 
264

Other taxes payable
 
93

 
63

Other noncurrent liabilities
 
252

 
251

Total liabilities
 
6,117

 
6,822

Commitments and contingencies
 

 

Stockholders' equity:
 
 
 
 
Preferred stock, $0.01 par value: 1,000,000,000 authorized, none issued
 

 

Common stock, $0.01 par value: 6,000,000,000 authorized; 501,891,243 and 501,808,229 shares issued; 494,240,780 and 497,400,113 shares outstanding at October 2, 2016, and December 31, 2015, respectively
 
5

 
5

Treasury stock, at cost, 7,650,463 and 4,408,116 shares of common stock at October 2, 2016, and December 31, 2015,
respectively
 
(351
)
 
(203
)
Additional paid-in capital
 
1,014

 
1,012

Retained earnings
 
1,423

 
876

Accumulated other comprehensive loss
 
(506
)
 
(622
)
Total Zoetis Inc. equity
 
1,585

 
1,068

Equity attributable to noncontrolling interests
 
13

 
23

Total equity
 
1,598

 
1,091

Total liabilities and equity
 
$
7,715

 
$
7,913

 

See notes to condensed consolidated financial statements.
3 |


ZOETIS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EQUITY
(UNAUDITED)

 
Zoetis
 
 
 
 
 
 
 
 
 
 
 
 
 
Accumulated

 
Equity

 
 
 
 
 
 
 
 
Additional

 
 
 
Other

 
Attributable to

 
 
 
 
Common

 
Treasury

 
Paid-in

 
Retained

 
Comprehensive

 
Noncontrolling

 
Total

(MILLIONS OF DOLLARS)
 
Stock(a)

 
Stock(a)

 
Capital

 
Earnings

 
Loss

 
Interests

 
Equity

Balance, December 31, 2014
 
$
5

 
$

 
$
958

 
$
709

 
$
(361
)
 
$
26

 
$
1,337

Nine months ended September 27, 2015
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 

 

 
317

 

 
2

 
319

Other comprehensive income/(loss)
 

 

 

 

 
(201
)
 
(1
)
 
(202
)
Share-based compensation awards(b)
 

 
(2
)
 
33

 

 

 

 
31

Treasury stock acquired(c)
 

 
(148
)
 

 

 

 

 
(148
)
Employee benefit plan contribution from Pfizer Inc.(d)
 

 

 
2

 

 

 

 
2

Dividends declared
 

 

 

 
(83
)
 

 
(2
)
 
(85
)
Balance, September 27, 2015
 
$
5

 
$
(150
)
 
$
993

 
$
943

 
$
(562
)
 
$
25

 
$
1,254

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2015
 
$
5

 
$
(203
)
 
$
1,012

 
$
876

 
$
(622
)
 
$
23

 
$
1,091

Nine months ended October 2, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 

 

 

 
667

 

 
(2
)
 
665

Other comprehensive income/(loss)
 

 

 

 

 
114

 

 
114

Share-based compensation awards (b)
 

 
77

 

 
(26
)
 

 

 
51

Treasury stock acquired(c)
 

 
(225
)
 

 

 

 

 
(225
)
Employee benefit plan contribution from Pfizer Inc.(d)
 

 

 
2

 

 

 

 
2

Divestitures(e)
 

 

 

 

 
2

 
(8
)
 
(6
)
Dividends declared
 

 

 

 
(94
)
 

 

 
(94
)
Balance, October 2, 2016
 
$
5

 
$
(351
)
 
$
1,014

 
$
1,423

 
$
(506
)
 
$
13

 
$
1,598

(a) 
As of October 2, 2016, and September 27, 2015, there were 494,240,780 and 498,333,086 outstanding shares of common stock, respectively, and 7,650,463 and 3,240,447 shares of treasury stock, respectively. Treasury stock is recognized at the cost to reacquire the shares. For additional information, see Note 13. Stockholders' Equity.
(b) 
Includes the issuance of shares of Zoetis Inc. common stock and the reissuance of treasury stock in connection with the vesting of employee share-based awards. Upon reissuance of treasury stock, differences between the proceeds from reissuance and the cost of the treasury stock that result in gains are recorded in Additional paid-in capital. Losses are recorded in Additional paid-in capital to the extent that they can offset previous gains. If no such credit exists, the differences are recorded in Retained earnings. Also includes the reacquisition of shares of treasury stock associated with the vesting of employee share-based awards to satisfy tax withholding requirements. For additional information, see Note 12. Share-Based Payments and Note. 13. Stockholders' Equity.
(c) 
Reflects the acquisition of treasury shares in connection with the share repurchase program. For additional information, see Note 13. Stockholders' Equity.
(d) 
Represents contributed capital from Pfizer Inc. associated with service credit continuation for certain Zoetis Inc. employees in Pfizer Inc.'s U.S. qualified defined benefit and U.S. retiree medical plans. See Note 11. Benefit Plans.
(e) 
Reflects the divestiture of our share of our Taiwan joint venture. See Note 4B. Acquisitions and Divestitures: Divestitures.




See notes to condensed consolidated financial statements.
4 |


ZOETIS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

 
 
Nine Months Ended
 
 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

Operating Activities
 
 
 
 
Net income before allocation to noncontrolling interests
 
$
665

 
$
319

Adjustments to reconcile net income before noncontrolling interests to net cash provided by operating activities:
 
 
 
 
Depreciation and amortization expense
 
177

 
144

Share-based compensation expense
 
28

 
31

Restructuring, net of payments
 
(15
)
 
207

Asset write-offs and asset impairments
 
2

 
48

Gains on sales of assets
 
(27
)
 

Provision for losses on inventory
 
65

 
59

Deferred taxes
 
(52
)
 
(81
)
Employee benefit plan contribution from Pfizer Inc.
 
2

 
2

Other non-cash adjustments
 
13

 
11

Other changes in assets and liabilities, net of acquisitions and divestitures
 
 
 
 
    Accounts receivable
 
44

 
(150
)
    Inventories
 
(133
)
 
(201
)
    Other assets
 
(53
)
 
(64
)
    Accounts payable
 
(56
)
 
30

    Other liabilities
 
(291
)
 
(37
)
    Other tax accounts, net
 
58

 
68

Net cash provided by operating activities
 
427

 
386

Investing Activities
 
 
 
 
Purchases of property, plant and equipment
 
(156
)
 
(143
)
Acquisitions
 
(88
)
 
(229
)
Net proceeds from sales of assets
 
89

 
2

Other investing activities
 

 
(8
)
Net cash used in investing activities
 
(155
)
 
(378
)
Financing Activities
 
 
 
 
Increase (decrease) in short-term borrowings, net
 
(5
)
 
2

Principal payments on long-term debt
 
(400
)
 

Payment of contingent consideration related to previously acquired assets
 
(28
)
 

Share-based compensation-related proceeds, net of taxes paid on withholding shares and excess tax benefits(a)
 
24

 
4

Purchases of treasury stock(b) 
 
(225
)
 
(150
)
Cash dividends paid
 
(141
)
 
(127
)
Net cash used in financing activities
 
(775
)
 
(271
)
Effect of exchange-rate changes on cash and cash equivalents
 

 
(27
)
Net decrease in cash and cash equivalents
 
(503
)
 
(290
)
Cash and cash equivalents at beginning of period
 
1,154

 
882

Cash and cash equivalents at end of period
 
$
651

 
$
592

 
 
 
 
 
Supplemental cash flow information
 
 
 
 
Cash paid during the period for:
 
 
 
 
  Income taxes
 
$
295

 
$
175

  Interest, net of capitalized interest
 
140

 
117

Non-cash transactions:
 
 
 
 
     Purchases of property, plant and equipment
 
16

 
12

     Contingent purchase price consideration
 
29

 
22

(a) 
Effective 2016, excess tax benefits are reflected within operating activities. See Note 3. Significant Accounting Policies for additional information.
(b) 
Reflects the acquisition of treasury shares in connection with the share repurchase program. For additional information, see Note 13. Stockholders' Equity.

See notes to condensed consolidated financial statements.
5 |


ZOETIS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1.
Organization
Zoetis Inc. (including its subsidiaries, collectively, Zoetis, the company, we, us or our) is a global leader in the discovery, development, manufacture and commercialization of animal health medicines and vaccines, with a focus on both livestock and companion animals. We organize and operate our business in two geographic regions: the United States (U.S.) and International.
We directly market our products in approximately 45 countries across North America, Europe, Africa, Asia, Australia and South America. Our products are sold in more than 100 countries, including developed markets and emerging markets. We have a diversified business, marketing products across eight core species: cattle, swine, poultry, sheep and fish (collectively, livestock) and dogs, cats and horses (collectively, companion animals); and within five major product categories: anti-infectives, vaccines, parasiticides, medicated feed additives and other pharmaceuticals.
2.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements were prepared following the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by accounting principles generally accepted in the United States of America (U.S. GAAP) can be condensed or omitted. Balance sheet amounts and operating results for subsidiaries operating outside the United States are as of and for the three and nine-month periods ended August 28, 2016, and August 23, 2015.
We follow a 13-week quarterly accounting cycle pursuant to which the first three quarters end on a Sunday and the fiscal year always ends on December 31 for our operations in the United States and on November 30 for subsidiaries operating outside the United States. As a result of this convention, the first quarter of fiscal 2016 had six additional days and the fourth quarter of fiscal 2016 will have five less days compared with the respective quarters of fiscal 2015.
Revenue, expenses, assets and liabilities can vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be representative of those for the full year.
We are responsible for the unaudited condensed consolidated financial statements included in this Form 10-Q. The condensed consolidated financial statements include all normal and recurring adjustments that are considered necessary for the fair presentation of our financial position and operating results. The information included in this interim report should be read in conjunction with the financial statements and accompanying notes included in our 2015 Annual Report on Form 10-K.
Certain reclassifications have been made to prior year data to conform to current year presentation.
3.
Significant Accounting Policies
New Accounting Standards
In October 2016, the Financial Accounting Standards Board (FASB) issued an accounting standards update that will require the recognition of the income tax consequences of an intra-entity asset transfer, other than inventory, when the transfer occurs as opposed to when the asset is sold to an outside third party. The provisions of the new standard are effective beginning January 1, 2018, for annual and interim reporting periods. Early adoption is permitted beginning on January 1, 2017. The new standard requires a modified retrospective adoption approach, as of the beginning of the period of adoption. We are continuing to assess the potential impact that adopting this new standard will have on our consolidated financial statements.
In March 2016, the FASB issued an accounting standards update which simplifies the accounting for employee share-based payments. The new standard requires the immediate recognition of all excess tax benefits and deficiencies in the income statement, and requires classification of excess tax benefits as an operating activity as opposed to a financing activity in the statements of cash flows. The standard also clarifies that all cash payments made to taxing authorities on the employees' behalf for shares withheld should be presented as financing activities on the statements of cash flows and provides for a policy election to either estimate the number of awards that are expected to vest or account for forfeitures as they occur. The provisions of the new standard are effective beginning January 1, 2017, and early adoption is permitted if all amendments are adopted in the same period. We elected to early adopt the new standard effective January 1, 2016. Excess tax benefits of $7 million generated during the first nine months of 2016 are reflected as a component of Provision for taxes on income as presented in the condensed consolidated statements of income. We have elected to apply the change in cash flow classification for excess tax benefits on a prospective basis. Cash payments made to taxing authorities on the behalf of company employees are reflected as a financing outflow in the condensed consolidated statements of cash flows, consistent with prior years. We continue to include the impact of estimated forfeitures when determining share-based compensation expense.
In February 2016, the FASB issued an accounting standards update which requires lessees to recognize most leases on the balance sheet with a corresponding right of use asset. Leases will be classified as financing or operating which will drive the expense recognition pattern. For lessees, the income statement presentation and expense recognition pattern for financing and operating leases is similar to the current model for capital

6 |


and operating leases, respectively. Accounting for lessors remains largely unchanged. Companies may elect to exclude short-term leases. The update also requires additional disclosures that will better enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. The provisions of the new standard are effective beginning January 1, 2019, for annual and interim reporting periods. Early adoption is permitted beginning on January 1, 2017. The new standard requires a modified retrospective adoption approach, at the beginning of the earliest comparative period presented in the financial statements. We continue to assess the potential impact that adopting this new guidance will have on our consolidated financial statements.
In July 2015, the FASB issued an accounting standards update to simplify the measurement of inventory by requiring that inventory be measured at the lower of cost or net realizable value, rather than at the lower of cost or market, with market being defined as either replacement cost, net realizable value or net realizable value less a normal profit margin. The provisions of the new standard are effective beginning January 1, 2017, for annual and interim reporting periods. The guidance will be adopted prospectively and early adoption is permitted. We plan to adopt this guidance as of January 1, 2017, the required effective date, and do not expect this guidance to have a significant impact on our consolidated financial statements.
In February 2015, the FASB issued an accounting standards update that provides revised guidance on whether to consolidate certain legal entities, such as limited partnerships, limited liability corporations and securitization structures. We adopted this guidance effective January 1, 2016. This guidance did not have a significant impact on our consolidated financial statements.
In May 2014, the FASB issued an accounting standards update that outlines a new, single comprehensive model for companies to use in accounting for revenue arising from contracts with customers. This update supersedes most current revenue recognition guidance under U.S. GAAP. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance includes a five-step model for determining how, when and how much revenue should be recognized. This update also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. We plan to adopt this guidance as of January 1, 2018, the required effective date. The new standard allows for either full retrospective or modified retrospective transition upon adoption. We continue to assess the transition method we will elect for adoption as well as the potential impact that adopting this new guidance will have on our consolidated financial statements.
4.
Acquisitions and Divestitures
A. Acquisitions
Acquisition of Pharmaq
On November 9, 2015, we completed the acquisition of Pharmaq, a privately held Norwegian aquaculture company. We acquired 100% of the issued share capital of Pharmaq for an aggregate cash purchase price of $765 million, adjusted to reflect cash, working capital and net indebtedness as of the closing date for net cash consideration transferred to the seller of $668 million. The acquisition expands the Zoetis aquaculture portfolio.
The transaction was accounted for as a business combination, with the assets acquired and liabilities assumed measured at their respective acquisition date fair values as summarized below:
(MILLIONS OF DOLLARS)
 
Cash and cash equivalents
$
16

Accounts receivable(a)
21

Inventories(b)
42

Other current assets
2

Property, plant and equipment
11

Intangible assets(c)
550

Accounts payable
(4
)
Accrued expenses(d)
(38
)
Accrued compensation and related items
(4
)
Long-term debt(d)
(89
)
Noncurrent deferred tax liabilities(e)
(139
)
Other non-current liabilities
(2
)
Total net assets acquired
366

Goodwill(f)
302

Total consideration
$
668

(a) 
Accounts receivable were measured at fair value as of the acquisition date and are substantially comprised of gross trade receivables of $21 million, $1 million of which is expected to be uncollectible.
(b) 
Inventories recorded as of the acquisition date reflect fair value adjustments of $17 million which relates primarily to finished goods. The fair value was calculated based on estimated selling profit margin.

7 |


(c) 
The acquisition date fair value of intangible assets acquired was determined using the income approach and consists of the following: $160 million related to currently marketed vaccine products, $30 million related to currently marketed therapeutics, $80 million related to customer relationships and $280 million related to in-process research and development (IPR&D). The most significant IPR&D project acquired, with an acquisition date fair value of $150 million, relates to the salmon rickettsial syndrome (SRS) vaccine. The vaccine was commercially launched, subsequent to the acquisition, during November 2015. Other significant acquired IPR&D projects relate to a vaccine for pancreatic disease, “PD” and Alphaflux, a therapeutic drug for the treatment of sea lice and vaccine technology for new species including Tilapia and Pangasius, were assigned acquisition date fair values of $50 million, $40 million, and $40 million, respectively. Vaccine developed technology and customer relationships will be amortized over a 15 year useful life while therapeutic developed technology will be amortized over 10 years.
(d) 
Pharmaq callable bonds and derivative contracts were recorded at acquisition date fair value and settled immediately following the closing.
(e) 
The Pharmaq acquisition was structured as a stock purchase therefore we assumed the historical tax bases of its assets and liabilities. We also established net deferred tax assets and liabilities associated with the fair value adjustments recorded as part of the opening balance sheet. The components of the Pharmaq net deferred tax liability are included within amounts reported in Note 7. Income Taxes.
(f) 
Goodwill of $302 million is the excess of consideration transferred over the value of net assets acquired and was allocated to our existing reportable segments and is primarily attributable to corporate synergies related to platform functions. The primary strategic purpose of the acquisition was to enhance the company’s existing product portfolio by enabling Zoetis to further expand into aquaculture. The goodwill recorded is not deductible for tax purposes.
All amounts recorded are subject to final valuation; however, any difference between such amounts and the final fair value determination for net assets acquired is not expected to be material to our consolidated financial statements. Any adjustments to our preliminary purchase price allocation identified during the measurement period, which will not exceed one year from the acquisition date, will be accounted for prospectively.
Acquisition of Abbott Animal Health
On February 10, 2015, we completed the purchase of certain assets of Abbott Animal Health (AAH), a subsidiary of Abbott Laboratories (Abbott). AAH is a companion animal health business focused on the veterinary surgical suite. The purchase expands our companion animal product portfolio to include veterinarian solutions for anesthesia, pain management, and diabetes monitoring.
The $254 million purchase price included net cash of $229 million and an additional contingent payment of $25 million (acquisition date fair value of $22 million) which was due to Abbott within one year of the acquisition date, subject to certain deductions in the event of sales disruptions due to supply issues. The $25 million payment was made to Abbott in February 2016.
The transaction was accounted for as a business combination, with the net assets acquired measured at their respective acquisition date fair values. Final amounts recorded for the acquisition include $12 million of inventory, $8 million of IPR&D associated with oncology and osteoarthritis projects, $5 million of trade names related to diabetes and pain management products, $16 million of developed technology assets associated with pain management and surgical products, $23 million of other intangible assets including a favorable supply agreement and product exclusivity rights and property, plant and equipment of less than $1 million. Trade names and developed technology assets will be amortized over 15 years while other intangible assets acquired have a weighted average useful life of 5 years.
Goodwill of $187 million is the excess of consideration transferred over the fair value of assets acquired and was allocated to our reportable segments and is predominantly attributable to synergies expected to be realized through the integration of AAH operations into the existing Zoetis business. The goodwill recorded is deductible for tax purposes.
The valuation was finalized during the first quarter of 2016. Final amounts noted above reflect a net increase of $14 million in intangible assets from the preliminary valuation, offset by a decrease in goodwill and inventory fair value adjustments.
B. Divestitures
On April 28, 2016, we completed the sale of our 55 percent ownership share of a Taiwan joint venture, including a manufacturing site in Hsinchu, Taiwan to Yung Shin Pharmaceutical Industrial Co., Ltd., a pharmaceutical company with an animal health business and headquarters in Taiwan. The sale also included a portfolio of products in conjunction with our comprehensive operational efficiency program. These products include medicated feed additives, anti-infective medicines and nutritional premixes for livestock, sold primarily in Taiwan and in international markets. We received $13 million in cash upon closing. The assets and liabilities related to this sale had been previously included within held for sale classification as of December 31, 2015.
On February 17, 2016, we completed the sale of our manufacturing site in Haridwar, India to the India-based pharmaceutical company Zydus Cadila (Cadila Healthcare Ltd.). The agreement also included the sale of a portfolio of our products in conjunction with our comprehensive operational efficiency program. These products included medicated feed additives, anti-infectives, parasiticides, and nutritionals for livestock, sold primarily in India. These assets had been previously included within held for sale classification as of December 31, 2015.
On February 12, 2016, we completed the sale of two of our manufacturing sites in the United States: Laurinburg, North Carolina, and Longmont, Colorado, to Huvepharma NV (Huvepharma), a European animal health company. Huvepharma also assumed the assets and operations and the lease of our manufacturing and distribution site in Van Buren, Arkansas. The agreement included the sale of a portfolio of products in conjunction with our comprehensive operational efficiency program. These products included medicated feed additives, water soluble therapeutics and nutritionals for livestock sold in the U.S. and international markets. The related assets had been previously included within held for sale classification as of December 31, 2015.
During the first nine months of 2016, we received total cash proceeds of approximately $88 million related to the divestitures of our share of our Taiwan joint venture and the India and U.S. manufacturing sites noted above. During the first quarter of 2016, we recognized a net pre-tax gain of approximately $33 million, partially offset by a net pre-tax loss of approximately $6 million recognized during the second quarter of 2016. Gains and losses related to divestitures are recorded within Other (income)/deductions— net.

8 |


The divestiture transactions required transitional supply and service agreements, including technology transfers, where necessary and appropriate, as well as other customary ancillary agreements.
5.
Restructuring Charges and Other Costs Associated with Acquisitions and Cost-Reduction/Productivity Initiatives
In connection with our cost-reduction/productivity initiatives, we typically incur costs and charges associated with site closings and other facility rationalization actions, workforce reductions and the expansion of shared services, including the development of global systems. In connection with our acquisition activity, we typically incur costs and charges associated with executing the transactions, integrating the acquired operations, which may include expenditures for consulting and the integration of systems and processes, product transfers and restructuring the consolidated company, which may include charges related to employees, assets and activities that will not continue in the consolidated company. All operating functions can be impacted by these actions, including sales and marketing, manufacturing and research and development (R&D), as well as functions such as business technology, shared services and corporate operations.
The components of costs incurred in connection with restructuring initiatives, acquisitions and cost-reduction/productivity initiatives are as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Restructuring charges/(benefits) and certain acquisition-related costs:
 
 
 
 
 
 
 
 
Integration costs(a)
 
$

 
$
5

 
$
2

 
$
9

Restructuring charges/(benefits)(b):
 
 
 
 
 
 
 
 
Employee termination costs
 
3

 

 
(20
)
 
237

Asset impairment charges
 

 
8

 

 
34

Exit costs
 
1

 

 
3

 

Total Restructuring charges/(benefits) and certain acquisition-related costs
 
$
4

 
$
13

 
$
(15
)
 
$
280

(a) 
Integration costs represent external, incremental costs directly related to integrating acquired businesses and primarily include expenditures for consulting and the integration of systems and processes, as well as product transfer costs.
(b) 
The restructuring charges/(benefits) for the three and nine months ended October 2, 2016, and September 27, 2015, primarily relate to our operational efficiency initiative and supply network strategy.
The restructuring charges/(benefits) for the three and nine months ended October 2, 2016, are associated with the following: U.S. ($0 million and $2 million benefit, respectively), International ($1 million benefit and $16 million benefit, respectively) and Manufacturing/research/corporate ($5 million and $1 million, respectively).
The restructuring charges for the three and nine months ended September 27, 2015, are associated with the following: U.S. ($3 million benefit and $27 million, respectively), International ($2 million and $117 million, respectively) and Manufacturing/research/corporate ($9 million and $127 million, respectively).
During 2015, we launched a comprehensive operational efficiency program, which was incremental to the previously announced supply network strategy. These initiatives have focused on reducing complexity in our product portfolios through the elimination of approximately 5,000 product stock keeping units (SKUs), changing our selling approach in certain markets, reducing our presence in certain countries, and planning to sell or exit ten manufacturing sites over the long term. As of October 2, 2016, we divested three U.S. manufacturing sites, one international manufacturing site, and our 55 percent ownership share of a Taiwan joint venture, inclusive of its related manufacturing site, and exited one international manufacturing site. See Note 4B. Acquisitions and Divestitures: Divestitures for additional information. We are also continuing to optimize our resource allocation and efficiency by reducing resources associated with non-customer facing activities and operating more efficiently as a result of less internal complexity and more standardization of processes. As part of these initiatives, we expect to reduce certain positions through divestitures, normal attrition and involuntary terminations by approximately 2,000 to 2,500, subject to consultations with works councils and unions in certain countries. As of October 2, 2016, approximately 1,800 positions have been eliminated and additional reductions are expected primarily over the next nine months.

9 |


Restructuring charges/(benefits) related to these initiatives are as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Operational efficiency initiative:
 
 
 
 
 
 
 
 
Employee termination costs(a)
 
$
3

 
$

 
$
(26
)
 
$
228

Asset impairment
 

 
8

 

 
33

Exit costs
 
1

 

 
4

 

 
 
4

 
8

 
(22
)
 
261

 
 
 
 
 
 
 
 
 
Supply network strategy:
 
 
 
 
 
 
 
 
Employee termination costs
 

 

 
6

 
9

Asset impairment charges
 

 

 

 
1

 
 

 

 
6

 
10

Total restructuring charges/(benefits) related to the operational efficiency initiative and supply network strategy
 
4

 
8

 
(16
)
 
271

 
 
 
 
 
 
 
 
 
Other operational efficiency initiative charges
 
 
 
 
 
 
 
 
    Cost of sales:
 
 
 
 
 
 
 
 
        Inventory write-offs
 
1

 
5

 
1

 
5

    Selling, general and administrative expenses:
 
 
 
 
 
 
 
 
        Accelerated depreciation
 

 

 
1

 

        Consulting fees
 
4

 
8

 
11

 
28

    Other (income)/deductions:
 
 
 
 
 
 
 
 
        Net gain on sale of assets(b)
 

 

 
(27
)
 

Total other operational efficiency initiative charges
 
5

 
13

 
(14
)
 
33

 
 
 
 
 
 
 
 
 
Other supply network strategy charges
 
 
 
 
 
 
 
 
    Cost of sales:
 
 
 
 
 
 
 
 
        Accelerated depreciation
 
2

 

 
4

 

        Consulting fees
 

 
3

 
3

 
13

Total other supply network strategy charges
 
2

 
3

 
7

 
13

Total costs associated with the operational efficiency initiative and supply network strategy
 
$
11

 
$
24

 
$
(23
)
 
$
317

(a)
For the nine months ended October 2, 2016, includes a reduction in employee termination accruals primarily as a result of higher than expected voluntary attrition rates experienced in the first half of 2016.
(b) 
For the nine months ended October 2, 2016, represents the net gain on the sale of certain manufacturing sites and products, partially offset by the loss on the sale of our share of our Taiwan joint venture, as part of our operational efficiency initiative.
The components of, and changes in, our restructuring accruals are as follows:
 
 
Employee

 
 
 
 
 
 
Termination

 
Exit

 
 
(MILLIONS OF DOLLARS)
 
Costs

 
Costs

 
Accrual

Balance, December 31, 2015(a)
 
$
221

 
$
1

 
$
222

Provision
 
(20
)
 
3

 
(17
)
Utilization and other(b)
 
(99
)
 
(2
)
 
(101
)
Balance, October 2, 2016(a)
 
$
102

 
$
2

 
$
104

(a) 
At October 2, 2016, and December 31, 2015, included in Accrued expenses ($70 million and $162 million, respectively) and Other noncurrent liabilities ($34 million and $60 million, respectively).
(b) 
Includes adjustments for foreign currency translation.

10 |


6.
Other (Income)/Deductions—Net
The components of Other (income)/deductions—net are as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Royalty-related income
 
$
(8
)
 
$
(5
)
 
$
(20
)
 
$
(19
)
Identifiable intangible asset impairment charges(a)
 
1

 

 
1

 
2

Net gain on sale of assets(b)
 

 

 
(27
)
 

Foreign currency loss(c)
 
5

 
6

 
22

 
18

Other, net(d)
 
(1
)
 
(3
)
 
(5
)
 
(1
)
Other (income)/deductions—net
 
$
(3
)
 
$
(2
)
 
$
(29
)
 
$

(a) 
For the three and nine months ended October 2, 2016, represents an impairment of finite-lived trademarks related to a canine pain management product. For the nine months ended September 27, 2015, represents an impairment of IPR&D assets related to the termination of a canine oncology project.
(b) 
For the nine months ended October 2, 2016, represents the net gain on the sale of certain manufacturing sites and products, partially offset by the loss on the sale of our share of a Taiwan joint venture, as part of our operational efficiency initiative.
(c) 
Primarily driven by costs related to hedging and exposures to certain emerging market currencies.
(d) 
For the nine months ended October 2, 2016, primarily represents income associated with certain state business employment tax incentive credits. For the nine months ended September 27, 2015, primarily represents inventory losses of $3 million sustained as a result of weather damage at storage facilities in Brazil and Australia, partially offset by interest income and other miscellaneous income.
7.
Income Taxes
A.
Taxes on Income
The effective tax rate was 28.8% for the three months ended October 2, 2016, compared with 30.4% for the three months ended September 27, 2015. The lower effective tax rate for the three months ended October 2, 2016, was primarily attributable to:
a $7 million discrete tax benefit related to a revaluation of the company’s deferred tax assets and liabilities using the tax rates expected to be in place going forward as a result of the implementation of operational changes; and
the impact of the extent and location of restructuring charges related to the operational efficiency initiative, supply network strategy, asset impairments and gains and losses on asset divestitures,
partially offset by:
changes in the jurisdictional mix of earnings, which includes the impact of the location of earnings from operations and repatriation costs. The jurisdictional mix of earnings can vary as a result of repatriation decisions and operating fluctuations in the normal course of business and the impact of non-deductible items.
The effective tax rate was 33.3% for the nine months ended October 2, 2016, compared with 33.0% for the nine months ended September 27, 2015. The higher effective tax rate for the nine months ended October 2, 2016, was primarily attributable to:
changes in the jurisdictional mix of earnings, which includes the impact of the location of earnings from operations and repatriation costs. The jurisdictional mix of earnings can vary as a result of repatriation decisions and operating fluctuations in the normal course of business and the impact of non-deductible items;
a $38 million net discrete tax expense recorded in the first half of 2016, related to changes in uncertain tax positions due to the impact of the European Commission’s negative decision on the excess profits rulings in Belgium (see C. Tax Contingencies), partially offset by a revaluation of the company's deferred tax assets and liabilities using the tax rates expected to be in place going forward as a result of the decision; and
a valuation allowance of $3 million recorded in the second quarter of 2015,
partially offset by:
a $7 million discrete tax benefit recorded in the third quarter of 2016, related to a revaluation of the company’s deferred tax assets and liabilities using the tax rates expected to be in place going forward as a result of the implementation of operational changes;
a $10 million and $9 million discrete tax benefit recorded in the first quarter of 2016 and 2015, respectively, related to a revaluation of deferred taxes as a result of a change in statutory tax rates;
a $7 million discrete tax benefit related to the adoption of a new accounting standard in 2016 requiring the excess tax benefits for share-based payments to be recognized as a component of Provision for taxes on income. See Note 3. Significant Accounting Policies;
the impact of the extent and location of restructuring charges related to the operational efficiency initiative, supply network strategy, asset impairments and gains and losses on asset divestitures; and
a $6 million discrete tax benefit recorded in the second quarter of 2015 related to prior period tax adjustments.

11 |


B.
Deferred Taxes
As of October 2, 2016, the total net deferred income tax liability of $147 million is included in Noncurrent deferred tax assets ($119 million) and Noncurrent deferred tax liabilities ($266 million).
As of December 31, 2015, the total net deferred income tax liability of $182 million is included in Noncurrent deferred tax assets ($82 million) and Noncurrent deferred tax liabilities ($264 million).
C.
Tax Contingencies
As of October 2, 2016, the tax liabilities associated with uncertain tax positions of $87 million (exclusive of interest and penalties related to uncertain tax positions of $10 million) are included in Noncurrent deferred tax assets ($5 million) and Other taxes payable ($82 million).
As of December 31, 2015, the tax liabilities associated with uncertain tax positions of $61 million (exclusive of interest and penalties related to uncertain tax positions of $7 million) are included in Noncurrent deferred tax assets ($6 million) and Other taxes payable ($55 million).
The increase in tax liabilities associated with uncertain tax positions as of October 2, 2016, is primarily due to a net tax charge of approximately $22 million. The components of this net charge is a tax liability of $50 million related to the impact of the European Commission’s negative decision on January 11, 2016, regarding the excess profits rulings in Belgium, reduced by a cash settlement of $28 million for the 2013-2014 periods. This charge does not include any benefits associated with a successful appeal of the decision.
Aside from the above, our tax liabilities for uncertain tax positions relate primarily to issues common among multinational corporations. Any settlements or statute of limitations expirations could result in a significant decrease in our uncertain tax positions. Substantially all of these unrecognized tax benefits, if recognized, would impact our effective income tax rate.
We believe that it is reasonably possible that our reserves for uncertain tax positions could decrease within the next twelve months by approximately $22 million due to the expected remaining payment due related to the impact of the European Commission’s negative decision on the excess profits rulings in Belgium. Our assessments are based on estimates and assumptions that have been deemed reasonable by management, but our estimates of uncertain tax positions and potential tax benefits may not be representative of actual outcomes, and any variation from such estimates could materially affect our financial statements in the period of settlement or when the statutes of limitations expire, as we treat these events as discrete items in the period of resolution. Finalizing audits with the relevant taxing authorities can include formal administrative and legal proceedings, and, as a result, it is difficult to estimate the timing and range of possible changes related to our uncertain tax positions, and such changes could be significant.
8.
Financial Instruments
A.
Debt
Credit Facilities
In December 2012, we entered into a revolving credit agreement with a syndicate of banks providing for a five-year $1.0 billion senior unsecured revolving credit facility (the credit facility), which became effective in February 2013 upon the completion of the initial public offering and expires in December 2017. Subject to certain conditions, we have the right to increase the credit facility to up to $1.5 billion. The credit facility contains a financial covenant requiring us to not exceed a maximum total leverage ratio (the ratio of consolidated net debt as of the end of the period to consolidated Earnings Before Interest, Income Taxes, Depreciation and Amortization (EBITDA) for such period) of 3.50:1. Upon entering into a material acquisition, the maximum total leverage ratio increases to 4.25:1, and extends until the fourth full consecutive fiscal quarter ended immediately following the consummation of a material acquisition. On November 10, 2015, we designated the acquisition of Pharmaq a material acquisition under the revolving credit agreement. For additional information, see Note 4. Acquisitions and Divestitures. On February 19, 2016, we amended this financial covenant to add back to Adjusted Consolidated EBITDA, any operational efficiency restructuring charge (defined as charges recorded by the company during the second quarter of 2015, related to our operational efficiency program announced on May 5, 2015, in an aggregate amount for all such charges not to exceed $237 million) and Venezuela-related charges (defined as the write-down, impairment and other charges recorded by the company during the fourth quarter of 2015 relating to Venezuela, in an aggregate amount for all such charges not to exceed $95 million).
The credit facility also contains a financial covenant requiring that we maintain a minimum interest coverage ratio (the ratio of EBITDA at the end of the period to interest expense for such period) of 3.50:1. In addition, the credit facility contains other customary covenants.
We were in compliance with all financial covenants as of October 2, 2016, and December 31, 2015. There were no amounts drawn under the credit facility as of October 2, 2016, or December 31, 2015.
We have additional lines of credit and other credit arrangements with a group of banks and other financial intermediaries for general corporate purposes. We maintain cash and cash equivalent balances in excess of our outstanding short-term borrowings. As of October 2, 2016, we had access to $81 million of lines of credit which expire at various times through 2017 and are renewed annually. We did not have any borrowings outstanding related to these facilities as of October 2, 2016. Short-term borrowings outstanding related to these facilities were $4 million as of December 31, 2015.
Commercial Paper Program
In February 2013, we entered into a commercial paper program with a capacity of up to $1.0 billion. As of October 2, 2016, and December 31, 2015, there was no commercial paper issued under this program.

12 |


Short-Term Borrowings
As of October 2, 2016, we did not have any short-term borrowings outstanding. As of December 31, 2015, short-term borrowings outstanding, including lines of credit, were $5 million, with a weighted-average interest rate of 5.2%.
Senior Notes and Other Long-Term Debt
On November 13, 2015, we issued $1.25 billion aggregate principal amount of our senior notes (2015 senior notes), with an original issue discount of $2 million. On January 28, 2013, we issued $3.65 billion aggregate principal amount of our senior notes (the 2013 senior notes offering) in a private placement, with an original issue discount of $10 million.
There was no current portion of long-term debt as of October 2, 2016. The current portion of long-term debt was $400 million as of December 31, 2015, with a weighted-average interest rate of 1.150%.
The 2013 and 2015 senior notes are governed by an indenture and supplemental indenture (collectively, the indenture) between us and Deutsche Bank Trust Company Americas, as trustee. The indenture contains certain covenants, including limitations on our, and certain of our subsidiaries' ability to incur liens or engage in sale-leaseback transactions. The indenture also contains restrictions on our ability to consolidate, merge or sell substantially all of our assets. In addition, the indenture contains other customary terms, including certain events of default, upon the occurrence of which the 2013 and 2015 senior notes may be declared immediately due and payable.
Pursuant to the indenture, we are able to redeem the 2013 and 2015 senior notes, in whole or in part, at any time by paying a “make whole” premium, plus accrued and unpaid interest to, but excluding, the date of redemption. Pursuant to our tax matters agreement with Pfizer, we will not be permitted to redeem the 2013 senior notes due 2023 pursuant to this optional redemption provision, except under limited circumstances. Upon the occurrence of a change of control of us and a downgrade of the 2013 and 2015 senior notes below an investment grade rating by each of Moody's Investors Service, Inc. and Standard & Poor's Ratings Services, we are, in certain circumstances, required to make an offer to repurchase all of the outstanding 2013 and 2015 senior notes at a price equal to 101% of the aggregate principal amount of the 2013 and 2015 senior notes together with accrued and unpaid interest to, but excluding, the date of repurchase.
The components of our long-term debt are as follows:
 
 
October 2,

 
December 31,

(MILLIONS OF DOLLARS)
 
2016

 
2015

1.150% 2013 senior notes due 2016
 
$

 
$
400

1.875% 2013 senior notes due 2018
 
750

 
750

3.450% 2015 senior notes due 2020
 
500

 
500

5.100% bank loan due 2021
 
1

 

3.250% 2013 senior notes due 2023
 
1,350

 
1,350

4.500% 2015 senior notes due 2025
 
750

 
750

4.700% 2013 senior notes due 2043
 
1,150

 
1,150

 
 
4,501

 
4,900

Unamortized debt discount / debt issuance costs
 
(34
)
 
(37
)
Less current portion of long-term debt
 

 
(400
)
Long-term debt
 
$
4,467

 
$
4,463

The fair value of our long-term debt, including the current portion of long-term debt, was $4,760 million and $4,759 million as of October 2, 2016, and December 31, 2015, respectively, and has been determined using a third-party matrix-pricing model that uses significant inputs derived from, or corroborated by, observable market data and Zoetis’ credit rating (Level 2 inputs).
The principal amount of long-term debt outstanding, as of October 2, 2016, matures in the following years:
 
 
 
 
 
 
 
 
 
 
After

 
 
(MILLIONS OF DOLLARS)
 
2017

 
2018

 
2019

 
2020

 
2020

 
Total

Maturities
 
$

 
$
750

 
$

 
$
500

 
$
3,251

 
$
4,501

Interest Expense
Interest expense, net of capitalized interest, was $41 million and $125 million for the three and nine months ended October 2, 2016, respectively, and $29 million and $86 million for the three and nine months ended September 27, 2015, respectively. Capitalized interest was $1 million and $2 million for the three and nine months ended October 2, 2016, and $1 million and $3 million for the three and nine months ended September 27, 2015, respectively.
B.
Derivative Financial Instruments
Foreign Exchange Risk
A significant portion of our revenue, earnings and net investment in foreign affiliates is exposed to changes in foreign exchange rates. We seek to manage our foreign exchange risk, in part, through operational means, including managing same-currency revenue in relation to same-

13 |


currency costs and same-currency assets in relation to same-currency liabilities. Depending on market conditions, foreign exchange risk is also managed through the use of derivative financial instruments. These financial instruments serve to protect net income against the impact of the translation into U.S. dollars of certain foreign exchange-denominated transactions. The aggregate notional amount of foreign exchange derivative financial instruments offsetting foreign currency exposures was $1.2 billion and $1.4 billion, as of October 2, 2016, and December 31, 2015, respectively. The derivative financial instruments primarily offset exposures in the Australian dollar, Brazilian real, Canadian dollar, euro, Japanese Yen, and U.K. pound. The vast majority of the foreign exchange derivative financial instruments mature within 60 days and all mature within 180 days.
All derivative contracts used to manage foreign currency risk are measured at fair value and are reported as assets or liabilities on the condensed consolidated balance sheet. The company has not designated the foreign currency forward-exchange contracts as hedging instruments. We recognize the gains and losses on forward-exchange contracts that are used to offset the same foreign currency assets or liabilities immediately into earnings along with the earnings impact of the items they generally offset. These contracts essentially take the opposite currency position of that reflected in the month-end balance sheet to counterbalance the effect of any currency movement.
Interest Rate Risk
The company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rates and to reduce its overall cost of borrowing. In anticipation of issuing fixed-rate debt, we may use forward-starting interest rate swaps that are designated as cash flow hedges to hedge against changes in interest rates that could impact expected future issuances of debt. To the extent these hedges of cash flows related to anticipated debt are effective, any unrealized gains or losses on the forward-starting interest rate swaps are reported in Accumulated other comprehensive loss and are recognized in income over the life of the future fixed-rate notes. When the company discontinues hedge accounting because it is no longer probable that an anticipated transaction will occur within the originally expected period of execution, or within an additional two-month period thereafter, changes to fair value accumulated in other comprehensive income are recognized immediately in earnings.
In the first nine months of 2016, we entered into interest rate swaps with an aggregate notional value of $250 million, having a term of ten years and an effective date and mandatory termination date of December 2017. We designated these swaps as cash flow hedges against interest rate exposure related principally to the anticipated future issuance of fixed-rate debt to be used primarily to refinance our 1.875% 2013 senior note due in 2018.
Fair Value of Derivative Instruments
The classification and fair values of derivative instruments are as follows:
 
 
Fair Value of Derivatives
 
 
October 2,

 
December 31,

(MILLIONS OF DOLLARS)
Balance Sheet Location
2016

 
2015

Derivatives Not Designated as Hedging Instruments
 
 
 
 
   Foreign currency forward-exchange contracts
Other current assets
$
4

 
$
8

   Foreign currency forward-exchange contracts
Other current liabilities 
(18
)
 
(10
)
Total derivatives not designated as hedging instruments
 
(14
)
 
(2
)
 
 
 
 
 
Derivatives Designated as Hedging Instruments:
 
 
 
 
   Interest rate swap contracts
Other current liabilities
(4
)
 

Total derivatives designated as hedging instruments
 
(4
)
 

 
 
 
 
 
Total derivatives
 
$
(18
)
 
$
(2
)
We use a market approach in valuing financial instruments on a recurring basis. Our derivative financial instruments are measured at fair value on a recurring basis using Level 2 inputs in the calculation of fair value.
The amounts of net gains/(losses) on derivative instruments not designated as hedging instruments, recorded in Other (income)/deductions, are as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Foreign currency forward-exchange contracts
 
$
(25
)
 
$
18

 
$
(29
)
 
$
24

These amounts were substantially offset in Other (income)/deductions—net by the effect of changing exchange rates on the underlying foreign currency exposures.
The amounts of net gains/(losses) on derivative instruments designated as cash flow hedges, recorded, net of tax, in Accumulated other comprehensive loss, are as follows:

14 |


 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Interest rate swap contracts
 
$
1

 
$
(3
)
 
$
(2
)
 
$
(3
)
9.
Inventories
The components of inventory are as follows:
 
 
October 2,

 
December 31,

(MILLIONS OF DOLLARS)
 
2016

 
2015

Finished goods
 
$
774

 
$
758

Work-in-process
 
562

 
384

Raw materials and supplies
 
227

 
325

Inventories
 
$
1,563

 
$
1,467

10.
Goodwill and Other Intangible Assets
A.
Goodwill
The components of, and changes in, the carrying amount of goodwill are as follows:
(MILLIONS OF DOLLARS)
 
U.S.

 
International

 
Total

Balance, December 31, 2015
 
$
665

 
$
790

 
$
1,455

Additions / Adjustments(a)
 
(4
)
 
20

 
16

Other(b)
 

 
26

 
26

Balance, October 2, 2016
 
$
661

 
$
836

 
$
1,497

(a) Primarily includes a $16 million purchase price allocation associated with the acquisition of a veterinary diagnostics business in Denmark and a $12 million purchase price allocation associated with the acquisition of a livestock business in South America, offset by a $13 million reduction in the acquisition date fair value of goodwill associated with the acquisition of certain assets of Abbott Animal Health. See Note 4A. Acquisitions and Divestitures: Acquisitions.
(b) Includes adjustments for foreign currency translation.
The gross goodwill balance was $2,033 million and $1,991 million as of October 2, 2016, and December 31, 2015, respectively. Accumulated goodwill impairment losses were $536 million as of October 2, 2016, and December 31, 2015.

15 |


B.
Other Intangible Assets
The components of identifiable intangible assets are as follows:
 
 
As of October 2, 2016
 
As of December 31, 2015
 
 
 
 
 
 
Identifiable

 
 
 
 
 
Identifiable

 
 
Gross

 
 
 
Intangible Assets

 
Gross

 
 
 
Intangible Assets

 
 
Carrying

 
Accumulated

 
Less Accumulated

 
Carrying

 
Accumulated

 
Less Accumulated

(MILLIONS OF DOLLARS)
 
Amount

 
Amortization

 
Amortization

 
Amount

 
Amortization

 
Amortization

Finite-lived intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
Developed technology rights(a)
 
$
1,083

 
$
(330
)
 
$
753

 
$
1,010

 
$
(274
)
 
$
736

Brands
 
213

 
(130
)
 
83

 
212

 
(121
)
 
91

Trademarks and trade names
 
63

 
(45
)
 
18

 
63

 
(44
)
 
19

Other(a)
 
231

 
(127
)
 
104

 
214

 
(118
)
 
96

Total finite-lived intangible assets
 
1,590

 
(632
)
 
958

 
1,499

 
(557
)
 
942

Indefinite-lived intangible assets:
 
 
 
 
 
 
 
 
 
 
 
 
Brands
 
36

 

 
36

 
36

 

 
36

Trademarks and trade names
 
67

 

 
67

 
66

 

 
66

In-process research and development(b)
 
214

 

 
214

 
138

 

 
138

Product rights
 
7

 

 
7

 
8

 

 
8

Total indefinite-lived intangible assets
 
324

 

 
324

 
248

 

 
248

Identifiable intangible assets
 
$
1,914

 
$
(632
)
 
$
1,282

 
$
1,747

 
$
(557
)
 
$
1,190

(a) 
Includes the acquisition of intangible assets associated with the purchase of a veterinary diagnostics business in Denmark in the third quarter of 2016, the acquisition of intangible assets associated with the purchase of a livestock business in South America in the first quarter of 2016 and an increase in the acquisition date fair value of intangible assets associated with the acquisition of certain assets of Abbott Animal Health, as well as the impact of foreign exchange. See Note 4A. Acquisitions and Divestitures: Acquisitions.
(b) 
Includes the acquisition of intangible assets associated with the purchase of a veterinary diagnostics business in Denmark in the third quarter of 2016.
C.
Amortization
Amortization expense related to finite-lived acquired intangible assets that contribute to our ability to sell, manufacture, research, market and distribute products, compounds and intellectual property is included in Amortization of intangible assets as it benefits multiple business functions. Amortization expense related to finite-lived acquired intangible assets that are associated with a single function is included in Cost of sales, Selling, general and administrative expenses or Research and development expenses, as appropriate. Total amortization expense for finite-lived intangible assets was $24 million and $72 million for the three and nine months ended October 2, 2016, respectively, and $16 million and $47 million for the three and nine months ended September 27, 2015, respectively.
11.
Benefit Plans
Our employees ceased to participate in the Pfizer, Inc. U.S. qualified defined benefit plans and the U.S. retiree medical plan effective December 31, 2012, and liabilities associated with our employees under these plans were retained by Pfizer. Pfizer is continuing to credit certain employees' service with Zoetis generally through December 31, 2017 (or termination of employment from Zoetis, if earlier) for certain early retirement benefits with respect to Pfizer's U.S. defined benefit pension and retiree medical plans. Pension and postretirement benefit expense associated with the extended service for certain employees in the U.S. plans totaled approximately $2 million in each three month period ended October 2, 2016, and September 27, 2015, and $5 million in each nine month period ended October 2, 2016, and September 27, 2015.
The following table provides the net periodic benefit cost associated with our international defined benefit pension plans:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Service cost
 
$
3

 
$
2

 
$
7

 
$
6

Interest cost
 

 
1

 
2

 
3

Expected return on plan assets
 
(1
)
 
(1
)
 
(2
)
 
(2
)
Amortization of net actuarial loss
 
1

 

 
1

 
1

Curtailment gain
 

 
1

 
(1
)
 
1

Net periodic benefit cost
 
$
3

 
$
3

 
$
7

 
$
9

Total company contributions to the international pension plans were $1 million and $7 million for the three and nine months ended October 2, 2016, and $3 million and $6 million for the three and nine months ended September 27, 2015, respectively. We expect to contribute a total of approximately $9 million to these plans in 2016.

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12.
Share-Based Payments
The company may grant a variety of share-based payments under the Zoetis 2013 Equity and Incentive Plan (the Equity Plan) to employees and non-employee directors. The principal types of share-based awards available under the Equity Plan may include, but are not limited to, stock options, restricted stock and restricted stock units (RSUs), deferred stock units (DSUs), performance-vesting restricted stock units (PSUs) and other equity-based or cash-based awards.
The components of share-based compensation expense are as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 2,

 
September 27,

 
October 2,

 
September 27,

(MILLIONS OF DOLLARS)
 
2016

 
2015

 
2016

 
2015

Stock options / stock appreciation rights
 
$
3

 
$
3

 
$
8

 
$
14

RSUs / DSUs
 
5

 
6

 
17

 
15

PSUs
 
1

 
1

 
3

 
2

Share-based compensation expense—total(a)(b)
 
$
9

 
$
10

 
$
28

 
$
31

(a) For the nine months ended October 2, 2016, we capitalized $1 million of share-based compensation expense to inventory; for the three months ended October 2, 2016, amounts capitalized to inventory were insignificant. For the three and nine months ended September 27, 2015, we capitalized $1 million of share-based compensation expense to inventory.
(b) Includes additional share-based compensation expense as a result of accelerated vesting of the outstanding stock options and the settlement, on a pro-rata basis, of other equity awards of terminated employees in connection with our operational efficiency initiative and supply network strategy for the nine months ended October 2, 2016, of approximately $1 million, which is included in Restructuring charges/(benefits) and certain acquisition-related costs. For the three months ended October 2, 2016, and the three and nine months ended September 27, 2015, the amounts were insignificant.
During the nine months ended October 2, 2016, the company granted 930,441 stock options with a weighted-average exercise price of $42.32 per stock option and a weighted-average fair value of $11.29 per option. The fair-value based method for valuing each Zoetis stock option grant on the grant date uses the Black-Scholes-Merton option-pricing model, which incorporates a number of valuation assumptions. The weighted-average fair value was estimated based on the following assumptions: risk-free interest rate of 1.55%; expected dividend yield of 0.89%; expected stock price volatility of 26.75%; and expected term of 6.5 years. In general, stock options vest after P3Y years of continuous service and the values determined through this fair-value based method generally are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.
During the nine months ended October 2, 2016, the company granted 732,671 RSUs with a weighted-average grant date fair value of $42.10 per RSU. RSUs are accounted for using a fair-value-based method that utilizes the closing price of Zoetis common stock on the date of grant. In general, RSUs vest after three years of continuous service from the grant date and the values are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.
During the nine months ended October 2, 2016, the company granted 198,445 PSUs with a weighted-average grant date fair value of $50.20 per PSU. PSUs are accounted for using a Monte Carlo simulation model. The units underlying the PSUs will be earned and vested over a three-year performance period, based upon the total shareholder return of the company in comparison to the total shareholder return of the companies comprising the S&P 500 index at the start of the performance period (Relative TSR). The weighted-average fair value was estimated based on volatility assumptions of Zoetis common stock and an average of peer companies, which were 23.8% and 25.2%, respectively. Depending on the company’s Relative TSR performance at the end of the performance period, the recipient may earn between 0% and 200% of the target number of units. Vested units are settled in shares of the company’s common stock. PSU values are amortized on a straight-line basis over the vesting term into Cost of sales, Selling, general and administrative expenses, or Research and development expenses, as appropriate.
13.
Stockholders' Equity
Zoetis is authorized to issue 6 billion shares of common stock and 1 billion shares of preferred stock.
In November 2014, the company's Board of Directors authorized a $500 million share repurchase program. Purchases of Zoetis shares may be made at the discretion of management, depending on market conditions and business needs. As of October 2, 2016, there was approximately $75 million remaining under this authorization.

17 |


Changes in common shares and treasury stock were as follows:
(MILLIONS)
 
Common Shares Issued(a)