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 animal health industry, focused on the discovery, development, manufacture and commercialization of medicines, vaccines, diagnostic products and services, biodevices, genetic tests and precision animal health technology. 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: dogs, cats and horses (collectively, companion animals) and cattle, swine, poultry, fish and sheep (collectively, livestock); and within seven major product categories: parasiticides, vaccines, dermatology, anti-infectives, other pharmaceutical products, animal health diagnostics and medicated feed additives.
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 U.S. are as of and for the three and nine months ended August 31, 2022 and August 31, 2021.
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 2021 Annual Report on Form 10-K.
3. Accounting Standards
Recently Issued Accounting Standards
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. In January 2021, it issued a subsequent amendment to the initial guidance: ASU No. 2021-01, Reference Rate Reform (Topic 848). The new guidance provides temporary optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions that reference the London Interbank Offered Rate (LIBOR) or another reference rate expected to be discontinued because of reference rate reform. Adoption of the guidance is optional and effective as of March 12, 2020, but only available through December 31, 2022. We currently have a revolving credit facility and various hedging transactions that reference LIBOR. We will make specific amendments to our affected contracts and hedge documentation to adopt these standards during the transition period and we do not expect these changes to have a material impact on our consolidated financial statements or related disclosures.
4. Revenue
A. Revenue from Product Sales
We offer a diversified portfolio of products which allows us to capitalize on local and regional customer needs. Generally, our products are promoted to veterinarians and livestock producers by our sales organization which includes sales representatives and technical and veterinary operations specialists, and then sold directly by us or through distributors, retailers or e-commerce outlets. The depth of our product portfolio enables us to address the varying needs of customers in different species and geographies. Many of our top-selling product lines are distributed across both of our operating segments, leveraging our research and development (R&D) operations and manufacturing and supply chain network.
Over the course of our history, we have focused on developing a diverse portfolio of animal health products, including medicines, vaccines and diagnostics, complemented by biodevices, genetic tests and a range of services. We refer to all different brands or a particular product, or its dosage forms for all species, as a product line. We have approximately 300 comprehensive product lines, including products for both companion animals and livestock within each of our major product categories.
Our major product categories are:
•parasiticides: products that prevent or eliminate external and internal parasites such as fleas, ticks and worms;
•vaccines: biological preparations that help prevent diseases of the respiratory, gastrointestinal and reproductive tracts or induce a specific immune response;
•dermatology products: products that relieve itch associated with allergic conditions and atopic dermatitis;
•anti-infectives: products that prevent, kill or slow the growth of bacteria, fungi or protozoa;
•other pharmaceutical products: pain and sedation, antiemetic, reproductive and oncology products;
•animal health diagnostics: blood, urine and fecal analysis testing capabilities, including point-of-care diagnostic products, instruments and reagents, rapid immunoassay tests, reference laboratory kits and services and blood glucose monitors; and
•medicated feed additives: products added to animal feed that provide medicines to livestock.
Our remaining revenue is derived from other non-pharmaceutical product categories, such as nutritionals and agribusiness, as well as products and services in biodevices, genetic tests and precision animal health.
Our companion animal products help extend and improve the quality of life for pets; increase convenience and compliance for pet owners; and help veterinarians improve the quality of their care and the efficiency of their businesses. Growth in the companion animal medicines, vaccines and diagnostics sector is driven by economic development, related increases in disposable income and increases in pet ownership and spending on pet care. Companion animals are also living longer, deepening the human-animal bond, receiving increased medical treatment and benefiting from advances in animal health medicine, vaccines and diagnostics.
Our livestock products primarily help prevent or treat diseases and conditions to allow veterinarians and producers to care for their animals and to enable the cost-effective production of safe, high-quality animal protein. Human population growth and increasing standards of living are important long-term growth drivers for our livestock products in three major ways. First, population growth and increasing standards of living drive demand for improved nutrition, particularly through increased consumption of animal protein. Second, population growth leads to greater natural resource constraints driving a need for enhanced productivity. Finally, as standards of living improve and the global food chain faces increased scrutiny, there is more focus on food quality, safety and reliability of supply.
The following tables present our revenue disaggregated by geographic area, species and major product category:
Revenue by geographic area | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
United States | | $ | 1,090 | | | $ | 1,065 | | | $ | 3,201 | | | $ | 3,002 | |
Australia | | 80 | | | 70 | | | 225 | | | 196 | |
Brazil | | 70 | | | 78 | | | 233 | | | 227 | |
Canada | | 56 | | | 56 | | | 172 | | | 169 | |
Chile | | 31 | | | 32 | | | 106 | | | 100 | |
China | | 92 | | | 72 | | | 291 | | | 289 | |
France | | 28 | | | 31 | | | 91 | | | 98 | |
Germany | | 43 | | | 47 | | | 132 | | | 135 | |
Italy | | 24 | | | 30 | | | 86 | | | 87 | |
Japan | | 37 | | | 43 | | | 137 | | | 140 | |
Mexico | | 33 | | | 31 | | | 101 | | | 98 | |
Spain | | 29 | | | 33 | | | 97 | | | 97 | |
United Kingdom | | 59 | | | 61 | | | 174 | | | 173 | |
Other developed markets | | 121 | | | 127 | | | 354 | | | 350 | |
Other emerging markets | | 186 | | | 193 | | | 581 | | | 591 | |
| | 1,979 | | | 1,969 | | | 5,981 | | | 5,752 | |
Contract manufacturing & human health | | 23 | | | 21 | | | 59 | | | 57 | |
Total Revenue | | $ | 2,002 | | | $ | 1,990 | | | $ | 6,040 | | | $ | 5,809 | |
Revenue by major species | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
U.S. | | | | | | | | |
Companion animal | | $ | 819 | | | $ | 775 | | | $ | 2,488 | | | $ | 2,227 | |
Livestock | | 271 | | | 290 | | | 713 | | | 775 | |
| | 1,090 | | | 1,065 | | | 3,201 | | | 3,002 | |
International | | | | | | | | |
Companion animal | | 452 | | | 427 | | | 1,412 | | | 1,280 | |
Livestock | | 437 | | | 477 | | | 1,368 | | | 1,470 | |
| | 889 | | | 904 | | | 2,780 | | | 2,750 | |
Total | | | | | | | | |
Companion animal | | 1,271 | | | 1,202 | | | 3,900 | | | 3,507 | |
Livestock | | 708 | | | 767 | | | 2,081 | | | 2,245 | |
Contract manufacturing & human health | | 23 | | | 21 | | | 59 | | | 57 | |
Total Revenue | | $ | 2,002 | | | $ | 1,990 | | | $ | 6,040 | | | $ | 5,809 | |
Revenue by species | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Companion Animal: | | | | | | | | |
Dogs and Cats | | $ | 1,213 | | | $ | 1,142 | | | $ | 3,715 | | | $ | 3,319 | |
Horses | | 58 | | | 60 | | | 185 | | | 188 | |
| | 1,271 | | | 1,202 | | | 3,900 | | | 3,507 | |
Livestock: | | | | | | | | |
Cattle | | 371 | | | 403 | | | 1,063 | | | 1,144 | |
Swine | | 129 | | | 153 | | | 427 | | | 504 | |
Poultry | | 116 | | | 124 | | | 361 | | | 389 | |
Fish | | 60 | | | 56 | | | 151 | | | 132 | |
Sheep and other | | 32 | | | 31 | | | 79 | | | 76 | |
| | 708 | | | 767 | | | 2,081 | | | 2,245 | |
Contract manufacturing & human health | | 23 | | | 21 | | | 59 | | | 57 | |
Total Revenue | | $ | 2,002 | | | $ | 1,990 | | | $ | 6,040 | | | $ | 5,809 | |
Revenue by major product category | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Parasiticides | | $ | 422 | | | $ | 396 | | | $ | 1,417 | | | $ | 1,246 | |
Vaccines | | 449 | | | 421 | | | 1,300 | | | 1,251 | |
Dermatology | | 348 | | | 326 | | | 978 | | | 859 | |
Anti-infectives | | 284 | | | 329 | | | 802 | | | 909 | |
Other pharmaceuticals | | 252 | | | 243 | | | 771 | | | 717 | |
Animal health diagnostics | | 83 | | | 95 | | | 268 | | | 283 | |
Medicated feed additives | | 78 | | | 99 | | | 261 | | | 314 | |
Other non-pharmaceuticals | | 63 | | | 60 | | | 184 | | | 173 | |
| | 1,979 | | | 1,969 | | | 5,981 | | | 5,752 | |
Contract manufacturing & human health | | 23 | | | 21 | | | 59 | | | 57 | |
Total Revenue | | $ | 2,002 | | | $ | 1,990 | | | $ | 6,040 | | | $ | 5,809 | |
| | | | | | | | |
B. Revenue from Contracts with Customers
Contract liabilities reflected within Other current liabilities as of December 31, 2021 and 2020, and subsequently recognized as revenue during the first nine months of 2022 and 2021 were approximately $3 million and $4 million, respectively. Contract liabilities as of September 30, 2022 and December 31, 2021 were approximately $16 million and $12 million, respectively.
Estimated future revenue expected to be generated from long-term contracts with unsatisfied performance obligations as of September 30, 2022 is not material.
5. Acquisitions
During the second quarter of 2022, we completed the acquisition of Basepaws, a privately held petcare genetics company based in the U.S., which provides pet owners with genetic tests, analytics and early health risk assessments that can help manage the health, wellness and quality of care for their pets. This transaction did not have a significant impact on our consolidated financial statements.
During 2021, we entered into an agreement to acquire Jurox, a privately held animal health company based in Australia, which develops, manufactures and markets a wide range of veterinary medicines for treating companion animals and livestock. On September 30, 2022, after satisfying all customary closing conditions, including clearance from the Australian Competition and Consumer Commission, we completed the acquisition of Jurox. We acquired 100% of the outstanding shares for an aggregate purchase price of $226 million, adjusted to reflect cash, working capital and indebtedness as of the closing date for net cash consideration transferred to the seller of $215 million.
In 2021, we also acquired certain assets to expand our portfolio of equine care products, which did not have a significant impact on our consolidated financial statements.
6. Restructuring Charges and Other Costs Associated with Acquisitions, Cost-Reduction and 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 R&D, as well as enabling functions such as information 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 |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Restructuring charges and certain acquisition-related costs: | | | | | | | | |
| | | | | | | | |
Integration costs(a) | | $ | 1 | | | $ | 1 | | | $ | 4 | | | $ | 6 | |
Restructuring charges(b): | | | | | | | | |
Employee termination costs | | 2 | | | 7 | | | 2 | | | 17 | |
| | | | | | | | |
Asset impairment charges | | 2 | | | — | | | 2 | | | 13 | |
Exit costs | | 1 | | | 1 | | | 1 | | | 3 | |
Total Restructuring charges and certain acquisition-related costs | | $ | 6 | | | $ | 9 | | | $ | 9 | | | $ | 39 | |
(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 for the three and nine months ended September 30, 2022 represents employee termination and exit costs associated with cost-reduction and productivity initiatives in certain international markets, as well as asset impairment charges primarily related to the consolidation of manufacturing sites in China.
The restructuring charges for the three months ended September 30, 2021 primarily represents employee termination costs associated with the realignment of our international operations. The restructuring charges for the nine months ended September 30, 2021 primarily represents employee termination costs associated with our international operations and other costs associated with cost-reduction and productivity initiatives, as well as asset impairment charges related to the consolidation of manufacturing sites in China.
| | | | | | | | | | | | | | |
| | | | | | | | | | |
(MILLIONS OF DOLLARS) | | | | | | | | | | Accrual(a) |
Balance, December 31, 2021(a) | | | | | | | | | | $ | 25 | |
Provision | | | | | | | | | | 5 | |
Non-cash activity | | | | | | | | | | (2) | |
Utilization and other(b) | | | | | | | | | | (13) | |
| | | | | | | | | | |
Balance, September 30, 2022(a) | | | | | | | | | | $ | 15 | |
(a) At September 30, 2022 and December 31, 2021, included in Accrued expenses ($5 million and $14 million, respectively) and Other noncurrent liabilities ($10 million and $11 million, respectively).
(b) Includes adjustments for foreign currency translation.
7. Other (Income)/Deductions—Net
The components of Other (income)/deductions—net are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Royalty-related income | | $ | (1) | | | $ | (3) | | | $ | (3) | | | $ | (7) | |
Interest income | | (13) | | | (1) | | | (20) | | | (4) | |
Identifiable intangible asset impairment charges | | 1 | | | — | | | 1 | | | — | |
Other asset impairment charges | | — | | | 3 | | | — | | | 3 | |
Net loss on sale of assets | | — | | | — | | | — | | | 3 | |
Foreign currency loss(a) | | 11 | | | 8 | | | 36 | | | 20 | |
| | | | | | | | |
Other, net | | (1) | | | (3) | | | (8) | | | 1 | |
Other (income)/deductions—net | | $ | (3) | | | $ | 4 | | | $ | 6 | | | $ | 16 | |
(a) Primarily driven by costs related to hedging and exposures to certain emerging and developed market currencies.
8. Income Taxes
A. Taxes on Income
Our effective tax rate was 20.8% for the three months ended September 30, 2022, compared with 16.2% for the three months ended September 30, 2021. The higher effective tax rate for the three months ended September 30, 2022, 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, operating fluctuations in the normal course of business and the impact of non-deductible items and non-taxable items. In addition, the three months ended September 30, 2021 included a tax benefit related to foreign-derived intangible income.
Our effective tax rate was 20.0% for the nine months ended September 30, 2022, compared with 18.2% for the nine months ended September 30, 2021. The higher effective tax rate for the nine months ended September 30, 2022, 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, operating fluctuations in the normal course of business and the impact of non-deductible items and non-taxable items. In addition, the nine months ended September 30, 2021 included a tax benefit related to foreign-derived intangible income.
On August 16, 2022, the U.S. Inflation Reduction Act of 2022 (the “IRA”) was enacted which, among other changes, implements a 15% alternative minimum tax on financial statement income of certain large corporations, a 1% excise tax on net stock repurchases and several tax incentives to promote clean energy. The alternative minimum tax and excise tax are effective in taxable years beginning after December 31, 2022 and the incentives to promote clean energy have various different effective dates. We do not currently expect the IRA to have a material impact on our financial results, including our annual estimated effective tax rate, when it becomes effective. We will continue to evaluate its impact as further information becomes available and as additional guidance is provided by the U.S. Department of Treasury and the Internal Revenue Service.
B. Deferred Taxes
As of September 30, 2022, the total net deferred income tax liability of $145 million is included in Noncurrent deferred tax assets ($111 million) and Noncurrent deferred tax liabilities ($256 million).
As of December 31, 2021, the total net deferred income tax liability of $220 million is included in Noncurrent deferred tax assets ($100 million) and Noncurrent deferred tax liabilities ($320 million).
C. Tax Contingencies
As of September 30, 2022, the net tax liabilities associated with uncertain tax positions of $179 million (exclusive of interest and penalties related to uncertain tax positions of $16 million) are included in Noncurrent deferred tax assets and Other noncurrent assets ($1 million) and Other taxes payable ($178 million).
As of December 31, 2021, the net tax liabilities associated with uncertain tax positions of $189 million (exclusive of interest and penalties related to uncertain tax positions of $15 million) are included in Noncurrent deferred tax assets and Other noncurrent assets ($1 million) and Other taxes payable ($188 million).
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 do not expect that within the next twelve months any of our uncertain tax positions could significantly decrease as a result of settlements with taxing authorities or the expiration of the statutes of limitations. 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.
9. Financial Instruments
A. Debt
Credit Facilities
In December 2016, we entered into an amended and restated revolving credit agreement with a syndicate of banks providing for a multi-year $1.0 billion senior unsecured revolving credit facility (the credit facility). In December 2018, the maturity for the amended and restated credit facility was extended through December 2023. 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 4.00:1, and extends until the fourth full consecutive fiscal quarter ended immediately following the consummation of a material acquisition.
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 September 30, 2022 and December 31, 2021. There were no amounts drawn under the credit facility as of September 30, 2022 or December 31, 2021.
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 September 30, 2022, we had access to $50 million of lines of credit which expire at various times and are generally renewed annually. There were $3 million of borrowings outstanding related to these facilities as of September 30, 2022 and no borrowings outstanding related to these facilities as of December 31, 2021.
Commercial Paper Program
In February 2013, we entered into a commercial paper program with a capacity of up to $1.0 billion. As of September 30, 2022 and December 31, 2021, there was no commercial paper outstanding under this program.
Senior Notes and Other Long-Term Debt
On August 20, 2021, we redeemed, upon maturity, the $300 million aggregate principal amount of our 2018 floating rate senior notes due 2021 and the $300 million aggregate principal amount of our 2018 senior notes due 2021.
On May 12, 2020, we issued $1.25 billion aggregate principal amount of our senior notes (2020 senior notes), with an original issue discount of $10 million. These notes are comprised of $750 million aggregate principal amount of 2.000% senior notes due 2030 and $500 million aggregate principal amount of 3.000% senior notes due 2050. On October 13, 2020, the net proceeds were used to repay the $500 million aggregate principal amount of our 3.450% 2015 senior notes due 2020 and the remainder is being used for general corporate purposes. On August 20, 2018, we issued $1.5 billion aggregate principal amount of our senior notes (2018 senior notes), with an original issue discount of $4 million. On September 12, 2017, we issued $1.25 billion aggregate principal amount of our senior notes (2017 senior notes), with an original issue discount of $7 million. 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 (2013 senior notes offering) in a private placement, with an original issue discount of $10 million.
The 2013, 2015, 2017, 2018 and 2020 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, 2015, 2017, 2018 and 2020 senior notes may be declared immediately due and payable.
Pursuant to the indenture, we are able to redeem the 2013, 2015, 2017, 2018 and 2020 senior notes of any series, 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. Upon the occurrence of a change of control of us and a downgrade of the 2013, 2015, 2017, 2018 and 2020 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, 2015, 2017, 2018 and 2020 senior notes at a price equal to 101% of the aggregate principal amount of the 2013, 2015, 2017, 2018 and 2020 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: | | | | | | | | | | | | | | |
| | September 30, | | December 31, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 |
3.250% 2013 senior notes due 2023 | | $ | 1,350 | | | $ | 1,350 | |
4.500% 2015 senior notes due 2025 | | 750 | | | 750 | |
3.000% 2017 senior notes due 2027 | | 750 | | | 750 | |
3.900% 2018 senior notes due 2028 | | 500 | | | 500 | |
2.000% 2020 senior notes due 2030 | | 750 | | | 750 | |
4.700% 2013 senior notes due 2043 | | 1,150 | | | 1,150 | |
3.950% 2017 senior notes due 2047 | | 500 | | | 500 | |
4.450% 2018 senior notes due 2048 | | 400 | | | 400 | |
3.000% 2020 senior notes due 2050 | | 500 | | | 500 | |
| | 6,650 | | | 6,650 | |
Unamortized debt discount / debt issuance costs | | (56) | | | (60) | |
Less current portion of long-term debt | | 1,350 | | | — | |
Cumulative fair value adjustment for interest rate swap contracts | | (34) | | | 2 | |
Long-term debt, net of discount and issuance costs | | $ | 5,210 | | | $ | 6,592 | |
The fair value of our long-term debt was $4,575 million and $7,443 million as of September 30, 2022 and December 31, 2021, 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 September 30, 2022, matures in the following years: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | After | | |
(MILLIONS OF DOLLARS) | | 2022 | | 2023 | | 2024 | | 2025 | | 2026 | | 2026 | | Total |
Maturities | | $ | — | | | $ | 1,350 | | | $ | — | | | $ | 750 | | | $ | — | | | $ | 4,550 | | | $ | 6,650 | |
Interest Expense
Interest expense, net of capitalized interest, was $53 million and $159 million for the three and nine months ended September 30, 2022, respectively, and $56 million and $170 million for the three and nine months ended September 30, 2021, respectively. Capitalized interest expense was $5 million and $16 million for the three and nine months ended September 30, 2022, respectively, and $5 million and $14 million for the three and nine months ended September 30, 2021, 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-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 various derivative financial instruments. These derivative financial instruments serve to manage the exposure of our net investment in certain foreign operations to changes in foreign exchange rates and protect net income against the impact of translation into U.S. dollars of certain foreign exchange-denominated transactions.
All derivative financial instruments used to manage foreign currency risk are measured at fair value and are reported as assets or liabilities on the Condensed Consolidated Balance Sheets. The derivative financial instruments primarily offset exposures in the British pound, Canadian dollar, Chinese yuan, euro, Japanese yen and Norwegian krone. Changes in fair value are reported in earnings or in Accumulated other comprehensive income/(loss), depending on the nature and purpose of the financial instrument, as follows:
•For foreign currency forward-exchange contracts not designated as hedging instruments, we recognize the gains and losses 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. The vast majority of the foreign currency forward-exchange contracts mature within 60 days and all mature within three years.
•For foreign exchange derivative instruments that are designated as hedging instruments against our net investment in foreign operations, changes in the fair value are recorded as a component of cumulative translation adjustment within Accumulated other comprehensive income/(loss) and reclassified into earnings when the foreign investment is sold or substantially liquidated. These instruments include cross-currency interest rate swaps and foreign currency forward-exchange contracts. Gains and losses excluded from the assessment of hedge effectiveness are recognized in earnings (Interest expense—net of capitalized interest). The cash flows from these contracts are reflected within the investing section of our Condensed Consolidated Statement of Cash Flows. These contracts have varying maturities of up to three years.
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. Unrealized gains or losses on the forward-starting interest rate swaps are reported in Accumulated other comprehensive loss and are recognized in earnings 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.
•As of September 30, 2022, we had outstanding forward-starting interest rate swaps, having an effective date and mandatory termination date in March 2023, to hedge against interest rate exposure related principally to the anticipated future issuance of fixed-rate debt to be used primarily to refinance our 3.250% 2013 senior notes due 2023, and a forward-starting interest rate swap, having an effective date and mandatory termination date in March 2026, to hedge against interest rate exposure related principally to the anticipated future issuance of fixed-rate debt to be used primarily to refinance our 4.500% 2015 senior notes due 2025.
•We may use fixed-to-floating interest rate swaps that are designated as fair value hedges to hedge against changes in the fair value of certain fixed-rate debt attributable to changes in the benchmark LIBOR or the Secured Overnight Financing Rate (SOFR). These derivative instruments effectively convert a portion of the company’s long-term debt from fixed-rate to floating-rate debt based on three-month LIBOR or daily SOFR plus a spread. Gains or losses on the fixed-to-floating interest rate swaps due to changes in LIBOR or SOFR are recorded in Interest expense, net of capitalized interest. Changes in the fair value of the fixed-to-floating interest rate swaps are offset by changes in the fair value of the underlying fixed-rate debt. As of September 30, 2022, we had outstanding fixed-to-floating interest rate swaps that correspond to a portion of the 3.900% 2018 senior notes due 2028 and the 2.00% senior notes due 2030. The amounts recorded during the three and nine months ended September 30, 2022 for changes in the fair value of these hedges are not material to our consolidated financial statements.
Outstanding Positions
The aggregate notional amount of derivative instruments are as follows: | | | | | | | | | | | | | | |
| | Notional |
| | September 30, | | December 31, |
(MILLIONS) | | 2022 | | 2021 |
Derivatives not Designated as Hedging Instruments | | | | |
Foreign currency forward-exchange contracts | | $ | 1,989 | | | $ | 1,749 | |
| | | | |
Derivatives Designated as Hedging Instruments | | | | |
Foreign exchange derivative instruments (in foreign currency): | | | | |
Euro | | 650 | | | 650 | |
Danish krone | | 600 | | | 600 | |
Swiss franc | | 25 | | | 25 | |
| | | | |
| | | | |
Forward-starting interest rate swaps | | $ | 700 | | | $ | 550 | |
| | | | |
Fixed-to-floating interest rate swap contracts | | $ | 250 | | | $ | 200 | |
| | | | |
Fair Value of Derivative Instruments
The classification and fair values of derivative instruments are as follows: | | | | | | | | | | | | | | |
| | Fair Value of Derivatives |
| | September 30, | | December 31, |
(MILLIONS OF DOLLARS) | Balance Sheet Location | 2022 | | 2021 |
Derivatives Not Designated as Hedging Instruments | | | | |
Foreign currency forward-exchange contracts | Other current assets | $ | 14 | | | $ | 16 | |
Foreign currency forward-exchange contracts | Other current liabilities | (17) | | | (15) | |
Total derivatives not designated as hedging instruments | | $ | (3) | | | $ | 1 | |
| | | | |
Derivatives Designated as Hedging Instruments: | | | | |
Forward-starting interest rate swap contracts | Other current assets | $ | 102 | | | $ | — | |
Forward-starting interest rate swap contracts | Other noncurrent assets | 10 | | | 17 | |
| | | | |
Forward-starting interest rate swap contracts | Other noncurrent liabilities | — | | | (5) | |
Foreign exchange derivative instruments | Other current assets | 53 | | | 12 | |
Foreign exchange derivative instruments | Other noncurrent assets | 40 | | | 14 | |
Foreign exchange derivative instruments | Other current liabilities | — | | | (3) | |
| | | | |
| | | | |
Fixed-to-floating interest rate swap contracts | Other noncurrent assets | — | | | 2 | |
Fixed-to-floating interest rate swap contracts | Other noncurrent liabilities | (34) | | | — | |
Total derivatives designated as hedging instruments | | 171 | | | 37 | |
Total derivatives | | $ | 168 | | | $ | 38 | |
The company’s derivative transactions are subject to master netting agreements that mitigate credit risk by permitting net settlement of transactions with the same counterparty. The company also has collateral security agreements with certain of its counterparties. Under these collateral security agreements either party is required to post cash collateral when the net fair value of derivative instruments covered by the collateral agreement exceeds contractually established thresholds. At September 30, 2022, there was $63 million of collateral received and $16 million of collateral posted related to derivative instruments recorded in Other current liabilities and Other current assets, respectively. At December 31, 2021, there was $23 million of collateral received related to derivative instruments recorded in Other noncurrent assets.
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 losses on derivative instruments not designated as hedging instruments, recorded in Other (income)/deductions—net, are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Foreign currency forward-exchange contracts | | $ | (23) | | | $ | (2) | | | $ | (49) | | | $ | (13) | |
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 unrecognized net gains/(losses) on derivative instruments designated as hedging instruments, recorded, net of tax, in Accumulated other comprehensive loss, are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Forward-starting interest rate swap contracts | | $ | 30 | | | $ | 1 | | | $ | 77 | | | $ | 20 | |
Foreign exchange derivative instruments | | $ | 39 | | | $ | 16 | | | $ | 84 | | | $ | 33 | |
Gains on derivative instruments designated as hedging instruments, recognized within Interest expense, net of capitalized interest, are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Foreign exchange derivative instruments | | $ | 4 | | | $ | 3 | | | $ | 11 | | | $ | 9 | |
| | | | | | | | |
| | | | | | | | |
The net amount of deferred losses related to derivative instruments designated as cash flow hedges that is expected to be reclassified from Accumulated other comprehensive loss into earnings over the next 12 months is insignificant.
10. Inventories
The components of inventory are as follows: | | | | | | | | | | | | | | |
| | September 30, | | December 31, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 |
Finished goods | | $ | 1,026 | | | $ | 888 | |
Work-in-process | | 830 | | | 696 | |
Raw materials and supplies | | 447 | | | 339 | |
Inventories | | $ | 2,303 | | | $ | 1,923 | |
11. 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, 2021 | | $ | 1,424 | | | $ | 1,258 | | | $ | 2,682 | |
Additions | | 61 | | | — | | | 61 | |
Other(a) | | — | | | (51) | | | (51) | |
Balance, September 30, 2022 | | $ | 1,485 | | | $ | 1,207 | | | $ | 2,692 | |
(a) Includes adjustments for foreign currency translation.
The gross goodwill balance was $3,228 million and $3,218 million as of September 30, 2022 and December 31, 2021, respectively. Accumulated goodwill impairment losses (generated entirely in fiscal 2002) were $536 million as of September 30, 2022 and December 31, 2021.
B. Other Intangible Assets
The components of identifiable intangible assets are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | As of September 30, 2022 | | As of December 31, 2021 |
| | | | | | 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 | | $ | 1,865 | | | $ | (1,009) | | | $ | 856 | | | $ | 1,933 | | | $ | (949) | | | $ | 984 | |
Brands and tradenames | | 395 | | | (234) | | | 161 | | | 426 | | | (260) | | | 166 | |
Other | | 357 | | | (229) | | | 128 | | | 473 | | | (335) | | | 138 | |
Total finite-lived intangible assets | | 2,617 | | | (1,472) | | | 1,145 | | | 2,832 | | | (1,544) | | | 1,288 | |
Indefinite-lived intangible assets: | | | | | | | | | | | | |
Brands and tradenames | | 91 | | | — | | | 91 | | | 91 | | | — | | | 91 | |
In-process research and development | | 76 | | | — | | | 76 | | | 88 | | | — | | | 88 | |
Product rights | | 7 | | | — | | | 7 | | | 7 | | | — | | | 7 | |
Total indefinite-lived intangible assets | | 174 | | | — | | | 174 | | | 186 | | | — | | | 186 | |
Identifiable intangible assets | | $ | 2,791 | | | $ | (1,472) | | | $ | 1,319 | | | $ | 3,018 | | | $ | (1,544) | | | $ | 1,474 | |
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 $48 million and $147 million for the three and nine months ended September 30, 2022, respectively and $51 million and $154 million for the three and nine months ended September 30, 2021, respectively.
12. Share-based Payments
The Zoetis 2013 Equity and Incentive Plan (the Equity Plan) provides long-term incentives to our 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. At our 2022 Annual Shareholder Meeting on May 19, 2022, our shareholders approved our Amended and Restated Equity Plan, which, among other things, extended the plan termination date to May 19, 2032 and increased the number of shares approved for issuance from 25 million shares to 30 million shares.
The components of share-based compensation expense are as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
Stock options / stock appreciation rights | | $ | 2 | | | $ | 2 | | | $ | 7 | | | $ | 7 | |
RSUs / DSUs | | 9 | | | 8 | | | 26 | | | 25 | |
PSUs | | 4 | | | 5 | | | 13 | | | 12 | |
Share-based compensation expense—total(a) | | $ | 15 | | | $ | 15 | | | $ | 46 | | | $ | 44 | |
(a) Amounts capitalized to inventory were not material for the three and nine months ended September 30, 2022 and 2021.
During the nine months ended September 30, 2022, the company granted 235,900 stock options with a weighted-average exercise price of $201.23 per stock option and a weighted-average fair value of $51.13 per stock 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 1.81%; expected dividend yield of 0.64%; expected stock price volatility of 27.64%; and expected term of 4.9 years. In general, stock options vest after three 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 September 30, 2022, the company granted 205,095 RSUs, with a weighted-average grant date fair value of $200.66 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 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 September 30, 2022, the company granted 104,113 PSUs with a weighted-average grant date fair value of $235.52 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 stock market index at the start of the performance period, excluding companies that during the performance period are acquired or no longer publicly traded (Relative TSR). The weighted-average fair value was estimated based on volatility assumptions of Zoetis common stock and an average of the S&P 500 companies, which were 28.4% and 38.1%, respectively. Depending on the company’s Relative TSR performance at the end of the performance period, the recipient may earn from 0% to 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 December 2018, the company's Board of Directors authorized a $2.0 billion share repurchase program. This program was completed as of June 30, 2022. In December 2021, the company's Board of Directors authorized an additional $3.5 billion share repurchase program. As of September 30, 2022, there was approximately $3.0 billion remaining under this authorization. Purchases of Zoetis shares may be made at the discretion of management, depending on market conditions and business needs.
Accumulated other comprehensive loss
Changes, net of tax, in accumulated other comprehensive loss, were as follows: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | |
| | | | Currency Translation Adjustments | | | | |
| | | | | | Other Currency | | Benefit Plans | | Accumulated Other |
| | Cash Flow | | Net Investment | | Translation | | Actuarial | | Comprehensive |
(MILLIONS OF DOLLARS) | | Hedges | | Hedges | | Adjustments | | (Losses)/Gains | | Loss |
Balance, December 31, 2021 | | $ | 4 | | | $ | 5 | | | $ | (756) | | | $ | (17) | | | $ | (764) | |
Other comprehensive income/(loss), net of tax | | 78 | | | 84 | | | (208) | | | 1 | |
| (45) | |
| | | | | | | | | | |
Balance, September 30, 2022 | | $ | 82 | | | $ | 89 | | | $ | (964) | | | $ | (16) | | | $ | (809) | |
| | | | | | | | | | |
Balance, December 31, 2020 | | $ | (15) | | | $ | (37) | | | $ | (655) | | | $ | (23) | | | $ | (730) | |
Other comprehensive income, net of tax | | 21 | | | 33 | | | 9 | | | — | | | 63 | |
| | | | | | | | | | |
Balance, September 30, 2021 | | $ | 6 | | | $ | (4) | | | $ | (646) | | | $ | (23) | | | $ | (667) | |
14. Earnings per Share
The following table presents the calculation of basic and diluted earnings per share: | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Three Months Ended | | Nine Months Ended |
(MILLIONS OF DOLLARS AND SHARES, EXCEPT PER SHARE DATA) | | September 30, | | September 30, |
| 2022 | | 2021 | | 2022 | | 2021 |
Numerator | | | | | | | | |
Net income before allocation to noncontrolling interests | | $ | 528 | | | $ | 552 | | | $ | 1,651 | | | $ | 1,621 | |
Less: Net loss attributable to noncontrolling interests | | (1) | | | — | | | (2) | | | (2) | |
Net income attributable to Zoetis Inc. | | $ | 529 | | | $ | 552 | | | $ | 1,653 | | | $ | 1,623 | |
Denominator | | | | | | | | |
Weighted-average common shares outstanding | | 467.8 | | | 474.0 | | | 470.0 | | | 474.8 | |
Common stock equivalents: stock options, RSUs, PSUs and DSUs | | 1.3 | | | 2.3 | | | 1.6 | | | 2.3 | |
Weighted-average common and potential dilutive shares outstanding | | 469.1 | | | 476.3 | | | 471.6 | | | 477.1 | |
| | | | | | | | |
Earnings per share attributable to Zoetis Inc. stockholders—basic | | $ | 1.13 | | | $ | 1.16 | | | $ | 3.52 | | | $ | 3.42 | |
Earnings per share attributable to Zoetis Inc. stockholders—diluted | | $ | 1.13 | | | $ | 1.16 | | | $ | 3.51 | | | $ | 3.40 | |
The number of stock options outstanding under the company's Equity Plan that were excluded from the computation of diluted earnings per share, as the effect would have been antidilutive, were de minimis for the three and nine months ended September 30, 2022 and 2021.
15. Commitments and Contingencies
We and certain of our subsidiaries are subject to numerous contingencies arising in the ordinary course of business. For a discussion of our tax contingencies, see Note 8. Income Taxes.
A. Legal Proceedings
Our non-tax contingencies include, among others, the following:
• Product liability and other product-related litigation, which can include injury, consumer, off-label promotion, antitrust and breach of contract claims.
• Commercial and other matters, which can include product-pricing claims and environmental claims and proceedings.
• Patent litigation, which typically involves challenges to the coverage and/or validity of our patents or those of third parties on various products or processes.
• Government investigations, which can involve regulation by national, state and local government agencies in the U.S. and in other countries.
Certain of these contingencies could result in losses, including damages, fines and/or civil penalties, and/or criminal charges, which could be substantial.
We believe that we have strong defenses in these types of matters, but litigation is inherently unpredictable and excessive verdicts do occur. We do not believe that any of these matters will have a material adverse effect on our financial position. However, we could incur judgments, enter into settlements or revise our expectations regarding the outcome of certain matters, and such developments could have a material adverse effect on our results of operations or cash flows in the period in which the amounts are paid.
We have accrued for losses that are both probable and reasonably estimable. Substantially all of these contingencies are subject to significant uncertainties and, therefore, determining the likelihood of a loss and/or the measurement of any loss can be complex. Consequently, we are unable to estimate the range of reasonably possible loss in excess of amounts accrued. Our assessments are based on estimates and assumptions that have been deemed reasonable by management, but the assessment process relies on estimates and assumptions that may prove to be incomplete or inaccurate, and unanticipated events and circumstances may occur that might cause us to change those estimates and assumptions.
Amounts recorded for legal and environmental contingencies can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions.
The principal matters to which we are a party are discussed below. In determining whether a pending matter is significant for financial reporting and disclosure purposes, we consider both quantitative and qualitative factors in order to assess materiality, such as, among other things, the amount of damages and the nature of any other relief sought in the proceeding, if such damages and other relief are specified; our view of the merits of the claims and of the strength of our defenses; whether the action purports to be a class action and our view of the likelihood that a class will be certified by the court; the jurisdiction in which the proceeding is pending; any experience that we or, to our knowledge, other companies have had in similar proceedings; whether disclosure of the action would be important to a reader of our financial statements, including whether disclosure might change a reader’s judgment about our financial statements in light of all of the information about the company that is available to the reader; the potential impact of the proceeding on our reputation; and the extent of public interest in the matter. In addition, with respect to patent matters, we consider, among other things, the financial significance of the product protected by the patent.
Ulianopolis, Brazil
In February 2012, the Municipality of Ulianopolis (State of Para, Brazil) filed a complaint against Fort Dodge Saúde Animal Ltda. (FDSAL), a Zoetis entity, and five other large companies alleging that waste sent to a local waste incineration facility for destruction, but that was not ultimately destroyed as the facility lost its operating permit, caused environmental impacts requiring cleanup.
The Municipality is seeking recovery of cleanup costs purportedly related to FDSAL's share of all waste accumulated at the incineration facility awaiting destruction, and compensatory damages to be allocated among the six defendants. We believe we have strong arguments against the claim, including defense strategies against any claim of joint and several liability.
At the request of the Municipal prosecutor, in April 2012, the lawsuit was suspended for one year. Since that time, the prosecutor has initiated investigations into the Municipality's actions in the matter as well as the efforts undertaken by the six defendants to remove and dispose of their individual waste from the incineration facility. On October 3, 2014, the Municipal prosecutor announced that the investigation remained ongoing and outlined the terms of a proposed Term of Reference (a document that establishes the minimum elements to be addressed in the preparation of an Environmental Impact Assessment), under which the companies would be liable to withdraw the waste and remediate the area.
On March 5, 2015, we presented our response to the prosecutor’s proposed Term of Reference, arguing that the proposed terms were overly general in nature and expressing our interest in discussing alternatives to address the matter. The prosecutor agreed to consider our request to engage a technical consultant to conduct an environmental diagnostic of the contaminated area. On May 29, 2015, we, in conjunction with the other defendant companies, submitted a draft cooperation agreement to the prosecutor, which outlined the proposed terms and conditions for the engagement of a technical consultant to conduct the environmental diagnostic. On August 19, 2016, the parties and the prosecutor agreed to engage the services of a third-party consultant to conduct a limited environmental assessment of the site. The site assessment was conducted during June 2017, and a written report summarizing the results of the assessment was provided to the parties and the prosecutor in November 2017. The report noted that waste is still present on the site and that further (Phase II) environmental assessments are needed before a plan to manage that remaining waste can be prepared. On April 1, 2019, the defendants met with the Prosecutor to discuss the conclusions set forth in the written report. Following that discussion, on April 10, 2019, the Prosecutor issued a procedural order requesting that the defendants prepare and submit a technical proposal outlining the steps needed to conduct the additional Phase II environmental assessments. The defendants presented the technical proposal to the Prosecutor on October 21, 2019. On March 3, 2020, the Prosecutor notified the defendants that he submitted the proposal to the Ministry of the Environment for its review and consideration by the Prosecutor. On July 15, 2020, the Prosecutor recommended certain amendments to the proposal for the Phase II testing. On September 28, 2020, the parties and the Prosecutor agreed to the final terms and conditions concerning the cooperation agreement with respect to the Phase II testing. Due to the ongoing issues presented by the COVID-19 pandemic, the parties have been unable to secure a start date for the Phase II testing and have no timeline at this point for when testing will begin.
Lascadoil Contamination in Animal Feed
An investigation by the U.S. Food and Drug Administration (FDA) and the Michigan Department of Agriculture into the alleged contamination of the feed supply of certain turkey and hog feed mills in Michigan led to the recall of certain batches of soy oil (intended for use as an animal feed additive) that had originated with Shur-Green Farms LLC, a producer of soy oil, and that had been contaminated with lascadoil, an industrial by-product of certain Zoetis manufacturing processes. The contaminated feed is believed to have caused the deaths of approximately 50,000 turkeys and the contamination (but not death) of at least 20,000 hogs in August 2014. The investigation posited that Shur-Green inadvertently contaminated soy oil with lascadoil which it purchased from Zoetis for use as a bio-fuel ingredient, and then sold the contaminated soy oil to fat recycling vendors, who in turn unknowingly sold to feed mills for use in animal feed.
During the course of its investigation, the FDA identified the process used to manufacture Zoetis’ Avatec® (lasalocid sodium) and Bovatec® (lasalocid sodium) products as the possible source of the lascadoil, since lascadoil contains small amounts of lasalocid, the active ingredient found in both products. Zoetis sold the industrial lascadoil byproduct to Shur-Green, through its broker, Heritage Interactive Services, LLC. Under the terms of the sale agreement, the lascadoil could only be incinerated or resold for use in biofuel, and the agreement expressly prohibited the reselling of lascadoil for use as a component in food. The FDA inspected the Zoetis site where Avatec and Bovatec are manufactured, and found no evidence that Zoetis was involved in the contamination of the animal feed.
On March 10, 2015, plaintiffs Restaurant Recycling, LLC (Restaurant Recycling) and Superior Feed Ingredients, LLC (Superior), both of whom are in the fat recycling business, filed a complaint in the Seventeenth Circuit Court for the State of Michigan against Shur-Green Farms alleging negligence and breach of warranty claims arising from their purchase of soy oil allegedly contaminated with lascadoil. Plaintiffs resold the allegedly contaminated soy oil to turkey feed mills for use in feed ingredient. Plaintiffs also named Zoetis as a defendant in the complaint alleging that Zoetis failed to properly manufacture its products and breached an implied warranty that the soy oil was fit for use at turkey and hog mills. Zoetis was served with the complaint on June 3, 2015, and we filed our answer, denying all allegations, on July 15, 2015. On August 10, 2015, several of the turkey feed mills filed a joint complaint against Restaurant Recycling, Superior, Shur-Green Farms and others, alleging claims for negligence, misrepresentation, and breach of warranty, arising out of their alleged purchase and use of the contaminated soy oil. The complaint raises only one count against Zoetis for negligence. We filed an answer to the complaint on November 2, 2015, denying the allegation. On May 16, 2016, two additional turkey producers filed a complaint in the Seventeenth Circuit Court for the State of Michigan against the company, Restaurant Recycling, Superior, Shur-Green Farms and others, alleging claims for negligence and breach of warranties. We filed an answer to the complaint on June 20, 2016, denying the allegations. The Court has consolidated all three cases in Michigan for purposes of discovery and disposition. On July 28, 2017, we filed a motion for summary disposition on the grounds that no genuine issues of material fact exist and that Zoetis is entitled to judgment as a matter of law. On October 19, 2017, the Court granted our motion and dismissed all claims against Zoetis. On October 31, 2017, the plaintiffs filed motions for reconsideration of the Court's decision granting summary disposition. The Court, denied all such motions on December 6, 2017, for the same reasons cited in the Court’s original decision. On December 27, 2017, the plaintiffs filed a request with the Michigan Court of Appeals seeking an interlocutory (or interim) appeal of the lower Court’s decision, which we opposed on January 17, 2018. On July 5, 2018, the Court of Appeals denied the plaintiffs’ request for an interlocutory appeal. The case was remanded back to the lower Court, where it was scheduled to proceed to trial by jury. We have been advised that the remaining parties have reached an agreement to settle the dispute, and on June 24, 2020, the remaining parties jointly stipulated to the dismissal of all remaining claims. On July 13, 2020, Plaintiffs filed a claim of appeal with Michigan Court of Appeals seeking
reversal of the lower Court’s decision granting Zoetis’ motion for summary disposition. Plaintiffs’ filed their appeal brief on October 29, 2020, and we filed our reply brief on December 3, 2020. The Court of Appeals heard oral arguments on December 7, 2021.
On September 15, 2022, the Court of Appeals affirmed the lower Court’s ruling in favor of Zoetis. The plaintiffs do not have an automatic right to appeal the decision of the Court of Appeals; rather, they must petition the Supreme Court of Michigan for leave to appeal further. On October 27, 2022, the plaintiffs filed an application to the Michigan Supreme Court for leave to appeal the Court of Appeals' opinion. We have until November 24, 2022, by which to oppose that application.
Belgium Excess Profit Tax Regime
On February 14, 2019, the General Court of the European Union (General Court) annulled the January 11, 2016 decision of the European Commission (EC) that selective tax advantages granted by Belgium under its "excess profit" tax scheme constitute illegal state aid. As a result of the 2016 decision, the company recorded a net tax charge of approximately $35 million in the first half of 2016. On May 8, 2019, the EC filed an appeal to the decision of the General Court. On September 16, 2019, the EC opened separate in-depth investigations to assess whether Belgium excess profit rulings granted to 39 multinational companies, including Zoetis, constituted state aid for those companies. On September 16, 2021, the European Court of Justice upheld the EC’s decision that the Belgium excess profit ruling system is considered an aid scheme and referred the case back to the General Court to rule on open questions. On May 24, 2022, the General Court resumed all proceedings involved with the Excess Profit Rulings cases, including Zoetis. On June 23, 2022, as requested by the General Court, the company provided observations in relations to (i) the impact of the Court of Justice’s decision that the Belgium excess profit ruling system is considered an aid scheme and (ii) the impact of recent case laws by the General Court with regards to the existence of a selective advantage. The company has not reflected any potential benefits in its consolidated financial statements as of September 30, 2022 as a result of the 2019 annulment. We will continue to monitor the developments of the appeal and its ultimate resolution.
B. Guarantees and Indemnifications
In the ordinary course of business and in connection with the sale of assets and businesses, we indemnify our counterparties against certain liabilities that may arise in connection with the transaction or related to activities prior to the transaction. These indemnifications typically pertain to environmental, tax, employee and/or product-related matters and patent-infringement claims. If the indemnified party were to make a successful claim pursuant to the terms of the indemnification, we would be required to reimburse the loss. These indemnifications are generally subject to threshold amounts, specified claim periods and other restrictions and limitations. Historically, we have not paid significant amounts under these provisions and, as of September 30, 2022, recorded amounts for the estimated fair value of these indemnifications were not significant.
16. Segment Information
Operating Segments
We manage our operations through two geographic operating segments: the U.S. and International. Each operating segment has responsibility for its commercial activities. Within each of these operating segments, we offer a diversified product portfolio, including parasiticides, vaccines, dermatology, anti-infectives, other pharmaceuticals, animal health diagnostics and medicated feed additives, for both companion animal and livestock customers. Our chief operating decision maker uses the revenue and earnings of the two operating segments, among other factors, for performance evaluation and resource allocation.
Other Costs and Business Activities
Certain costs are not allocated to our operating segment results, such as costs associated with the following:
• Other business activities, includes our Client Supply Services (CSS) contract manufacturing results, our human health business, and expenses associated with our dedicated veterinary medicine research and development organization, research alliances, U.S. regulatory affairs and other operations focused on the development of our products. Other R&D-related costs associated with non-U.S. market and regulatory activities are generally included in the international commercial segment.
• Corporate, includes enabling functions such as information technology, facilities, legal, finance, human resources, business development, certain diagnostic costs and communications, among others. These costs also include compensation costs and other miscellaneous operating expenses not charged to our operating segments, as well as interest income and expense.
•Certain transactions and events such as (i) Purchase accounting adjustments, where we incur expenses associated with the amortization of fair value adjustments to inventory, intangible assets and property, plant and equipment; (ii) Acquisition-related activities, where we incur costs associated with acquiring and integrating newly acquired businesses, such as transaction costs and integration costs; and (iii) Certain significant items, which comprise substantive, unusual items that, either as a result of their nature or size, would not be expected to occur as part of our normal business on a regular basis, such as restructuring charges and implementation costs associated with our cost-reduction/productivity initiatives that are not associated with an acquisition, certain asset impairment charges, certain legal and commercial settlements and the impact of divestiture-related gains and losses.
•Other unallocated includes (i) certain overhead expenses associated with our global manufacturing operations not charged to our operating segments; (ii) certain costs associated with finance that specifically support our global manufacturing operations; (iii) certain supply chain and global logistics costs; and (iv) procurement costs.
Segment Assets
We manage our assets on a total company basis, not by operating segment. Therefore, our chief operating decision maker does not regularly review any asset information by operating segment and, accordingly, we do not report asset information by operating segment.
Selected Statement of Income Information
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Earnings | | Depreciation and Amortization(a) |
| | Three Months Ended | | Three Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
U.S. | | | | | | | | |
Revenue | | $ | 1,090 | | | $ | 1,065 | | | | | |
Cost of sales | | 204 | | | 199 | | | | | |
Gross profit | | 886 | | | 866 | | | | | |
Gross margin | | 81.3 | % | | 81.3 | % | | | | |
Operating expenses | | 206 | | | 183 | | | | | |
Other (income)/deductions-net | | 1 | | | — | | | | | |
U.S. Earnings | | 679 | | | 683 | | | $ | 12 | | | $ | 13 | |
| | | | | | | | |
International | | | | | | | | |
Revenue(b) | | 889 | | | 904 | | | | | |
Cost of sales | | 256 | | | 273 | | | | | |
Gross profit | | 633 | | | 631 | | | | | |
Gross margin | | 71.2 | % | | 69.8 | % | | | | |
Operating expenses | | 150 | | | 152 | | | | | |
Other (income)/deductions-net | | (3) | | | (4) | | | | | |
International Earnings | | 486 | | | 483 | | | 21 | | | 17 | |
| | | | | | | | |
Total operating segments | | 1,165 | | | 1,166 | | | 33 | | | 30 | |
| | | | | | | | |
Other business activities | | (106) | | | (106) | | | 7 | | | 6 | |
Reconciling Items: | | | | | | | | |
Corporate | | (245) | | | (252) | | | 33 | | | 29 | |
Purchase accounting adjustments | | (40) | | | (45) | | | 40 | | | 45 | |
Acquisition-related costs | | (1) | | | (1) | | | — | | | — | |
Certain significant items(c) | | (6) | | | (12) | | | — | | | — | |
Other unallocated | | (100) | | | (91) | | | 2 | | | — | |
Total Earnings(d) | | $ | 667 | | | $ | 659 | | | $ | 115 | | | $ | 110 | |
(a) Certain production facilities are shared. Depreciation and amortization is allocated to the reportable operating segments based on estimates of where the benefits of the related assets are realized.
(b) Revenue denominated in euros was $183 million and $204 million for the three months ended September 30, 2022 and 2021, respectively.
(c) For the three months ended September 30, 2022, primarily represents employee termination and exit costs associated with cost-reduction and productivity initiatives in certain international markets, as well as asset impairment charges related to the consolidation of manufacturing sites in China.
For the three months ended September 30, 2021, primarily represents employee termination costs associated with the realignment of our international operations and asset impairment charges related to a dairy product termination.
(d) Defined as income before provision for taxes on income.
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Earnings | | Depreciation and Amortization(a) |
| | Nine Months Ended | | Nine Months Ended |
| | September 30, | | September 30, |
(MILLIONS OF DOLLARS) | | 2022 | | 2021 | | 2022 | | 2021 |
U.S. | | | | | | | | |
Revenue | | $ | 3,201 | | | $ | 3,002 | | | | | |
Cost of sales | | 587 | | | 575 | | | | | |
Gross profit | | 2,614 | | | 2,427 | | | | | |
Gross margin | | 81.7 | % | | 80.8 | % | | | | |
Operating expenses | | 578 | | | 484 | | | | | |
Other (income)/deductions-net | | (6) | | | 2 | | | | | |
U.S. Earnings | | 2,042 | | | 1,941 | | | $ | 40 | | | $ | 40 | |
| | | | | | | | |
International | | | | | | | | |
Revenue(b) | | 2,780 | | | 2,750 | | | | | |
Cost of sales | | 809 | | | 833 | | | | | |
Gross profit | | 1,971 | | | 1,917 | | | | | |
Gross margin | | 70.9 | % | | 69.7 | % | | | | |
Operating expenses | | 456 | | | 429 | | | | | |
Other (income)/deductions-net | | (5) | | | (4) | | | | | |
International Earnings | | 1,520 | | | 1,492 | | | 62 | | | 52 | |
| | | | | | | | |
Total operating segments | | 3,562 | | | 3,433 | | | 102 | | | 92 | |
| | | | | | | | |
Other business activities | | (315) | | | (301) | | | 21 | | | 20 | |
Reconciling Items: | | | | | | | | |
Corporate | | (771) | | | (744) | | | 99 | | | 84 | |
Purchase accounting adjustments | | (120) | | | (133) | | | 120 | | | 133 | |
Acquisition-related costs | | (4) | | | (8) | | | — | | | — | |
Certain significant items(c) | | (10) | | | (44) | | | — | | | — | |
Other unallocated | | (278) | | | (221) | | | 4 | | | 2 | |
Total Earnings(d) | | $ | 2,064 | | | $ | 1,982 | | | $ | 346 | | | $ | 331 | |
(a) Certain production facilities are shared. Depreciation and amortization is allocated to the reportable operating segments based on estimates of where the benefits of the related assets are realized.
(b) Revenue denominated in euros was $590 million and $605 million for the nine months ended September 30, 2022 and 2021, respectively.
(c) For the nine months ended September 30, 2022, primarily represents inventory and asset impairment charges related to the consolidation of manufacturing sites in China, as well as employee termination and exit costs associated with cost-reduction and productivity initiatives in certain international markets.
For the nine months ended September 30, 2021, primarily represents asset impairment charges related to the consolidation of manufacturing sites in China and a dairy product termination, as well as employee termination costs associated with our international operations and other costs associated with cost-reduction and productivity initiatives.
(d) Defined as income before provision for taxes on income.
17. Subsequent Events
On September 30, 2022, after satisfying all customary closing conditions, including clearance from the Australian Competition and Consumer Commission, we completed the acquisition of Jurox. The closing of the transaction occurred subsequent to the Balance Sheet date for subsidiaries operating outside the U.S., as referenced in Note 2. Basis of Presentation. See Note 5. Acquisitions for additional information regarding the terms of the transaction.