Zoetis Inc. (ZTS) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Introduction

Our management’s discussion and analysis of financial condition and results of operations (MD&A) is provided to assist readers in understanding our performance, as reflected in the results of our operations, our financial condition and our cash flows. This MD&A should be read in conjunction with our consolidated financial statements and notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data. The discussion in this MD&A contains forward-looking statements that involve substantial risks and uncertainties. Our objective is to also provide discussion of material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be indicative of future results, which could differ materially from historical performance and from those anticipated in the forward-looking statements as a result of various factors such as those discussed in Item 1A. Risk Factors and Forward-looking statements and factors that may affect future results sections of this MD&A.

A discussion regarding our financial condition and results of operations for fiscal 2021 compared to fiscal 2020 is presented below. A discussion regarding our financial condition and results of operations for fiscal 2020 compared to fiscal 2019 can be found under Item 7 of Part II of our Annual Report on Form 10-K for the fiscal year ended December 31, 2020, filed with the SEC on February 16, 2021 (our “2020 Annual Report”), which is available free of charge on the SEC’s website at www.sec.gov.

Overview of our business

We are 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. For 70 years, we have been innovating ways to predict, prevent, detect, and treat animal illness, and continue to stand by those raising and caring for animals worldwide - from livestock farmers to veterinarians and pet owners.

We manage our operations through two geographic operating segments: the United States (U.S.) and International. Within each of these operating segments, we offer a diversified product portfolio for both companion animals and livestock customers in order to capitalize on local and regional trends and customer needs. See Notes to Consolidated Financial Statements—Note 19. Segment Information.

We directly market our products to veterinarians and livestock producers located in approximately 45 countries across North America, Europe, Africa, Asia, Australia and South America, and are a market leader in nearly all of the major regions in which we operate. Through our efforts to establish an early and direct presence in many emerging markets, such as Brazil, Chile, China and Mexico, we believe we are one of the largest animal health medicines and vaccines businesses as measured by revenue across emerging markets as a whole. In markets where we do not have a direct commercial presence, we generally contract with distributors that provide logistics and sales and marketing support for our products.

We believe our investments in one of the industry’s largest sales organizations, including our extensive network of technical and veterinary operations specialists, our high-quality manufacturing and reliability of supply, and our long track record of developing products that meet customer needs, has led to enduring and valued relationships with our customers. Our research and development (R&D) efforts enable us to deliver innovative products to address unmet needs and evolve our product lines so they remain relevant for our customers.

We have approximately 300 product lines that we sell in over 100 countries for the prediction, prevention, detection and treatment of diseases and conditions that affect various companion animal and livestock species. The diversity of our product portfolio and our global operations provides stability to our overall business. For instance, in livestock, impacts on our revenue that may result from disease outbreaks or weather conditions in a particular market or region are often offset by increased sales in other regions from exports and other species as consumers shift to other proteins.

A summary of our 2021 performance compared with the comparable 2020 and 2019 periods follows:

(a)    Adjusted net income is a non-GAAP financial measure. See the Non-GAAP financial measures and Adjusted net income sections of this MD&A for more information.

Our operating environment

Industry

The animal health industry, which focuses on both companion animals and livestock, is a growing industry that impacts billions of people worldwide. The primary companion animal species are dogs, cats and horses. Factors influencing growth in demand for companion animal medicines, vaccines and diagnostics include:

•economic development and related increases in disposable income, particularly in many emerging markets;

•increasing pet ownership and pet owners’ commitment to the health and well-being of their pets;

•companion animals living longer;

•increasing medical treatment of companion animals; and

•advances in companion animal medicines, vaccines and diagnostics.

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The primary livestock species for the production of animal protein are cattle (both beef and dairy), swine, poultry, fish and sheep. Livestock health and production are essential to meeting the growing demand for animal protein of a global population. Factors influencing growth in demand for livestock medicines and vaccines include:

•human population growth and increasing standards of living, particularly in many emerging markets;

•increasing demand for improved nutrition, particularly animal protein;

•natural resource constraints, such as scarcity of arable land, fresh water and increased competition for cultivated land, resulting in fewer resources that will be available to meet an increasing demand for animal protein;

•increasing urbanization; and

•increased focus on food safety and food security.

Product development initiatives

Our future success depends on both our existing product portfolio and our pipeline of new products, including new products that we may develop through joint ventures and products that we are able to obtain through license or acquisition. We believe we are an industry leader in animal health R&D, with a track record of generating new products and product lifecycle innovation. The majority of our R&D programs focus on product lifecycle innovation, which is defined as R&D programs that leverage existing animal health products by adding new species or claims, achieving approvals in new markets or creating new combinations and reformulations. In addition to traditional medicines and vaccines, we develop products across additional categories to address the needs of veterinarians and producers to predict, prevent, detect and treat conditions in both companion animals and livestock, including products and services in diagnostics, genetics, precision animal health and digital and data analytics.

Perceptions of product quality, safety and reliability

We believe that animal health customers value high-quality manufacturing and reliability of supply. The importance of quality and safety concerns to pet owners, veterinarians and livestock producers also contributes to animal health brand loyalty, which often continues after the loss of patent-based and regulatory exclusivity. We depend on positive perceptions of the safety and quality of our products by our customers, veterinarians and end-users.

In addition, negative beliefs about animal health products generally could impact demand for our products. For example, the issue of the potential transfer of increased antibacterial resistance in bacteria from food-producing animals to human pathogens, and the causality of that transfer, continue to be the subject of global scientific and regulatory discussion. Antibacterials refer to small molecules that can be used to treat or prevent bacterial infections and are a sub-categorization of the products that make up our anti-infectives and medicated feed additives portfolios. In some countries, this issue has led to government restrictions and bans on the use of specific antibacterials in some food-producing animals, regardless of the route of administration (in feed or injectable). These restrictions are more prevalent in countries where animal protein is plentiful and governments are willing to take action even when there is scientific uncertainty. In addition, consumer preferences in some markets have impacted the use of antibacterials in food producing animals. Such restrictions and consumer preferences in some cases may negatively impact sales of our antibacterial products, but in other instances may increase sales of our products that can be used as antibacterial alternatives. Our total revenue attributable to antibacterials for livestock was approximately $1.1 billion for the year ended December 31, 2021.

Similarly, concerns regarding greenhouse gas emissions and other potential environmental impacts of livestock production have led to some consumers opting to limit or avoid consuming animal products. However, we believe the impact of this trend is limited as the livestock industry is still expected to continue to grow in order to feed a growing global population.

Changing distribution channels for companion animal products

In most markets, companion animal owners typically purchase their animal health products directly from veterinarians. However, in the U.S. and certain other markets, companion animal owners increasingly have the option to purchase animal health products from sources other than veterinarians, such as Internet-based retailers, “big-box” retail stores or other over-the-counter distribution channels. This trend has been demonstrated by the shift away from the veterinarian distribution channel in the sale of flea and tick products in recent years and has been accelerated by the increase in e-commerce during the COVID-19 pandemic. We believe the ability of pet owners to purchase our products online and from retail stores may increase pet owner compliance and result in increased sales, particularly in the near term. However, over time, we may be unable to sustain our current margins due to the increased purchasing power of such retailers as compared to traditional veterinary practices.

In addition, this trend could negatively impact the sales of products we primarily sell through the veterinarian distribution channel, as any decrease in visits to veterinarians by companion animal owners could reduce our market share and sales of such products. A reduction in the number of pet owners who purchase our products directly from their veterinarian could also lead to increased use of generic alternatives to our products or the increased substitution of our products with other animal health products or human health products if such other products are deemed to be lower-cost alternatives.

The overall economic environment

In addition to industry-specific factors, we, like other businesses, face challenges related to global economic conditions. Growth in both the livestock and companion animal sectors is driven by overall economic development and related growth, particularly in many emerging markets. In the past, certain of our customers and suppliers have been affected directly by economic downturns, which decreased the demand for our products and, in some cases, hindered our ability to collect amounts due from customers.

The cost of medicines and vaccines to our livestock producer customers is small relative to other production costs, including feed, and the use of these products is intended to improve livestock producers’ economic outcomes. As a result, demand for our products has historically been more stable than demand for other production inputs. Similarly, industry sources have reported that pet owners indicated a preference for reducing spending on other aspects of their lifestyle, including entertainment, clothing and household goods, before reducing spending on pet care. Each of these factors, plus our broad and innovative portfolio, contributes to our ability to incorporate inflationary challenges into our product pricing and mitigate the impact on our results. While these factors have mitigated the impact of prior downturns in the global economy, future economic

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challenges, including inflation, could increase cost sensitivity among our customers, which may result in reduced demand for our products, which could have a material adverse effect on our operating results and financial condition.

Competition

The animal health industry is highly competitive. Although our business is the largest based on revenue in the animal health industry (which includes medicines, vaccines and diagnostics), we face competition in the regions in which we operate. Principal methods of competition vary depending on the particular region, species, product category or individual product. Some of these methods include new product development, quality, price, service and promotion to veterinary professionals, pet owners and livestock producers. Our competitors include standalone animal health businesses and the animal health businesses of large pharmaceutical companies. In recent years, there has been an increase in consolidation in the animal health industry. There are also many start-up companies working in the animal health area. In addition to competition from established market participants, there could be new entrants to the animal health medicines, vaccines and diagnostics industry in the future. We also compete with companies that produce generic products, following our products’ loss of exclusivity in a given market. For example, Draxxin currently competes with generic products in key markets including the U.S., Europe, Canada, Mexico and Australia. For more information regarding the generic competition we currently have and expect to encounter as patents on certain of our key products expire, see Item 1. Business – Intellectual Property.

Weather conditions, climate change and the availability of natural resources

The animal health industry and demand for many of our animal health products in a particular region are affected by weather conditions, as usage of our products follows varying weather patterns and weather-related pressures from pests, such as ticks. As a result, we may experience regional and seasonal fluctuations in our results of operations.

In addition, veterinary hospitals and practitioners depend on visits from and access to the animals under their care. Veterinarians’ patient volume and ability to operate could be adversely affected if they experience prolonged snow, ice or other severe weather conditions, particularly in regions not accustomed to sustained inclement weather. Furthermore, weather conditions, including excessive cold or heat, natural disasters and other events, could negatively impact our livestock customers by impairing the health or growth of their animals or the production or availability of feed, as well as disrupting their normal operations. For example, livestock producers depend on the availability of natural resources, including large supplies of fresh water. Their animals’ health and their ability to operate could be adversely affected if they experience a shortage of fresh water due to human population growth, climate change or floods, droughts or other weather conditions. In the event of adverse weather conditions, climate-change related impacts or a shortage of fresh water, veterinarians and livestock producers may purchase less of our products.

For example, drought conditions could negatively impact, among other things, the supply of corn and the availability of grazing pastures. A decrease in harvested corn results in higher corn prices, which could negatively impact the profitability of livestock producers of cattle, pork and poultry. Higher corn prices and reduced availability of grazing pastures contribute to reductions in herd or flock sizes that in turn result in less spending on animal health products. As such, a prolonged drought could have a material adverse impact on our operating results and financial condition.

Adverse weather conditions, natural disasters and climate change may also impact the aquaculture business. Changes in water temperatures could affect the timing of reproduction and growth of various fish species, as well as trigger the outbreak of certain waterborne diseases.

Uncertainty Relating to COVID-19

We continue to closely monitor the impact of the coronavirus (COVID-19) pandemic and the resulting global recession on all aspects of our business across geographies, including how it has and may continue to impact our customers, workforce, suppliers and vendors. Although we are unable to fully predict the impact that the COVID-19 pandemic will ultimately have on our future financial position and operating results, we continue to monitor the potential effects, including impacts on our supply chain, the effect on customer demand, and changes to our operations. We cannot predict the impact that the COVID-19 pandemic will have on our customers, vendors and suppliers; however, any material effect on these parties could adversely impact us.

The situation surrounding COVID-19 remains fluid, and we will continue to actively monitor the situation and may take actions that alter our business operations that we determine are in the best interests of our workforce, customers, vendors, suppliers, and other stakeholders, or as required by federal, state, or local authorities.

For further information regarding the impact of COVID-19 on the Company, see Item 1A, Risk Factors in this Annual Report on Form 10-K.

Disease Outbreaks

Sales of our livestock products have in the past, and may in the future be, adversely affected by the outbreak of disease carried by animals. Outbreaks of disease may reduce regional or global sales of particular animal-derived food products or result in reduced exports of such products, either due to heightened export restrictions or import prohibitions, which may reduce demand for our products. Also, the outbreak of any highly contagious disease near our main production sites could require us to immediately halt production of our products at such sites or force us to incur substantial expenses in procuring raw materials or products elsewhere. Alternatively, sales of products that treat specific disease outbreaks may increase.

Manufacturing and supply

In order to sell our products, we must be able to produce and ship our products in sufficient quantities. Many of our products involve complex manufacturing processes and are sole-sourced from certain manufacturing sites. Minor deviations in our manufacturing or logistical processes, such as temperature excursions or improper package sealing, could result in delays, inventory shortages, unanticipated costs, product recalls, product liability and/or regulatory action. In addition, a number of factors could cause production interruptions that could result in launch delays, inventory shortages, recalls, unanticipated costs or issues with our agreements under which we supply third parties.

In 2021, we experienced isolated supply challenges for Librela, Solensia and some of our other products, resulting from strong demand as well as competition for manufacturing inputs with human health vaccine development during the pandemic. Some of these challenges are expected to continue in 2022, but are being managed by our global manufacturing network through certain supply chain optimizations, controlled launches for new products in additional markets and customer coordination.

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Our manufacturing network may be unable to meet the demand for our products or we may have excess capacity if demand for our products changes. The unpredictability of a product's regulatory or commercial success or failure, the lead time necessary to construct highly technical and complex manufacturing sites, and shifting customer demand increase the potential for capacity imbalances.

Foreign exchange rates

Significant portions of our revenue and costs are exposed to changes in foreign exchange rates. Our products are sold in more than 100 countries and, as a result, our revenue is influenced by changes in foreign exchange rates. For the year ended December 31, 2021, approximately 44% of our revenue was denominated in foreign currencies. 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. As we operate in multiple foreign currencies, including the Australian dollar, Brazilian real, British pound, Canadian dollar, Chinese yuan, euro and other currencies, changes in those currencies relative to the U.S. dollar will impact our revenue, cost of goods and expenses, and consequently, net income. Exchange rate fluctuations may also have an impact beyond our reported financial results and directly impact operations. These fluctuations may affect the ability to buy and sell our goods and services between markets impacted by significant exchange rate variances. For the year ended December 31, 2021, approximately 56% of our total revenue was in U.S. dollars. Our year-over-year total revenue growth was favorably impacted by 1% from changes in foreign currency values relative to the U.S. dollar.

Our growth strategies

We seek to enhance the health of animals and to bring solutions to our customers who raise and care for them. We have a global presence in both developed and emerging markets and across eight core species. We intend to grow our business by pursuing the following core strategies:

•drive innovative growth - We seek to deliver new products and solutions as well as lifecycle innovations across the continuum of care that spans from disease prediction and prevention to detection and treatment. We are focused on innovating across vaccines, pharmaceuticals, diagnostics, genetics, biodevices, and other product segments, and across all core species. Where appropriate, we complement internal R&D programs with external innovations;

•enhance customer experience - We believe that delighting our customers with compelling and personalized experiences that enable them to provide the best care for animals is critical for our success. We are focused on providing greater value to our customers through the integration and connectedness of our portfolio and by reducing frictions in the way they engage with us and our products and solutions;

•lead in digital and data analytics - We believe that healthcare insights enabled by data and digital technology and complemented with our comprehensive portfolio of products and solutions will be critical in enhancing care for animals and improving livestock productivity;

•cultivate a high-performing organization - We view the strength of our leadership team and our talented colleagues around the world as a critical component of our past and future success. We are committed to continuing to be a company our colleagues can be proud of and to attracting, retaining and developing the best, most diverse talent in the industry. We are further committed to sustaining a diverse, equitable and inclusive work environment for our colleagues; and

•champion a healthier, more sustainable future - As the world’s leading animal health company, our business purpose is well aligned with our social purpose. We strive to make a meaningful difference in society through the three pillars of our sustainability approach: (1) by caring and collaborating with our customers, colleagues, and communities, and the animals that depend on them by improving access to care for animals, by creating a diverse, equitable, and inclusive work environment, and by supporting the veterinary profession; (2) by leveraging our innovation capabilities to develop solutions that improve productivity, keep animals healthy, and fight emerging infectious diseases; and (3) by taking actions to protect our planet that reduce our footprint on the environment.

Components of revenue and costs and expenses

Our revenue, costs and expenses are reported for the year ended December 31 for each year presented, except for operations outside the U.S., for which the financial information is included in our consolidated financial statements for the fiscal year ended November 30 for each year presented.

Revenue

Our revenue is primarily derived from our diversified product portfolio of medicines, vaccines and diagnostic products and services used to treat and protect companion animals and livestock. 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. In 2021, our two top-selling products, Apoquel and Simparica/Simparica Trio, each contributed approximately 10% of our revenue, and combined with our next three top-selling products, Revolution/Revolution Plus/Stronghold, Cytopoint and the ceftiofur line, these five contributed approximately 33% of our revenue. Our ten top-selling product lines contributed 47% of our revenue. For additional information regarding our products, including descriptions of our product lines that each represented approximately 1% or more of our revenue in 2021, see Item 1. Business—Products.

Costs and expenses

Costs of sales consist primarily of cost of materials, facilities and other infrastructure used to manufacture our medicine and vaccine products, as well as costs to operate our reference labs and royalty expenses associated with the intellectual property of our products, when relevant.

Selling, general and administrative (SG&A) expenses consist of, among other things, the internal and external costs of marketing, promotion, advertising and shipping and handling as well as certain costs related to business technology, facilities, legal, finance, human resources, business development, public affairs and procurement.

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Research and development (R&D) expenses consist primarily of project costs specific to new product R&D and product lifecycle innovation, overhead costs associated with R&D operations and investments that support local market clinical trials for approved indications and expenses related to regulatory approvals for our products. We do not disaggregate R&D expenses by research stage or by therapeutic area for purposes of managing our business.

Amortization of intangible assets consists primarily of the amortization expense for identifiable finite-lived intangible assets that have been acquired through business combinations. These assets consist of, but are not limited to, developed technology, brands and trademarks.

Restructuring charges and certain acquisition-related costs consist of all restructuring charges (those associated with acquisition activity and those associated with cost reduction/productivity initiatives), as well as costs associated with acquiring and integrating businesses. Restructuring charges are associated with employees, assets and activities that will not continue in the company. Acquisition-related costs are associated with acquiring and integrating acquired businesses, such as Abaxis in 2018, and may include transaction costs and expenditures for consulting and the integration of systems and processes.

Other (income)/deductions—net consists of various items, primarily net (gains)/losses on asset disposals, interest income, royalty-related income, foreign exchange translation (gains)/losses and certain asset impairment charges.

Significant accounting policies and application of critical accounting estimates

In presenting our financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. For a description of our significant accounting policies, see Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies.

We believe that the following accounting policies are critical to an understanding of our consolidated financial statements as they require the application of the most difficult, subjective and complex judgments and, therefore, could have the greatest impact on our financial statements: (i) fair value; (ii) revenue; (iii) asset impairment reviews; and (iv) contingencies.

Below are some of our more critical accounting estimates. See also Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies: Estimates and Assumptions for a discussion about the risks associated with estimates and assumptions.

Fair value

For a discussion about the application of fair value to our long-term debt and financial instruments, see Notes to Consolidated Financial Statements—

Note 9. Financial Instruments.

For a discussion about the application of fair value to our business combinations, see Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies: Fair Value.

For a discussion about the application of fair value to our asset impairment reviews, see Asset impairment reviews below.

Revenue

Our gross product revenue is subject to deductions that are generally estimated and recorded in the same period that the revenue is recognized and primarily represents sales returns and revenue incentives. For example:

•for sales returns, we perform calculations in each market that incorporate the following, as appropriate: local returns policies and practices; returns as a percentage of revenue; an understanding of the reasons for past returns; estimated shelf life by product; an estimate of the amount of time between shipment and return or lag time; and any other factors that could impact the estimate of future returns, product recalls, discontinuation of products or a changing competitive environment; and

•for revenue incentives, we use our historical experience with similar incentives programs to estimate the impact of such programs on revenue.

If any of our ratios, factors, assessments, experiences or judgments are not indicative or accurate predictors of our future experience, our results could be materially affected. Although the amounts recorded for these revenue deductions are dependent on estimates and assumptions, historically our adjustments to actual results have not been material. The sensitivity of our estimates can vary by program, type of customer and geographic location.

Amounts recorded for revenue deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. For further information about the risks associated with estimates and assumptions, see Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies: Estimates and Assumptions.

Asset impairment reviews

We review all of our long-lived assets for impairment indicators throughout the year and we perform detailed testing whenever impairment indicators are present. In addition, we perform impairment testing for goodwill and indefinite-lived intangible assets at least annually. When necessary, we record charges for impairments of long-lived assets for the amount by which the fair value is less than the carrying value of these assets.

Our impairment review processes are described below and in Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies: Amortization of Intangible Assets, Depreciation and Certain Long-Lived Assets and, for deferred tax assets, in Note 3. Significant Accounting Policies: Deferred Tax Assets and Liabilities and Income Tax Contingencies.

Examples of events or circumstances that may be indicative of impairment include:

•a significant adverse change in the extent or manner in which an asset is used. For example, restrictions imposed by the regulatory authorities could affect our ability to manufacture or sell a product; and

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•a projection or forecast that demonstrates losses or reduced profits associated with an asset. This could result, for example, from the introduction of a competitor’s product that results in a significant loss of market share or the inability to achieve the previously projected revenue growth, or from the lack of acceptance of a product by customers.

For finite-lived identifiable intangible assets, such as developed technology rights, and for other long-lived assets, such as property, plant and equipment, whenever impairment indicators are present, we calculate the undiscounted value of the projected cash flows associated with the asset, or asset group, and compare this estimated amount to the carrying amount. If the carrying amount is found to be greater, we record an impairment loss for the excess of book value over fair value. In addition, in all cases of an impairment review, we re-evaluate the remaining useful lives of the assets and modify them, as appropriate.

Our impairment reviews of most of our long-lived assets depend on the determination of fair value, as defined by U.S. GAAP, and these judgments can materially impact our results of operations. A single estimate of fair value can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. For information about the risks associated with estimates and assumptions, see Notes to Consolidated Financial Statements—Note 3. Significant Accounting Policies: Estimates and Assumptions.

Intangible assets other than goodwill

We test indefinite-lived intangible assets for impairment at least annually, or more frequently if impairment indicators exist, by first assessing qualitative factors to determine whether it is more likely than not that the fair value of the indefinite-lived intangible asset is less than its carrying amount. If we conclude it is more likely than not that the fair value is less than the carrying amount, a quantitative test that compares the fair value of the indefinite-lived intangible asset with its carrying value is performed. If the fair value is less than the carrying amount, an impairment loss is recognized. Impairments of identifiable intangible assets other than goodwill, are recorded in Restructuring charges and certain acquisition-related costs and Other (income)/deductions—net, as applicable. We did not have any significant intangible asset impairment charges for the years ended December 31, 2021, 2020 and 2019.

When we are required to determine the fair value of intangible assets other than goodwill, we use an income approach, specifically the multi-period excess earnings method, also known as the discounted cash flow method. We start with a forecast of all the expected net cash flows associated with the asset, which includes the application of a terminal value for indefinite-lived assets, and then we apply an asset-specific discount rate to arrive at a net present value amount. Some of the more significant estimates and assumptions inherent in this approach include: the amount and timing of the projected net cash flows, which includes the expected impact of competitive, legal and/or regulatory forces on the projections, the impact of technological risk associated with IPR&D assets, as well as the selection of a long-term growth rate; the discount rate, which seeks to reflect the risks inherent in the projected cash flows; foreign currency fluctuations; and the effective tax rate, which seeks to incorporate the geographic diversity of the projected cash flows.

While all identifiable intangible assets can be impacted by events and thus lead to impairment, in general, identifiable intangible assets that are at the highest risk of impairment include IPR&D assets (approximately $88 million as of December 31, 2021). IPR&D assets are higher-risk assets because R&D is an inherently risky activity.

For a description of our accounting policy, see Notes to Consolidated Financial Statements—Note 3. Significant Accounting Policies: Amortization of Intangible Assets, Depreciation and Certain Long-Lived Assets.

Goodwill

Goodwill represents the excess of the consideration transferred over the fair value of net assets of businesses purchased and is assigned to reporting units. We test goodwill for impairment on at least an annual basis, or more frequently if necessary, either by assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount or by performing a periodic quantitative assessment.

Factors considered in the qualitative assessment include general macroeconomic conditions, conditions specific to the industry and market, cost factors which could have a significant effect on earnings or cash flows, the overall financial performance of the reporting unit and whether there have been sustained declines in our share price. Additionally, we evaluate the extent to which the fair value exceeded the carrying value of the reporting unit at the date of the last quantitative assessment performed.

When performing a quantitative assessment to test for goodwill impairment we utilize the income approach, which is forward-looking, and relies primarily on internal forecasts. Within the income approach, the method that we use is the discounted cash flow method. We start with a forecast of all the expected net cash flows associated with the reporting unit, which includes the application of a terminal value, and then apply a reporting unit-specific discount rate to arrive at a net present value. Some of the more significant estimates and assumptions inherent in this approach include: the amount and timing of the projected net cash flows, which includes the expected impact of technological risk and competitive, legal and/or regulatory forces on the projections, as well as the selection of a long-term growth rate; the discount rate, which seeks to reflect the various risks inherent in the projected cash flows; and the effective tax rate, which seeks to incorporate the geographic diversity of the projected cash flows.

We test goodwill for impairment on at least an annual basis, or more frequently if necessary, either by assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount or by performing a periodic quantitative assessment. In 2021 and 2020, we performed a periodic quantitative impairment assessment as of September 30, 2021 and 2020, respectively, which did not result in the impairment of goodwill associated with any of our reporting units.

For all of our reporting units, there are a number of future events and factors that may impact future results and that could potentially have an impact on the outcome of subsequent goodwill impairment testing. For a list of these factors, see Forward-looking statements and factors that may affect future results.

For a description of our accounting policy, see Notes to Consolidated Financial Statements— Note 3. Significant Accounting Policies: Amortization of Intangible Assets, Depreciation and Certain Long-Lived Assets.

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Contingencies

For a discussion about income tax contingencies, see Notes to Consolidated Financial Statements— Note 8D. Tax Matters: Tax Contingencies.

For a discussion about legal contingencies, guarantees and indemnifications, see Notes to Consolidated Financial Statement— Note 18. Commitments and Contingencies.

Non-GAAP financial measures

We report information in accordance with U.S. generally accepted accounting principles (GAAP). Management also measures performance using non-GAAP financial measures that may exclude certain amounts from the most directly comparable GAAP measure. Despite the importance of these measures to management in goal setting and performance measurement, non-GAAP financial measures have no standardized meaning prescribed by U.S. GAAP and, therefore, have limits in their usefulness to investors and may not be comparable to the calculation of similar measures of other companies. We present certain identified non-GAAP measures solely to provide investors with useful information to more fully understand how management assesses performance.

Operational Growth

We believe that it is important to not only understand overall revenue and earnings growth, but also “operational growth.” Operational growth is a non-GAAP financial measure defined as revenue or earnings growth excluding the impact of foreign exchange. This measure provides information on the change in revenue and earnings as if foreign currency exchange rates had not changed between the current and prior periods to facilitate a period-to-period comparison. We believe this non-GAAP measure provides a useful comparison to previous periods for the company and investors, but should not be viewed as a substitute for U.S. GAAP reported growth.

Adjusted Net Income and Adjusted Earnings Per Share

Adjusted net income and the corresponding adjusted earnings per share (EPS) are non-GAAP financial measures of performance used by management. We believe these financial measures are useful supplemental information to investors when considered together with our U.S. GAAP financial measures. We report adjusted net income to portray the results of our major operations, and the discovery, development, manufacture and commercialization of our products, prior to considering certain income statement elements. We define adjusted net income and adjusted EPS as net income attributable to Zoetis and EPS before the impact of purchase accounting adjustments, acquisition-related costs and certain significant items.

We recognize that, as an internal measure of performance, the adjusted net income and adjusted EPS measures have limitations, and we do not restrict our performance management process solely to these metrics. A limitation of the adjusted net income and adjusted EPS measures is that they provide a view of our operations without including all events during a period, such as the effects of an acquisition or amortization of purchased intangibles, and do not provide a comparable view of our performance to other companies. The adjusted net income and adjusted EPS measures are not, and should not be viewed as, a substitute for U.S. GAAP reported net income attributable to Zoetis and reported EPS. See the Adjusted Net Income section below for more information.

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Analysis of the Consolidated Statements of Income

The following discussion and analysis of our Consolidated Statements of Income should be read along with our consolidated financial statements, and the notes thereto.

* Calculation not meaningful.

(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.

Revenue

Total revenue by operating segment was as follows:

On a global basis, the mix of revenue between companion animal and livestock products was as follows:

2021 vs. 2020

Total revenue increased by $1,101 million, or 16%, in 2021 compared with 2020 reflecting operational revenue growth of $1,002 million, or 15%. Operational revenue growth was primarily due to the following:

•volume growth from in-line products, including key dermatology products, of approximately 9%;

•volume growth from new products of approximately 5%; and

•price growth of approximately 1%.

Foreign exchange increased our reported revenue growth by approximately 1%.

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Costs and Expenses

Cost of sales

2021 vs. 2020

Cost of sales as a percentage of revenue decreased from 31% to 30% in 2021 compared with 2020, primarily as a result of:

•favorable product mix;

•lower inventory obsolescence, scrap and other charges;

•favorable foreign exchange; and

•price increases,

partially offset by:

•higher freight and import costs; and

•unfavorable manufacturing and other costs.

Selling, general and administrative expenses

2021 vs. 2020

SG&A expenses increased $275 million, or 16%, in 2021 compared with 2020, primarily as a result of:

•an increase in certain compensation-related costs;

•an increase in investments to support revenue growth;

•higher freight and logistics costs;

•higher charitable contributions; and

•unfavorable foreign exchange,

partially offset by:

•the reduced impact of purchase accounting adjustments and certain significant items.

Research and development expenses

2021 vs. 2020

R&D expenses increased $45 million, or 10%, in 2021 compared with 2020, primarily as a result of:

•an increase in certain compensation-related costs to support innovation;

•increased spending driven by project investments; and

•unfavorable foreign exchange.

Amortization of intangible assets

2021 vs. 2020

Amortization of intangible assets increased $1 million, or 1%, in 2021 compared with 2020, primarily as a result of certain intangible assets acquired during 2021 and 2020.

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Restructuring charges and certain acquisition-related costs

2021 vs. 2020

Restructuring charges and certain acquisition-related costs increased by $18 million in 2021 compared with 2020. Restructuring charges and certain acquisition-related costs in 2021 primarily consisted of employee termination costs associated with the realignment of our international operations and other costs associated with cost-reduction and productivity initiatives, asset impairment charges related to the consolidation of manufacturing sites in China and integration costs related to recent acquisitions. Restructuring charges and certain acquisition-related costs in 2020 consisted of integration costs related to acquisitions, restructuring charges related to CEO transition-related costs and employee termination costs related to other cost-reduction and productivity initiatives.

For additional information regarding restructuring charges and acquisition-related costs, see Notes to Consolidated Financial Statements— Note 6. Restructuring Charges and Other Costs Associated with Acquisitions, Cost-Reduction and Productivity Initiatives.

Interest expense, net of capitalized interest

2021 vs. 2020

Interest expense, net of capitalized interest, decreased by $7 million, or 3%, in 2021 compared with 2020, primarily as a result of the redemption of $500 million aggregate principal amount of our senior notes in October 2020, as well as the redemption of our $300 million aggregate principal amount of our 2018 floating rate senior notes and the $300 million aggregate principal amount of our 2018 senior notes in August 2021, partially offset by the issuance of $1.25 billion aggregate principal amount of our senior notes in May 2020 and lower gains on cross-currency interest rate swaps as compared to the prior year.

Other (income)/deductions—net

* Calculation not meaningful.

2021 vs. 2020

The change in Other (income)/deductions—net is primarily as a result of a net gain in 2020 related to a cash payment received pursuant to an agreement related to the 2016 sale of a certain U.S. manufacturing site, as well as higher foreign currency losses and lower interest income in the current year, partially offset by an impairment of an equity investment in the prior year.

Provision for taxes on income

The income tax provision in the Consolidated Statements of Income includes tax costs and benefits, such as uncertain tax positions, repatriation decisions and audit settlements, among others.

2021 vs. 2020

The higher effective tax rate in 2021 compared with 2020 is primarily due to the following components:

•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 and non-taxable items. In addition, 2021 includes a tax benefit related to foreign-derived intangible income;

•a $6 million and $19 million discrete tax benefit recorded in 2021 and 2020, respectively, related to changes in various other tax items;

•a $7 million discrete tax benefit recorded in 2020 related to a remeasurement of deferred tax assets and liabilities resulting from the integration of acquired businesses;

•a $1 million discrete tax expense and a $4 million discrete tax benefit recorded in 2021 and 2020, respectively, related to a remeasurement of deferred tax assets and liabilities as a result of changes in statutory tax rates; and

•a $24 million and $29 million discrete tax benefit recorded in 2021 and 2020, respectively, related to the excess tax benefits for share-based payments,

partially offset by:

•a $5 million discrete tax expense recorded in 2020 related to changes in valuation allowances; and

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•an $8 million and $4 million discrete tax benefit recorded in 2021 and 2020, respectively, related to the effective settlement of certain issues with tax authorities.

Operating Segment Results

Beginning in the first quarter of 2021, certain costs associated with information technology that specifically support our global manufacturing operations, which were previously reported in Other unallocated, are now reported in Corporate. In addition, in the first quarter of 2021, the company realigned certain management responsibilities. These changes did not impact the determination of our operating segments, however they resulted in the reallocation of certain costs between segments. These changes primarily include the following: (i) certain diagnostics costs, which were previously reported in Corporate, are now reported in our U.S. results; and (ii) certain other miscellaneous costs, which were previously reported in our U.S. results, are now reported in Corporate.

In 2020, the company realigned certain management responsibilities. These changes did not impact the determination of our operating segments, however they resulted in the reallocation of certain costs between segments. These changes primarily include the following: (i) R&D costs related to our aquaculture business, which were previously reported in our international commercial segment, are now reported in Other business activities; (ii) certain other miscellaneous costs, which were previously reported in international commercial segment results, are now reported in Corporate; and (iii) certain diagnostics and other miscellaneous costs, which were previously reported in our U.S. results, are now reported in Corporate.

Certain reclassifications of prior year information have been made to conform to the current year's presentation.

On a global basis, the mix of revenue between companion animal and livestock products was as follows:

Earnings by segment and the operational and foreign exchange changes versus the comparable prior year period were as follows:

* Calculation not meaningful.

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2021 vs. 2020

U.S. operating segment

U.S. segment revenue increased by $485 million, or 14%, in 2021 compared with 2020, of which $599 million resulted from growth in companion animal products, offset by a $114 million decline in livestock products.

•Companion animal revenue growth was driven primarily by increased sales of parasiticides including Simparica Trio, as well as the ProHeart and Revolution/Stronghold franchises. In-line product growth benefited from increased sales of our key dermatology portfolio, vaccines and diagnostics products.

•Livestock revenue declined due to cattle, poultry and swine. Cattle product sales declined as a result of increased generic competition and challenges in the beef and dairy end-markets due to rising input costs. The poultry portfolio declined as a result of the expanded use of lower cost alternatives and smaller flock sizes reducing disease pressure, as well as generic competition. The decline in swine product sales was primarily due to pricing pressures on our anti-infective and vaccine portfolio and a non-recurring government purchase in the prior year.

U.S. segment earnings increased by $330 million, or 15%, in 2021 compared with 2020, primarily due to revenue and gross margin growth, partially offset by higher operating expenses.

International operating segment

International segment revenue increased by $617 million, or 20%, in 2021 compared with 2020. Operational revenue growth was $519 million, or 17%, reflecting growth of $383 million in companion animal products and $136 million in livestock products.

•Companion animal operational revenue growth resulted primarily from increased sales of our parasiticide products including the Simparica/Simparica Trio and Revolution/Stronghold franchises. Also contributing to growth were our key dermatology portfolio, vaccine products, the recent launches of our mAb therapies, Librela and Solensia, and diagnostics products. Growth across the broader in-line portfolio benefited from increased pet ownership and standards of care.

•Livestock operational revenue growth was primarily driven by increased sales in cattle, swine and fish. Growth in cattle product sales was mainly due to the effect of marketing campaigns, key account penetration and favorable export market conditions in Brazil and favorable conditions in other emerging markets. Sales of swine products grew as a result of expanding pork production in the wake of African Swine Fever in China in the first half of the year. Fish growth was due to an increase in sales of the Alpha Flux sea lice treatment product, an increase in vaccine sales in key salmon markets and the 2020 acquisition of Fish Vet Group.

•Additionally, International segment revenue was favorably impacted by foreign exchange which increased revenue by approximately $98 million, or 3%, primarily driven by the euro, Chinese yuan, Australian dollar and Canadian dollar, partially offset by the Brazilian real and Argentinian peso.

International segment earnings increased by $401 million, or 26%, in 2021 compared with 2020. Operational earnings growth was $324 million, or 21%, primarily due to revenue and gross margin growth, partially offset by higher operating expenses.

Other business activities

Other business activities includes our CSS contract manufacturing results, our human health business and expenses associated with our dedicated veterinary medicine R&D 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 segment.

2021 vs. 2020

Other business activities net loss increased by $34 million, or 9%, in 2021 compared with 2020, reflecting an increase in R&D costs due to an increase in compensation-related costs, an increase in project investments and unfavorable foreign exchange.

Reconciling items

Reconciling items include certain costs that are not allocated to our operating segments results, such as costs associated with the following:

•Corporate, which includes certain costs associated with information technology, facilities, legal, finance, human resources, business development and communications, among others. These costs also include certain compensation costs, certain procurement costs, and other miscellaneous operating expenses that are not charged to our operating segments, as well as interest income and expense;

•Certain transactions and events such as (i) Purchase accounting adjustments, which includes expenses associated with the amortization of fair value adjustments to inventory, intangible assets and property, plant and equipment; (ii) Acquisition-related activities, which includes costs for acquisition and integration; and (iii) Certain significant items, which includes non-acquisition-related restructuring charges, certain asset impairment charges, certain legal and commercial settlements, and costs associated with cost reduction/productivity initiatives; and

•Other unallocated, which 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) certain procurement costs.

2021 vs. 2020

Corporate expenses increased by $173 million, or 20%, in 2021 compared with 2020, primarily due to increases in certain compensation-related costs, investments in information technology, charitable contributions and unfavorable foreign exchange. Lower interest income was offset by lower interest expense.

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Other unallocated expenses increased by $31 million, or 11%, in 2021 compared with 2020, primarily due to higher manufacturing costs, higher freight charges and unfavorable foreign exchange, partially offset by lower inventory obsolescence, scrap and other charges.

See Notes to Consolidated Financial Statements— Note 19. Segment Information for further information.

Adjusted net income

General description of adjusted net income (a non-GAAP financial measure)

Adjusted net income is an alternative view of performance used by management, and we believe that investors’ understanding of our performance is enhanced by disclosing this performance measure. The adjusted net income measure is an important internal measurement for us. Additionally, we measure our overall performance on this basis in conjunction with other performance metrics. The following are examples of how the adjusted net income measure is utilized:

•senior management receives a monthly analysis of our operating results that is prepared on an adjusted net income basis;

•our annual budgets are prepared on an adjusted net income basis; and

•other goal setting and performance measurements.

Purchase accounting adjustments

Adjusted net income is calculated prior to considering certain significant purchase accounting impacts that result from business combinations and net asset acquisitions. These impacts, primarily associated with the acquisition of Abaxis (acquired in July 2018), the Pharmaq business (acquired in November 2015), certain assets of Abbott Animal Health (acquired in February 2015), King Animal Health (acquired in 2011), Fort Dodge Animal Health (acquired in 2009), and Pharmacia Animal Health business (acquired in 2003), include amortization related to the increase in fair value of the acquired finite-lived intangible assets and depreciation related to the increase/decrease to fair value of the acquired fixed assets. Therefore, the adjusted net income measure includes the revenue earned upon the sale of the acquired products without considering the aforementioned significant charges.

While certain purchase accounting adjustments can occur through 20 or more years, this presentation provides an alternative view of our performance that is used by management to internally assess business performance. We believe the elimination of amortization attributable to acquired intangible assets provides management and investors an alternative view of our business results by providing a degree of parity to internally developed intangible assets for which R&D costs previously have been expensed.

A completely accurate comparison of internally developed intangible assets and acquired intangible assets cannot be achieved through adjusted net income. These components of adjusted net income are derived solely from the impact of the items listed above. We have not factored in the impact of any other differences in experience that might have occurred if we had discovered and developed those intangible assets on our own, and this approach does not intend to be representative of the results that would have occurred in those circumstances. For example, our R&D costs in total, and in the periods presented, may have been different; our speed to commercialization and resulting revenue, if any, may have been different; or our costs to manufacture may have been different. In addition, our marketing efforts may have been received differently by our customers. As such, in total, there can be no assurance that our adjusted net income amounts would have been the same as presented had we discovered and developed the acquired intangible assets.

Acquisition-related costs

Adjusted net income is calculated prior to considering transaction and integration costs associated with significant business combinations or net asset acquisitions because these costs are unique to each transaction and represent costs that were incurred to acquire and integrate certain businesses as a result of the acquisition decision. We have made no adjustments for the resulting synergies.

We believe that viewing income prior to considering these charges provides investors with a useful additional perspective because the significant costs incurred in a business combination result primarily from the need to eliminate duplicate assets, activities or employees––a natural result of acquiring a fully integrated set of activities. For this reason, we believe that the costs incurred to convert disparate systems, to close duplicative facilities or to eliminate duplicate positions (for example, in the context of a business combination) can be viewed differently from those costs incurred in the ordinary course of business.

The integration costs associated with a business combination may occur over several years, with the more significant impacts generally ending within three years of the transaction. Because of the need for certain external approvals for some actions, the span of time needed to achieve certain restructuring and integration activities can be lengthy. For example, due to the regulated nature of the animal health medicines and vaccines business, the closure of excess facilities can take several years, as all manufacturing changes are subject to extensive validation and testing and must be approved by the FDA and/or other regulatory authorities.

Certain significant items

Adjusted net income is calculated excluding certain significant items. Certain significant items represent substantive, unusual items that are evaluated on an individual basis. Such evaluation considers both the quantitative and the qualitative aspect of their unusual nature. Unusual, in this context, may represent items that are not part of our ongoing business; items that, either as a result of their nature or size, we would not expect to occur as part of our normal business on a regular basis; items that would be nonrecurring; or items that relate to products that we no longer sell. While not all-inclusive, examples of items that could be included as certain significant items would be costs related to a major non-acquisition-related restructuring charge and associated implementation costs for a program that is specific in nature with a defined term, such as those related to our non-acquisition-related cost-reduction and productivity initiatives; amounts related to disposals of products or facilities that do not qualify as discontinued operations as defined by U.S. GAAP; certain intangible asset impairments; adjustments related to the resolution of certain tax positions; significant currency devaluation; the impact of adopting certain significant, event-driven tax legislation; costs related to our CEO transition in fiscal 2020; or charges related to legal matters. See Notes to Consolidated Financial Statements— Note 18. Commitments and Contingencies. Our normal, ongoing defense costs or settlements of and accruals on legal matters made in the normal course of our business would not be considered certain significant items.

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Reconciliation

A reconciliation of net income attributable to Zoetis, as reported under U.S. GAAP, to adjusted net income follows:

* Calculation not meaningful.

(a)    The effective tax rate on adjusted pretax income is 18.6%, 18.3% and 18.2% in 2021, 2020 and 2019, respectively.

The higher effective tax rate for 2021, compared with 2020, was primarily attributable to (i) changes in the jurisdictional mix of earnings, which includes the impact of the location of earnings, repatriation costs, operating fluctuations in the normal course of business and the impact of non-deductible and non-taxable items. In addition, 2021 includes a tax benefit related to foreign-derived intangible income, (ii) a $7 million and $20 million net discrete tax benefit recorded in 2021 and 2020, respectively, related to changes in other tax items, (iii) a $24 million and $29 million discrete tax benefit recorded in 2021 and 2020, respectively, related to the excess tax benefits for share-based payments, and (iv) a $1 million discrete tax expense and a $3 million discrete tax benefit recorded in 2021 and 2020, respectively, related to a remeasurement of deferred tax assets and liabilities as a result of changes in statutory tax rates, partially offset by an $8 million and $4 million net discrete tax benefit recorded in 2021 and 2020, respectively, related to the effective settlement of certain issues with tax authorities.

The higher effective tax rate for 2020, compared with 2019, was primarily attributable to (i) changes in the jurisdictional mix of earnings, which includes the impact of the location of earnings, repatriation costs, operating fluctuations in the normal course of business and the impact of non-deductible and non-taxable items, (ii) an $18 million net discrete tax benefit recorded in 2019 related to changes in valuation allowances, and (iii) a $4 million and $10 million net discrete tax benefit recorded in 2020 and 2019, respectively, related to the effective settlement of certain issues with tax authorities, partially offset by (i) a $20 million and $4 million net discrete tax benefit recorded in 2020 and 2019, respectively, related to changes in other tax items, and (ii) a $29 million and $20 million discrete tax benefit recorded in 2020 and 2019, respectively, related to the excess tax benefits for share-based payments.

A reconciliation of reported diluted earnings per share (EPS), as reported under U.S. GAAP, to non-GAAP adjusted diluted EPS follows:

* Calculation not meaningful.

(a)    Diluted earnings per share was computed using the weighted-average common shares outstanding during the period plus the common stock equivalents related to stock options, restricted stock units, performance-vesting restricted stock units and deferred stock units.

Adjusted net income includes the following charges for each of the periods presented:

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Adjusted net income, as shown above, excludes the following items:

(a)    Amortization and depreciation expenses related to Purchase accounting adjustments with respect to identifiable intangible assets and property, plant and equipment.

(b)    Income taxes include the tax effect of the associated pre-tax amounts, calculated by determining the jurisdictional location of the pre-tax amounts and applying that jurisdiction's applicable tax rate.

Income taxes in Purchase accounting adjustments also includes:

•For 2021, tax benefits related to a remeasurement of deferred tax assets and liabilities as a result of changes in statutory tax rates.

•For 2020, a tax benefit related to a remeasurement of deferred tax assets and liabilities resulting from the integration of acquired businesses and changes in statutory tax rates.

•For 2019, tax benefits related to a remeasurement of deferred tax assets and liabilities as a result of changes in statutory tax rates and an adjustment related to a change in tax basis.

Income taxes in Acquisition-related costs also includes:

•For 2020, a tax expense related to a remeasurement of deferred tax assets and liabilities resulting from the integration of acquired businesses.

Income taxes in Certain significant items also includes:

•For 2020, a tax expense related to changes in valuation allowances related to impairments of acquired assets.

(c)    Primarily represents employee and lease termination costs related to the 2018 acquisition of Abaxis.

(d)    For 2020 and 2019, represents net gain resulting from payments received pursuant to an agreement related to the 2016 sale of certain U.S. manufacturing sites.

(e)    Primarily represents product transfer costs related to cost-reduction and productivity initiatives, included in Cost of sales.

(f)    For 2021, primarily represents employee termination costs associated with the realignment of our international operations and other costs associated with cost-reduction and productivity initiatives. For 2020 and 2019, represents employee termination costs incurred as a result of the CEO transition.

(g)    For 2021, primarily represents asset impairment charges related to:

•Developed technology rights and trademarks in our dairy cattle, diagnostics and aquatic health businesses, included in Other (income)/deductions-net;

•The consolidation of manufacturing sites in China, included in Restructuring charges and certain acquisition related costs; and

•Property, plant and equipment and inventory related to a dairy product termination included in Other (income)/deductions-net and Cost of sales.

For 2020, primarily represents asset impairment charges related to:

•Developed technology rights in our precision animal health and aquatic health businesses, included in Other (income)/deductions-net;

•Inventory in our precision animal health business, included in Cost of sales; and

•Property, plant and equipment in our precision animal health business, included in Other (income)/deductions-net.

(h)    Represents a net loss related to the sale of certain assets of our poultry automation business located in the U.S. and Canada.

(i)    For 2020, primarily represents CEO transition-related costs. For 2019, primarily represents a change in estimate related to inventory costing and CEO transition-related costs.

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The classification of the above items excluded from adjusted net income are as follows:

Analysis of the Consolidated Statements of Comprehensive Income

Substantially all changes in other comprehensive income for the periods presented are related to foreign currency translation adjustments. These changes result from the strengthening or weakening of the U.S. dollar as compared to the currencies in the countries in which we do business. The gains and losses associated with these changes are deferred on the balance sheet in Accumulated other comprehensive loss until realized.

Analysis of the Consolidated Balance Sheets

December 31, 2021 vs. December 31, 2020

For a discussion about the changes in Cash and cash equivalents, Short-term borrowings, Current portion of long-term debt and Long-term debt, net of discount and issuance costs, see “Analysis of financial condition, liquidity and capital resources” below.

Accounts Receivable, less allowance for doubtful accounts increased primarily as a result of higher net sales in the period and the timing of customer payments, partially offset by the impact of foreign exchange and rebate credits issued to customers.

Inventories increased primarily as a result of the build-up of certain products for increased demand and new product launches, partially offset by higher sales than anticipated for certain products. See Notes to Consolidated Financial Statements - Note 11. Inventories.

Other current assets increased primarily due to the mark-to-market adjustment of derivative instruments and higher prepaid expenses, partially offset by the timing of income tax payments.

Property, plant and equipment less accumulated depreciation increased primarily as a result of capital spending, partially offset by depreciation expense. See Notes to Consolidated Financial Statements - Note 12. Property, Plant and Equipment

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The decreases in Operating lease right of use assets and Operating lease liabilities reflect lease amortization and payments, partially offset by assets acquired through new lease obligations. See Notes to Consolidated Financial Statements - Note 10. Leases.

Identifiable intangible assets, less accumulated amortization decreased primarily as a result of amortization expense, the impairment of certain intangible assets and the impact of foreign exchange, partially offset by intangible asset additions from acquisitions. See Notes to Consolidated Financial Statements - Note 13. Goodwill and Other Intangible Assets.

Dividends payable increased as a result of an increase in the dividend rate for the first quarter 2022 dividend, which was declared on December 7, 2021.

Accrued expenses increased primarily as a result of accrued contract rebates, accrued third-party inventory and other accrued expenses.

Accrued compensation and related items increased primarily due to the accrual of 2021 annual incentive bonuses and a higher sales incentive bonus accrual, as well as the reclassification of FICA payroll taxes to be paid in 2022 under the CARES Act from Other noncurrent liabilities, partially offset by the payment of the 2020 annual incentive bonuses.

The net changes in Noncurrent deferred tax assets, Noncurrent deferred tax liabilities, Income taxes payable and Other taxes payable primarily reflect adjustments to the accrual for the income tax provision, the timing of income tax payments, the tax impact of various acquisitions, the impact of the remeasurement of deferred tax assets and liabilities as a result of changes in tax rates.

Other current liabilities and Other noncurrent liabilities decreased primarily due to the mark-to-market adjustment of derivative instruments, the reclassification of FICA payroll taxes to be paid in 2022 under the CARES Act to Accrued compensation and related items and decreases in accrued pension benefits and deferred compensation related to net investment activity.

For an analysis of the changes in Total Equity, see the Consolidated Statements of Equity and Notes to Consolidated Financial Statements— Note 16. Stockholders' Equity.

Analysis of the Consolidated Statements of Cash Flows

*    Calculation not meaningful.

Operating activities

2021 vs. 2020

Net cash provided by operating activities was $2,213 million in 2021 compared with $2,126 million in 2020. The increase in operating cash flows was primarily attributable to higher cash earnings, partially offset by timing of receipts and payments in the ordinary course of business.

Investing activities

2021 vs. 2020

Net cash used in investing activities was $458 million in 2021 compared with $572 million in 2020. The net cash used in investing activities for 2021 was primarily attributable to capital expenditures, acquisitions and purchase of investments, partially offset by proceeds from cross-currency interest rate swaps. The net cash used in investing activities for 2020 was primarily due to capital expenditures, acquisitions and net payments for cross-currency interest rate swaps, partially offset by proceeds from the sale of assets, including a cash payment received pursuant to an agreement related to the 2016 sale of certain U.S. manufacturing sites.

Financing activities

2021 vs. 2020

Net cash used in financing activities was $1,862 million in 2021 compared with net cash provided by financing activities of $123 million in 2020. The net cash used in financing activities for 2021 was primarily attributable to the purchase of treasury shares, the repayment of 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, the payment of dividends and taxes paid on withholding shares, partially offset by proceeds in connection with the issuance of common stock under our equity incentive plan. The net cash provided by financing activities for 2020 was primarily attributable to the proceeds received from the issuance of senior notes in May 2020 and net proceeds in connection with the issuance of common stock under our equity incentive plan, partially offset by the payment of dividends and the purchase of treasury shares.

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Analysis of financial condition, liquidity and capital resources

While we believe our cash and cash equivalents on hand, our operating cash flows and our existing financing arrangements will be sufficient to support our cash needs for the next twelve months and beyond, this may be subject to the environment in which we operate. Risks to our meeting future funding requirements include global economic conditions described in the following paragraph.

Global financial markets may be impacted by macroeconomic, business and financial volatility. As markets change, we will continue to monitor our liquidity position. While we do not anticipate it, there can be no assurance that a challenging economic environment or an economic downturn will not impact our liquidity or our ability to obtain future financing.

Selected measures of liquidity and capital resources

Certain relevant measures of our liquidity and capital resources follow:

(a)    Accounts receivable are usually collected over a period of 45 to 75 days. For the years ended December 31, 2021 and 2020, the number of days that accounts receivables were outstanding have remained within this range. We regularly monitor our accounts receivable for collectability, particularly in markets where economic conditions remain uncertain. We believe that our allowance for doubtful accounts is appropriate. Our assessment is based on such factors as past due aging, historical and expected collection patterns, the financial condition of our customers, the robust nature of our credit and collection practices and the economic environment.

For additional information about the sources and uses of our funds, see the Analysis of the Consolidated Balance Sheets and Analysis of the Consolidated Statements of Cash Flows sections of this MD&A.

Credit facility and other lines of credit

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 December 31, 2021 and December 31, 2020. There were no amounts drawn under the credit facility as of December 31, 2021 or December 31, 2020.

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 December 31, 2021, we had access to $63 million of lines of credit which expire at various times through 2022, and are generally renewed annually. We had no borrowings outstanding related to these facilities as of December 31, 2021 and $4 million borrowings outstanding as of December 31, 2020.

Domestic and international short-term funds

Many of our operations are conducted outside the U.S. The amount of funds held in the U.S. will fluctuate due to the timing of receipts and payments in the ordinary course of business and due to other reasons, such as business development activities. As part of our ongoing liquidity assessments, we regularly monitor the mix of U.S. and international cash flows (both inflows and outflows). Actual repatriation of overseas funds can result in additional U.S and local income taxes, such as U.S. state income taxes, local withholding taxes, and taxes on currency gains and losses. See Notes to Consolidated Financial Statements— Note 8. Tax Matters.

Global economic conditions

Challenging economic conditions in recent years have not had, nor do we anticipate that it will have, a significant impact on our liquidity. Due to our operating cash flows, financial assets, access to capital markets and available lines of credit and revolving credit agreements, we continue to believe that we have the ability to meet our liquidity needs for the foreseeable future. As markets change, we continue to monitor our liquidity position. There can be no assurance that a challenging economic environment or an economic downturn would not impact our ability to obtain financing in the future.

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Contractual obligations

In the normal course of business, we enter into contracts and commitments that obligate us to make payments in the future. These obligations include long-term debt, including interest obligations, purchase obligations, operating lease commitments, other liabilities, benefit plan obligations and uncertain tax positions. See Notes to Consolidated Financial Statements—Note 9. Financial Instruments, Note 18. Commitments and Contingencies, Note 10. Leases, Note 6. Restructuring Charges and Other Costs Associated with Acquisitions, Cost-Reduction and Productivity Initiatives, Note 14. Benefit Plans and Note 8. Tax Matters for further information on material cash requirements from known contractual and other obligations.

Debt securities

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) 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 lease-back 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. 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, 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.

Our outstanding debt securities are as follows:

Credit ratings

Two major corporate debt-rating organizations, Moody's and S&P, assign ratings to our short-term and long-term debt. A security rating is not a recommendation to buy, sell or hold securities and the rating is subject to revision or withdrawal at any time by the rating organization. Each rating should be evaluated independently of any other rating.

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The following table provides the current ratings assigned by these rating agencies to our commercial paper and senior unsecured non-credit-enhanced long-term debt:

Pension obligations

Our employees ceased to participate in the Pfizer U.S. qualified defined benefit and U.S. retiree medical plans effective December 31, 2012, and liabilities associated with our employees under these plans were retained by Pfizer. As part of the separation from Pfizer, Pfizer continued 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. In connection with the employee matters agreement, Zoetis is responsible for payment of three-fifths of the total cost of the service credit continuation (approximately $38 million) for these plans. The amount of the service cost continuation payment to be paid by Zoetis to Pfizer was determined and fixed based on an actuarial assessment of the value of the grow-in benefits and will be paid in equal installments over a period of 10 years. As of December 31, 2021, the remaining payments due to Pfizer (approximately $4 million in the aggregate) are to be paid over the next year.

As part of the separation from Pfizer, Pfizer transferred to us the net pension obligations associated with certain international defined benefit plans. We expect to contribute a total of approximately $5 million to these plans in 2022.

As of December 31, 2021, the supplemental savings plan liability was approximately $51 million.

For additional information, see Notes to Consolidated Financial Statements— Note 14. Benefit Plans.

Share repurchase program

In December 2018, the company's Board of Directors authorized a $2.0 billion share repurchase program. As of December 31, 2021, there was approximately $681 million remaining under this authorization. Purchases of Zoetis shares may be made at the discretion of management, depending on market conditions and business needs. Share repurchases may be executed through various means, including open market or privately negotiated transactions. The company temporarily suspended share repurchases beginning in the second quarter of 2020. In January 2021, the company resumed share repurchases under its share repurchase program. During 2021, approximately 4.0 million shares were repurchased.

In December 2021, the company's Board of Directors authorized a $3.5 billion share repurchase program.

Off-balance sheet arrangements

In the ordinary course of business and in connection with the sale of assets and businesses, we may indemnify our counterparties against certain liabilities that may arise in connection with a transaction or that are related to activities prior to a 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 December 31, 2021 and December 31, 2020, recorded amounts for the estimated fair value of these indemnifications are not significant.

New accounting standards

See Note 3. Significant Accounting Policies in the Notes to Consolidated Financial Statements for discussion of recent accounting pronouncements, including the respective dates of adoption or expected adoption and effects or expected effects on our consolidated financial position, results of operations and cash flows.

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Forward-looking statements and factors that may affect future results

This report contains “forward-looking” statements. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We generally identify forward-looking statements by using words such as “anticipate,” “estimate,” “could,” “expect,” “intend,” “project,” “plan,” “predict,” “believe,” “seek,” “continue,” “outlook,” "objective," "target," “may,” “might,” “will,” “should,” “can have,” “likely” or the negative version of these words or comparable words or by using future dates in connection with any discussion of future performance, actions or events.

In particular, forward-looking statements include statements relating to the impact of the COVID-19 global pandemic and any recovery therefrom on our business, our 2022 financial guidance, future actions, business plans or prospects, prospective products, product approvals or products under development, product supply disruptions, R&D costs, timing and likelihood of success, future operating or financial performance, future results of current and anticipated products and services, strategies, sales efforts, expenses, production efficiencies, production margins, anticipated timing of generic market entries, integration of acquired businesses, interest rates, tax rates and tax regimes and any changes thereto, foreign exchange rates, growth in emerging markets, the outcome of contingencies, such as legal proceedings, plans related to share repurchases and dividends, government regulation and financial results. These statements are not guarantees of future performance, actions or events. Forward-looking statements are subject to risks and uncertainties, many of which are beyond our control, and are based on assumptions that could prove to be inaccurate. Among the factors that could cause actual results to differ materially from past results, future plans and projected results are the following:

•the impact of the COVID-19 global pandemic on our business, supply chain, customers and workforce;

•unanticipated safety, quality or efficacy concerns or issues with any of our products;

•failure of our R&D, acquisition and licensing efforts to generate new products and product lifecycle innovations;

•the possible impact and timing of competing products, including generic alternatives, on our products and our ability to compete against such products;

•disruptive innovations and advances in medical practices and technologies;

•difficulties or delays in the development or commercialization of new products;

•consolidation of our customers or distributors;

•changes in the distribution channel for companion animal products;

•failure to successfully acquire businesses, license rights or products, integrate businesses, form and manage alliances or divest businesses;

•restrictions and bans on the use of and consumer preferences regarding antibacterials in food-producing animals;

•perceived adverse effects linked to the consumption of food derived from animals that utilize our products or animals generally;

•adverse global economic conditions, including inflation;

•increased regulation or decreased governmental support relating to the raising, processing or consumption of food-producing animals;

•fluctuations in foreign exchange rates and potential currency controls;

•legal factors, including product liability claims, antitrust litigation and governmental investigations, including tax disputes, environmental concerns, commercial disputes and patent disputes with branded and generic competitors, any of which could preclude commercialization of products or negatively affect the profitability of existing products;

•failure to protect our intellectual property rights or to operate our business without infringing the intellectual property rights of others;

•product launch delays, inventory shortages, recalls or unanticipated costs caused by manufacturing problems and capacity imbalances;

•an outbreak of infectious disease carried by animals;

•adverse weather conditions and the availability of natural resources;

•the impact of climate change;

•the economic, political, legal and business environment of the foreign jurisdictions in which we do business;

•a cyber-attack, information security breach or other misappropriation of our data;

•quarterly fluctuations in demand or costs;

•governmental laws and regulations affecting domestic and foreign operations, including without limitation, tax obligations and changes affecting the tax treatment by the United States of income earned outside the United States that may result from pending or possible future proposals;

•governmental laws and regulations affecting our interactions with veterinary healthcare providers; and

•the other factors set forth under "Risk Factors" in Item 1A of Part I of this 2021 Annual Report.

In addition, there may also be other risks that we are unable to predict at this time. These risks or uncertainties may cause actual results to differ materially from past results and those anticipated, estimated, implied or projected. Such risks and uncertainties may be amplified by the COVID-19 pandemic and its impact on the global economy and our business. You should not put undue reliance on forward-looking statements. Forward-looking statements speak only as of the date on which they are made. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law or by the rules and regulations of the SEC. You are advised, however, to consult any further disclosures we make on related subjects in our Form 10-Q and 8-K reports and our other filings with the SEC. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the above to be a complete discussion of all potential risks or uncertainties.

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