Financial Instruments


A.	Debt

Credit Facilities

In December 2016, we entered into an amended and restated revolving credit agreement with a syndicate of banks providing for a multi-year $1.0 billion senior unsecured revolving credit facility (the credit facility). In December 2018, the maturity for the amended and restated credit facility was extended through December 2023. Subject to certain conditions, we have the right to increase the credit facility to up to $1.5 billion. The credit facility contains a financial covenant requiring us to not exceed a maximum total leverage ratio (the ratio of consolidated net debt as of the end of the period to consolidated Earnings Before Interest, Income Taxes, Depreciation and Amortization (EBITDA) for such period) of 3.50:1. Upon entering into a material acquisition, the maximum total leverage ratio increases to 4.00:1, and extends until the fourth full consecutive fiscal quarter ended immediately following the consummation of a material acquisition. The credit facility also contains a clause which adds back to Adjusted Consolidated EBITDA, any operational efficiency restructuring charge (defined as charges recorded by the company during the period commencing on October 1, 2016 and ending December 31, 2019, related to operational efficiency initiatives), provided that for any twelve-month period such charges added back to Adjusted Consolidated EBITDA shall not exceed $100 million in the aggregate.

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, 2018 and December 31, 2017. There were no amounts drawn under the credit facility as of December 31, 2018 or December 31, 2017.

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, 2018, we had access to $77 million of lines of credit which expire at various times through 2019, and are generally renewed annually. We had $9 million borrowings outstanding related to these facilities as of December 31, 2018.

Commercial Paper Program and Other Short-Term Borrowings

In February 2013, we entered into a commercial paper program with a capacity of up to $1.0 billion. As of December 31, 2018, and 2017, there was no commercial paper outstanding under this program. As of December 31, 2018, we had $9 million short-term borrowings outstanding. As of December 31, 2017, we did not have any short-term borrowings outstanding.

Senior Notes and Other Long-Term Debt

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. These notes are comprised of $300 million aggregate principal amount of floating rate senior notes due 2021 (the "2018 floating rate senior notes"), and $300 million aggregate principal amount of 3.250% senior notes due 2021, $500 million aggregate principal amount of 3.900% senior notes due 2028 and $400 million aggregate principal amount of 4.450% senior notes due 2048 (collectively, the "2018 fixed rate senior notes"). Net proceeds from this offering were partially used to pay down and terminate a revolving credit agreement and repay outstanding commercial paper, which were borrowed to finance a portion of the cash consideration for the acquisition of Abaxis (see Note 5. Acquisitions and Divestitures). The remainder of the net proceeds will be used for general corporate purposes.

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. These notes are comprised of $750 million aggregate principal amount of 3.000% senior notes due 2027 and $500 million aggregate principal amount of 3.950% senior notes due 2047. Net proceeds from this offering were partially used in October 2017 to repay, prior to maturity, the aggregate principal amount of $750 million, and a make-whole amount and accrued interest of $4 million, of our 1.875% senior notes due 2018. The remainder of the net proceeds were used for general corporate purposes.

On November 13, 2015, we issued $1.25 billion aggregate principal amount of our senior notes (2015 senior notes), with an original issue discount of $2 million. On January 28, 2013, we issued $3.65 billion aggregate principal amount of our senior notes (the 2013 senior notes offering) in a private placement, with an original issue discount of $10 million.

The 2013, 2015, 2017 and 2018 senior notes are governed by an indenture and supplemental indenture (collectively, the indenture) between us and Deutsche Bank Trust Company Americas, as trustee. The indenture contains certain covenants, including limitations on our and certain of our subsidiaries' ability to incur liens or engage in sale-leaseback transactions. The indenture also contains restrictions on our ability to consolidate, merge or sell substantially all of our assets. In addition, the indenture contains other customary terms, including certain events of default, upon the occurrence of which the 2013, 2015, 2017 and 2018 senior notes may be declared immediately due and payable.

Pursuant to the indenture, we are able to redeem the 2013, 2015 and 2017 senior notes and the 2018 fixed rate 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. The 2018 floating rate senior notes are not redeemable at our option prior to their maturity date. 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 and 2018 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 and 2018 senior notes at a price equal to 101% of the aggregate principal amount of the 2013, 2015, 2017 and 2018 senior notes together with accrued and unpaid interest to, but excluding, the date of repurchase.

The components of our long-term debt are as follows:



	As of December 31,
(MILLIONS OF DOLLARS)	2018			2017
3.450% 2015 senior notes due 2020	$	500		$	500
2018 floating rate (three-month USD LIBOR plus 0.44%) senior notes due 2021	300			—
3.250% 2018 senior notes due 2021	300			—
3.250% 2013 senior notes due 2023	1,350			1,350
4.500% 2015 senior notes due 2025	750			750
3.000% 2017 senior notes due 2027	750			750
3.900% 2018 senior notes due 2028	500			—
4.700% 2013 senior notes due 2043	1,150			1,150
3.950% 2017 senior notes due 2047	500			500
4.450% 2018 senior notes due 2048	400			—
	6,500			5,000
Unamortized debt discount / debt issuance costs	(57		)	(47		)
Long-term debt, net of discount and issuance costs	$	6,443		$	4,953

The fair value of our long-term debt was $6,474 million and $5,291 million as of December 31, 2018, and December 31, 2017, respectively, and has been determined using a third-party matrix-pricing model that uses significant inputs derived from, or corroborated by, observable market data and Zoetis’ credit rating (Level 2 inputs). See Note 3. Significant Accounting Policies— Fair Value.

The principal amount of long-term debt outstanding as of December 31, 2018, matures in the following years:



											After
(MILLIONS OF DOLLARS)	2019		2020		2021		2022		2023		2023		Total
Maturities	$	—	$	500	$	600	$	—	$	1,350	$	4,050	$	6,500

Interest Expense

Interest expense, net of capitalized interest, was $206 million for 2018, $175 million for 2017 and $166 million for 2016. Capitalized interest expense was $9 million for 2018, $4 million for 2017, and $3 million for 2016.

B. Investments

As part of the acquisition of Abaxis, we acquired short and long-term investments in debt securities (see Note 5. Acquisitions and Divestitures). These investments are classified as available-for-sale securities and, therefore, are measured at fair value at each reporting date. The changes in fair value are recognized in Accumulated other comprehensive income/(loss). We utilized Level 2 inputs such as observable quoted prices for similar assets and liabilities in active markets and observable quoted prices for identical or similar assets in markets that are not very active. See Note 3. Significant Accounting Policies— Fair Value.

At December 31, 2018, the investment securities portfolio consisted of debt securities that were virtually all investment-grade. Information on investments in the debt securities at December 31, 2018, including the contractual maturities, or as necessary, the estimated maturities, of the available-for-sale securities is as follows:



	Gross Unrealized								Maturities by Period^(a)
(MILLIONS OF DOLLARS)	Amortized Cost		Gains		Losses		Fair Value		Within 1 year		Over 1 to 5 years		Over 5 years		Total
Available-for-sale debt securities
Municipal Bonds	$	1	$	—	$	—	$	1	$	1	$	—	$	—	$	1
Corporate Bonds	100		—		—		100		98		2		—		100
Total debt securities	$	101	$	—	$	—	$	101	$	99	$	2	$	—	$	101

^(a)Long term investments are included in Other noncurrent assets.


C.	Derivative Financial Instruments

Foreign Exchange Risk

A significant portion of our revenue, earnings and net investment in foreign affiliates is exposed to changes in foreign exchange rates. We seek to manage our foreign exchange risk, in part, through operational means, including managing same-currency revenue in relation to same-currency costs and same-currency assets in relation to same-currency liabilities. Depending on market conditions, foreign exchange risk is also managed through the use of various derivative financial instruments. These derivative financial instruments serve to manage the exposure of our net investment in certain foreign operations to changes in foreign exchange rates and protect net income against the impact of translation into U.S. dollars of certain foreign exchange-denominated transactions.

All derivative financial instruments used to manage foreign currency risk are measured at fair value and are reported as assets or liabilities on the condensed consolidated balance sheet. The derivative financial instruments primarily offset exposures in the Australian dollar, Brazilian real, British pound, Canadian dollar, Chinese renminbi, euro, and Norwegian krone. Changes in fair value are reported in earnings or in Accumulated other comprehensive income/(loss), depending on the nature and purpose of the financial instrument, as follows:

•

For foreign exchange contracts not designated as hedging instruments, we recognize the gains and losses on forward-exchange contracts that are used to offset the same foreign currency assets or liabilities immediately into earnings along with the earnings impact of the items they generally offset. These contracts essentially take the opposite currency position of that reflected in the month-end balance sheet to counterbalance the effect of any currency movement. The aggregate notional amount of foreign exchange derivative financial instruments offsetting foreign currency exposures was $1.3 billion and $1.4 billion, as of December 31, 2018, and December 31, 2017, respectively. The vast majority of the foreign exchange derivative financial instruments mature within 60 days and all mature within one year.

•

For cross-currency interest rate swaps, which are designated as a hedge against our net investment in foreign operations, changes in the fair value are deferred as a component of cumulative translation adjustment within Accumulated other comprehensive loss and reclassified into earnings when the foreign investment is sold or substantially liquidated. Gains and losses excluded from the assessment of hedge effectiveness are recognized in earnings (Interest expense—net of capitalized interest). The impact of the periodic exchange of interest payments is reflected within the operating section of our consolidated statement of cash flows. The aggregate notional amount of cross-currency interest rate swap contracts was 400 million euro as of December 31, 2018, with a term of up to seven years. We did not have any cross-currency interest rate swap contracts as of December 31, 2017.

Interest Rate Risk

The company may use interest rate swap contracts on certain investing and borrowing transactions to manage its net exposure to interest rates and to reduce its overall cost of borrowing. In anticipation of issuing fixed-rate debt, we may use forward-starting interest rate swaps that are designated as cash flow hedges to hedge against changes in interest rates that could impact expected future issuances of debt. Unrealized gains or losses on the forward-starting interest rate swaps are reported in Accumulated other comprehensive loss and are recognized in earnings over the life of the future fixed-rate notes. When the company discontinues hedge accounting because it is no longer probable that an anticipated transaction will occur within the originally expected period of execution, or within an additional two-month period thereafter, changes to fair value accumulated in other comprehensive income are recognized immediately in earnings.

During 2018 and 2017, we entered into forward starting interest rate swaps with an aggregate notional value of $350 million and $500 million, respectively. In addition, we entered into treasury lock trades with an aggregate notional value of $350 million and $500 million, respectively. We designated these swaps and treasury locks (contracts) as cash flow hedges against interest rate exposure related principally to the issuance of fixed-rate debt to be used primarily to fund the acquisition of Abaxis in 2018 and to refinance our 1.875% 2013 senior notes due 2018. Upon issuance of our 2018 senior notes, we terminated the contracts we entered into in 2018 and paid $2 million in cash to the counterparties for settlement. Upon issuance of our 2017 senior notes, we terminated the contracts entered into in 2017 and paid $3 million in cash to the counterparties for settlement. See A. Debt: Senior Notes and Other Long-Term Debt. There was $0.1 million of ineffectiveness related to the forward interest rate swaps entered into in 2017 through the date of settlement which was immediately recognized as a loss within Interest expense—net of capitalized interest. In addition, in previous years we had entered into various forward-starting interest rate swap contracts that were designated as cash flow hedges and that were terminated upon issuance of fixed-rate notes. The settlement amounts, which represent the fair value of the contracts at the time of termination, were recorded in Accumulated other comprehensive loss, and will be amortized into income over the life of the 2018 and 2017 senior notes.

There were no outstanding interest rate swap contracts as of December 31, 2018 and December 31, 2017.

Fair Value of Derivative Instruments

The classification and fair values of derivative instruments are as follows:



		Fair Value of Derivatives
		As of December 31,
(MILLIONS OF DOLLARS)	Balance Sheet Location	2018			2017
Derivatives Not Designated as Hedging Instruments:
Foreign currency forward-exchange contracts	Other current assets	$	6		$	10
Foreign currency forward-exchange contracts	Other current liabilities	(7		)	(9		)
Total derivatives not designated as hedging instruments		(1		)	1

Derivatives Designated as Hedging Instruments:
Cross-currency interest rate swap contracts	Other current assets	3			—
Cross-currency interest rate swap contracts	Other non-current assets	8			—
Total derivatives designated as hedging instruments		11			—

Total derivatives		$	10		$	1

The company’s cross-currency interest rate swaps are subject to master netting arrangements to mitigate credit risk by permitting net settlement of transactions with the same counterparty. We may also enter into collateral security arrangements with certain of our counterparties to exchange cash collateral when the net fair value of certain derivative instruments fluctuates from contractually established thresholds. At December 31, 2018, there was no collateral posted related to our derivatives.

We use a market approach in valuing financial instruments on a recurring basis. Our derivative financial instruments are measured at fair value on a recurring basis using Level 2 inputs in the calculation of fair value. See Note 3. Significant Accounting Policies— Fair Value.

The amounts of net gains/(losses) on derivative instruments not designated as hedging instruments, recorded in Other (income)/deductions, are as follows:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2018		2017
Foreign currency forward-exchange contracts	$	6	$	(33	)

These amounts were substantially offset in Other (income)/deductions—net by the effect of changing exchange rates on the underlying foreign currency exposures.

The amounts of unrecognized net gains/(losses) on derivative instruments designated as cash flow hedges, recorded, net of tax, in Other comprehensive income/(loss), are as follows:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2018		2017
Interest rate swaps	$	—	$	(11	)

The amounts of unrecognized net gains/(losses) on cross-currency interest rate swap contracts, recorded, net of tax, in Accumulated other comprehensive income/(loss), are as follows:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2018		2017
Cross-currency interest rate swap contracts	$	9	$	—

Gains/(losses) on cross-currency interest rate swap contracts, recognized within Interest expense, net of capitalized interest, are as follows:



	Year Ended December 31,
(MILLIONS OF DOLLARS)	2018		2017
Cross-currency interest rate swap contracts	$	6	$	—

The net amount of deferred gains/(losses) related to derivative instruments designated as cash flow hedges that is expected to be reclassified from Accumulated other comprehensive loss into earnings over the next 12 months is insignificant.