Elanco Animal Health Incorporated (ELAN) Earnings Call Transcript & Summary

Hi, good afternoon. Thank you for joining us. My name is Mike Ryskin. I'm on the Research Team on the Life Science Tools team, but also focusing on Animal Health. So for our next session, we have Elanco. And I'm honored to be joined by Jeff Simmons, CEO. We've also got the IR team on the line, and Todd Young, CFO, may be hop in any second now. Jeff, thank you for joining us.

Thanks, Mike. Great to be here.

Great. So just to get the ball rolling, we got a full slate of questions, but maybe just to start, can you sort of give us an overview of the distributor issues that came up in this last earnings call, I think, has been the biggest focus for investors? Could you walk through the status of your distributor relationships? How that's changed in recent months, sort of the move from 8 to 4 that you've talked about? And what impact that's had on your inventory as you sort of walk through the last 3, 6 months?

Yes. So just at a very high level, Mike. And since earnings, just to really reiterate a couple of things that are obvious. Our strategy hasn't changed. Our underlying business continues to grow. We can talk more about that. Our share of voice and our competitiveness is strong, and there's not any change in our sales and marketing approach or numbers of reps. And we have a very collaborative partnering relationship, and I think this is understood with our distributors. So -- and we're not going direct. And this buy-sell relationship, if I had to summarize it, is going from a broad-based buy-sell to one that's much more targeted and optimized around playing to both parties' strength. So this is -- just to answer your question, specifically, is this has been an evolution. When we launched the IPO, we talked about part of the margin expansion was bringing commissions down and targeting and playing to the strengths of the distributors. So we've been doing this now for a couple of years, and we've been tightening terms. And then in January -- December, January, I highlighted in U.S. Pat, we're going to go from 8 distributors to 4. So kind of that last lever of really getting exclusive. And then we did a month-to-month assessment of their strengths. And what we saw was logistics, servicing, enabling campaigns, there was a lot of green on those scorecards. What we saw the gap was actually creating new vet clinic placements of products. So actually, Credelio, Interceptor Plus Galliprant, they're taking share, what we saw was our optimization was there. So COVID, why COVID, why this change, this actually catalyzed this decision on an evolution that was happening. It was a little more significant and drastic than we assumed simply because we had one of the major players not have the working capital, and it really created an opportunity but really an obvious decision that we had to make this shift. And so -- but it's been an evolution, no change to the strategy overall, but we're going from a broad-based, have inventory at all levels to one that's very targeted.

Got it. That's really helpful. Appreciate the clarity, actually, on the fact that was just one of the major players not having the working capital because that's sort of been a point of debate as well regarding the -- I believe, it's Patterson, Covetrus, MWI and Midwest that -- you highlighted this targeted optimized approach as opposed to going direct outright. Could you give us an example of that, sort of walk through the math or the dynamics there? What exactly does that mean in terms of, let's say, you've got a product and, let's say, you've got a relationship with distributor X, what does targeted optimized mean in terms of how you're managing the inventory, how you're selling the product in, how they're moving it out, all of that?

Yes. Very simply, I mean, there's 3 kinds of distribution models. There's direct, there's agency, where you actually keep possession of the product and they take orders and support you, and then there's buy-sell. And I think now there's becoming differences inside the buy-sell. So back when we started Companion Animals, we've built a $1 billion franchise for us in the U.S. Companion Animal and even globally off distributors, with distributors. And that relationship will continue, as I've mentioned. But they buy our product, they turn around, they sell it or they distribute it. Over the years, there's become fewer. They become more sophisticated and more efficient, which is good. But in the past, we used -- and even recently, a broad-based approach is putting inventory in that would grow brands, take shelf space, be in distribution centers so you could drop ship. They're able to drop ship quicker and create service quicker more efficiently. Even when we went from 8 to 4, we assumed there needed to be more inventory in the chain and they showed their efficiencies. And the names that you just mentioned, what their acquisitions, their services have gotten better and their value-add has gotten better. So what we've done now is we've decided to have just enough inventory, Mike, to actually keep customer services at the level we want. And with this tighter number of distributors, we will pay them a commission, some for logistics, some for value add and then more variable for the demand that they create.

Got it. Thanks. And then sort of speaking to your comment on the level of inventory you're keeping, I think you had indicated that when you switched from the 8 to the 4, the 4 that you stuck with already used to carry something like 80% of your volume. And when you consolidated, they stepped up to the full 100%, meaning they took on whatever the other 4 were churning. So after the first -- 1Q, 2Q, drawdown of about $150 million, is it really just the case that you're back to that prior 80% level in terms of what each of them is carrying or is it even further below that?

Yes. It's -- so let me just hit a few things. Channel inventory levels, they've always varied over time. And I've said, we've used a consistent formula for a long period of time. I mean I'm talking more than a decade, where 90-day historical trailing demand might -- things that are in place really and what season we're in, if we're coming into an upcoming season. But it's a pretty tight formula that they understand. We've even linked it into our contracts, the whole bit. So that's important. As you look going forward, what's the kind of level that's there -- and it has changed over time. Just think about in the last 3 to 4 years for us, Credelio launched, Interceptor Plus, Galliprant, the vaccines from BI, Aratana, even our Rumensin defense strategy. So lots of change that impacts that over time. And as the portfolio and our sales got bigger in these areas, it varied. So what I will tell you is a metric that we've shared since the earnings is this -- just to give you the size of this is this will take us to 10% plus below our -- 10% below our 2016 levels before a lot of the transformation I just mentioned. So it would be more than what you mentioned.

Okay. That's helpful. So one other comment you made there that I want to touch on before we move on to some of the other topics is you talked about some of the differentiated products within the Elanco portfolio, things like Credelio, Galliprant Interceptor Plus and the more recent launches. Is this an indication that those products, some of the new, more innovative products, they are better positioned for the Elanco sales force? And when you talk about this more targeted optimized approach, there could be sort of a bifurcation depending on product class or product bucket within your portfolio in terms of which channel you're using, who's best suited to bring it to market?

There are differences between the 4 major players, and they offer different things, and we will continue to play to our strengths, not only Animal Health company distributor, but between the distributors. But I want to be very clear, we don't have an intention to go direct to the majority of our market in the vet clinic market. That is not our intention. The retail market, as you know, Mike, is very different and that's handled differently. They support us in the retail market. But Bayer and us, there's opportunity there to work directly with the major retailers. But to the vet clinics, it is our intention to continue to use these exclusive distributors that add value and play to their strength, whether that's with differentiated products like Galliprant or Credelio or that's with our vaccines.

Okay. Great. And then one last one here. So you've laid out this road map of -- you have the 1Q impact weight on the quarter. It seems like it was the very last week, 2 weeks of March. And then you're projecting an $80 million to $100 million impact in 2Q. So is it fair to say that once we're through this period through the first half of the year, you expect normalized sales growth in Companion Animal to come back to the prior run rate? This is sort of -- if you would put on the magic hat and sort of ignore the COVID impact, ignore the Bayer portfolio, if you just think about the distributor channel, is it fair to say that second half sales can be affected? And then, therefore, if you sell out from the vets is consistent, and you've indicated it was mid-single digits previously, but that should continue in that prior dollar level going forward?

Yes, with that one assumption you made, I think that the COVID impact, we can talk some about that, I think, here later. But it does bring some uncertainty, this program and the $80 million to the $100 million that we said in Q2 does include global, does include Food Animal as well. So that overlaps a lot of COVID assumptions. But yes, we do believe and are quite confident that, number one, this is a discrete event, that is the case. And run rates, we've seen an underlying demand continue and we feel very good about. So yes, we don't see this and any overlay into the second half of the year. Other people and other questions have even been asked, what about Bayer keeps lower inventory with a direct approach to over $1 billion of sales in retail. So -- and then I just want to reemphasize, Mike, Companion Animal mid-single-digit over the last 12 months, leading indicators are strong with the kinetic data I shared on the earnings call with Credelio, 7% growth in market penetration, exceeding all K9 flee and tick, 10% on puppy starts, that's double the category, and Interceptor Plus, as I mentioned, 22% growth in number of new patients. So underlying demand, EDI, kinetic data is strong. Take COVID. Even, we think, the scenarios we have, this should be a discrete event only in the first half, only with the numbers that we mentioned for the second quarter of $80 million to $100 million.

Great. So the $80 million to $100 million, just to clarify, what you said, $80 million to $100 million, is that specific for some of the distributor events? Or is that also including an assumption for COVID impact on the overall portfolio?

No, that's looking at going to the levels that we're forecasting. So -- and it does include Food Animal and International. So this is a structural change to our inventory targeted buy-sell global Companion Animal, Food Animal. And the $80 million to $100 million is on the numbers that we see, the assumptions that we had as we came out at the earnings time.

Okay. Got it. That's great. That's really helpful. I'm going to move on from some of that to sort of some of the other topics. I think still have a lot of questions there. Obviously, the other big story coming into 2020 is the Bayer transaction. So I think there was a lot to like about this deal previously. I mean you pitched it pretty well late in 2019 and early 2020 sort of really building enthusiasm for the deal. But if we take another look at it now, in a post-COVID world, it seems like Bayer is an even better asset potentially, more online exposure, less prescription in the portfolio, less drugs that have to come via the vet's office. These benefits just sort of thinking thematically about the way the industry could change, do you anticipate that some of these changes could be short lived? Or do you think that's something that you could start seeing a structural change in terms of how the pharmacy functions as a vet office, how people get their animal health drugs, especially in the Companion Animal space?

Yes, Mike. So I always tell people, let's look at the industry globally. Non-U.S. continues to be more and more important, Food Animal, Companion Animal and one common threat is the veterinarian is in the center. It can't be an Animal Health without the veterinarian being in the center. So what we are really working hard is keep the veterinarian in the center and let's take the pet market and make that pet owner experience better. Let them shop where they want to shop with the SKUs and the price points that they want. And what I do believe there's a lot of things with COVID that are going to stick. And I do believe that one of those is that 1 out of 3 pet owners were not going to the vet clinic here in the United States. Feline was even greater than that. You go internationally, a lot of the data we're seeing even in Asia, it's that or more, and the vet practice is still very new there. So I believe COVID is going to allow all, a lot more pet owners to realize that they don't have to take the traditional route with their pet to get the Animal Health needs that they have. Yes, wellness is needed. We believe pet owners should be in vet clinics, taking care of the wellness, but how it's done and drug purchases will change. So I think that it accelerates. I believe it sticks, and I believe that you need a portfolio partnerships, capability and a presence. And then with a telemedicine or other capabilities, what our distributor partners can help us do is create that bridge and help the veterinarian stay and build a relationship with the pet owner. So I think it's a catalyst. It's an accelerator, and I believe, Mike, it sticks. And I think that this capability also globalized becomes even more important.

Great. Right along that line, just sort of thinking about the breadth of the portfolio that you'll have once the Bayer transaction goes through, #2 in the Animal Health market in terms of total revenues. So very broad portfolio in parasiticides, one of the larger ones out there with a number of products even after the divestments you allowed and then, of course, broad range of products also in Companion Animal, too. If you sort of think of 2021 potential recessionary environment, do you anticipate pricing pressure on some of the products? Do you anticipate that some of the pet owners might be more likely to switch to the less premium brands? I want to focus mostly on Companion Animal, but then if you've got any comments on the last that could be helpful. I guess one of the things we think about is, even if people keep medicating their pets, which they're very likely to do, there's a lot of options out there. And going forward with Bayer, you can have even more opportunity for people to sort of trade down from the Credelios to maybe the Serestos or the Advantages of the world?

Yes. So I have to start broad, just 31 years in Animal Health and living and leading through 2008, this is -- this shutting off the switch, what happened with COVID and now the build and the transition back. I've said in the past and written and spoke a lot about animals being an X factor to society, it got exaggerated and highlighted. It got Washington, D.C. to say Animal Health is an essential business, keep the plants running. Shelters are empty with dogs. Meat cases, they say second to toilet paper is animal protein. So I think the viability of the need for what we do has actually created kind of an exposure that, will that have an economic effect, I definitely think it's having a durability effect that I see, whether it's keeping plants open to the closeness we are with our customers, to telemedicine companies wanting to partner, there's a lot of things. So I start with that to say the durability of this industry has probably been never more demonstrated than the last 9 weeks because of the turning off of an economy and turning back on. So I highlight that. Now going to the macroeconomics. I think what is critical is, yes, we are going into an economic slowdown. Yes, we need to plan for the worst here. But what I think you do need is the following: you need size and scale to do that; you need portfolios that have different price points; and you need channels that can reach people in different ways; and you need global because there are some economies -- our China office is in full swing and very active and things are going pretty full swing across most of Asia right now. So I think that brings diversity, but it also brings the ability to weather and reach customers. And that's why I do think that the larger scale multinational companies are better appropriately positioned for this. And where an Elanco plus Bayer puts us even in a, I think, in a better position market-wise and portfolio geographic wise post-midyear when we want to bring these 2 companies together.

Okay. Great. I want to pivot a little bit to the other area of focus that we've had for a couple of weeks now. It's been the livestock market. I think a lot of focus has been on Companion Animal, rightly so because that's what people see the most. But once the slaughterhouse shutdowns started coming in about a month ago, it's really sort of garnered national attention that sort of gripped everyone's focus. And as you said, there really hasn't been another proxy of this for us to look back to and sort of try to normalize what's going on. So thinking about what's going on in the livestock, could you talk us through what you expect you could see as far as timing dynamics, just how this plays out over the next couple of months? We've got different species, whether it's dairy, swine, cow, poultry that are all seeing different impacts based on cattle, you can move to feedlots, swine you're kind of stuck with. You've got the magnitude of the shutdowns. So -- and then you've got the other factor of it of restaurant closed, food service demand down, things moving to grocery. So a lot of movement here. Could you sort of close your eyes and sort of walk us through what you expect over the next 1, 3, 6, 9 months, we could see across these different species from a demand perspective, especially as it relates to your portfolio?

Yes. Mike, I wish I could give you the model, and I know that's not what you're asking for, but I know that, hey -- let me -- with the relationships that I have with some of the executives in these major meat companies -- and processing plants and production, right? And there's 4 species. So we'll hit each one of them. But I will say the one consistent thing is they need to see some consistency and predictability. And with that, you're going to start to see supply chains to get reloaded. You're going to see people wanting to go ahead and put in late-stage Animal Health products like we may have in the last 28 or 30 days before processing. But without that, right now, I would say, is there's still a search for predictability which will create, I believe, the start of recovery on the Food Animal side. And I'm really lasering in on the 4 protein segments in the U.S., but we're seeing it happen in Brazil as well and we're seeing it a little bit in Latin America and a little bit in Europe. So what is that? Well, I'll start with where I have the biggest concerns, which is primarily in pork. Now pork, the plants, I -- data here this morning that they've got now back 50% to 70%, and you're hearing about plants being open, and most of them maybe being back open. But when you talk to the CEOs, they want the following. It's all about capacity. So the capacity number and then the constancy of keeping those lines open, and that's going to take some weeks. So you're going to need to see free flow lines. This is a labor issue right now more than anything else, higher capacity. Pork has nowhere to go. Pork has 3-month windows where the supply chain becomes breakable and you euthanize animals and things like that. So to me, pork is probably the most vulnerable. Now there -- I think there's the right pressure there and the right interventions to get those plants going. So I'm hoping -- I'm watching pork for the first kind of early sign of recovery because they're the most economic pressure and the most vulnerability in the supply chain. Cattle, you can put on grass. Cattle is probably second, beef cattle to this. So look and watch for full capacity run rates for weeks, not days. And I think we're coming into it over the next couple of months to really watch. I think the end of the second quarter will determine the level of damage in the second half. It will carry into the second half. So beef is what we see is we're seeing a little less. We're hearing about, hey, they're 40%, 50%. They've been down, and that's coming up. Pork is a little better than beef right now because I think of the pressure and the concentration of the processors. So poultry, most flexible, can move, cannot only move but can move in 60 days, can also move cuts of meat inside that plant, more agile plants that can move from restaurant to grocery. So I think poultry is best positioned. Poultry is more global. So I think probably more open to trade. So -- and then last is -- dairy is to me, no school lunches. They got a backup. They've got compounding problems from restaurant food service, demand issues to a very slow supply chain and, as you know, a market that's controlled. When I look at Elanco, we, as you know, future protein. So aqua and fish, well positioned. We feel good about our global poultry and aqua business. Pork, as you know, is more targeted. Our pork dependency out in Asia is better. We're out of the Paylean business. That was a late stage product. So pork mostly therapeutic and global. So we don't see major needs there. Dairy is Rumensin primarily, and that's targeted in most all feeds. It really becomes beef, and it's late-stage usage of products that are cattle on feed and feed yards is where it will impact us. And we've tried to calculate that in. But why we didn't give guidance is we really believe these next 2 months determine second half damage -- or impact, excuse me, so.

Got it. That last comment is really helpful in sort of the lag between what we're seeing in the feedlot data, what we're seeing on the COVID data and when you see the impact. So you're assuming there will be more of a delay. I guess my question around that is, speaking to the cattle side of the industry, into the pork side of the industry, where these people are already being pressured, are you seeing purchasing decisions being delayed? Are you seeing people already starting to cut back in terms of how much product they want to bring in, whether it's feedlot operators, or some of the feed mix or their suppliers? Or are they still sort of in a wait and see mode?

It depends. I would say the short-term impact on us, I mean, is Optaflexx. It's our ractopamine in cattle. It's used in the last 28, 30 days of a cow -- a beef cow in a feed yard. We're recommending to pull that right now. Just good usage standards is if you don't know when the animal is going to slaughter, then you have to be careful on late-stage use. And there's other products that are geared towards when the animal is going to be slaughtered. So I think those are the ones being impacted the most. Again, we're in a much better position on pigs and Optaflexx is contained primarily just to the U.S. beef market. But I would say, when you look back to your macroeconomic question, sure, the production chain is being challenged. Therapy, not typically -- it's the last to go, or prevention like vaccines, which we have. It's anything that impacts health that drives productivity. That's probably the most vulnerable. So that's -- and I would say, let's keep our eyes on the next 4 weeks, pork and beef and consistency of high-capacity plants running and no breakage, that to me, will, I think, be a lead indicator of how much downward business we might see in the second half.

Got it. I think -- I don't know if you heard one of the other presentations this week was Jack Bendheim at Phibro, he commented that he expects up to 5% of livestock production to be gone this year across the industry, across the space. Is it -- in your mind, is it still too early to sort of make any kind of statements like that on overall protein? Or do you think you could really see some pressure in terms of reduction of herd size?

Yes, I think I don't know overall numbers. I mean, I'm reading a lot and talking to a lot of the experts, but you definitely can see that these supply chains have to lower. There's demand there, but, yes, animal numbers will come down in certain areas. What's the global effect and how prevailing will it be into the second half will be the question. And we've seen a little bit better recovery than we expected in Asia. So there is some balance here, but you've got economics and pressures as well in Latin America that may be bigger headwinds than we realized. So as I think Todd shared on the call, that's why we've been more hesitant on guidance to really fully understand this, at least these big factors. So yes, I think less numbers and some economic pressures will also come, but the demand persists. And the good news is protein demand, probably also less [Audio Gap] antibiotic-free or premium cuts have actually been impacted where, I think, you're going to see this persisting demand continue to pick up as we go to the second half of the year.

Okay. That's all really helpful. I appreciate all that color. We've got just a couple of minutes left. I want to get on my last couple of points quickly. First, I want to talk about the Bayer deal, sort of the roadmap, as you laid it out for synergies for cost cuts sort for the business evolution in the next couple of years, the targets you laid out in August when you first announced it. And also the longer-term view by 2022, 2023, the 60% gross margin, 31% adjusted EBITDA margin. I didn't get a chance to discuss that on the earnings call, but I just want to be clear, is that something that could be affected by COVID and by the distributor changes? Or is that still all in play? Sort of what's the update there?

Mike, I think Todd is on. So while he's here, I'm going to at least get him to be in to participate here. So our CFO, Todd Young. Todd, if you're there, I wouldn't mind you jumping in, if that's okay.

Absolutely. No, Mike. Thanks for listeners on the call. I think overall, we have pulled our guidance. The current uncertainty certainly is something that makes us cautious with respect to giving a future view of our numbers and those percentages. Clearly, we're going to have more debt on a leverage perspective at close because of the reduction in EBITDA we're seeing here in Q1 and Q2, offset by very strong performance. It's been better in Q1 than it was on a year ago basis. Certainly, as we look out over time and we annualize this inventory reset that we're doing structurally as well as then get the Bayer business in play, we're confident in the durability of our industry. We're confident in the productivity initiatives we're driving as well as the synergies we're going to be able to capture on this combined business. And so with that, over time, we expect to get to those metrics, but there may be a delay as a result of just the current COVID impact on our business.

Great. And then I guess, Jeff, one last one for us because we're about out of time. I just want to ask sort of big picture question we've been asking all of our companies is, what is your thought process on longer-term impact to the industry and to Elanco specifically from COVID? Sort of what are the long-term implications to the space, both from the Companion Animal, again, things we talked about in terms of vet visits, channel implications, things like that as well as the livestock side of things, whether it's tied to the recession, whether it's tied to the slaughterhouse, I guess I'm asking is 2021, 2022, 2023, what's different about Animal Health? What's not different?

Yes. I think I'll start with what's not different. I think you've got to innovate. You've got to have a global business, I believe, with a portfolio of solutions, not just one product. I think that's absolutely critical. So spaces of greatest needs, problems or opportunities offering solutions and having the global scale to reach the key end-user customers, veterinarians, pet owners and farmers, you need that. That's not going to change, I believe. I think COVID also has emphasized the need for a global diverse business that's innovating with the need to be able to sustain any volatility, durable industry and a global company that's innovating is, I think, still the core foundational needs. And then I think one of the trends that I just will highlight is I do believe that people are going to want to do things more virtually because they've experienced it. As they say, you do something for 40 days or you experience it for 2 to 3 months, it becomes a habit. And so I think all of us have seen that, hey, there's a lot of things we didn't realize we didn't need to do. So we have to enable the vet clinic to have a deep relationship with pet owners. And I believe that, that may even be the case for farmers to where, whether it's a sales rep from Elanco making 5 face-to-face calls but interknitting 3 to 5 phone calls in there and what a 5-minute detail does, I think that's going to change our industry to helping that veterinarian stay connected to pet owners. And this is where I believe I kind of conclude by saying Elanco is an execution story. We've got to execute, we're in a durable industry. We're building a global independent leader that, I believe, can create a lot of value for your investors, Mike. But I think what's absolutely critical for us now is to execute what's in front of us. There's a lot of controllables that we can do to create this great company that we're in the midst of. And bringing Bayer across the line midyear is absolutely important, and we believe we can do that even in the midst of COVID, which I think is a testament of the amount of focus and execution that we have. And look forward to continuing to communicate closely with you and all the investors through the rest of your conference. Thanks for doing this.

Thank you so much. Jeff, Jim, Todd, thanks for joining us. Really appreciate the time. Enjoy the rest of your day and enjoy the rest of the conference. Thank you everyone for dialing in.

Thank you.

Thank you.