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

Great. So good afternoon, everyone. Thank you for joining us. This is Dave Risinger. And I cover both major and specialty pharmaceuticals at Morgan Stanley. I need to refer you to disclaimers at www.morganstanley.com/researchdisclosures. And if you're a member of the press, please disconnect and contact the Morgan Stanley Public relations office. So I am very pleased to welcome Jeff Simmons, who is the CEO of Elanco. As the Head of Elanco Animal Health for the past decade, he's directed the company's transformation into a premier global player, now 2, #2 in the business. With a balance of diversified businesses, Jeff has overseen the completion of 12 acquisitions, built 5 new businesses, including the $1 billion-plus Companion Animal business, and also a leading aquaculture operation. So we're very pleased to have Jeff with us today. Jeff, let me turn it over to you for some opening comments, and then we'll go into the dialogue.

Thanks, Dave. Thanks for the opportunity and Morgan Stanley. We're looking forward to a great dialogue and a great conference. I think at a very high level, Elanco is in an exciting time right now in our history, 66 years as an animal health company. As you know, we're coming up on our 2-year date of when we IPO-ed from Lilly. We're in the midst of 1 month behind us with the largest industry acquisition of Bayer. And so good early progress with Bayer. We can get into this, Dave, but the deal rationale is still very much intact from a little over a year ago when we announced it. And I think as we look at the trends, we talked about the benefits from the mix, the globalization, the scale, making Elanco into this global #2 player is very strong, and the Bayer business is doing well. It's benefited some from the COVID situation. The integration is complex. We'll face some challenges, but it's going well. Bayer's, I think, business has benefited a little bit from some retailers buying ahead a little bit with COVID and the cutover that we had. But bottom line, underlying growth continues to be strong at 4% to 5% range. And we see it driven by the big brands of Seresto and some with Advantage and the retail business, e-commerce business trends that were accelerated with COVID. I want to say we, our Elanco core brands, the Credelio, the Interceptor Plus, Galliprant continue to gain share. We even -- third-party data like Kinetick data show share gains all the way into and through July. So we continue to see our portfolios winning in the marketplace. And then I think our distributor strategy that we changed is working very well. Immediately, we saw positive benefits as we talked about in the second quarter, and that continues forward. And great relationships with our partners there. I think on the other side, things we need to watch as we go forward, Dave, and we can talk about in the comments is I see the U.S. livestock business and the farm animal business facing pressure in the second half that are really COVID overhangs. When you look at supply chain disruptions, and even getting -- the processing plants are back-flowing, but supply chains are not, and the trade dynamic on the other side of that. So those are dynamics that will play out. Still really like that business, great middle- and long-term prospects, but that will be a little bit of an overhang. The other on the Bayer business that I want to highlight that's important, and then I will close here is the seasonality of the Bayer business we saw. And it's been this way for quite some time. They've got a business that has about 60% of the sales in the first half, 70% of the profits or EBITDA in the first half, so got to see that Bayer seasonality play out. And then as I mentioned, the COVID buying and cutover buying, it was to retailers, it was a pet business direct. That will play out quickly, I think, in the second half as they don't want to keep inventory that will play down. And then I think, hey, exciting times right now on the Bayer side. We have moved our cutover over from Bayer to Tata Consulting Services. We're switching over our systems with Lilly at the same time. But that brings -- I would say, I'm very pleased that we're running and all things are going, but the cost of running systems and the cost of standing up, that spend will play out in the second half. When I get all done though and step back, we're tracking to our original initial expectations outside of the channel and COVID. We're controlling what we can control, very disciplined right now on our execution. You'll see that in our productivity gains, good cash and OpEx management, improving margins. We're focused on debt deleverage. We can talk about this. We expect to make rapid progress over the next couple of years that rapid -- or excuse me, robust cash flow will start to play out next year. So -- and I would say we are reaffirming our guidance for the Elanco core business for the third quarter from what we see at this point in time. So I'll stop there, a lot to talk about, Dave.

Right. Thank you very much, Jeff. So at a high level, you've mentioned to me that you've done it before when it comes to acquiring a large company out of Europe. Can you speak to that a little bit more and how that gives you confidence and the ability to execute on the Bayer integration? And then also just talk about sort of key learnings and integration progress to date that would be more specific. What's happened in the past 6 weeks since you closed the deal, and how do things look?

Yes. So I would say this is, I don't know, #12 or #13 in acquisitions. We've done 3 or 4 European companies. And so -- but I think you look at them always with a fresh eye, but we have built the muscle and the capability. A lot of the same people that have been involved in the past. So we've taken a very disciplined approach. I think COVID has made us become very laser-focused. But I will tell you, I have full confidence in our ability to integrate Bayer successfully. We've got a proven track record. We've got senior leadership across the board from both companies sitting at the table, driving this. And I would say we brought all -- let me give you a couple of updates here. I'll maybe blend your 2 questions. We've successfully brought all Bayer Animal Health employees in over the last month to an Elanco IT platform that we're actually working with Tata. So we've lifted everything out of Bayer in a month's time and put them into a Tata system. Tata, as you know, it is their business, it's their expertise. And so we're running off from that system that's hosted by Tata, and it's gone very well. The basic and essential things, product flow, invoicing, employees paid, our systems are up and working after a month. And the major things that could go wrong, we believe, we've got those protected. And the first month are showing that we're performing against them. I want to continue to emphasize, too, that there's no transition service agreements with Bayer. We have little risk there as really our relationship with Bayer outside of them holding stock is really minimal at this time and being an R&D partner. So -- and then I would say, let's remind ourselves, too, that Elanco is on track and going very well. I just had my own computer changed over this week. Our cutover with Lilly continues to track. So we're getting our IT infrastructure right now in place on that. ERP testing is taking place. Cutovers are happening. And that is tracking for -- into the early first quarter, and that's going well. So when I look at Bayer, the simple things that really matter, one, you've got to keep momentum in the business. You saw, Dave, both companies as you look at the second quarter and coming into that August 1 date when we closed, both businesses had momentum. Our focus immediately, and we've learned this from other acquisitions, was immediately everyone had an October 1 goal. Let's close the quarter. Let's win. Let's make the customers see no change. And that isn't going to be perfect everywhere, but our goal is let momentum beat distraction with everyone focusing on their 1 or 2 personal goals. And actually, COVID has allowed that era of essentialism to actually help. So that, I would say, leadership is in place. Value capture targets are being worked on. And we're keeping the momentum that we had on day 1. I think on the soft stuff with people, what I think I've learned is, one, is we immediately, in 5 days, did what we did with Novartis in 5, 6 weeks. As on Zoom, we traveled the world. We touched everybody with global town halls, local departments. So everybody saw us, everybody heard expectations and the vision for the company. So everyone was touched and understood. We've already started the work on the new organizational structure. And we've got customers, distributors, all of those key essentials in place. I think culturally, what I see is it's not Germany, U.S., it's not Bayer, Elanco. I think it's 166 years. This is not only the industry's largest transaction, it's the industry's 2 longest-standing brands. And I think you've got legacy here with animals. People want to be in the animal business. You can't tell that between Bayer and Elanco. And we want independence. And so I say animals and independence are what really break the cultural barriers. Sure, there's cultural differences, but the macro, there's more cultural similarities. So I think we got good clarity, good energy, lots of complexity. I wouldn't say this without my team agreeing that every day, there's -- you don't do this without lots of complexity. But COVID hasn't slowed us down. It's probably made us more focused. So that's where we are.

Great. That's very helpful color. So with respect to the tough comps, so obviously, Bayer's growth over the last 3 quarters has been abnormally strong in part due to easy comps for Bayer itself versus year ago periods and in part due to channel inventory increases. How quickly can you normalize the Bayer inventory? Will you be sort of at the right level of inventory as you exit 2020? What's the right way to think about that?

Yes. My simple answer right upfront is, yes, we do believe that. So with Bayer, just to highlight, Bayer reported 12 -- 4.6% growth, including some inventory buildup in that first half of 2020. And it was really driven, I say, by the 2 Cs. I mean the first was the COVID impact. And then when we came into -- coming into Elanco and the expectation of Elanco, there was a little bit of cutover buying as well. Most of these are the major pet retailers, mostly in the U.S., all in the pet business. They don't like to carry inventory, Dave, as you know, of any high levels, they just want enough to service. So I see that playing out in the second half nicely, and we've got good eyes on it. There's good understanding. There's a few players. There's no distributor in the middle. So I feel that's very important. I think as we look at that business and you really look at underlying business, we're seeing an underlying business of Bayer in that 4% to 5% growth range. And again, that comes from some of the trends that we've seen a little bit stronger than that on the e-commerce and the pet retail side, a little bit challenged on U.S. farm animal, given COVID. But overall, it's -- that's what we see, and that's going well. And I'll just pick up on, again, we feel very good that we will have this inventory at the levels we want at the end of the year.

Okay. And just so I understand, so the underlying business at Bayer, 4% to 5%, so you're talking about organic growth, but for what period? Meaning, is that including any unusual benefits?

No. I think the underlying, you've seen higher than that overall. And what I'm trying to do here is to say, as you pull out a COVID impact to buy ahead, a cutover, that can be 5% to 6%. We're seeing a really nice, strong underlying growth, 4% to 5%. And as you recall, when we looked at the business, we see Seresto that's leading that growth, retail right along with it, pet retail, we're seeing the global portfolio, the international portfolio, especially food, animal, contributing to the growth a little lesser extent. And then Advantage, we had modeled and said in purchasing this, that we would see some low single-digit decline. What we've seen with Advantage is it's actually with COVID and a lot of the movement out of the vet clinic, it stabilized. It's actually been growing. It's not necessarily how we may think of it long term, but those are the contributors to growth.

And is that sort of 4% to 5% that you mentioned in terms of organic growth excluding the unusual benefits, is that sustainable for Bayer?

Well, we'll put more color on this, Dave, in the December investor conference. We definitely have a dynamic marketplace right now. I think a key question that everyone is asking and we're digging into is how much of the change and the shift of what pet owners purchase behaviors are going to be going forward with COVID. Are they used to buying at the door? How will telemedicine with vets play into this? How does it impact brands that don't need a vet script and not? So I feel good about that underlying demand as it stands for 2020 or as we look at the business now. Going forward, we'll assess that. And we'll assess it not only in this market shift in the change, but hey, how can Elanco globalize these brands? How do we put them with our portfolio? So that's the story that still needs to be developed over the next few months that we're working on.

Got it. Okay. That's helpful. Very good. And then maybe you could just -- since we've been talking about Bayer, could you just discuss the margin profile at a high level? And obviously, there's differences in accounting, so it's hard to sort of see the numbers and really understand exactly what the impact will be. If you could talk to that that would be helpful.

Yes, Dave, I can -- I think it's good just to start with, historically, Bayer has reported gross margins at about 68%, that was even noted when we worked and announced the acquisition. As you just said, a word of caution, I think when you convert the accounting, we see about 300 to 400 basis points lower. And that's things like how we report supply chain costs, et cetera. So you see Bayer at about 64%. And then as you go down through the margin differential washes out a little bit more as you move down the income statement. But let's be clear, Bayer certainly brings accretive gross margin to the new company, a higher percentage of companion animal products, and several large brands, right? I mean you've got 3, 4 brands here that are large. All of those things are positive for an integration and a spin-out of Bayer corporate and to our net accretive impact on our margin. Our cost synergies will probably impact more sales and marketing expenses, other parts further down in the income statement. But overall, we expect Bayer to accelerate our ability to reach our margin targets as we've mentioned. They add the possibility. As I've said, we're not going to put a cap on necessarily our margin targets. They give us more optionality and possibility to exceed those.

That's very helpful. And then how did you -- or how would you characterize, you said that when you consider the other costs, it nets out on the income statement. So where were Bayer's operating and EBITDA margins?

Yes, I don't know was that -- it was, I think, in the 24% range for EBITDA.

Got it.

So our cost synergies will be focused heavily, as Todd and others have shared, replicating call points, so that will hit sales and marketing. You'd be looking at, of course, a different footprint. That will impact a little gross margin but also our cost structure. And then how we operate R&D going forward will all be the key drivers, of course, different, bigger procurement leverage as well.

Makes sense. And sorry to drill you with the financial questions when Todd isn't on the phone. But one more, just at a high level, so you had mentioned that dropping out the Bayer corporate will benefit Bayer Animal Health margins. So in a sense, are you saying that the Bayer Animal Health that you acquired inherently would have a higher than that 24% range for EBITDA. Is that the right way to think about it?

Yes, you've got 2 pushes and pulls at the macro level and lots of micro, right? And we've seen this with the Novartis and others is when you pull out, you can run it more efficiently, but you've got to also stand up systems at the same time. So what I think -- what we're doing right now is we're going to run 2 systems for a while. It's the right thing to do. It makes us competitive. It gets this thing done. It allows us to do it well. So we're standing up the Lilly system. And we'll have Bayer employees on a Tata system. That's going to be some added costs. But no question, you've got 2 pharma divisions creating an independent company that's going to be synergy. How that all plays out in our margin story, what I would emphasize to you, Dave, is we continue to see, one, the Elanco core margin story is staying. The road map is the same, Dave Urbanek in manufacturing. It's thriving. It's happening, and we can talk about that if you'd like. And then two, on the Bayer side, we're going to drive synergies quickly on footprint, call points and getting those efficiencies. But it will be balanced a little bit by 2 systems and the stand-up. And Todd will elaborate that with some of the investors over the next couple of days.