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

Okay. Great. Thanks. This is Erin Wright. I cover Life Sciences Tools, Diagnostics at Crédit Suisse, and I welcome you to our 2020 Health Care Conference. We're obviously in a virtual format this year, which is a little interesting, but feel free to ask questions via e-mail. You can e-mail me at erin.wright@creditsuisse.com or credit-suisse.com, if you'd like to -- if you'd like me to follow-up with any sort of questions with the company. And after the meetings today, we are hosting a little debrief and cocktail hour with A.J. Rice, Matt Miksic and myself. If you would like to have a link to that, maybe my French Bulldog will come along for any sort of beverages, but she's our team mascot here. But on that topic, I don't want to waste any more time, but I do want to introduce Jeff Simmons, the President and CEO of Elanco Animal Health. And thank you for joining us, Jeff. I think you wanted to kick it off with a few opening remarks, and then we'll head into Q&A.

Yes. Thank you, Erin, and Crédit Suisse for this opportunity, and I enjoy -- look forward to the discussion. I want to just kick it off to give everybody a level set. Everyone is kind of got a different history with Elanco. So again, 60 -- almost 67 years as an Animal Health company, we rang the bell in September of 2018 and started as a new company, and it's a pretty straightforward story, another independent Animal Health company, about a 1,000 points of margin expansion and a nice pipeline that would play out. Four things happened in the last 24 months, an animal pandemic and African Swine Fever, a human pandemic. And then 2 consolidations. Bayer came available kind of as maybe the last major deal in the industry. We were #4, they're #5 and some consolidation in the distribution channel as well. So what I would say is those events, I stand here 20 to 25 months after that, and I believe we're in a very strong position, but it has been noisy. And I think, Erin, we will get into some of this. But I would say a few things. We're building a global leader in a really durable market, which we feel very good about. The major essentials, the fundamentals, the things we've got to get right are coming together. So standing up the company. We're months away from exiting Lilly's IT system and being on our own, most all the employees are. But we had to take all the Bayer employees. We closed that deal and the value drivers of that deal, more pets, more retail pet, more size and scale, more international all has played out and is actually -- COVID is probably extenuated the significance of that in a more of a bigger way. So systems, stand up, Bayer, the essentials are really coming together. And as we talk about our strategy here in a minute on pipeline, margin expansion and portfolio, we feel very good about what we're about to do and pivot into 2021. We have an investor conference in December to share us some of the details. But there has been noise, and I'm not walking away from that, accountable for that. But what it's gotten us is into, I believe, a position of higher and greater value creation. And that's what it's about. And we're an execution story, and we've got to execute. So with that, Erin, thank you. You've been one of the earliest students of this industry, I know, and look forward to some discussion.

Thanks. Great. And I don't want to get it too much into the minutia here, but yes, obviously, I think bigger picture, yes, the industrial logic behind this deal and everything is you're going to emerge as this sizable Animal Health company with scale even greater than what you once were. But I do want to ask about just the recent quarter a little bit just because there were several investor questions around some of the moving pieces with Bayer contribution and stocking dynamics. I guess what were those core underlying organic growth trends for each, I guess, across both Companion Animal and Production Animal businesses for Bayer and Elanco, excluding some of those divestitures and moving pieces that I mentioned before? And also what's kind of implied in that fourth quarter trend that you gave?

Yes. So if you look at the third quarter, I think there's a few, what I would call event-driven discrete things that were comparison. So I would start on the Companion Animal side, we had a large retailer back last third quarter, make a onetime big significant purchase. So that was a factor. We had, of course, the COVID factor as well in Bayer, which we've talked some about on the Bayer business, where they had 2 things that drove the Bayer business. They actually had a buy ahead because of the cutover, which is common with the retailers. This is to be, I think, expected with large retailers and some increased actually inventory gain because of the COVID buy ahead. So that was Bayer, and we quantified that as well. And then I think the divestitures and some of the like-to-like comparison. So that was Q3 on pet health. I would say, though, when you take out the divestitures and you take out this retailer purchase, we're seeing in the underlying legacy business, Erin, a mid-single-digit growth in our underlying business, all the way from the end-user demand even into to distributors. So that's that. And then on the Food Animal side, we had Posilac, bST, we used to have, and there was a like-to-like item in terms of a comparison there. And then we had some Surmax as well, a change in a deal with use in Europe that's not being used now and then some COVID impact that we would quantify. So that's at a high level. What I think there's been more confusion on is Q4. Is there a softness? So yes, there was no question, 2 quarters out of 3 in the third quarter, 2 months in the third quarter, there were some questions. But here's what I'd like to do is just walk through very quickly what we believe are the main items in Q4 against the guidance that we gave. So some have said, "Hey, it's a little over $100 million. It appears to be soft, maybe a little more than that." So let me just try to walk through that. First of all, we've said between $20 million and $30 million remaining COVID effect. We've got about $10 million of that remaining Bayer inventory that will roll out. We've got about $30 million of divestitures that need to be calculated, $10 million on the Bayer side, $20 million on the Elanco side. And then the remainder is quite significant in its discrete items. So it's a pricing program that Bayer had in the fourth quarter, last year that we're not going to do. We're going to push that into next year. We want to keep the end of the year very clean. India, we report the top line. The deal is not close. Excuse me, we report the bottom line, not the top line. And then there's some accounting Todd talked about on the call. So that's quite a significant, I would say, like-to-like difference that we highlighted. Okay.

Okay. That's helpful. And then just sticking with the fourth quarter a little bit. I know you just gave top line guidance, but how should we be thinking about conceptually the gross margin trend? You obviously have the absorption benefit in the third quarter. That won't extend into the fourth quarter, but you obviously have the better Bayer mix, too. So on a year-over-year basis, the margin should still improve. Is that the right, still way to think about it? And also from an EBITDA standpoint, what are -- are there other profit headwinds we should be kind of aware of in the fourth quarter?

Yes. We haven't given guidance a lot of moving parts, but things that you need to consider is the seasonality of the Bayer business, as we've said, over 60% of it's in the first half. It lessens and gets smaller as you go through the second half of the year. So Bayer plays a smaller part and then some of these comparisons that were just mentioned. I think that's a factor. And then, Erin, as you know, looking at our fourth quarter last year, there is a seasonality step down. And as we have more poultry, more Food Animal, less Companion Animal in the fourth quarter. So there's a natural step down sequentially from third into fourth quarter that we see. So those are things to consider. We haven't gotten into EPS or EBITDA with some of the moving parts. What I would highlight is we continue to see, when you take out these events, mid-single-digit growth for legacy Elanco, we see 4% to 5% for the Bayer business coming into this fourth quarter. And you know what's happening in retail Pat. And outside of the poultry and a few of the things we'll talk about that may persist a little bit in international markets, we've seen up to this point, low to mid-single-digit in international coming in. So that's -- that, I think on what you're going to see then is the majority, a good share of this is events at the top line and then the like-to-like comparison step down a little bit in gross margin.

Okay. Okay. That makes sense. And then for Companion Animal, how are the trends progressing in your view? How did they progress throughout the quarter? And do you think there was an element of pent-up demand, we would obviously we've seen some data points on that, and it's been a little bit mixed. Also any sort of tangible evidence of increased pet ownership as well, if you could speak to that?

Yes. We've seen pretty consistent demand. Again, I would say the Bayer business, of course, again, is front-end loaded. I would highlight again, those events of the divestitures in Walmart retailer that purchased ahead. But so you kind of see that mid-single-digit. Yes, we continue to see, just when we look at our overall business, retail continues to grow. In a significant way, and we continue to have more capability and more portfolio there. Credelio and Credelio pairing as you and I have talked with Interceptor Plus the broadest portfolio. The pairing has increased with Interceptor Plus and Credelio and Credelio is up over 80%. I think that -- some of that is no question increased demand. But again, solid mid-single-digit. Growing in the tick fleet heartworm retail share and growing with Credelio share as well.

Okay. And then switching to the livestock segment, some of the dynamics there. You mentioned poultry, aquaculture as being kind of areas that were pressured. So does that continue? Does that get better or improve? Or what are you seeing in the market right now?

Yes. There's -- I really want to highlight, I think, a couple of things on the farm animal side that, as I've talked to investors that I really want to note is, first of all, as you see our future protein and health category, it's growing. It's been a big growth driver for us. We have a higher percentage of farm animal than some of the comparisons in our industry. We have a higher international poultry and actually salmon business as a well as a percentage of our overall business. So a couple of things that happened in the quarter that I think will persist to the rest of this year in a little bit to 2021 is the salmon industry. The salmon industry has seen about a 40% reduction in prices, a little bit of a shock to the industry. It's an industry, as you all know, is dependent on restaurants and food service. So it's been a lingering COVID effect. We see as COVID improves. The use of our products will come back. They're more premium products that are used and have high efficacy, and they want that because of the returns, performance and driving performance to help is less of a concern when the industry and the demand is down. And then international poultry remain mid-single-digit markets -- or excuse me, midsized markets where we're seeing the Middle East, Caribbean. We've got large shares there, and we're seeing that change. And our mix, and then last is in cattle. So cattle, we're seeing a change in the third quarter. There was a cattle run a little sooner. Cattle arrived to the feed yard. They're usually treated with an antibiotic vaccines that does not play to necessarily our portfolio. Once they get in the yard, then it's days on feed, that impacts products like Optaflexx, Rumensin. And again, we see that improving, but that impact in the third quarter. As I look into 2021, a little bit more of a COVID impact that we've talked about. And that international poultry and salmon markets will persist, we believe, the rest of this year, a little bit into next year. I think how it's going to be offset, Erin, is Asia swine ones to grow. We'll be launching new products as we go into 2021. As we've talked about, we've got 3 farm animal products right now that we've already introduced. And then again, I think as things improve, the economics change, our portfolio will lift. We're not really losing share as much is less usage, especially in international poultry.

Okay. Okay. That's great. And then heading into 2021, since you're talking about it, I guess, can you remind us what stocking, destocking dynamics we should keep in mind on the Bayer side of the business. There was obviously a ramp-up kind of with COVID and the timing thereon of that? And then also with your distribution changes, what we should keep in mind?

Yes. We believe going into 2021, things will be at the levels we want. So on the Elanco side, I just want to really emphasize is we really did not have an impact here in the third quarter. We believe we're at the right levels. We're using the key distributors, mainly in the U.S. pet health market. It's working very well. As you look at a Credelio share, Galliprant share. So we're at the right levels. No change, and we said if there was any change at all in inventory levels, we would let you know in the quarter. But right now, we feel that, that strategy and that decision has worked with better operational margins, numbers and prices. And then on the Bayer side, we'll have $10 million come out this quarter that we believe is the last unwind that was purchased mainly ahead for the cutover. And then any more that they've kept, and we believe that's about $25 million, that's directly related to the increased demand of Bayer. So simply, 2021, we see no change, no effect of inventory on either one of the portfolios.

Okay. All right. And then in terms of the -- some of the competitive headwinds that you've highlighted before, $60 million to $90 million in competitive headwinds in 2020 associated with Rumensin and parasiticides. Is that still the range you're thinking about? I mean it seems to actually play out a little bit better than maybe your expectations, but did some of that just get pushed out to 2021? Or how should we be thinking about the timing?

Yes. I think as we've said, I mean, between COVID and the distribution change and some of the competition, yes, but I want to be very clear, we still feel very good about a business that grows competitively into the future, starting really stepping up into that in 2021. We believe the road to 31% EBITDA is definitely clear and is possible as we look out. The starting point, as you and I've talked to Aaron, has changed some, and 60% gross margins. And we'll take a nice step into that in 2021. And hopefully, a lot of this noise, there'll be some comparison challenges next year, but actually, we think there'll be good clarity going forward. I think when you look at competitive pressures, we continue to look at Trifexis and Rumensin, the 2 that when we launched the IPO, we're continuing to hold to the assumptions that we have. We're pressure testing against those, looking at our competitors, looking at the marketplace. And then we're offsetting that with innovation as well as our portfolio approach. And examples that we can talk about are like parasiticides in that competitive marketplace, we're looking at it holistically. We're looking at globally. Because we see the global market as especially internationally, a nice growth path for for us. We see Seresto Advantage as we've talked in China as a key growth driver. We see feline as well as canine. So we introduced Elura, but we'll have other cat and feline innovation. We see that market. And then we see, of course, retail beyond the vet clinic. So international, feline and the retail market. And then our portfolio, Credelio Interceptor Plus is being very competitive in the marketplace and then we'll innovate behind that, Erin, as we go forward.

Okay. Great. And since you mentioned that the long-term margin target, 60% gross margin, 31% EBITDA margin, that's still intact longer term. Did you give some sort of a time frame, have to ask?

Yes. No, we have not. But I would say, I want to be very clear, there is a path to that. Bayer opens up a lot of opportunity. You saw within 60 days, we pulled the first $100 million of synergies. We'll start realizing that in the second half of next year. We try to do that mostly in that sales organization early, so we can stabilize that sales force as we get into 2021. And then we'll look to be continuing that road of restructuring and bringing the company together. And we'll talk some about that. I won't constantly point to December in our investor conference, but we will talk about the path to those targets and what we see as the key levers to get there.

You're more than welcome to use this platform to preannounce anything. So feel free. But you stated switching a little bit onto the innovation part. I guess you've stated now 5 new product launches by year-end 2021. We know about 4 of them. I guess, is it safe to assume that the fifth one is Companion Animal here? And will that be blockbuster territory or at peak sales?

So let me -- yes, let me be clear, we've said at least 5 by the end of next year. We've got 3 that are in farm animal. We brought in Elura that will be in the feline market for CKD. And look for us for the next one to be in the pet market. What I would tell you is we're looking at innovation, and we'll talk some more about this next month. But we're looking at innovation holistically. What you need is, yes, we want blockbusters. And I will say up the 25 products by 2024, and we'll put more of an update on that and more clarity on those next month at our conference. But look for us to have a constant stream, a good mix between farm animal and pet health. But I think the other is how much innovation growth we can account each year from that pipeline. And that's what we're going to try to put some clarity to, to have a very consistent material level of innovation growth every year. And that will be key. So -- but yes, the fifth product, we do believe will be a pet product, and we'll put more clarity to those and the markets that they're entering because they're entering significant markets. When it comes to blockbuster status, let me be clear, we're a bigger company. Bars got to be higher. All innovations have got to be more material, we believe. And yes, we will what I would say, in the 25, we'll be entering all of those big significant markets, pet derm, pet pain, pet parasiticides, some other pet therapy markets as well as the farm animal side, looking at raised without antibiotics, environmental, some of those big markets.

Okay. Okay. Great. And then back to sort of your cadence of innovation, so you have the 5 product launches. But then will you be back to sort of your 3 product launches per year sort of average? Or is it not going to be quite that linear on a year-to-year basis? I'm looking out 2022 plus?

Right. I would say that, again, that number will quantify and clarify next month. But again, the 25 products, again, we have some coming in from Bayer, pretty linear fashion. And a nice mix between really strong organic innovation growth in niche markets to blockbusters mixed throughout that time period. And again, we'll -- I would say that there always never be a perfect science to landing 3 to 5 a year, but it is pretty consistent flow throughout that time period.

Okay. And then in terms of those therapeutic areas of focus, I know that on the call, you didn't explicitly mention atopic dermatitis? So I did want to ask -- I assume that's still on your radar screen, where do your developments stand on that front? Do you think you'll be second or third to market with the JAK inhibitor in that category?

Hard to predict with our industry and exposure, and I'll be very clear to all the investors. Our goal is to continue to march down the line of more transparency to innovation. We know as a company, we need to do that. We've done a lot more now than we did 2 years ago, and we'll do more over the next year. We will be in atopic dermatitis market. We will be playing in the market of Apoquel and other products. And we'll come to market with a product that will have some differences as well. We're not commenting when, and I can't -- Mark, am I going to be second or third what I will say is we'll have a team, we'll have a capability, and we'll have some differentiation on that product to be able to be a market player.

Okay. Great. And then switching to the fleet to heartworm parasiticide market, you now have various different modalities there. You have Seresto Advantage, Credelio, Interceptor. How are you leveraging now that kind of vast portfolio? And how do they compete with each other, but at the same time, offer this complimentary sort of offering? And how are you dividing it up between kind of the channels? Because obviously, some are over-the-counter, some are more retail channel focused and some are more bed focused, if you could characterize how you're positioning those portfolios, that would be great.