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

Good morning, everyone, and thank you for joining us. My name is Nathan Rich, and I cover the animal health space here at Goldman. We're very pleased to introduce our next session with Elanco Animal Health. We're joined by the company's President and CEO, Jeff Simmons. Before we jump into the Q&A, I just wanted to remind everyone on the webcast [Operator Instructions] And with that, Jeff, thanks so much for your time, and thanks for joining us today.

Maybe to start at a high level, if you could just summarize for investors, the company's in December issued guidance for 3% to 4% annual revenue growth and working towards an EBITDA margin of 31% by 2024. If achieved, that would significantly improve the company's financial profile over the next 3 years. I guess to start, what are the key priorities, in your view, that the business needs to achieve that would put them -- put it on a path to achieve these targets?

Yes. Thank you, Nathan, and thanks to you and Goldman for the opportunity in the conference today. Yes. So Elanco, as you said, we come into 2021 with a lot of momentum. I have to kind of start this session like I do a lot of sessions I do internally and externally with the pandemic and what has happened, definitely a tragedy and a challenge to the global population. When you look at our industry, it highlighted the importance of pets and protein, the durability of our industry. And what is Elanco doing? What were we doing back in September of 2018 when we launched this company was we're building an independent global leader that can reach the world's animals. From supply chain to regulatory, to people that can represent the portfolios, to manufacturing footprint, there will be few companies that can reach and influence and serve the world's animals, and that's what we're doing here at Elanco. We're well on that journey. And from the time we launched the IPO in 2018 to now, Nathan, as you know, we have a stronger value proposition. So let me just highlight what I would say the 4 tough choices and back to our IPP strategy. We've made 4 tough choices that you're starting to see the benefits play out in an accelerated way in our '21 results. The first was the Bayer acquisition, a more durable, more diverse Elanco Pets now matched Farm Animal 50-50. You've got a 50-50 almost U.S.-international business. And you've got everything from omnichannel pet retail all the way to a much bigger international business. So Bayer was something you're seeing the benefits on and that'll drive a lot of the margin expansion as well. The other one is our distribution change, just a tighter, stronger distribution channel where we're in control of the share of voice and the economics and the value and that has actually put us in a much stronger position as well. And you saw that in gross-to-net pricing all the way through. The third is commercial leadership, made a challenge and a change over 80% of the senior commercial leadership and really putting Bayer experts in the right places, putting in the right Elanco people. And that is playing out as well, I see. And lastly is restructuring. We saw some of that yesterday and we can talk about yesterday's announcement on manufacturing, but we've accelerated 2 major restructurings before that soon after the acquisition. Those were 4 hard choices. Those are driving growth benefits. And then that links to our December investor conference and our strategy, IPP. Our algorithm is critical. We turn that 3% to 4% of consistent growth, again, an algorithm aggregated over time, into double digit EBITDA, cash conversion, delevering. And as we pass the stand-up cost going into next year, you're going to start to see, as you say, this flywheel of value turn into one of the strongest in the industry. So we're an execution story. We've got a lot of momentum. We've been hitting our targets and delivering since August 1 of last year when we acquired Bayer, and it's all based on that algorithm in the IPP strategy. We want to be transparent and clear and predictable to our investors as we go forward relative to these results.

Can we maybe dive into the 2 of the key pieces, one being top line, getting to the 3% to 4% revenue growth faster than what Elanco had done the past couple of years. Kind of what's the delta that gets us there from the growth that the company had been seeing to this 3% to 4% longer-term target?

Yes. Well, first, back to that $500 million to $600 million of innovation, Nathan, that we've talked about, getting to 2 to 3 percentage points of growth pretty consistently on average per year. We start very strongly with 8 of the 25 new products between now and 2025 that we currently have in development. These 8 are being launched. They'll be a key driver, as we've said, $80 million to $100 million this year, that trajectory will flow. So innovation is one. Two is having a more diverse, durable Elanco after Bayer. We're seeing things like pet retail, international pet, our aqua business, a stronger cattle portfolio with a few new Bayer products in there and a few new launches. All of these things would be another big driver that would really come back to the rationale of IPP and the Bayer portfolio strength and the size and scale, Nathan, that's going to give us that growth that we're talking about.

And then the other piece of the long-term guidance is the -- going from EBITDA margins of 22% to 23% this year to 31% by 2024. It seems like synergies are a big piece of that. You had the announcement yesterday on the manufacturing optimization. Could you maybe just elaborate a little bit on that announcement? And I guess what really stood out to us is it allowed you to pull forward the gross margin target by a little bit, 2023 now versus 2023 to 2024 previously, but also reduce your annual CapEx by, I think, about 20% of the total, if I'm right. Was that a unique opportunity? It seems like it was a pretty sizable improvement in both the margin profile and cash flow profile of the business going forward. So could you maybe just elaborate on what you saw -- what the opportunity was and kind of what led you to take that action?

Yes, Nathan. So I kind of make -- to revisit, we were -- we accelerated that restructuring that I mentioned earlier. So we had a restructuring right out of the gate when we announced last summer where we actually addressed the overlapping sales force, get the sales force right out of the gates. We did that last summer. And then going into the end of last year, as you know, another restructuring that came, which was overlapping, R&D, G&A, other things, offices, getting the G&A right as we went forward. This is kind of that third phase, which is looking at the footprint. And what I would say is our manufacturing team, our operations team have built a muscle here with Novartis and other acquisitions, understanding completely that, hey, you've got to have full plants that are efficient, that are fully occupied to optimize margin expansion. So this was the lens we look through and then getting partners. So we exited Brazil and going to leave that plant. And then we're selling but going to stay in both Shawnee, Kansas as well as the Speke, U.K. plant, and partnering with TriRx that has an intention to fill those plants. You're exactly right. When you look at the conversion, 600 employees with a more secure, better future with full plants, but a simpler, more streamlined Elanco with 3 less facilities that we're responsible for. CapEx, $25 million to $30 million a year, these are aging sites. And then better cash conversion on our balance sheet where we're not holding that inventory. So we're going to be turning that into $75 million to $85 million of cash. All of this is bringing gross margin into a stronger set, and yes, accelerating up to 60% by 2023. So a simpler, streamlined, stronger Elanco; a stronger footprint; a partner; and again, on the road to that $300 million by 2023, 2 years earlier, on the EBITDA synergies. We are a company, as you know, with the acquisitions we made even inside of Lilly that knows how to capture these synergies, and it's part of this being -- we're an execution story to get this 1,000 points of margin expansion.

Great. So it sounds like well on track in terms of taking the actions that you need to take to get to the margin targets that you've outlined.

Yes. And the next phase, Nathan, just to highlight, is a lot of it is a cost discipline, overlapping those stand-up costs, as we've talked about. And then back into the P&L, it's going to be procurement, it's going to be leveraging that size and scale. And SKU rationalization, doing the appropriate things. That's a lot of blocking and tackling here in this fourth phase.

Great. If I could ask on one of the subjects that's been a little bit more topical recently, the parasiticides business. There's been a lot of focus on the monthly data. We look at Nielsen. If I look at the month of May, showed a decline in both the flea and tick category as well as for Seresto. Maybe one of the shortcomings of some of this data is it only captures a small portion of sales and the monthly data can be volatile. So I guess, Jeff, from your point of view, how much variability do you typically see month-to-month during the course of the flea and tick season? And I think you had talked about maybe a cooler spring driving some of that volatility. Could you maybe just talk about how sensitive the flea and tick business, especially in the retail channel, is to weather?

Yes. Well, I'd back up first and say much bigger pet business for Elanco overall and a global pet business. I think when you look at parasiticides, we have the broadest portfolio. So we cover the vaccines, we cover the in-the-vet clinic, para as well as pain and then, yes, the retail business. So what I'd say is, overall, we still have a lot of tailwind coming out of COVID when you look especially pet numbers up, visits up, compliance up, wellness sales are up relative to where we were even as much as last year and definitely over a 2-year average. As we shared, Seresto has come through the issues from a PR perspective very well and came into April in a strong position relative to the 2-year average. But yes, there's no question a pet retail business on the parasiticide size is a little more susceptible to weather. We had a cooler May. I'm not going to get into inter-quarter discussions relative to results. But I like the fundamentals of our overall retail business, the trajectory that it's on, the relationships, the business, the market share is where we are today. And as we look even going forward, the life cycle management, the innovation and the capabilities like digital and omnichannel that we're putting against this and the international growth that we're seeing with products like Advantage and Seresto in the China market as an example. So when I step back, I still see the overall underlying total pet, total para and even retail over the period, very, very good and things tracking well.

Great. I know we don't have Todd on the line, but if I could ask one on the 2Q guidance. You said that the global Seresto revenue was ahead of expectations in April. Was it also ahead of what was included in the second quarter guidance? I'm just trying to get a sense of maybe what's baked into the 2Q revenue guidance and how we can put the volatility that we might see month-to-month in context.

Yes. I think I'm not going to get into a lot of detail here, Nathan, but to say that, yes, we've taken a balanced perspective on our whole portfolio and in that context as well in the Q2 guidance as we looked at that. So no change to that.

Okay. Fair enough. And last one on Seresto at a high level. You talked about the double-digit growth that, that product has seen. I think that you can expect that type of growth going forward. Can you just maybe talk about what has resonated so well with the consumer with respect to that product and what you see is the biggest opportunity to continue the growth of Seresto going forward?

Yes. So we saw -- just as a reminder to everybody, we saw a major lift in the product coming through COVID. So over $420 million of sales last year in 2020. So a challenging compare because of a significant step-up in total growth. But as we look over the trajectory, we look at, one, the 2-year averages, like we've talked about; two, the trajectory of the product, Nathan, what we see here, fifth largest product overall in Animal Health. Why? And the loyalty to this product. We saw in the recent market research that we talked about at the last quarterly earnings that 98% of current users on the market research we've done are returning or plan to return to the product this spring and we saw that even in our diligence. Why do you see that loyalty? It is a very specific market segment of pet owners. They want convenience. They want 8 months of coverage, good economic coverage, safe coverage. Ticks and fleas, I don't need to worry about them. It's got a nice feline market as well. And now it's building into international markets where maybe the vet clinics are not as connected. So this, to us, now -- what Elanco sees is life cycle management, increasing capabilities of digital and omnichannel and then starting to put connected care and the next generation of innovation around this. And our pet retailers like this, especially the large e-commerce players like this, because of the loyalty and the brand awareness around Seresto. So a good brand. We haven't given long-term projections that you maybe noted there relative to growth rate, but we do see the product continuing to grow and being a critical brand with strong IP going forward.

Great. Makes sense. Maybe shifting over to the livestock business. Maybe starting at the market level. The business, like you said in your earlier remarks, was impacted by COVID last year, probably partly related to the decline in foodservice demand. I guess how are you thinking about the recovery in that business this year as economies reopen? And I know it's probably different species to species, but could you just maybe provide some high-level thoughts on how that market trends this year?

Yes. I'll start maybe at the highest level when I think about our Farm Animal business overall. And when I look at this businesses, I think industry-wise projected low single-digit growth. As we look at it, we're looking at probably a little bit more growth than that, probably more mid-single digits. So when I look at what are the growth drivers for us and what's going on environmentally as well. I think on the positive, on the push side, you're seeing, first of all, 5 new products entering for us as we look at raised without antibiotics; the Increxxa BRD product in cattle; Experior, which we see long-term being a blockbuster. Those 5 products will contribute a lot of that growth in the second half of this year, but that will be a key driver. The other is with high commodity costs, Nathan, as you know. This is a big factor. Now the economics of cattle, swine and poultry have held up. But when you have higher corn prices and ingredient costs, performance-based products like Elanco has, which we have a little bit of a heavier-based, performance-based portfolio, that's been beneficial to us. Rumensin, Optaflexx, our anticoccidials in poultry are giving higher returns against those higher feed costs to producers. That's also a driver. I think the third is the Bayer portfolio, especially in cattle, adding Cydectin and Baytril to our cattle portfolio, that's increased. And then as we've talked, China will be another key growth driver for us, 1 percentage point of total growth to Elanco globally coming out of China. I think the pushes back -- or the pulls, the challenges are a few things. First is, as we've mentioned, salmon, restaurants opening, salmon prices down. We are seeing a recovery of salmon prices. We do see our business rebounding in the second half, but challenged in the first half. We see poultry still today with COVID impacting the Eastern Europe, the Indias, the ASEAN countries, that has restricted people economically to move up to eating more poultry like they normally were. So that's impacted some of our poultry business. We see that improving -- slowly but improving in the second half as well. Those are 2 negatives. And then we said, keep our eyes on African swine fever. Prices have dropped on pigs domestically in China. That's driven a lot by some of the cases in the northern part of the country. We do see the industrialized market that we serve more stable, better biosecurity. But they have had some recent challenges. So that, to us, still, we're holding to strong growth in China, 1% total, all linked to our overall plans. But those are the pushes and pulls that I would see in Farm Animal, but good growth and also a compare that's favorable to us, as you know, from last year with distribution changes as well as COVID impact.

One of the other topics I wanted to touch while were on the Farm Animal business is the shared class antibiotics. It's obviously been a longer-term trend. I think that as a percent of your Farm Animal business has continued to come down. Are we getting closer to a point of stabilization where I know there's still use for those products in a lot of instances in certain markets? I guess where do you think we will be 3 to 5 years from now on the use of shared class antibiotics?

Yes. I do believe it's stabilized and leveled off, right? And especially as you start to look at higher feed cost and the economic pressures inside of producers as well as people wanting good economic choices on protein out in the marketplace, cost still matters there as well. There's a balance of giving consumers what they want, animals what they need and the impact on the environment. So when you look at that, I think shared class antibiotics have found their place, which is, one, just what we did back when we announced our initiative more than, what, 7 years ago is bring alternatives: remove growth, promote and claims on shared class antibiotics, and we did that many years ago; create therapeutic use that's prudent and targeted, so injectable products is a higher percentage right now of our portfolio than the feed grade; and then on feed grade, it is very much targeted and scripted by a veterinarian and managed and documented at another level relative to where we were maybe 10 years ago. So I believe it's stabilized. Animal health still matters. I think people are aware of that more than ever, that for safe food, you need healthy animals and antibiotics will be needed at appropriate times but done in a very different way. For Elanco, we believe we've got the right portfolio. It is much smaller part of our mix. It's very targeted. There are still countries around the world in Asia and parts of Europe that could reclassify again. But again, we don't see that as anything material as we become a much bigger, more durable with a stronger mix in our portfolio overall.

Great. I wanted to shift over to the pipeline. You -- the company has definitely stepped up its pace of innovation, and you've mentioned the 25 adjusted launches driving $500 million to $600 million of revenue by 2025. If I look over the next several years, it's a pretty steady stream of launches, 8 this year, kind of 5 to 10 in that ballpark each year after that. You gave a lot of the detail on the pipeline at the Analyst Day. But I guess maybe summarizing for investors like what are the key categories of products in your view that you need to be successful with to be on track to hit the $500 million to $600 million over time. And how would you kind of characterize like the line of sight that you have on being able to successfully bring these products to market over the next several years?

Yes. I would start with Elanco has a track record to bring in innovation over the decades, but even over the last 5 years. We contributed, as you know, on average, about 3 new products a year and they contributed about $450 million over that period of time coming into last year's sales. So now we add this $500 million to $600 million that is balanced, we believe. It's probablized. It's a mix between Farm Animal and the Pet Health market. It is, as we've talked about, 45 shots on goal, probablized to 25. We're given kind of, as you know, Nathan, historical transparency and also visibility to the numbers and the spaces that we're in. So yes, on average, that's -- that 2 to 3 percentage points of growth coming from innovation and the algorithm. On average. It won't be the same every year. This year with these 8 products, that will be a key contributor over the period to the $500 million to $600 million. And I would first start to say, we look at it as a blend, as a higher threshold coming in. Now that Elanco is a $4.5 billion company, we have a higher threshold. So these products have to be materially in size. We need faster ramp rates. So that's what we're looking at as well. So hey, how can they be differentiated coming into the market and how can we price them so that they're positive to our margin story? And a nice blend between portfolio builders and blockbusters, and when I step back, I would say that, that blend is very appropriate as we come forward. And a lot in clinical development, when we put Bayer plus Elanco together, our clinical development capabilities are stronger than they've ever been in our history. Now it's execution. Look for us to continue to build out para, derm, paint, aging pet. Over on the Farm Animal side, it's raised without antibiotics and the microbiome and our nutritional health, vaccines, food safety, more poultry. Those are all areas that I would tell you that we're targeting, that we are positioned already as a leader and we can bring products in that are additive. We're not doing something radically different or new that would actually create significant risk to our investors or to our company.

And how do you think about the organization's capacity to support that stream of launches both from a manufacturing standpoint and a sales force standpoint? Because it seems like that's really going to be key to hitting on that 3% to 4% growth is getting the sales contribution that you expect from these products.

Well, first of all, we're 8 products already in launch mode, right? So it's -- we're integrating them in and Increxxa and Experior going into a large cattle portfolio. This doesn't take more sales reps. This takes the opportunity to build out and the same customer base with the same people. It's capabilities around our market enablers we had in our algorithm. So digital channel, making sure we're using all of the channel appropriately, making sure that we're pricing this right, the geographic expansion and just launch excellence. Those 5 key enablers, we've built capabilities with Bayer around those 5. We're very focused. But when we think about launching this new innovation, Nathan, it's going to be there. That's where we're going to be targeted and where we're going to be focused.

Great. And I guess how should investors -- or how do you plan to help, I guess, investors track the progress with these new launches as well as the regulatory submissions? What are sort of the key kind of benchmarks or guideposts that we should look for to kind of track the company's progress against these targets?

Yes. I'll take your question and I'll back it out first and then I'll answer it specifically. I think when I back it out, we were very thoughtful in our December investor conference, and Tiffany and our IR group and looking at this algorithm, to say, look, Animal Health with multiple species, geographies and therapeutic classes has a lot of pushes and pulls. So the algorithm really matters in terms of how we get that 3% to 4% growth, double-digit EBITDA, bottom line growth is going across that focused brands, core and defend and market enablers. So what I want to do is really highlight for you the importance of that overall when we back up. So I think that's really important. How we'll track it is we'll always be anchoring back over time. It's not going to always be specific to the quarter or the year. Over time, how are we doing relative to that algorithm. We'll update you on registrations. We'll update you on launches as we have within Experior or our Credelio Plus. Exactly the numbers per quarter, that will come with time, but we're going to be a little more cautious at a high level for competitive reasons as well as just overall managing the trends and the trajectory. So look at us to anchor back to the specifics by product and then we'll give you the numbers back to the algorithm over time.

I wanted to touch on 2 of the areas you mentioned on the Pet Health side, parasiticides and dermatology. Both seem to be key parts of the pipeline. I guess maybe starting with the parasiticides business. Obviously, it's a mature market. There are opportunities for innovation. I guess -- I think in the past, you've kind of talked about maybe longer duration products. There's been a lot of attention on combination products. Just maybe where do you see Elanco kind of being able to differentiate in the parasiticides space with what you have in the pipeline?

Yes. It starts really what we've got now as a whole company, as you know, Nathan. I think omnichannel matters. So when we look and say, hey, the broadest portfolio in parasiticides, the broadest capabilities from the standpoint of hitting a vet clinic, a retail, a pet owner directly with e-commerce, from China to the U.S., so the geographic, I think, is absolutely critical. And I would even say the canine/feline is we're starting to build a feline with Elura and Credelio Cats, we see continued opportunity also there. So first, its capabilities to be able to reach the pet owner with what they want, where they want and bring the veterinarian into that discussion. So I think Bayer has given us not only a much bigger portfolio and scale, but it's given us capabilities when we put them together that will be very competitive long term in the parasiticide segment. Then what we've shared is we've got 11 candidates in our pipeline in development that we're confident we'll deliver again a new product every year. And then as you just step back and look at our overall portfolio, today's competitiveness is only going to be additive, is when we talk about retail, Seresto, Advantage, leading brands; Credelio Plus international. With a large parasiticide, we've got everything we need internationally to compete at parity or greater internationally. In the U.S., Credelio Plus, Interceptor Plus, the broadest coverage. Any pet owner that wants full coverage needs 2 products today and we have 2 that have as strong of an offering as anybody else, and then bringing new products into this market as well. So I think we're well positioned with innovation, omnichannel portfolio and now I think an organization that's got the deepest capabilities to execute.

And a similar question on the dermatology side. Obviously, a large incumbent in that space. I guess kind of given where the market stands today, where do you think there's the opportunity to add incremental value to the vet in the products that you have in development?

Yes, Nathan. So dermatology, a market that is growing significantly, a very big market. It is a market that we're -- outside of one product, we're really not in. So when we get into this market, it's going to be accretive and very attractive to us as we -- as you know, and we will focus heavily on as we look at our candidates and our pipeline. Very focused on any other way you would differentiate, which is starting with the pet owner: it is how we make it more convenient, is that duration, is it simplicity of use, is it -- second is safety, the safety profile of the product and what can be done. Value to the veterinarian would be another one as well. But at the early forefront, I would just say, is bringing innovation into one of the largest, fastest-growing pet health markets with our capabilities with almost every dollar being accretive is critical to our valuation for the company and for our strength as a leader in this space as we go forward. So it is a key priority for us.

And then just going back to the Analyst Day, you talked about maybe using external M&A to maybe tack on incremental opportunities where you could see fit. I mean how big of a focus could that be? Are there areas that you think maybe you would look externally to kind of bolt on -- to kind of further bolster the product offering that you have?

Yes. So our primary focus is on those 45 candidates turning into 25 launches and then launching very, very well. We know that organic innovation is what we need, is the only thing that we've included in that $500 million to $600 million and our growth rate and our algorithm going forward. But yes, we have a history to be a partner with companies to -- we're agnostic to whether it's inside or outside. We've got, with our R&D team, an agile organization that can adjust. And as you look at our history, when you point to a Novozymes relationship that's co-innovating with us in the nutritional health space to even Aratana in the past or even the parvovirus that we've done here recently as well. So we'll stay agnostic and opportunistic, but we'll keep our focus on that organic pipeline as our primary focus.

And how should investors think about -- shifting over to cash flow. Because I think that as all of this comes together, you've kind of talked about the EBITDA growth that the business could see. How do we think about free cash flow conversion? Some of the onetime cash costs associated with the deal stepping down over time, CapEx changing over time that we talked about earlier. How does that turn into free cash flow for the business? And any sense of kind of phasing over the next few years?

Yes. Thank you, Nathan, for the question because I think it's really critical to understand the stand-up and what we've done. So we IPO-ed and separated from Lilly. We had a Lilly IT system that we moved into Elanco, and that started in 2018. That has just been completed in the last quarter. That was a major milestone, but that was a major cost, now the stand-up of our current system. Then with Bayer, we moved that into TCS. Now we're moving the TCS system. We don't have TSAs with Bayer as much as with TCS. Now we're going to move that over the next couple of years. So last year and this year are significant onetime costs. As we pass them going into next year, you're going to start to see free cash flow, and we haven't given specific numbers here, but you're going to see a significant step-up in the free cash flow conversion with that. Then you add on things like we did yesterday where you have less recap costs on plants, a simpler footprint, all of these are going to be where we see the movement and the step-up that Todd has talked about during the Investor Day conference and better free cash flow conversion in a more significant way as we start heading into 2022 forward in the period.

Great. And I know we touched on this earlier as well, but just as it relates to the achievement of synergies as well as some of the productivity initiatives that you have. The kind of actions or next steps that you need to take, it seems like kind of well on track to hit the $150 million to $170 million of synergies this year. What still needs to be done to put the business on a path to achieve the $300 million by 2023?

Yes. We are tracking again $300 million of that EBITDA synergy 2 years faster than when we came out and talking about it with Bayer, well on our way. The 2 restructurings we've done, the footprint change from yesterday are all key moves. As you can imagine, cost discipline, the standing up and the synergy that comes from the standing up of systems and just making a more efficient Elanco. We've -- as you know, with the many acquisitions we've made, we've built a muscle here. Bayer gives us more opportunity and optionality to get to that $300 million of synergy is -- we're well on track. We're tracking to it. It's now going to be, to me, it's the blocking and tackling. The big moves have been made. Now it's procurement, disciplined cost and leveraging the synergies of the 2 companies. Those are going to be the key factors to deliver that.

Okay. Great. I think we are almost at time. So with that, Jeff, thanks a lot for your time today. Everyone on the webcast, thanks so much for tuning in. We really appreciate it, and best of luck with the rest of the conference.

Thank you. Thank you, Nathan.