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

Good afternoon, everyone. My name is Joe Modisett. I lead our health care investment banking effort in the U.S. It's great today that we have Elanco with us. We have Jeff Simmons, President and CEO. And before we jump into Q&A, I'm going to read some of the standard disclosures here. So for important disclosures, please see the Morgan Stanley research disclosure website, www.morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representative.

So Welcome, Jeff. You've been quite busy here over since the IPO. And I thought maybe it's just as we start, obviously, there's been a lot of changes to your business. Obviously, you stood up the business coming out of Lilly. You've done a number of major strategic deals, Bayer being the most -- the largest and probably the most important. A lot of operational changes, whether it be channel strategy or productivity initiatives, all with a pretty dynamic backdrop, right, of both the Pet Health and the Farm Animal. It would be great if you were to think about what are the 2 or 3 things that investors should be focused on, just given all those moving parts kind of taking a step back, what's the right place for investors to start to focus here with the story?

Yes. Thanks, Joe. Look forward to the opportunity and excited to have this discussion. We've had a great conference here, and thanks to Morgan Stanley. Yes, at a high level, I think it's a great question. If I'd put it in 3 words: it's choices that we've made, delivery where the business is today, and future. And I do think your time frame is right. I mean we IPO-ed in September of 2018. So coming up here in 3 years, and a lot changed, right, in the environment from the standpoint of not just the pandemic, but before that, the Bayer asset becoming available. So the investor conference last December really allowed us to launch this new company and really Elanco plus Bayer and that really drove the expectations forward. So the 3 things I think I would keep the focus on is, one, choices that we've made. Bayer has allowed us to become a company of scale, more Pet than Farm Animal now, so a nice balance. The omnichannel, the international presence, 3x the pet business, all the things that were original of the premise of doing the Bayer deal have paid off and are paying out and are real. And so we now are a global independent animal health company that is standing up that has more diversity, durability and value proposition than we actually had when we launched the IPO. So Bayer was a tough choice. We also saw restructuring. We've accelerated and had significant numbers of restructuring to continue to drive EBITDA growth, which we'll talk some about, which we are doing and making a more optimized company while we're standing it up. We also made some distribution changes where we consolidate distribution, took more demand creation in our own hands and that was a decision that is paying off significantly. We've also made some leadership changes as well. So I think these choices, again, in the midst of a backdrop of ASF, African Swine Fever, COVID and other challenges, even say a Seresto challenge that we had from a PR perspective. I think the second one, though, is delivery. I think this is important. Since the Bayer acquisition, so Q4 of last year, Q1 and Q2, we are exceeding expectations. In December, we laid out a growth algorithm and a strategy, very clear growth 3% to 4%. This year, we're growing at 5% to 7%, exceeding expectations. We're up about 280 basis points. If you look at guidance on margin expansion. We're going to need, Joe, to keep that same clip on margin expansion to hit the 31% by 2024. So that's a pretty linear line that we've talked about that's going to be critical. So that's important. The delivery continues and we stand by a very strong, exceeding planned guidance for 2021. And then I think the third is our future. We've made continued transformation to make us stronger. We consolidated 3 manufacturing plants in Q2. And we know that full plants are critical. If we can't fill our plants, we're making the transformations and moves much more rapidly, I think, than anyone anticipates and that will help us accelerate our margin expansion to be at 60% gross margin by 2023. The other move we made was Kindred. We brought Kindred in, entering us now in one of the strongest pipelines in derm, a $1 billion headed to $1.5 billion, $2 billion market. And I would say that the second thing about our future is a heavy focus on a late-stage robust pet blockbuster pipeline in development that has the Kindred assets, our derm assets, parasiticides, parvo pain, these things that we know drive the multiples in this business. So tough choices that have strengthened us, made us a bigger value proposition. Delivery, 3 quarters in a row of delivery, exceeding our Investor Day commitments. And third is a future, stay into really an EBITDA growth expansion trajectory driving to a pipeline that will deliver $600 million to $700 million of innovation between now and 2025.

Great. Maybe we'll, again, take a step back, talk a little bit about your end markets, we'll then drill down a little bit in each one on your portfolio. So starting with Pet Health. Obviously, strong tailwinds, but a lot of different moving pieces, right? You've got the puppy boom, how long is that going to last? You've got a move to e-commerce and digital as well as you mentioned, parasiticides, there's competition. Is that market expanding? How do you see all those different factors playing? And how do you see this market growing, both near term and long term, just given those different factors and maybe other things I haven't mentioned?

Yes, Joe, the common question even at this conference is, hey, how do we decipher as we start to get on to compares to last year and looking at this pet market. What I would say is, absolutely the pet boom that we've seen 4%, 5%, 6% growth in U.S., China, U.K., I do think that trajectory will lessen some. But no question, we got a jump that will stay and persist going forward. I think the area that we must get our attention focused on is the pet owner experience. The pet owner experience changed rapidly and positively during the COVID situation. What happened? Curbside, telemedicine, omnichannel, drop-shipping, all of these things. And I think wellness programs might be the biggest one, which is really the ability to get people to come in on a regular basis to sign up and be part of a regimen of wellness programs. What's that done? Well, the backdrop of pet vaccine market has grown significantly and persisted. I think getting the pet owner experience at another level will be what we look back 2 years from now and say, COVID changed our industry. Yes, there were more pets. But actually, we made the pet experience better. And the veterinarian played very big role in this transformation. That clinics are stretched right now, labor shortages. That's kind of right at the end of the rope here relative to fatigue and we're doing like everybody else in the industry, we can, to help the veterinarian. But I think we have transformed to make the vet -- the pet owner experience better. For us, the omnichannel is better. I mean that's one of the big premises of the Bayer deal is, meet pet owners where they want to shop. Look, there's 1/3 of pet owners that were not shopping online going into the pandemic that have surveyed to say they're going to stay there. So you've got more than half the pet owners in the U.S. that are experiencing that. And that's not just OTC products, that's scripted products as well. So that plays well to some of our portfolio as well as our capabilities. I think on growth rates, too, I would just note one thing. There's really an added element of growth in pets right now that needs to be normalized, I call it the 3Ds. There's some data companies that have been purchased by Animal Health, diagnostics, as well as derm. And I would say, Elanco leaning in, going into derm coming up, but some of that escalated growth rate from some other of the proxy companies are really driven by those 3 factors. We're targeting on markets that we know we can grow and win in, and that we can talk some about those.

Okay. And kind of specific to your business, obviously, your vaccines business has seen really good growth in this backdrop. How -- what has been kind of the biggest contributor to that? What have you seen kind of with the changes you mentioned, how has that benefited? You mentioned a little bit about the vaccine business, but what else have you seen there?

Yes. Well, I think an acquisition we made back a while ago, we've continued to innovate against it is that we've got one of the leading pet vaccine lines in the U.S. And what we have done is, work very hard to make sure our share of voice is up, our distribution partners are participating in these wellness programs. We have increased investment in digital, so that we're helping pet owners realize their participation in those wellness and getting in for the clinics and participate in as much as we can and the value beyond our services with the vet clinics. All of those things are helping, I think, an overall industry backdrop that's expanded this market. That will come down some overtime, but something we've been trying for a long time in this industry is increased compliance, increased wellness to pets. And I believe we've done a lot here in a year that may have taken 3 to 4 years under normal conditions.

Turning to the parasiticide. You mentioned Seresto reiterating your confidence in those expectations despite, I think, the first half, having some tough comparisons, maybe some challenges on the weather there. What are you seeing in the market that gives you confidence in kind of meeting those expectations, despite second half of the year, usually being a little bit -- seasonality has been weaker than the first half?

Yes, Joe, that's right. It's the Seresto Advantage, as you see Bayer's portfolio very heavily front-end loaded business. But look, Seresto continues to be one of the largest brands in the Animal Health. We see a long runway of growth. It will meet, as you mentioned, our expectations for 2021 overall. What we see is a little bit of even the premise of the Bayer deal playing out. One is there is a lot of loyalty to this product. So just recent market research, even in the midst of some of the PR challenges, we saw over 98% of Seresto users responding saying they plan to reuse. The confidence level is high. Because of Elanco's leaning in more as an independent company versus Bayer Corporate, we've seen more advocacy from the veterinarians even during this opportunity. And then we look at this overall plan for growth. So one is continuing to get to new users in existing markets like the U.S. through digital. And a lot of Seresto users are not naturally first users into the vet clinic. They're not going into the vet clinic. So we're reaching them through other means and then our goal is to get them into the vet clinic. So market expansion in existing markets like the U.S. had a really strong Southern Europe expansion of that market here in the second quarter. Number two is international growth. So Asia, Latin America, we've got one of the largest now pet teams -- pet retail teams in China, and it manages doing extremely well followed by Seresto. So look at international growth, and then following connected care and life cycle management plans that we have going forward. So we see this product over $400 million. It's continuing to grow nicely, and we plan to continue that trajectory of growth.

Okay. And you mentioned international there for that. But overall, in your Pet Health business in international markets broadly, I mean, how do you see those -- where do you see the biggest growth opportunities? I think you mentioned China, the U.K., but where do you see the biggest growth in Pet Health, especially that could offset maybe some of the moderation that you're seeing. You've seen continued growth internationally, where do you see those opportunities and where are you investing internationally in this business?

Yes. So I think if you look at this holistically, first of all, the way we structured our business because of the different initiatives, Joe, is U.S. Pet Health, U.S. Farm Animal. That's allowed us more intensity, more expertise. We have a retail business, a specialty business, and a vet clinic business. We're seeing, as I shared at the investor conference, continuing to see that dedicated expertise and focus is given the operational results we need, especially as we changed our distribution model. Europe, very different there. So when we look at international, we continue to see European growth inside of Europe, both with the corporate clinics and the traditional business. International is set up as a separate operation because we see the businesses in the market being very different, being very aggressive with our growth. Yes, China, we see nice, steady, long-term double-digit growth out of China. And we have a portfolio today with Advantage and Seresto that are new to the market in a market that likes online. The vet clinic is new. It's not as prominent and mature, and they want multinational brands. So we see that. I think the other thing that's going to drive our overall international business is the $1.5 billion parasiticide market internationally. Our launch of Credelio Plus is ahead of expectations. And we see today, we've got as competitive, maybe the broadest portfolio internationally of any company. And we can really today with Credelio Plus compete with any product on the market. So those would be a couple of the key drivers in international.

Maybe we'll turn to the Farm Animal business here. That's helpful in the pet health side. Obviously, more challenges in this market with kind of the return to food service. You mentioned African Swine Flu, some high commodity prices impacting customers. Do you see any fundamental changes in the way customers are kind of operating in this environment that are going to last past this with all the recent COVID changes or other related changes that are going to impact your business?

Yes. I think overall, Joe, this is maybe a low single-digit market as you go forward, but a durable one, one that you can operate more efficiently in. And I believe that there's quite a bit of barrier to entry for companies that don't bring innovation. And I point to even a Rumensin that has increased competition in how we've continued to meet and exceed expectations there. It is one, broad portfolio; two, a real strong B2B presence; three, bringing value beyond product and then bringing innovation into that portfolio. So take a beef portfolio with Rumensin and Experior and Increxxa, the 2 new Bayer products. Then our Elanco knowledge solutions are always to actually do better than a nice solid low single-digit market. So this year, Elanco will grow our Farm Animal mid-single digit. It will be driven by 5 new innovations led by Increxxa, raised without antibiotics; and Experior, our environmental product that we see as a blockbuster in the medium and long term. I think -- so new products are going to be key. We also have $6, $7 corn. And you've got a portfolio in Elanco that is value-based. We can get more out of the feed conversion and weight gain, which is more value for people that are spending more on corn. So I think that's key. And then Bayer's portfolio has helped us a lot as we look at both our overall China portfolio on the Farm Animal side and China being a big growth driver as well as US beef. So number one in poultry. Poultry is a segment that's growing more 4% to 5% growth. So poultry and aqua will be another thing that we'll continue to lift. So Elanco will take share this year. It has a nice durable business, will be a nice foundational growth business for us where these pet health blockbusters, we'll talk more about, will be the incremental on top of it.

And obviously, there are different regions and kind of the return to food service are experiencing different levels, right? And you're seeing, obviously, positive trends, I think you saw in U.S. cattle and swine, but maybe some more challenging ones in developing markets for poultry and aqua. How do -- do you see changes in that as we -- I know it's been a month since earnings call, so maybe not changes since August, but how are you seeing those dynamics play out here in the market real time because things are changing quickly?

Yes, I think, we got to keep our eyes on the delta variant as we go into the fall and winter. I mean, we expected some improvement, and we saw, as we said in the earnings call, some green shoots in aqua. We saw salmon prices start to recover nicely. We've seen that even impact positively in our products like Clynav, on the other side though, you've got still some midsized markets, as I mentioned, in the Middle East, the Caribbean, India that have been continued to be set back by this next round of COVID, which has had an impact, I think, on the economies, which has had the impact on not just food service, but just the impact on people eating poultry and the ability to do that. So we think it will be a little bit of a slower recovery, but nothing that materially changes our medium and long-term outlook for poultry and aqua and nothing to change our guidance for 2021, but it's something to keep our eyes on as we go forward. So I think that's important. I think ASF, you mentioned this, maybe just to touch on that, too, a little bit always. We did see a great strong first quarter. We saw, as you can see in the prices, we saw a pullback in prices, a pullback in imports in the second quarter with that second round. I would say as we study it, it kind of do a double click, the industrial side of the swine business in Asia has really increased the capability of biosecurity. And that is the lead indicator keep your eye on, and I believe that they've recovered faster. They've got, I think, a higher bar in a firewall to any more ASF that's out there. And so I see a stable second half for our swine business in China, even though ASF continues to raise its head. And people have asked me at this conference about Germany and Dominican, where there's other cases. I think biosecurity is strong. It's not in any industrial operations. U.S. has taken a lot of great means on biosecurity. And I believe that we're in a good place there. It's not something we see as having a material effect at all in the second half.

Okay. So maybe we'll turn -- you've highlighted a couple, maybe we'll spend a little bit of time on it just given how important innovation is, right? I think you put out a commitment of $700 million by 2025 post Kindred. So it would be great to talk about what you're seeing that gives you confidence in that number. What are you most excited about? What are the things people should be focused on in terms of catalysts going forward?

I think, first of all, Joe, as we've talked about 40, 45 candidates, late-stage development at our investor conference, turning into more than 2 dozen new products. Now we're adding the Kindred assets on top of that, a very robust pipeline that has some significant pet blockbusters that will play to that $600 million to $700 million. But I want to start with the 8 launches this year. We've got all 8 products now into the marketplace. I would lead by on the Farm Animal side and highlight that without question, I think Increxxa has done nicely added into our bovine respiratory disease injectable portfolio in Europe and the U.S. Experior, as we've mentioned, is doing a great job and come back maybe talk about the environmental factors, but we're seeing a number of packers increase. We've said 1 to 7 packers. We're seeing people now process cattle, see the value, expand the use and continue to put this into their feeding regimen. It will be a little bit of a binary effect. It will come slow and then it will come quickly once they start to move their eyes on that. So -- and then Credelio Plus on the pet side, as I mentioned, continues to perform well and be very competitive in a very large international parasiticide market. So look for those products to continue to increase the significance of their contribution in that $600 million to $700 million as we go into 2022. I think as I look at the second element is a top priority for us right now is late-stage clinical development of a robust pipeline that covers parasiticides, where we can bring in the next era of innovation. Also, the parvovirus that we've talked about, most importantly, derm and pain, the next 2 big markets. Every dollar of sales is accretive for us in derm. We bring in 4 assets, 3 from Kindred to 1 from us that are in that late stage. And we believe that what will drive value the most for Elanco in this era is bringing in blockbusters, products that are significantly over $100 million that incrementally will drive growth and more importantly, even drive margin. So those -- that's where our focus is. And again, we've, since the Investor Day, gone from $500 million to $600 million to now $600 million to $700 million and a higher probability of pet blockbusters in that pipeline compared to where we were in December. So those are the key factors.

I know you discussed it in some detail on the Q2 call about ZoaShield and some of the market dynamics you'd seen there that probably ramp a little bit. So maybe talk about what you're seeing there and any changes in that since that call?

Yes. So we noted that ZoaShield would be a product that's used in poultry, primarily in the U.S., raised without antibiotic, would go into our portfolio with Correlink and some of the other products. Again, products approved. We have lined up a third-party manufacturer for this product. We have the supply, and it's in the marketplace. It's being used by the U.S. poultry industry. We saw one of the key competitive products having assumed a significant, much more supply and inventory in the supply chain than was expected earlier. So don't see any change on the value proposition, the contributions of this product over the medium and long term, but it was something that had an impact more in the second half as you look at the fall health programs for poultry.

Okay. So maybe on -- unless there's anything that you want to cover on the innovation portfolio, maybe move to the productivity improvements, which as you talked about before, are really important to the growth profile, right? Continuing to prove that. You've got a lot of moving pieces, right? You're realizing synergies from the Bayer deal. You're exiting manufacturing sites and you're also investing in a lot of growth. So as kind of CEO, what are the things that give you confidence that you're going to be able to manage all these different moving parts and also extract these productivity improvements while the car is running pretty aggressively?

Yes, we have taken -- if you look at even from precedents that are out in the industry, we've put 3 restructurings together. We have dropped hundreds of SKUs. We continue to shrink our footprint. We take -- we took 3 sites out last quarter. We are being extremely aggressive. I'd say our Board is very engaged in this as well as we are looking at a track record of making sure our plants are full. And here's really the formula. We are determined, and we have a clear roadmap under many different scenarios of the environment where we can get to 60% gross margin by 2023, 31% EBITDA by 2024. So with those markers, as we mentioned, one is, we start with the algorithm that we highlighted Joe, in December, which is that 3% to 4% consistent algorithm growth over time. That growth will be against a COGS line that we've said we're going to plan to keep flat. So we'll have the volume. We will continue to look at that 2% price in the industry, then we're going to be optimizing the organization. We're going to be looking at the value captures, the cost of the standups and the systems as we move out the Lilly system onto an Elanco system. Now we're doing the same from TCS. All of that is the next era of optimizing our footprint. That will drive double-digit EBITDA growth. You're seeing the lowering of cost to stand the company up. It will drive increased cash flow as we go forward in more of a step-up fashion, which will delever the company that is all pieces of this. So a very determined team that we're an execution story as we've mentioned, and again, a track record even this year where we'll come out as we look at our guidance at about 200 basis points in margin expansion on EBITDA relative to a pro forma Bayer from last year.

And how have -- I mean, we've seen across not just health care, but a number of industries supply chain pressures potentially impacting margins and making it difficult in some of these productivity. Are you seeing any of that? How is that impacting your business, supply chain?

Yes. I think there's -- without question, I mean, we've got, as you know, a lot more -- probably 50 corn bags with MFAs and medicated feed additives, then a lot of companies per $1 billion of sales. So a lot of complexity, I would say. Teams are all over this. We've got the right centers of excellence that are focused on this to be able to deliver on product on time and the right metrics. But yes, there's supply chain challenges out there. We believe we've got the right blend, the right mix. The other thing is it's great to have the diversity of Bayer, which has given us a nice -- much more of a balance between Pet Health, Farm Animal, more of global operations. So there's less dependency on maybe one market and one product, which has taken some pressure off. But it's there. And those pressures are there in supply chain as well as the inflationary pressures that we've highlighted as well. But we've got the right intervention plans in place and are making the right steps to offset those.

And you mentioned the capital conversion step up and kind of leverage reduction over time. And I assume you're tracking on that. Anything else you want to add on that? I know it's an important part of the story.

Yes. No, debt paydown is our top priority. We're confident on our revised target after Kindred of a Q1 2024 to reach that to under 3x net leverage will end this year, 5.5x net leverage. And again, we've refinanced our $500 million senior notes that were due on August 27, and we'll continue to pay down debt as we've outlined. And again, the cash flow plan is all driven off from that EBITDA line and the moves that we're making. So everything is on track as we've highlighted before.

And then obviously, you raised SEC investigation obviously seen in your disclosures. Any updates on that you can share post the 2Q call?

No, just reiteration here. To put this in context, this is about before mid-2020 distribution changes. And again, we are -- we voluntarily made the decision to disclose just in the spirit of the transparency that came even from the Investor Day conference. We received this in the quarter that we wanted to highlight it in, which was on July 1. And we've cooperated providing the documents and being well advised through this, and we believe our actions were absolutely appropriate. And we're keeping our energy on addressing any questions SEC has, but most importantly, driving our company forward. And but I believe, Joe, coming back to your first question, coming up on 3 years as an IPO, we have put ourselves in a much more significant material way of creating a bigger value proposition with the Bayer acquisition interventions in place, the EBITDA margin expansion we are on track and on trajectory to do, combined with a very robust pipeline of some significant pet blockbuster products, create a really great value proposition over the medium and long term for Elanco's investors.

I think that's a great place to conclude. So thanks again for joining us, and congratulations on the good improvements this year. Thanks, everyone.

Thanks, Joe.