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

All right, guys. I've done a decent job of staying on time so far. Next up, we have Elanco Animal Health, one of the largest players in the global animal health industry. And joining us is Jeff Simmons, President and CEO. Jeff, thanks very much for joining us today. We're going to keep with sort of the Q&A track the fireside. If you guys have questions, fire away. I'm going to start with trends within pet health and farm animal, and I'll sort of throw a little bit of a change. I think everyone starts on pet health. I'm going to start on the farm animal side.

All right.

And Jeff, I just would love your thoughts on the current lay of the land within farm animal. And I think investors pay a lot of attention to rising input costs, right? We see it every day in the news flow. And clearly, this is a concern for the cost side of the production animal business, but it also seems like the value of the animal has remained really robust. And so maybe just walk us through those 2 dynamics. You've got the rising input costs, but the value of the animal is healthy. What does that mean for the producer and what does that mean for your business?

Yes. So I'll start with some of the fundamentals. There's a lot of talk in cities like this that animal protein is on the down. It's actually more was consumed last year globally than any time in history. You look at beef prices, they're up 22%. Chicken breasts are up 34%. Sow pork, kind of is a good lead indicator, is up 21%. So we are outpacing the consumer price index. We are outpacing demand, not just the GDP but also I think the Western diet. How many people here, if I had a raise of hands, that are -- have been on some diet where their protein is up and carbs are down. So all of that says there's robust demand, different than when I was in 2008, you've seen cycles. And I think the other thing the industry has done in animal protein here in the U.S. but other places is you're not seeing the ups and downs. You're seeing supply and demand balance. So you're not seeing that up- and downswing. So in the end, the most important metric that we're looking at in Elanco is producer profitability, and it starts with high prices in the marketplace, which are still sustained; high demand, which we're seeing globally. Third is, driving this producer profitability, is exports, record exports right now, especially in beef, given what happened with African swine fever. All of those fundamentals, to me, say that we've got a robust future. And different than 2008, I think animal health companies are more diverse in terms of more species and more geography, which gives that diversity. For us, Elanco has got a more of a performance-driven portfolio. So we actually convert feed into protein. That's what our products, on the cents per ton, is 70%, 80% of the cost of a protein producer. We're set up pretty well in terms of turning that. Our value proposition is growing during a time like this. So -- and I see robustness going forward. And I see things like the demand and exports being the fundamentals that are going to drive that.

So even though we're going to continue to see these rising input costs, to your point, we should be focusing on value of the animal, producer profitability is in a good place, and that's good for business for Elanco across the vast majority of your different species. Is it fair?

Yes. And I think the stability that these markets have created, there's not the spikes up and down. The only one that probably is that cases, China swine, where we've seen up and down spikes. And I think that's -- otherwise, the leveling and exports is a big factor that's different than -- the last time we lived in a world like this, it was 2008, but we were coming down, and that's what caused that problem.

Okay. And it was a good segue. Let's go to maybe China and China swine. So if I'm correct, the guidance for the June quarter assumes that China swine was going to be difficult for 2Q '22. Has that been the case? Because prices have really moved around intra-quarter. If I'm correct, it's actually strengthened considerably as of late. So when you guys gave a little bit more of a modest view of China swine for 2Q, has that played out? Or have prices strengthening aided that business in the June quarter?

We haven't seen significant improvements. We still see challenge in Q2, like Q1, Jon, on pork prices. There has been some improvement. We all saw the article this morning that people are back out on the street. We'll see if that really plays out. I think that's really early information that we haven't seen play through the quarter yet. So given that, I think what you're seeing is we're expecting a more gradual improvement in the pork industry in swine in the second half, not a V-shaped recovery, but one that's much more of a slower climb and we think that maybe sets us up well for 2023. But at this point in time, it's going to take -- it's not an African swine fever. It's a balancing the market, an increase in demand, which we think is really linked more to the lockdowns. And so opening up the market is going to be key.

And that was one of the variables, Jeff, where I believe going into 2022, you thought, hey, China was going to account for roughly 1 point growth contribution to the top line. And now levels is a little bit south of that. Is that the right way to approach it?

Yes. But I would say, I mean, China will still be, we believe, a -- it was a significant contributor to growth last year. It's our second largest country. It will be, we believe, a major contributor of growth in 2022, driven by pigs and pets as well as poultry, but it is based a little bit on an assumption that these lockdowns lessen and the market starts to recover. Elanco set up well in China. As I step back, China's -- Novartis gave us a bigger pig footprint. We're bringing innovation. Bayer brought us a pet portfolio. Advantage is an example. It's driving a lot of growth. And so Elanco, as we look over the next 3 to 4 years, China will be a major contributor to organic growth given the current capabilities we have.

Okay. And just last one from me on farm animal. You've got a lot going on and a lot to talk to. But just maybe let's focus on cattle. So down 3% constant currency in the first quarter of 2022. I think you talked to some generic competition on some key brands. I'm guessing that was Rumensin. But you've also made -- there's a lot of R&D, right, within farm animal and most specific to cattle. Talk to us, cattle for 2022 is down the right place to be, but can that then pick up materially into 2023 and beyond as some of those differentiated products gain greater acceptance in the marketplace?

Yes. I think as we think about cattle in Q1, just to capture, one, a tough compare. Last year, we had kind of the COVID situation as well as some COVID recovery and some competitive stock-outs, and that led to a tough compare for us. I think secondly is the whole bovine respiratory disease injectable antibiotic market with the generics around Draxxin has caused a downward trend in pressure, I think, was another factor. And look, Rumensin we're holding at 85% market share. But we had a little bit more competition on some of the early contracts signed in the year. You're exactly right, Jon. As we look going forward, I think an example of our competitiveness is DSM selecting us as the takers of Bovaer. Look, we have put together a winning portfolio. We are entering into a new market, which I think is significant, this $1 billion to $2 billion new market of methane reduction. We can talk some about that. And launching Experior, which we see as the next blockbuster for Elanco, that's in the marketplace and the uptake is growing significantly. All of that puts us in a really strong position in the fundamentals of the market. So we're well positioned. Beef demand continues to remain high globally. And as we go forward now to 2025, we see beef being a major play for us.

Of that -- and I guess, Experior within that innovation pipeline as well.

Yes, absolutely.

Okay. Guys, if you have any questions, shout out. Pet Health, I'm going to try to go ahead and move over to the Pet Health side of the business. Talk to us about what's going on with the companion animal market. I mean, I've been up here for most of the day, but I feel like there's some mixed messages. I feel the therapeutic guys maybe have a little bit more of an upbeat view on the end market. It might be because they're not as tethered to vet visits like the diagnostic guys. But Jeff, how do you see the current companion animal landscape as we sit here today?

I do think being in animal health for over 30 years, it does matter what space you're in and the lens you look at, whether you're a diagnostic company, just a therapy company. As we look at a global broad-based portfolio animal health company, here's how Elanco looks, and I look through the lens the way we look through it. Vet visits, it should not be surprising. It's not surprising to us that they're coming down to pre-COVID levels. That, I think, should be expected, some of this high double-digit growth coming down. What I believe we'll be talking about 2 to 3 years after COVID, and we're already starting to see it, as visits come down, the spend per visit has remained or, in some places, strengthened. And I think that there's reasons for that. The elasticity, the expectation of spend remains. Surveys we've done and a lot of our competitors have done have shown that Gen Z and others are expecting to spend even more on their pet. And then on the elasticity, when you're spending on average of $25 to $40 a month, you take a 4%, 5%, 7% price increase. You can withstand that different than CPG, some of our Board members that are in the CPG, consumer product goods, maybe there's becoming some pressure. So I see resiliency there. It all comes back to the value proposition has accelerated to pet owners through COVID. People have experienced, whether it's curbside service, drop shipping, the importance of wellness visits that we've seen in our vaccine business. People now are much more aware of wellness visits, the convenience. We've even talked to an investor today that has his dog on Galliprant, and he during COVID went in, recognized that there's a pain problem in OA. Now he's getting that stuff drop-shipped every month to him, and the compliance is up. So to me, spend per visit, the value proposition and the elasticity to be able to continue to take price is taking a high double digit, maybe industry for us into a solid mid-single, maybe high single-digit industry that can demand maybe half of that in price increases on average.

Okay. Very helpful. And how about the flexibility that you guys have in terms of across your portfolio roughly on the Pet Health side. What percent of your revenues are derived or take place inside the practice, where it would be more subject to some of these capacity constraints versus that omnichannel approach that you've talked about where you can go ahead and secure products outside of the...

Yes. So I think we look at it in a couple of ways. I think on the omnichannel outside the vet, inside the vet or OTC EPA-type products as well as in scripted products. It's about 40% on the OTC side. It's about 60% in the vet clinic. I think the other is to look at the portfolio. The way we look at the portfolio is, say, wellness, that's vaccines as an example. Therapy, that's surgery. That's pain. That's -- and then you've got -- on the parasite, it's in and outside. It's hey, what do we do in e-commerce, what are we doing in the stores, the brick-and-mortar, and what are we doing in the vet clinic. So to me, that's the omnichannel we looked at with Bayer. That's set up well. That makes us pretty diverse. So it's not only splitting the in and outside the vet, but I think it's also the therapeutic classes. And candidly, when we even look at the U.S. Pet Health business, 3 out of those 4 channels are pretty strong.

Okay. Maybe a couple of quick hit and specific questions around numbers. A, family, down 5% in the first quarter of '22. International, you said, was up. U.S. was down and U.S. was impacted by some stock-outs in the quarter. Those stock-outs or the situation around stock-outs was supposed to improve around now, around June. Have you guys resolved that? Do you have your arms around stock-outs? Is that now in the rearview mirror for you guys?

Yes. I would say it's resolving and we believe it will be resolved during Q2. There was some impact going into Q2. It was again more paper and packaging. We have no across the board at Elanco. No active ingredient stock-outs or problems with active ingredients. I want to be clear there. I think the pushes and pulls, stock-outs was one. We have Advantage as a big family of products. As you know, Advantage Multi is a legacy parasiticide business that's been impacted some like Trifexis on our para business. On the other side, I would say a couple of things on Advantage. It's probably a little bit better expectation than we had when we originally bought Bayer. The brand loyalty is very high. We're going to leverage that more. We're launching Advantage XD this year. That's an Elanco compound inside the Bayer brand. Advocate, and we see Advantage in China is our fastest-growing product, and we'll continue to see Advantage expand there. We also see Advantage is probably the best price point when you look at an average of $20 or so less than that, yes, the value and in today's inflationary markets. So a lot of room for Advantage growth. In our model still for Bayer, we continue to see that as maybe low single-digit decline, but we see some upside that you saw out of the gate would bear through these things that are driving it.

And it seems like the stock-out, to your point, resolving shouldn't be an issue when we think about what the expectations were for 2Q. That seems to be in line with where management was.

Well, I think they'll be resolving. And I think there's also some of the continued pressure on the multi that we mentioned. But as we look into the second half and get into the second half, we don't see stock-out as an advantage being a factor. There will be a little bit of a factor here in Q2 as we mentioned.

Okay. Perfect. Innovation, and so then I'm going to throw some real-time numbers at you, sorry in advance for that. But $120 million to $160 million in 2022, $72 million in 2021. So the main drivers in '22 because you don't break it out by particular product, Experior and ZoaShield, Jeff, is that the right thought there just to be specific to 2022?

Yes, 2022 innovation, stepping from $70 million plus to $120 million to $160 million will be driven by 3, absolutely 3 products. Experior will be the biggest probably driver, Credelio Plus and ZoaShield. They will be the biggest drivers, and they will continue to be the foundation that will drive the $600 million to $700 million of growth, yes.

Okay. And that's a good transition. The $600 million to $700 million and so -- when I think about the ramp to $600 million to $700 million in 2025, that would be an incremental $450 million left in '23, '24, '25. If I try to turn that into contribution to growth, it's 300 basis points to annual growth contribution. One, is that fair? And two, at a high level, how much of that is specific to atopic derm in the triple?

Yes. So I think you look at -- first of all, the ones that we just mentioned will be foundational. Two, when I step back and look at our pipeline, you've got 4 derm products that we've been public about, 3 from Kindred, 1 from ourself, the JAK product. These are differentiated pet blockbusters that are in the late stage that we're heavily focused on. We've got one para that we've talked about per year on average that we've been moving forward. And one of those is a significant differentiated one. So no question, that will be material. It will be the 3 products I just mentioned plus those assets without question and a few other contributors like parvo. Maybe Bovaer plays late, but that's not figured in the $600 million to $700 million. There will be some cannibalization there. If you take an Experior, maybe taking some product from Optaflexx as an example or some of our para. The exciting thing about derm is we believe we've got one of the most robust late-stage derm differentiated pipelines and every dollar will be accretive to our growth. And that will be a big driver for us and we do believe that we have the muscle to compete. We've got differentiation, and we've got channels and ways that we can go into that market that we believe will add value, not take away value.

And just when I think about your growth construct, though. I mean, if you're able to get to the $600 million to $700 million, that's 300 basis points growth contribution from innovation, then we've seen some healthy price right in animal health. But what are some of the offsets? Because already there, that would get you to like more of a mid-single-digit type of a growth framework. Where do some of the offsets? I know you just talked about some cannibalization, but are some of these legacy products being impacted, which brings you closer down to that 3% to 4% long term?

Yes. I think in December 2020, when we came out with Bayer. We said, look, we believe strongly in this growth algorithm, we believe strongly in our pipeline and our margin expansion. And I think that growth algorithm to me is playing out very nicely. We exceeded it in year 1, 7% pro forma, 5% constant currency. We're guiding to a little less this year, which was expected in that 2% to 3%, Jon. And you're exactly right. When I think about the pushes and pulls, the pipeline, the price, as you said, some of the value-add international, aqua and poultry, we're seeing leadership there in China. It will be offset, we see by -- we've calculated and assumed some competitive innovation in there, some cannibalization. And I think the farm animal generic scenarios that we're seeing even in, say, the BRD market or some of the offsets. So we try to take a balanced approach even in an environment like we have right now, we continue to see the durability of our pipeline or our base business with the additions of the pipeline, being able to deliver that growth algorithm. And there's no one probably that can turn that 3% to 4%, 5% growth into double-digit and free cash flow conversion and delevering like Elanco.

Okay. And a big part of that growth algorithm still resides with that innovation bucket going from $140 million at the midpoint to $600 million to $700 million. Let's talk about some of those products and some of the blockbusters. You said 5 to 7 regulatory submissions in 2022 with up to 2 differentiated Pet Health potential blockbusters and atopic derm and parasite. Is that the complete filing, just to be clear?

Yes. We're being very careful here, and we've shared this with some of the investors today that will continue as we have from the investor conference to today and as we go into the end of this year and next year, creating more disclosure as we go, and we're balancing that from a competitiveness standpoint, as you have differentiated products, we feel it's very careful. We need to be careful from a differentiation standpoint and investor exposure. And as we get closer, and that progression happens. So that's all I'll comment at this time. But I think I would note, the major milestones we had a very big Q1. Ellen has come in with a lot of experience in animal health, built the capabilities further that Aaron had. So things like regulatory, CMNC, clinical, dog enrollment and a lot of experience of driving that late-stage pipeline. That's been done. We've concentrated our investment on that pipeline. Those 2 milestones that we mentioned, without noting and giving too much away are continued progression in key major material milestones that put us closer to an approval. So that's -- and these 2 blockbusters would be 1 in derm and 1 in para. They're differentiated, and they will be key growth drivers for us.

Okay. But in terms of thinking about, hey, if that's the complete safety, efficacy, CMC, you get it back, you put a bow on it and you make the submission to the agency versus safety or efficacy or CMC, we're not able to tell where it was at.

Well, I think if you understand the ADUFA process is one that evolves. There's constant iteration. What we would say is, these are, I would just say, up to the 2 submissions on top of the 3 to 5 more in addition to that.

Yes. Okay. Fair enough. And then talk to us about what happens for Elanco or what it means if you're #2, #3 or #4 for parasiticide. And I certainly don't think #4, but I think we actually have a veterinarian here today who talks about BI and a lot of the work that they've put into the triple. And it's not surprising. It's a very attractive market and for them. They're losing a bundle, right, on NexGard and Heartgard and losing share there. So you think they'd be focused on that part of the market. But Jeff, what does it mean for your company if you're #2 to market with a triple or #3? Or is it like, you know what, doesn't really mean a whole lot, it's going to be the level of differentiation we bring when we get there?

Yes. I think that no question, speed matters. I think that's absolutely the case. And I think we all know that. I do think that differentiation matters as much or more to be able to differentiate and bring a product that's differentiated. Something that also complements what you can do in the marketplace, I think, is key. Maybe I'll stop on the differentiation. There's a lot of comments about that. But to me, it comes back to 3 buckets, pretty simple. It's efficacy and some kind of difference in efficacy. It's safety and label and anything that can actually veterinarians can feel more comfortable with or it's convenience to the pet owner, longer duration, different dosing, all of these aspects. And what I would say is if it takes a few more months to make sure that you have one of those elements of differentiation stronger, I think that's key. I think on para, there's no question to your question, we're well equipped. I think having an omnichannel that comes from Bayer allows the vet to make that script travel. And that to me is an advantage that we have. And Bayer brought us 3x bigger of a pet international business. We're seeing that play out into China as well as even in Latin America. So we're more equipped today to deliver this late-stage pipeline and create faster adoption than ever before. And on derm, we don't have a dollar in that market of any significance. So bringing differentiated assets into a market that's $1.2 billion and growing quickly, that's all accretive to us.

And when you talk about efficacy, safety and convenience, I feel like one of your talk tracks in parasiticides has been worm coverage, right, around Credelio and Interceptor Plus. Is that something that we think we should focus on in terms of a level of differentiation for you guys in the triple?

Yes, I'll broaden that to say, I think the broadest coverage and the most convenient approach for pet owners is going to be key as you differentiate. Remember, too, you got a cycle of new customers every time puppies come back through and to be able to create that loyalty as well, marketing becomes key to not just in the differentiation, but creating brand loyalty will also be important.

Okay. I'm going to try to get through a lot -- I'm sorry, go ahead [indiscernible].

Can you expand a bit more on Bovaer [indiscernible] you said $1 billion to $2 billion is that a global TAM or is it just in U.S.? And then thirdly, how do you actually sell this to a market that's not regulated that doesn't have a [indiscernible]?

Sure. Yes, the question is on Bovaer. Bovaer is a product that feed additive that we have a license from DSM. It's still early. I will say that DSM looked at all the major players or most of the major players and selected Elanco, I think because of, one, we have the first FDA-approved product with an environmental claim with Experior we see livestock sustainability as an opportunity. And just to give -- just to put things in context to the value on the approval is livestock represents only 4% of greenhouse gas footprint, but represents up between 30% and 40% of methane. So there's carbon, ammonia, methane. Methane is the short-lived gas, as you know, they can cool this climate. So this is noted as one of the top technologies to reduce and cool the temperature of the climate by 2030. So there's a lot of interest. So our goal is, one, get the registration package from DSM to us, and that's happening as I speak. And we will represent this with the FDA. We need, and our goal is to 2 big drivers to speed to market and approval and second is manufacturing. We're the only major continent today with cattle that doesn't have this product approved. Brazil, Chile, Australia, it's being used and EFSA, European Food Safety Authorities approved it. Our focus will be on working closely with the FDA, I won't speak much on this, is how do we accelerate approval. The Biden administration wants the FDA at the table for regulatory approvals to drive the environmental change, we believe that will be key. We've said mid-decade, our goal is to work against that and do it quicker if we can. The second major stream is manufacturing part of the deal is that we will provide the manufacturing. We will provide the product and even maybe some product of DSM for other markets. So we're working diligently on existing versus new manufacturing and look at those options. How will you actually get paid? This will reduce methane 30% in dairy cattle, 50% in beef cattle. That's more than the whole industry has done in over 15 years. And there's 3 streams of value. One, the carbon market and today, there are climate-neutral farms in America today with livestock, mostly in dairy because it's contained, liquid manure, it's easier. So one is there's dairy farmers in Indiana selling carbon credits to California. That's one. And most of these dairy farms are making as much of the environment as they are off milk. The second is actually can be water credits and other credits. Third is the energy market, so biodigesters turning the manure into gas. And lastly is ESG credits that are coming for up the chain, whether that's from a Tyson Foods or a Kroger, it's these people that have already made their claims. That's where the value will come from. And again, a lot of positive trends here. We're not making any commitments beyond mid-decade, but I think there's a lot of push. We need a claim to capture the carbon credits. That's key. And Elanco spun out a company called Athian that can actually aggregate and monetize the credits for the farmer. That's not our business, but that's enabling farmers to get the value. And we see economic value with Bovaer to the farmer.

Just a pivot a little bit. I'm going to see what I can fit in the last 3 minutes, just near-term financials and long-term financials, Jeff. In 2021, 40% of your 2021 EBITDA was derived in the second half of the year, right, because of the parasiticide seasonality. This year, the guidance calls for closer to 45%. Maybe just take a second and just get us comfortable with that. I mean I know there's price, I know there's China, but maybe talk to us the variables on why this year can have a more back-end weighted component versus what we saw in '21?

Yes. So first of all, I think on the sales side, I think the price that we have taken and we've already instituted in Q1 and Q2 is going to have a step-up as we go into that second half. That's going to be key. Two is innovation. As you look at the products I just mentioned, especially the big 3, they're going to have a step up in Q2. I think the other Todd, our CFO, was highlighted a lot even today is we've seen sequential reductions in cost. We restructured more quickly than we've restructured anything, and that's played out as you saw going into Q4, there was a sequential down and then even in Q1. There will be a spend. Our top spend quarter is the second quarter with parasiticides and put a lot of money against Seresto, et cetera. So look at Q3 and Q4 for those costs to come back as a step down. Those would be the big drivers that I would highlight that will be the factors.

Okay. Very helpful. And I'm going to sort of ask a similar question a little bit, but long term, and there's a lot of numbers that I'm cheating and looking at. So let me see if I can lay this out effectively. If I just want take $4.725 billion in 2022 revenue and increase it by 4% per annum, you sort of land at $5.1 billion in '24. So you're up $400 million in absolute dollars, but your goal in 2024 adjusted EBITDA is 31% margin. So you would need $450 million in EBITDA growth and $400 million of revenue growth. Your contribution margin would be over 100% in inflationary environment. How do you get there? How do we get comfortable? What are the levers that you pull in order to navigate that?

Yes. So we're very grateful that we have done all the things we've done to put us in the position we have. I think the restructuring. If you normalize out the $120 million of inflationary costs and things, we would be at our 60% gross margin a year early, we would achieve it this year. So I think there's -- I'll keep it real simple. I think innovation and price, as we talk about $600 million to $700 million of accretive products coming between now and 2025, that's going to be a big step-up. Price is also a factor that we're trying to offset some of this inflation. I think that's a factor. I think the other big one is in '23 and '24 is our final big restructuring of Bayer, where we come off the system of Tata into Elanco, our last IT integration, and that will be another step-up in synergy that will be quite significant. And then I think the last one is just the expense management that we have taken, that's going to continue to play out. Those 4 things; pipeline, price, cost and the standup IT system will be the 4 biggest drivers that I believe will get there. Now are we in a dynamic environment that's changing as I speak? Absolutely, but the fundamentals are right. And I think I end Jon by saying, hey, when we step back, it's -- the strategy is working. Bayer, we just reviewed it with our board at the last board meeting. It's exceeding our expectation. It brought us the scale, the diversity, the synergy, higher-margin business, more omnichannel. So the strategy is working. Margin expansion has come. Free cash flow is working well, which is actually decreasing the debt. So we're on the track on margin expansion. And we've got a very durable, maybe not the highest growth rate, but this growth algorithm is working, and now we're going to lay $600 million to $700 million of innovation on top of it, which to me when you look at value proposition of where we are in the capital markets today, we have to be one of the most compelling value propositions. We're an execution story. We're not dependent on one event. Kindred helped us last year. Bovaer is going to help us this year. This thing is incrementally getting stronger.

So really putting all of those incremental dollars into that already existing infrastructure and then going ahead and monetizing it...

And being very balanced relative to the environment that we're in, but we're in a durable industry with a very diverse animal health company that's now global.

Fair enough. Jeff, thanks very much for your time.

Thank you.