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

Good afternoon, everyone. Thanks a lot for joining us. Again, my name is Nathan Rich, and I cover the animal health space here at Goldman. We're pleased to welcome Elanco for our next session. We have Todd Young, CFO; and Katy Grissom from Investor Relations. Todd, very good to see you. Sorry I couldn't be there in person. COVID had its own plan. So I'm glad to have the opportunity to host virtually at least, and my colleague, Lindsay Golub, is on stage, and she'll jump in with some questions as well. We'll take questions from the audience towards the end if anyone does want to ask a question. Thanks a lot for your time this afternoon.

I thought we could maybe start with the company's outlook for the balance of the year, Todd, if that's okay.

Sure, Nate.

Great. So when you reported the first quarter, you maintained your guidance for constant currency growth. I think you called out a few offsetting factors, some onetime headwinds in the second quarter as well as some price increases that you're planning to take. I want to get into each of those in a second. But before we do, maybe from just a high-level end market standpoint, can you -- you also kind of pointed to the durability of demand across both segments of your business. So could you maybe just talk about sort of what you're seeing more real time in pet health and livestock and kind of why you feel like that durability demand that we've seen in the past will continue to be there?

Sure. No. Thanks, Nate, for having us at the conference. And hopefully, COVID's not hitting you too hard at all. So overall, as we look at both the pet health business and the farm animal business, we're seeing good durability across both sides, both inside the U.S. and outside the U.S. For us, when it comes to the farm animal, the most important thing is producer profitability. Currently, input costs for our producers are high. The cost of grains and feed are high, and that's 70% to 80% of the cost of raising the animals and the feed. The good news for our business is the end price for that protein is also high. And so the producers have every incentive to use our products to keep the animals healthy because it converts the high-cost feed into protein they can sell on the back end. And so that's what we're always looking at, is how are our producers doing. And right now, that's generally good on a global basis. The one caveat has been pork prices in China have been low, and that's been negatively impacting our business because their producer profitability is underwater. When we look at the pet health business, it continues to be a place where all of our survey data says consumers are going to continue to spend more on their pets. We saw the rise in the value of companionship throughout the pandemic. And our surveys show people expect to spend more. I think, as we've talked about, we did increase prices in both U.S. retail and in the vet clinic in the first quarter, and we've not seen an impact on demand from that as it is a very durable business. We'll see how continued inflationary pressures and the economies go, but over the long term, rising GDP leads to greater pet ownership. That penetration in China is still very low relative to the U.S. And so we do think there's a lot of opportunities from just the macro tailwinds in both pet health and farm animal over the next 5 to 10 years.

Makes sense. And I guess on the pet health side, as we think about the back half of the year, I mean, the industry, I think, is going through a very period of -- a tough period of challenging comps in the first half of this year, but that eases at least from a traffic perspective and also from a revenue perspective as we get into the back half. I guess when you think about what's embedded in your outlook. Do you think that towards the end of the year we get back to more normalized traffic growth and kind of pet health spending once we get beyond this period of kind of tucked-in compares from the pandemic?

Certainly, with vet clinics and a lot of things generally getting very tight in March, April, May of 2020, 2021 was a big bounce back, and that just makes for a harder comp when things get spread out a little bit more. We're still -- our biggest sort of vet clinic specific is our vaccine business in the U.S. We don't have pet health vaccines outside the U.S., and that continues to progress well even in the face of slightly lower pet health. We think compliance has grown through the pandemic. Being at home, even hybrid work that makes it easier to care for your animal because you're not going into the office every day of the week are all positives. And that increase in compliance has been a large part of the growth as well, which really gets to individual pet owners spending more as they make sure they're giving their parasiticide products every month.

And then I wanted to move over to the $60 million of onetime headwinds that you called out. I think it was 4 factors: the aqua phasing, Russia and Ukraine conflict, I think those are pretty understandable. I did want to ask then the pet health stock-outs, which I think we're primarily on the Advantage family of products. I think Jeff had recently described the stock-out situation as resolving. I think you had expected it to normalize late in the second quarter. I guess are we on track to see that normalization that you expected? And then once you do see supply normalize, is there a restocking period by retailers to get kind of inventories maybe back up to where they were? Or given that this is like a flea and tick product and we're kind of beyond the heart of that season, does that maybe not occur until next year?

So yes, we called out the $60 million of specific changes relative to when we gave guidance in February that we've seen. As we noted in Q1, we didn't have an impact from the Russian invasion of Ukraine. China pet health wasn't impacted by lockdowns. And so those are headwinds we've specifically called out. With respect to the stocking, it is getting better, and it is resolving. There is risk that those are spot-on topicals in some cases that don't necessarily need to get bought except when they need to be bought. So it could have an impact on us from a catch-up. We're not expecting a restocking benefit. The other thing we're paying close attention to is retailing stocking inventory. There's been a lot of discussion with the retailers on their inventory management and concerns on the consumer. And so that's something we're also focused on. At the end of the day, we're really focused on end-user consumption, and that's continuing to track. The straight supply chain shortages, those are getting to the resolution, and we feel good about what our team is doing to deliver on those products within what we can control.

Okay. And then on the headwind from China and the lockdowns, I guess, what was your expectation in terms of when we would see those ease? And how quickly kind of post the lifting of the lockdowns do you see business bounce back? And I don't know if you've seen examples either in China previously or other markets with how fast like the pet health market has kind of picked up once those lockdowns have eased.

So we were expecting and we've made it clear in our guidance for the second half, where we did accelerate growth, that a portion of that is coming from picking up pet health business we expected to lose in Q2 in the second half of the year as the lockdowns ease and things go. So the reopening on June 1, we do know that clinics have reopened in Shanghai, which is a positive for our business. Our team is going back to the office. They still require a negative COVID test within 72 hours to be able to go into the office, and there's continued changes. So again, how it plays out, we don't know that, but we've been very clear. Our assumption is our pet health business comes back and we recover what we lose in Q2 in Qs 3 and 4. And then on the farm animal side, the big part is poor prices. Those have improved. They're still not back to where they were this time a year ago, but they have improved. And getting people out, getting together at foodservice is an important part of the pork production. And so that's, again, something we're very focused on with our team on the ground in China.

The last one I have on guidance and then I want to move to some bigger-picture questions. But the cadence of EBITDA this year that you laid out is a bit different than what we're used to. So can you maybe talk us through the different cadence that you expect this year relative to what we would normally see. And price, I believe, was the main driver. I guess how are you thinking about the contribution of price as we move from the first quarter, which I think was around 200 basis points through the balance of the year? And how much does that play a role in just the EBITDA cadence that's in your -- that's implied by guidance?

Great question, Nate. And certainly, increased price in the back half of the year is a big driver of our sales acceleration and thus increases in EBITDA. Our cost profile, we did a number of restructurings last year. We've continued to take cost out of the system. That was demonstrated in Q1 with both year-over-year and sequential reduction in our costs. Q2 is our highest OpEx quarter because we're investing in the OTC parasiticide market in the Northern Hemisphere, both in the Europe as well as the U.S. So we do expect higher OpEx in Q2 but then back in the back half to levels we saw in Q1. So that continued execution on spend control as well as the increasing sales growth is what drives that EBITDA acceleration in the back half as we recognize more of our synergies and also have continued growth from our innovation products, including Experior.

And if I could just try to put some maybe numbers around the price realization, I think we were trying to look at normalized for the onetime headwinds and kind of the cadence that you've outlined. And it seems like you would need something like 200 basis points of incremental price realization or roughly 4% total in the back half of the year to get to the EBITDA guidance that's out there. Is that sort of in the right range roughly in terms of the level of price accretion that we should expect?

Yes. I mean we've said more than our 2% historical but less than 5%. And I think you've done a good job of triangulating the answer.

Okay. So I wanted to move on to Seresto. Obviously, there's a few open actions by different organizations within the government. I think Jeff is testifying at a congressional subcommittee during this week. And the EPA is also reviewing one of Seresto's active ingredients. There's also OIG investigation into the EPA's review process for Seresto. Sorry, I know that was a lot. But I guess, from a high level, the company has stood by the safety and efficacy profile of Seresto. I guess can you maybe talk about what Jeff's message this week will be? And is there any new data on efficacy or safety relative to what you shared in the past that you're planning to highlight moving forward?

Thanks for the question, Nate. We're certainly very bullish on Seresto. It grew 6% in Q1. Our retail partners are big proponents of it. It's in the vet clinic. The vets are big proponents of Seresto. Just for grounding, it was approved in 2012. It's approved in about 80 countries around the world. There's been over 70 million dogs that have used the Seresto collar very safely to protect them against fleas and ticks -- dogs and cats, I should say. So a year ago, there was a article in the USA TODAY that had dog owners with, unfortunately, their pets passing away, and they wore a Seresto collar. We've provided a lot of pharmacovigilance data. We filed an 8-K in the spring last year laying out all of it. These are reports, and it's not a cause issue. It just reports and there's no causal link. And again, we've had lots of pharmacovigilance data and very strong demonstration of value of the product. So when that article hit, we did get an inquiry from the House subcommittee on consumer safety. We provided them lots of information that they wanted. We've not heard from them in over a year, and then we got notice that they've asked Jeff to come testify at this hearing. So that's what he'll do. He'll be there. He'll openly discuss whatever questions they have. And again, we believe it's a very safe, efficacious product that provides a lot of coverage at a really fair price point to protect animals against fleas and ticks, and thus their pet owners from Lyme disease and other things that come from these parasiticides.

And I guess just to level set for investors, so in the U.S., I think Seresto is like roughly a $250 million product, I think it was 60% plus or minus of total Seresto sales.

Yes. It's in that range, Nate. It's a little less than that year-over-year, but yes.

And I guess could you maybe lay out the potential outcomes as you guys understand them from both the congressional subcommittee hearing as well as maybe the EPA review, just to kind of level set for investors the potential outcomes from these different investigations that are going on?

Sure. So the congressional subcommittee doesn't have a direct authority over the product or the regulatory process. That's handled by the EPA. So they could continue to ask questions or could be follow-up, but they don't have a direct play in the regulatory process. The EPA is reviewing the active ingredients that are in the Seresto collar. They're not reviewing the Seresto collar itself. And so imidacloprid and flumethrin are the 2 active ingredients. And these are used in a lot of different household products and other pet health products and other products across the U.S. They are doing a review of that. We expect an interim decision to be in the second half of the year. And all of our interactions with the EPA on that don't give us any pause that there's going to be any event other than those products would get reregistered and continue to be used in a number of products across the U.S., including the Seresto collar.

Okay. Got it. Makes sense. And so I wanted to move on to your expectations for Seresto as well. So I think it grew mid-single digits in the first quarter. You expect growth for the year. Can you talk about what you're seeing as sort of the main drivers of growth? And I think that you've rolled it out to more -- to the vet clinic channel this year. You've obviously invested a lot in marketing the product. Maybe what the response has been to those investments that you've made in that channel expansion that you've done?

So I would say the channel expansion has not been a big driver of the growth. I mean it's good to have it there as an option in the vet clinic. And it's easier for a vet to prescribe an 8-month product than a 1-month product that they think will otherwise get filled at Petco or on Chewy or whatnot. So again, that's a big proponent of the value of Seresto, that. It has great value from both an efficacy and ease of use and a cost point. We think that's what continues to drive its growth. We've seen good growth across Europe as well as the U.S. It just is a really effective and easy solution for pet owners.

Got it. Okay. Moving over to the livestock business. We talked about the kind of strength of producers right now. They're seeing higher costs, but they're able to pass those costs through and so overall, in a pretty good position. I guess the one other thing we started to hear about from retailers is obviously consumer behavior is changing in response to inflation, and some have started to call out kind of trade down in terms of the type of proteins that consumers are buying. And I guess if we do see that become more widespread, could you maybe just talk about what impact that would have on the livestock business just given kind of relative exposures across the different species?

Sure. So one, the economics of the complete value chain, there's a lot of different players in that from the cow-calf operator, the feedlot owner, the packers and then on. And a lot of the cost increases have been from the packer to the end consumer versus at the feedlot. So there is value even if there was a trade down. It might not impact the producer profitability. It may just impact packer profitability at the Tysons or Cargills, JBS and the like. So that's one part of the equation. The next is, yes, to the extent it does affect the number of animals raised, we would rather sell products for cattle. That is a higher-margin business for us than poultry. But in the grand scheme of things, we have a lot of coverage of all the species. We're going to continue to have durable profitability from all of them because we're an important component of raising healthy animals to drive protein consumption. So it may have some impact on profitability in a given period; but over the long term, us being essential to our farm animal customers around the world will continue to drive value for Elanco.

Okay. Great. And I wanted to ask on Experior. That's obviously kind of one of the key revenue drivers, a product that's ramping. I think on the last call you had noted some large customers were committed to getting their animals on Experior. I guess can you maybe just talk about the visibility that you have on the Experior ramp for this year? And then I guess beyond that, it is at this point sort of an add-on product? And producers are obviously trying to handle a lot with inflation. I guess like does that change your thinking around the pace of adoption that you might see for Experior? If you can maybe just talk to kind of the overall kind of level of demand, that would be great.

So Experior is the first FDA-approved product that has an environmental label. So it reduces the amount of ammonia produced by the cow. So that's the label. It is not an add-on product. It is a product that is used in place of Optaflexx, in our case, or other beta agonists. And so while it's not on the label, tech to tech veterinarian sales can have the discussions with respect to the impact on the animal of where does the energy go if it doesn't come out in ammonia. It does convert to more beef on the carcass. And that's something that's known by the producers and the nutritionists. And from that standpoint, it isn't an add-on. It actually improves overall economics to that producer. And so when costs are up, anything that improves the economics and has a benefit of a green benefit we view as a really good thing. The other part of it is we have producer agreements with respect to how Experior is used as well as to get the data from them. One of the things as part of those agreements is they do a 4-day withdrawal period when they don't feed Experior the last 4 days before going to slaughter. That means there's no residual in the meat that is -- can be spotted. That means it has a better trade compliance when being exported into China and certain other markets than Optaflexx-fed beef. And so it has a green claim. It has very good economics for the producer, and it has a greater ability to be exported. For all those reasons, in the case of a higher macro environment, we think it is a product that is very much in demand versus being an add-on where you wouldn't do it because of inflation or higher feed costs. The other part of it is, yes, we've got -- 1 of the 5 biggest cattle producers in the U.S. has now gone in a number of its feedlots with Experior. And that means it's using our Rumensin after having switched to a generic competitor before because of the combo clearances that Experior has with Rumensin. So for all those reasons, it continues to set up as a great product for us and a big part of our innovation ramp in the back half of this year.

Great. Makes a lot of sense. I did want to ask on innovation generally. I think you had talked about progress on the last call on the late-stage pipeline for both parasiticides and derm, and I think still plan to make up to 2 submissions by the end of the year. I guess, from a high level, like what type of disclosure can we, as investors, kind of expect around those submissions and as we look to get a better sense of timing for when these 2 products might come to market?

We'll continue to try to be transparent and yet protect ourselves competitively given the transparency that our industry competitors have on the topic. We certainly -- I don't think we'd necessarily file a press release or an 8-K if we did a submission. But if we have one, in between earnings calls, we'd certainly disclose it on an earnings call versus not disclosing it. So we're very pleased with Ellen and her team. They had a great Q1. They've continued to have a very good Q2. They're really driving this portfolio forward. You saw our spending on R&D did come down in Q1. That was intentional. We cut out a lot of long-tail products that didn't make sense to continue to invest in. We've concentrated resources. And with that, we're excited about the productivity as well as the research platforms we're continuing to invest in as we progress. But certainly, our sales growth, our profitability is very much going to be driven by the derm and the parasiticide pet health blockbusters we have in the portfolio as well as Experior that came out last year. And we're excited by Bovaer, the product for methane reduction in dairy cows and beef cows that we in-licensed from DSM recently as we think that market is really big when you can reduce the amount of methane produced by a dairy cow by 30%, by a beef cow by more than that. And so that's a mid-decade part of our sustainability efforts on farm animal and part of what we think really helps drive growth in the back half of this decade.

And Jeff has really talked about wanting to bring differentiation in the parasiticide and dermatology products that you do bring to market. You're obviously going against strong incumbents. And so how do you kind of see differentiation? Like what does that lever look like as you look to convince a vet to, hopefully at some point, start prescribing your product over what's currently on the market?

So when we think about differentiation, we categorize it into 3 things: safety, convenience and efficacy. And so as we look at our current broad spectrum parasiticide, we have right now, with our 2 separate pills, the broadest coverage in animal health with all 5 major worms covered, which isn't in the current offering. So as we think about differentiation, that would be an example of one in derm that we think has value to pet owners because of tapeworm and the impact that has on animals. As we think about derm, I think everyone likely knows we acquired Kindred Biosciences last summer. One of the products in their portfolio is an IL-31 long acting. So that's a product that, rather than having to get a monthly injection, you can get 3 to 4 months. That would provide some real convenience to the pet owner without any efficacy. So those are all sorts of different items within the framework of things that we're bringing to market. In the case of the parasiticides, that's a big market. A lot of players were obviously active in that with Credelio, Interceptor Plus, Trifexis, Credelio Plus outside the U.S. with the broad-spectrum coverage, Credelio in the U.S., Credelio Cat. So again, that one, important, we want to get it to the market. On the derm side, it's entirely accretive for us. We don't have those dermatology products. So we're anxious to get them approved and then drive penetration with our vet sales force in the U.S.

Great. I have one more I wanted to ask around margins, and then maybe we could see if the audience has any questions. I guess, looking at the gross margin target, you're able to maintain the 60% margin target, I think, despite absorbing $120 million of inflationary costs. That's obviously no small lift. Can you maybe just talk about your ability to kind of find additional savings and kind of what allowed you to kind of maintain the gross margin outlook? And then maybe tied into that, how should we think about the EBITDA bridge from a margin standpoint going from 22% to 23% this year, the 31% margins by 2024? What are kind of the main buckets of either margin upside or savings that would allow you to get to your margin target?

It's a very big focus across Elanco. We've -- the manufacturing quality supply chain team has continued to figure out ways to run our facilities more efficiently, to source active pharmaceutical ingredients at a lower cost as we've moved those. That takes 2 to 3 years. And so we have those coming through now on Credelio that was started 3 years ago, and that provides a real benefit. We've got less headcount. We've done a number of restructurings over the last couple of years, and we've gotten smarter about what it takes to run our business on a global basis. And that keeps driving down costs. So overall, the team continues to find ways to do that as we're always trying to keep costs flat as we grow sales. Clearly, price increases. That flows straight through the bottom line, are very margin accretive. And the other part is our new innovative products are higher margin. Experior is a higher-margin product than Optaflexx. So as it grows and takes out Optaflexx as well as takes out the generic competitors and brings back more Rumensin, all of those items are accretive to gross margin as well as to our operating margin as we don't need incremental sales force to sell this incremental innovation. On the OpEx side, as I said, we've concentrated and focused R&D. That's allowing those costs to come down. And on the OpEx, a big item that's still using up cash, independent of our normal operating cash flows, is the integration of the Bayer business into the Elanco systems. One of the requirements when we bought Bayer was we had to use the Tata business consulting for their ERP and order-to-cash, billing, back-office processes versus Bayer doing a TSA to us. So we've been running essentially 2 separate systems and processes. Unfortunately, we sent 2 invoices to veterinarians to buy things. Those sorts of items that are disruptive to our clients. We're integrating that in. We expect it to be complete middle of next year. And as we called out, I think, on our February call, that will be $50 million to $60 million of incremental cost savings when that's complete. So a lot of initiatives across the company continue to do. We also changed our compensation internally to be more of an EVA-like metric, where we're looking at generating returns in excess of an 8.5% cost of capital every year in order to drive the bonus versus it being based off just internal targets or sales and EPS. So all those things are helping a lot of people and throughout the company thinking about how do they conserve capital, how do they drive greater efficiency and continuing that march forward. Inflation has made it harder, for sure, than what we expected when we put this out in December of 2020 given we didn't foresee what we're all experiencing right now.

Yes, that's really helpful to get all the disclosure. I don't know if you got the mic on. Right now, I think we're going to turn it over to the audience. Thank you all again for coming out to California. Are there any questions at this time? Maybe I'll kick one off right now to start with questions maybe on cash flow. How should we think about the cadence of cash flow over the next few years? You did $375 million of free cash flow in 2021. Is the growth in EBITDA, which this year will be around $100 million, a good proxy for how much cash flow should step up? Or are there other onetime cash costs that we should consider?

Yes. So the big one is the -- both the cost to obtain the synergies as well as this integration of the Bayer system. So we've called that out in the $250 million, $260 million range this year. And so we're going to both get the EBITDA growth over the next few years but also as we complete all of these one-off costs that have made us both noisy and cash intensive the last couple of years to accelerate. So the team is very much focused on both preserving capital but getting this efficiency and the synergies that come with it. All are going to be big drivers of operating cash flow improvements.

That's very helpful. Are there any other questions from investors today? Otherwise, I'll kick it back to Nate. Nate, I think we have about 3 minutes left. Go ahead.

Yes. Maybe one final one on my end. Going back to Seresto, I guess, if there is a change in the EPA's view on 1 of Seresto's 2 active ingredients, at this point, is it possible to talk about what the contingency might look like from the company and how you would approach that? Or is it kind of too early to say just given we obviously don't know the outcome of this potential review?

Yes. So there's no precedent that shows an immediate pull from the marketplace. So again, our expectation is there would be dialogue. There would be interaction with the EPA. And again, this isn't a view of Seresto. It is a view of the 2 active ingredients. And so you would have a lot of different producers who would be impacted that they would have to interact with. So we don't think that, that would create a immediate item, especially all the science, all of our pharmacodiligence data, there's no causal link here. It's reports of pets with the Seresto collar, not that the Seresto collar is creating any issues. And so we feel really good about the science, all of the data that demonstrates that science. And so again, we're confident that Seresto will continue to be on the U.S. market, on the global stage and continue to grow.

Great. I think we're just about at time. So why don't we wrap it up there. Todd, thanks very much for your time today. Sorry, I couldn't join you in person, but I really appreciate all the comments.

Yes, thank you for coming.

Thank you.

Thank you.