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

Good morning, everybody. I'm Chris Schott at JPMorgan, and it's my pleasure to be introducing Elanco this morning. From the company, we have Jeff Simmons, the company's President and CEO, and we're going to have the company's CFO, Todd Young, joining for Q&A. Before I turn it over to Jeff, I just want to remind people have a question, you can ask that through the portal, and I'll work those into the Q&A post the presentation. So with that, Jeff, Happy New Year. Thanks for joining us, and we turn over to you.

Well, good morning, and thanks, Chris. Thanks for JPMorgan and covering the animal health space and have been a long history of doing that. So thank you, and we appreciate the opportunity to engage with investors today. As always, look at Slide 2 for our disclaimers on our forward-looking statements and what I'm going to do here is just to cover really here on Slide 3, the following. I'd like to share a little bit about animal health. There's a lot of nonindustry people maybe looking at this space for the first time. So given the current economic times, how is the industry, how does it fare look specifically to Elanco, we're almost a 70-year-old company, the longest-standing brand in Animal Health and a little bit of our history and where we are as well as our strategy that we've had over 4 years and the 3 pillars to our strategy. Then looking at 2023, we'll give our guidance in February, but a little bit of the pushes and pulls on 2023. And then I'll highlight a few of what we think are 3 major trends to consider as we go forward and ending really with the compelling value proposition we see over the long term with Elanco. So with that, with many nuances and some of the details, let me go to some of the prepared remarks, starting on Slide 4. With an overview on Animal Health, as I said, given the limited industry presence at the conference, here's just kind of a summary slide. The total addressable market for Animal Health medicines and vaccines is about $37 billion globally. The industry has historically fared well during times of economic turbulence. And while not recession resistant, it's expected to be durable on both the pet health and the farm animal sides of the business as we look to 2023. The $14 billion global pet health market is poised to continue growing in 2023, albeit at a slower pace as the post-COVID normalization continues, and a weaker economic environment is expected for at least a portion of the year. As in recent years, growth will continue to be driven by, one, an increase in pet ownership, the increased global movement on humanization of pets, while on the other side, vet labor and capacity constraints are expected to persist in 2023. We expect, as always on the Pet Side, innovation, increased compliance and convenience enabled by e-commerce will drive growth. Shifting to the farm animal side, a bigger part of the industry, this $22 billion global industry is expected to grow in 2023, driven by the continued rise in global demand for animal protein, which is linked to GDP, but also the continued popularity of high-protein diets, and an important factor, efficient global trade. As the demand for protein increases, the importance of sustainable meat production has never mattered more. The intersection of both calories and climate creates the next industry opportunity, we believe, and positions livestock well to be a major contributor to the climate solution not the problem. We expect these growth drivers to be balanced by elevated input costs, primarily feed, that remain at historical levels as well as some drought and disease. Ultimately, we expect more muted growth in the farm animal side compared to the pet health in 2023. Overall, we believe Animal Health is well positioned to weather a wide range of macro conditions. I've seen this over the 30 years I've been in the industry with persistent positive long-term trends in both the pet and the farm animal markets. While these trends provide a beneficial backdrop, industry success has driven what's at the bottom of this slide, absolutely essential. One, you've got to have broad scale; 2, robust portfolios. You've got to innovate into those portfolios continually. You've got to have global reach where you're accessing vets and farmers at a direct level, and you've got to continue to add value-added capabilities. Now if we move to Slide 5, we'll take a look at Elanco specifically. We are an independent, product-focused animal health leader. Over the last 4 years, we have successfully completed our standup as a public company. Additionally, and intentionally, we increased our size and scale and exposure to more pet market by acquiring Bayer Animal Health. We've taken decisive actions to capture value and deliver productivity. We're nearing the completion of the Bayer Animal Health systems integration and have a path to bring meaningful innovation over the next 18 months. The result of this transformation is a global independent company that has the scale, portfolio diversity, an exciting pipeline and an optimized infrastructure, enabling us to reach the world's animals and be a valuable partner, not just to our customers but also to innovators. Over the last 4 years, Elanco has maintained a consistent strategy of innovation, portfolio and productivity, or we call IPP, as shown on Slide 6. We have delivered company-wide productivity actions since our 2018 IPO and through the Bayer acquisition, consistently, we've been expanding margins despite historical inflation and currency pressures, while we also have been exceeding our synergy goals. We have a broad, diverse portfolio. We're gaining share in markets that we expect and want to lead in. And finally, on the innovation side, we're filling the gaps with our pipeline, and our pipeline is progressing. We expect 2023 and 2024 to represent a historical launch window for Elanco. We believe this flywheel is poised to optimize our ability to serve customers and create long-term value. Let's now move to Slide 7 and look at innovation a little deeper. Today, more than ever, under the leadership of Dr. Ellen De Brabander, we believe Elanco's R&D organization is positioned very well to deliver consistent innovation in some of the market's biggest spaces and areas of unmet need. First, after several integrations, the 1 Elanco R&D organization has entered a more stable phase with a very capable organizational structure. Ellen has streamlined ways of working, place a deeper technical expertise in right areas. We've optimized resource allocation. We have prioritized assets that will compete in large market spaces, and we've removed lower value opportunities, such as microbiome and prioritize them -- prioritized now with much more funding and time allocation. This is paid benefits. Our focused pipeline is led by potential blockbuster products with a path to approval by the first half of 2024. Additionally, one of the key differentiators in this animal health cash market business is the importance of maximizing our existing portfolio with targeted life cycle management. Finally, we are focused on refilling and enhancing the early-stage pipeline with a bias towards best and first-in-class opportunities to drive consistent, high-impact innovation over time. Having strong pipeline candidates now across phases of both research and development, this is essential to future success. Finally, our track record as partner of choice differentiates Elanco in the industry. We have a strong history of both internal and external innovation and both remain important to our R&D strategy. Numerous examples, including licensing of Bexacat, Bovaer, other early-stage collaborations as well as the addition of Kindred Bio, which expanded our monoclonal antibody platform and enhanced our existing dermatology pipeline. We will continue to look for additional bolt-on opportunities to leverage our expertise, scale and relationships to enhance efforts across various platforms. On Slide 8, we share this in our third quarter earnings call, you can see that we have an exciting late-stage pipeline that's expected to make 2023 and 2024, a historical launch window for Elanco's pet health business. I've noted 2 milestones since our November call. The approval of Bexacat, a novel oral, actually first SGLT-2 into the United States market, and that will be for a treatment for fee line diabetes. And also an initial submission for our JAK inhibitor for dermatology, achieving our goal for submission of up to 2 pet health blockbusters in 2022. Our 3 late-stage development projects in parasiticides and dermatology are progressing nicely and aligned with our expectations. As we shared in November, we completed the initial submission for our differentiated broad spectrum parasiticide product and today share the update on our differentiated JAK inhibitor. Additionally, we're pleased with the progression of our IL-31 short-acting dermatology asset. This will be our second monoclonal antibody and we continue to expect to initiate its submission to the USDA in the first half of 2023. We believe all 3 of these assets are blockbuster potential innovations with a path towards approval in the U.S. by the first half of 2024. We expect Bexacat, along with Zorbium, Advantage XD and our parvovirus monoclonal antibodies and some OTC innovations to contribute to innovation growth in 2023. Ellen and her team are focused. It is working. She is optimizing. We are demonstrating it here in 2022 with proof points, and we're setting Elanco up to deliver consistent, high-impact innovation. We move now to the second pillar of our strategy around portfolio. Elanco sells products in more than 90 countries. We've got over 200 brands of those 10 of those brands were blockbusters in 2021. Our diverse global portfolio really allows us to be well positioned to reach the world's animals, we look at our business really in these 4 quadrants, U.S. international, pet and farm animal. Let's cover each 1 of them, starting with our highest margin business, the U.S. pet health business. We remain the industry leader in the over-the-counter parasiticides with Seresto and the Advantage family brands as this segment and industry navigates the impact of pressured economic conditions, we do expect stabilization in the retail space from price, innovation, both new product and life cycle management, more consistent supply and channel expansion. We will continue to face competition in the vet parasiticides from competitive innovations launched in the last few years. And the Elanco team is focused on executing on areas within our control like maximizing our therapeutics portfolio, including pain, where we are the U.S. market leader and advancing our late-stage pipeline. On the international pet side, primarily concentrated in parasiticides, where we're market leaders in topicals and collars. We also are able to leverage these strong brands with our oral broad spectrum parasiticide we have internationally, Credelio Plus as pet ownership increases around the world, especially in emerging markets, we see this as a robust segment. Despite the expected near-term headwinds though, resulting from the economic climate in Europe, we remain committed to geographic and channel expansion, including in e-commerce or retail in certain markets. Shifting now to the farm animal side in the U.S., where we're market leaders in swine and poultry and top 2 in cattle. Our broad portfolio has proven to be resilient in a variety of markets, including the introduction of generics, where we have been able to leverage our diversity, our scale and our innovations to protect the base. While we have navigated generic entrants across species, this has limited some opportunity to grow price. Although we lack scale and farm animal vaccines, we see great opportunity, as I mentioned, in livestock sustainability. This emerging part of our cattle portfolio with products like Experior and in time Bovaer are expected to position Elanco as our customers' leading partner on sustainability, one of their top needs at this time. Finally, we'll look for ways to expand our portfolio and deliver differentiated benefit to our customers through a value beyond product offering. Lastly, our international farm animal business. It generated about 1/3 of our 2021 revenue. It's the highest contribution of these 4 quadrants, but typically the lowest margin area. Excluding vaccines, we are the market leader in poultry and swine and a top 2 player in Aqua across cold and warm water markets. Aside from poultry salmonella vaccines, the farm animal vaccine gap persists here in international as in the U.S., and we see market access shifts away from certain medicated feed additives, especially in Europe. Continued portfolio expansion through life cycle management and geo expansion will contribute to our success in this international segment. Overall, our history of farm animal leadership, our intentional shift to pet health and our late-stage pipeline is expected to result in a more stable portfolio a better mix and higher margins. Now on Slide 10, I'll elaborate on our productivity delivery over the past 4 years. We've reported year-over-year adjusted EBITDA margin expansion in our last 7 quarters despite record levels of inflation and a decline in U.S. pet health, our highest margin business. Over the last several years, we have taken decisive actions to rightsize our physical footprint and corporate structure, allowing us to deliver cumulative adjusted EBITDA synergies above initial expectations. Our final integration activity, bringing the ERP systems together in the second quarter of this year represents the largest expected major onetime use of cash, setting us up for future improvements in free cash flow conversion. Finally, these intentional productivity actions are complemented by an enhanced ownership mentality, thanks to our shift to an EVA like Elanco cash earnings compensation metric for most all employees. We believe our established IPP strategy that I've just gone through is a flywheel, it's working. It's necessary to optimize serving customers and creating value over the long term. While we're excited about the pipeline opportunity over the next several years, I want to address some of the key considerations as we look at 2023. Slide 11 is a slide we used in our November call. And as we've shared in our Q3 earnings call, the global macro environment continues to be uncertain with pressure, likely expected to continue in the European and in the U.S. pet retail markets. Given the lack of pipeline disclosure in animal health, there's also uncertainty around competitive launches that may occur this year. Finally, from a financial perspective, we expect headwinds from increasing interest rates and continued volatile foreign currency markets. Offsetting these headwinds, Elanco's ability to reach the world's animals and our competitive portfolio are well positioned outside of certain known portfolio gaps. We've highlighted a number of new products we expect to bring to the market in 2023. We expect to continue holding share in line with our expectations. We see stabilization as we continue to capture value from pricing and deliver more consistent supply. The recent easing of COVID restrictions in China are a step in the right direction, but a return to normalcy will take time and as this gradual recovery occurs, we believe we're well positioned as we've held share that will recover with the market in China. Our continued productivity efforts and our systems integration will be important from our continued margin expansion efforts, but benefit from the expected decrease in inflationary pressures on manufacturing costs they will lag some as inventory usually takes about 9 months to move off from our balance sheet. This year, we'll prepare for the expected launches of our late-stage pet health blockbusters in the industry's largest markets. the U.S. parasiticide in dermatology, we will make the right investments in R&D, manufacturing and our systems to launch these capabilities, really reflecting a change in the trajectory from our 2022 operating cost reductions. While we plan to provide 2023 guidance during our fourth quarter '22 earnings call in February on balance, we believe this year will present a meaningful opportunity for Elanco's business, while executing against the continued environmental and competitive challenges. Maybe before I close, just briefly touch on what I believe are some unique trends to watch in animal health merging this year and going forward here on Slide 12. First, differentiated innovation. It has consistently been rewarded in Animal Health. We have seen in recent years and Elanco, we believe, is well positioned to benefit from this dynamic in coming years. The emergence of generic models, especially in farm animal increases the importance of bringing innovation and a valuable portfolio to solutions in farm animals. We expect companies with portfolio breadth, reach and differentiation will be rewarded. The other trend is globalization. We don't talk enough about this, I believe, and we're seeing increasing pet ownership and humanization of pets and this is driving expansion in pet markets outside of the U.S. Additionally, as an example, we see opportunity in fee line globally in that market broadly as that market matures. On the farm animal side, trade access of 4 meat globally is essential to enable sustainable demand, reduce volatility and support producer profitability, a key metric on the farm animal side. And finally, farm animal sustainability. This is an emerging trend that we expect to become the next era of opportunity in animal health. Historically, our industry has been focused on animal health and its connection to human health. Now the connection of animal health, human health and environmental health is becoming a reality. We believe livestock can play a positive role in sustainability especially here in the short term with methane reduction. With animal health products, with tools and analytics and with the evolution of the carbon market essential to drive this change. So in summary, we believe Elanco is well positioned to capitalize and benefit from some of these emerging trends. I'll close on Slide 13. Elanco as a leader and a durable animal health industry we believe, offers a compelling long-term value proposition. Our innovation, portfolio and productivity strategy positions us well to navigate near-term economic and competitive pressures as we execute delivering on cost savings through operational efficiency, obtaining regulatory approvals for our pipeline, launching with excellence, especially here over the next 2 years and remaining focused on debt pay down. We have made the difficult decisions that provide us with the optimized infrastructure to support future growth for innovation. Ultimately, we believe this strategy will drive meaningful long-term value for our investors. So with that, Chris, thank you for the opportunity. I look forward to having Todd join me, our CFO, to field some questions.

Thanks for those comments.

So I thought just maybe to kick off the Q&A here. Jeff, can you just reflect back on 2022, it was obviously a very dynamic year for Elanco and for the industry. I guess what went well and what were some of the surprises as you kind of reflect back on the year?

Yes. I think in summary, what went well or the 2Ps, I think productivity and pipeline we made some major advancements. I think as we mentioned, even in the face of all this inflation and FX and all the challenges and our largest business, with the highest margin business being down U.S. pet health, we were able to continue to expand margins. This has come from the infrastructure, the restructuring, the manufacturing partnerships that we've put in place. All of that, I think, has put us in a very competitive position and we're getting our cost base right. I think the other side and the advancement we're moving to this 1 last move, which is the integration of the Bayer system. I think on pipeline, look, Ellen has come in. She's taken a great R&D organization, a lot of matter in our pipeline. We said last year at this conference, a heavy focus on late-stage pet blockbuster products where there's high margin, big products, opportunity, unmet needs, and we've leaned in, that's happened. We've integrated Kindred, Bayer and Elanco together, and really, without increasing resources and R&D actually trimming them, we've actually increased our ability to drive the pipeline, and we've moved microbiome out, et cetera. So we believe we've got a team, a structure, a pipeline, we don't talk a lot about it. We had some good additions into the pipeline and some good movement from research to development as well. So I think those are the positives, and that's what's going to drive our company long term. I think on the other side, it's environment, to summarize in 2 points, it'd be environment and competitive innovation. I think in the environment, Todd can share, when we guided, we would have never assumed Ukraine war, China lockdowns, the strengthening dollar with a big international business, interest rates. These things were challenging. And then I think on the competitive innovation side, again, that had some impact. It was -- most of it aligned with our expectations, but there was some negative impact. Those would be the 2 factors.

Great. Great. And then I think the slide you had the swing factors for 2023. Since you provided, I think, those -- that outlook in on 3Q, anything within there that's kind of shifted either on the positive or negative side, you feel either more or less confident? Or do you feel like those are still kind of pretty consistent kind of view of the world versus where we were a few months ago?

Yes, we shared with some investors over the last few days. We think the categories are right on that slide that we shared in 2020 or in November in our earnings call, the pushes and the pulls, and I would just highlight that I think between now and February, as we come to the guidance, we're going to be taking a close look at those in terms of the magnitude. So we do think that on the positive side, innovation pricing. We do think China versus last year. There are some green shoots where a little bit. We don't think there's a V-shaped recovery, probably more of a slower U-shaped recovery I think these factors, the dollar where it's weakening with the bigger international business. But on the same side, I think that we continue to see the competitive pressures. We continue to see the challenges in the marketplace. We think China has still got some challenges. And I think the 2 economic areas we got our eyes on are pet retail and Europe. I mean those are the factors. So the level and extreme of those pushes and pulls will highlight more in the February earnings call.

And maybe you mentioned pet retail. Can you just elaborate a bit more, I think with Seresto and Advantage, we saw some headwinds in 2022, driven by macro. How much of that is kind of reflected at this point? And how much more headwind do you kind of think about as you go into next year -- this year now?

Yes. Pet retail kind of had a little bit of a perfect storm, but I stepped back and say, we did the Bayer deal saying, "Hey, really, really important in the pet business globally, omnichannel matters, meeting pet owners where they want to shop. We still have over 1/3 of pet owners that don't go to the veterinarian maybe this economic pressure that even increases being able to say, hey, many price points, many SKUs, scripted product, unscripted product, topical, oral and collar, all of that matters. And as we bring our pipeline that will matter. So I would say we don't see any change in that globally. Actually, we've seen pushes and pulls around the world, but all of our diligence has found that to play out. So we don't see any change in that. There's some bleeding across. But what happened in 2022, we think is a little bit specific to '22 and maybe '23 is one, we saw major retailers take down inventory. We saw some pet owners that say, hey, on the off-season, tick fleet. We have a lot of these sales during the first half during the spring and the early summer in the off season, people either went away or traded down or went to topical, say, "I'm not going to use a preventative, I'm going to use a treatment. And so -- or I'm going to trade down to a lower cost collar or topical. And then we saw some bleeding over of a lot of DTC and a lot of scripting of new products. We saw some bleeding over that. So those are the factors. What I would say as we look at '23, we think that there is some stabilizing. We're going to come into the season. We've got a lot of loyalty from the retailers, a lot of loyalty from e-commerce on these brands. We're going to see a pricing effect, better supply and we got more physical availability today than we've ever had it since we acquired the products, and we're innovating in the space. All of those are factors that we think are going to drive a more stabilizing retail business in 2023.

Great. And maybe a bigger picture 1 on just the health of the companion market. I think that's 1 of the big states for the sector over this past year is going into a recession. Like is this a industry that's generally insulated from those pressures? Or is there something to worry about here? Just your perspective on the kind of maybe beyond retail, just overall business?

I've seen a lot of seasons 33 years in this industry in 2008, we've seen a lot of change. But I think on the positive side and why we believe it's durable and it's resilient, it's not recession proof, but on the pet side, I think today, the pet owner has -- it's easier to be compliant. There's drop shipping delivery to the door much easier even at the vet clinic. All of these things drive convenience. Pet ownership is up, continues to climb. The humanization of pets even globally. International matters a lot more than it did in 2008 that's going to be a factor. And there's more price points and more channels. I think that's a factor in a positive way. On the other side, though, I don't think we can sit here and say that we're totally insulated from it. I do think that we saw, and I'm going to point to 1 example in Europe in Q3 that we noted in our results, we saw sellout data on pet products where the European pet owner was concerned about what was going to come, energy cost in the recession, we saw a pullback by most every competitive category and every competitor as well as ourselves in a pretty extreme manner, which says, hey, there is some elasticity, there is some price sensitivity, not every market is the same. So we're better than we have. It's durable, but there's still pockets. And today, I would point to Europe as an example, and Pet Retail as an example as well.

Great. Maybe just 1 other 1 on the product side, Seresto. Just next steps from an EPA perspective? I know it's been a topic discussion on the story, and we'd love to hear lays thoughts there?

A great product, Seresto, continues to be a brand that we stand with and is confident today as ever in the registration and the long-term need. I stopped and, say, in the U.S., there were 500,000 tick borne illnesses between Lyme disease and Rocky Mountain fever and Seresto is a key part of a total health solution that is needed and offer something very unique in the marketplace. It's a strong brand, a lot of loyalty to the brand. We did have some PR issues and we have engaged directly with the EPA. And Chris, to your question specifically, the next step is we're engaging in a collaborative way with the EPA. Remember, OTC products anything that's topical or collar on the pet goes through the EPA, not the FDA, EPA spends primarily a lot of time on the environmental side, the plan side. And we are working with them on a brand stewardship and oversight approach and initiatives that would actually create a better, better data and better opportunity to not be prone to PR issues but to let pet owners, veterinarians all of us know and understand the product. we're hoping for early here in 2023 to have a collaborative agreement with the EPA, which is actually good for Seresto in the long term.

Okay. So it's something in the near term, hopefully, get.

That's correct.

Okay. Great. One other question there are topics I've been having is operating costs. It's -- you've obviously managed the P&L pretty aggressively in response to some of the dynamics of the industry. Is this a sustainable level of spend, what we're seeing right now? And I guess I'm thinking of this in the context of your setting up some very important launches as we look out to '23 and more importantly, 2024. So how do we think about expenses playing through those next few years?