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

Thanks, guys. Jon Block with Stifel. Good afternoon. I'm sticking with the pause theme. And next, we have Elanco Animal Health, one of the largest players in the animal health industry. And joining us is Todd Young, the company's CFO. I'm going to lead the Q&A. Guys, if you have questions, just throw up your hand. Obviously, you'll take precedent, and I'm going to turn on my mic as well, I believe. I'm on. Can you hear me? Better? Okay. I'm not going to repeat all that, but let's get going, and I'll fire away with some questions. Todd, thanks for joining.

I'm going to get right into things with Seresto. And on the first quarter earnings call, Jeff talked to some formal results to be communicated by the EPA in the coming weeks. I think we've got a couple of these. Like here it comes, we're going to get clarity. And now we're almost a month later. I don't believe we've seen anything. So I guess the question is to you, any update that you want to let us know about? And is no news, good news? How do we think about that?

Yes. Just for clarity, the coming weeks was also, using the EPA's words, understanding that we don't control their relative timing. Is this really loud or is it just echoing in my ears?

I think we're okay.

All right. Good. No change. We're very pleased with the alignment we've reached with Seresto. We don't think it's going to have a commercial implication as the stewardship actions are very much in line with what we already do for many of our FDA products. And so I would not read the timing into anything other than EPA continuing to finalize things, which I would characterize as administrative.

So importantly, I'll sort of latch on to that finalize word, this isn't something where we thought it was going to get done. Oops, it didn't. Now the FDA comes into the mix. The thought is this is still at the goal line and whether that was weeks plus 1, weeks plus 2, we feel confident that this will be finalized?

Yes. So -- yes. So I think the -- in the earnings release on May 8, we also called out that the EPA had consulted with the FDA on this process. So even as they work through where things head between the 2 agencies, we're confident in the continued registration of Seresto based off all of this work and this is done. They're not like they're going back and relooking at data or doing anything but just timing.

We're dotting Is, we're crossing Ts. You guys were using the term stewardship. I'll just sort of maybe cut to the chase. And I think there's the expectation that the label becomes a little stricter for Seresto. I believe labels have become stricter for other parasiticides in the past. And so how would Elanco view a stricter label for Seresto? Any impact on product sales? And Todd, is there like an analog that you can point to in the past in what it has or hasn't meant for other parasiticides?

Yes. I think most importantly, right, Seresto has been around for over a decade, has treated millions of animals. It's proven to be very safe. It's been approved and used by regulatory bodies across the world. There's different labels outside the U.S. than in the U.S. and yet from a commercial standpoint, no differences on overall ability to commercialize the product. So if there is a label adjustment, we don't think it will have a commercial impact --

Okay. Fair enough. Maybe just one more around Seresto, and it's away from the EPA. But in the first quarter of '23, you temporarily suspended mAB, right, for some of your products, and Seresto was one of them. And now mAB has been reimplemented, I believe, around the time of mid- to late April. How have Seresto and some of these other products that came off mAB and now are back on, how have those trended? And we sometimes lean on some scanner data, maybe some slight softening there, but would love your thoughts.

So I think as we called out on the May earnings call, we did have mAB suspended. It has since been reinstated. The mAB, the -- I guess the retailers that priced below the mAB were really only on Seresto. There's very little on Advantage family products. And so again, there's been less impact as mAB's been going back on. We expected to have some softness in retail dispensing when the mAB got reintroduced, and prices of Seresto in the marketplace went from around $55 at some of the online retailers up to the mAB price, which is around $69. We've seen that in line with our expectations. It's not something we're concerned about. Seresto, we're pleased to return to growth in Q1, even when you exclude the bridging stock impact it had in the U.S. Outside of the U.S., Europe continues to be impacted. We've seen that in the back half last year with our results and continuing here in the first quarter. Europe was slower as you saw with international Pet Health revenues.

Okay. And just to tease out, I think, an important data point that you had in there was since the reimplementation of mAB, which was most specific to Seresto, that hasn't deviated from what your expectations were in 2Q and how that was going to play out?

It has not.

Okay. That's very helpful. I'm going to shift to Pet Health, and you really had a solid first quarter. Good results. It was aided by ERP. But at the end of the day, you still raised your guidance. It didn't seem like the distributors working down inventory was really an issue for you. It was somewhat odd. There's obviously a very big player that called out inventory. It wasn't an issue for you in 1Q '23, but we did hear about it from Zoetis. And then even after that, we heard about it from another big animal health player. So any challenges for you with inventory in the channel? And have you seen that start to service as some distributors might be scrutinizing inventory levels due to cost of capital and stuff like that?

I think everybody is looking at things from a cost-of-capital standpoint just given the new environment we're in. Overall, our distribution levels in the U.S. have been consistent across the total U.S. business since middle of 2020. That didn't change in Q1. There's a little bit more pressure, I would say, on the Farm Animal side, not enough to where we called it out specifically, but it is something we're paying attention to. But more Farm Animal for us than Pet Health at this point. And internationally -- international, we use distribution for a lot of the over-the-counter products. And so the bridging stock purchases of the legacy Bayer products in Q1 makes it harder for us to tease that out if there is anything, but based off conversations with our teams around the world, we're not seeing this as a significant issue.

And it -- not a significant issue. You did allude to some -- a little bit more in the Farm Animal. Just to be clear, was that Farm Animal sort of what happened throughout 1Q? Or subsequent you've seen maybe some moderation...

In 1Q.

In 1Q. Okay. I just wanted to be clear. And then you got a bunch of questions on the call on ERP and now you can quantify it. And you said, look, we do our best, right?

Yes.

We do our best and we put out the estimate. There are some key estimates that need to go into that process. And so your confidence that you adequately ring-fenced that when you were trying to sort of detail for The Street, what was pulled forward from 2Q to 1Q because now you're 2 months into 2Q.

Again, it's an unknowable number under SEC parlance. So I can't give us specifics because it's much like the China lockdowns, how much did that affect us? Well, we all estimate that based off the best information we have. Again, we gave first half guidance because we knew it would be noisy, and we're confident in the guidance we provided, including tightening the bottom end of the range for the first half coming off the end of Q1 because we take a lot of risk. For us, the implementation of the ERP, integrating the Bayer business into the Elanco business, switching over to all of our shared service center networks, it went really well. And so risk that we had in our guidance for that not going well got dealt with, and so we feel good about what we said for the first half in that.

Yes. I got the CFO up here, and ERPs aren't easy and you guys executed. Do you feel like that really wasn't appreciated fully at all from The Street? I mean you go ahead and...

Again, we keep executing, we keep doing well with what controls we have. The team worked very high on a global basis to pull it off, and very appreciative of them. Again, we're supposed to do those things well. And that's, I guess, my expectations. That's how we operate.

Fair enough. International Pet Health, you alluded to it a little bit earlier, but you sounded more cautious on International Pet Health. I just think the overall visibility is a little bit more limited. What are you seeing in some of those OUS markets? Is it the consumer and the weakening and the consumer confidence? Were there inventory levels that might have been a little bit higher? Maybe just walk us through on the ground what you're experiencing in the OUS Pet Health markets.

Yes. I think OUS is a little bit -- is tougher visibility-wise very much, as you said, Jon. And so that comes into play...

[indiscernible] industry data like vet has?

Exactly. And so the over-the-counter products, we saw going well, but not -- I guess, we had expected it to be in a tougher spot coming off the back half we had last year in Europe. That did continue and that's reflected in the results where Pet Health outside the U.S. was down. China did not rebound much in Q1. It got a little better, but it's been getting better in Q2 as the self-imposed lockdowns and then the Chinese New Year all impacted Q1 a little bit. So overall, we're more bullish on the execution we had in U.S. Pet Health. International Pet Health is not far out of line with our expectations, but certainly not seeing as much return as what we saw in the U.S.

Okay. And to maybe double-click on that a little bit, the International being less robust in the U.S. You called out China there. All my companies attending the conference are getting this question. So I just want to be clear because it's funny, a lot of companies throughout 1Q said, hey, look, China was very modest, Jan-Feb, picked up in March, in one of their earnings call, talked about a nice sort of pickup or slope in April. And there was a lot of headline news flow that came out about peak infection rates not occurring until June. There was a lot of concern, stocks sold off. Are you seeing that on the ground? Or did that slope that you experienced the improvement March into April, is that sort of fair to somewhat extrapolate going forward?

I mean, I think we've seen that improvement has continued. I think the -- our expectation, right, is that we aren't going to go back to lockdowns, but rather going to grow through COVID, much like we all have over time. And so it will have less of an impact than it did when they were locking things down strictly. But again, Jeff is actually on the ground there today, meeting with the Chinese team. I'll be catching up with him in India early next week to check on Asia. So we're going out and seeing how it feels on the ground with our people just because due to COVID, we haven't had that chance in a few years.

But fair to say maybe like the headlines of late to the best you can tell, hasn't really matched what's been going on in the business?

Yes, I can confirm that.

Okay. Very helpful and pretty consistent with some of the other companies that we've heard from. Another question on the overall business and then maybe we'll pivot to Farm Animal. In the second quarter of '23, you've got the ERP headwinds, right? So that's why you sort of frame the first half. Then I think, Todd, you talked to constant currency revenue growth returning in the back half of '23. And I was just a little unclear. Is that for each quarter of 2H '23? Is that a collective 2H '23 statement? How do we view that?

Well, I've only guided to the second half through the implication of our numbers, Jon. So I'm not going to give you Q3 guidance today. But we feel good about where the business is, how it's trending. We're going to have some vaccine supply come back in Q3 that will be positive. A lot of the headwinds we saw in Europe and China were pretty robust starting in Q3 last year. And then in Q4, we had the inventory come out of the retail channel. So a number of those things, plus then just the ramp in production of the innovation. We're excited for parvovirus. That will be a nice incremental second half as it grows. Experior is continuing to improve and ramp. So a lot of things contributing to the return to the growth in the second half of 2023 for us.

Okay. Fair enough. Just don't want to tell us if it's 3Q and 4Q, yes?

Exactly.

Okay. Got it. Farm Animal, I want to go into that. And I want to spend a decent amount of time on, call it, current and future innovation because there's a lot to talk about. But on Farm Animal, I believe China is roughly 5% of sales or was 5% of sales in 2022. What percent of that is specific to Farm Animal? I mean I just go back to...

So 75% of the $223 million we had last year in Chinese revenue was Farm; 25%, Pet.

Okay. I was going to say remember what it's been like 80%-plus, so you were 75%. On the first quarter conference call, you talked about the pig prices in China being under pressure to start the year and then assume some gradual improvement throughout the year. It hasn't improved. And I think there's a public company that sort of revised their estimates lower. Those pig prices continue to struggle. Risk factors around that, we haven't seen any improvement yet. Again, the guidance, I believe, assumes a gradual improvement. Maybe you can talk us through some of those dynamics.

Yes. Poultry is doing better, right? So again, we've got a portfolio there. And so that's the nature of the portfolio on the Farm Animal side is different things do have offset. So no impact on us with respect to the total company guidance we've given. But yes, swine is a little softer than we thought. Poultry is a little better.

So species diversification, we shouldn't think about the fact that prices haven't improved specific this one is a risk factor to your Farm Animal numbers per se?

No.

And then on vaccines, that was a little bit of a drag to recent results. You sort of talked to it earlier. You're looking for an improvement in vaccine supply to begin in beginning of 3Q '23. Your line of sight, and then it's not just you guys, but just for the industry, the difficulty around consistent supply of vaccines, why do we see it sort of ebb and flow so much? And then if it does sort of spike and then ease, how are you able to have that level of conviction that, that will be back online when we get to the third quarter of this year?

Yes. And again, the regulatory challenges, we all make a lot of different products in a lot of different places and species. And so you just are always going to have some things that aren't going perfectly. Overall, we've done good work. We feel like it's coming back. Channel levels have not met that we're going to stock-out customers. In some cases, there are, but in other cases, they're not. And so it can be just our sales to the channel being lower versus us losing our end customers. So overall, I think we feel good about the line of sight we have right now on vaccines returning, but the manufacturing team is always on top of staying in front of supply challenge.

Okay. And sort of, again, that's sort of another variable to think about when you're talking about that 2H growth coming back?

Yes.

Current innovation, future innovation and probably want to spend a good chunk of time here. So I'll start with current innovation. Each quarter, I feel like you and Jeff have these upbeat comments around Experior, but just it's hard to quantify, right? You're giving us the innovation bucket, but it's all in. You've got your U.S. Farm Animal revenues were down 8% normalized for ERP. And U.S. Farm is less than a $700 million annual business. So I just have a hard time getting it a big dollar, the contribution from Experior because if it was a big dollar contribution, a $700 million base, how would you be down 8% normalized? So maybe talk through some of those moving parts. And is there a way to better quantify Experior? Because I think you talked about it being potentially a blockbuster.

Yes. We still believe it will be a blockbuster. I think it's a fair question, Jon, with respect to the results. It hasn't ramped at the pace we expected it to 2 years ago by any stretch. I think if we look at the down 8%, implants we've been losing to competition on implants with the change in the regulatory. So that affected our business and then the vaccine supply item. And then we talked about some poultry rotations, which is really timing within the year driving the year-over-year decline of the 8%. The other part is, remember, Experior cannibalizes Optaflexx. So we also aren't telling you what the Optaflexx numbers, but there is an element of some cannibalization. Now the good news is, right, all the packers are all on board now, and that's a key element. They are not having any issues taking Experior-fed cattle. The top 6 feed lots in the country are all using it and using it at commercial levels. So we feel very good about the inroads we're making on Experior because with the current cattle cycle, cattle on feed are down about 5%. So Experior's economic value to producers, to the packers has increased, which makes it easier for them to use it. A year ago, when the exports to China were way up, they were making tons of money on every cow. Their incentive to change feeding regimes for their own economics was a lot less. As those margins have been squeezed, there's a greater openness to making these changes. And what we see is once changes happen, they're very sticky on the Farm Animal side. So we're still confident Experior rises to the blockbuster status for us.

And maybe to just put a time line around that. I go back to one of your competitor's recent Analyst Days, when they talked about a particular area of OA Pain mABs being $1 billion-plus sort of through it in this 3- to 5-year window. We're now 2 years post-Experior launch. You're hanging on to this blockbuster. And you just laid out a compelling argument why. When you think about past product launches and sort of the trajectory to peak sales, is it in that 3- to 5-year window? In other words, if it gets there, Todd, as it gets there, look, it's going to inflect in the next 12 to 24 months? Or do we have to sort of lengthen the time line beyond that 5-year horizon?

Yes. I mean it's certainly different between pet products and farm products, then it's different if there's already something in market that's being used versus...

A change in behavior.

The base of the changes. So again, we generally think of peak sales for products, right, I mean Rumensin got to peak sales like 42 years after launch. So you -- in competitive stuff...

[indiscernible] only 42 years for an Experior blockbuster.

Exactly. But we don't think of it in terms of -- that 3 to 5 years is certainly a reasonable framework. We think Experior, again, got off to a slower start. It's starting to ramp. We think that continues as it gets sticky with the feeding regimes.

Fair enough. Current innovation pawning forward. Parvo, I remember this product from when I covered Kindred management. You guys talked about shipping that in the coming weeks on the 1Q '23 earnings call. I think you expected approvals from 70% of the states in the first month because there's conditional approval. Where are we on the approval rate from the states in the first month?

States are in a really good spot. The big issue for us was we got a final label. And we -- it was a little different than what we expected. So we had to go and get new labels, print them, apply them to the packaging. So that's the main driver. And as we called out on the call, right, from approval of the launch, we typically have about 2 to 4 months, be it finalizing labels, getting state approvals, different elements that come into that. Parvo is kind of tracking in line with that. We're really excited. We're taking preorders. We're ready to go. This is going to be a great innovation that's going to save a lot of dogs' lives.

It's going to be a potential blockbuster, I think, is the way you...

We've said that globally, yes. I think the big win we had was the R&D team coming up with innovative packaging. Because it has to be kept at such a cold temperature, the concern originally, when we guided, as part of the Kindred deal was that's having to buy new freezers to hold the product because the vet space is already tight, and so getting the vets to put capital and all that. But we came up with an innovative package that allows it to stay cold and stay at the right temperature inside the normal vet refrigerator. And so now we're going to go direct with a product that will be just in the standard of that fridge and give every -- the ability to treat a parvo case when it comes up.

Okay. Helpful color. And so maybe just to round out current innovation, I think there's more there than people realize. You've got some of these new OTC parasiticides. We've talked Parvo, there's Bexacat, there's feline CKD, other products as well. This year, you gave, I think it's a $210 million to $250 million innovation. That's up roughly $100 million from the $133 million a year ago. And then, of course, to come close to your longer-term goals and aspirations, you got to have a nice ramp into '24. Where should The Street be focused? Like of those products that I just called out, where are the bigger opportunities? Are we doing our homework on Bexacat or Parvo or the OTC parasiticides?

For us, it is a portfolio approach. We're excited for Parvo and Experior and for those continue to ramp because we're at 200-liter capacity right now in Elwood, Kansas making Parvo. We're ramping that to 2,000 liters. That's going to give us plenty of supply. We expect we won't have supply to serve the market this year given the capacity. So that's more growth in '24. Experior, again, gaining traction and continuing to accelerate its adoption with the biggest feedyards, and that will then continue down. The nutritional portfolio we acquired at the start of the year for swine and dairy, again, getting good traction. That will continue to drive growth. And so a lot of good things. And you mentioned it, Bexacat, ZORBIUM, some of the smaller products, we're really liking the traction we're getting in the vet clinic talking about those because they're unique products that then allow us to talk about our parasiticide portfolio and other things as well. The over-the-counter refreshes, the Advantage coming back original, K9 Advantix coming back, Advantage XD for longer duration, and then in Europe, we just received approval for an over-the-counter oral product we're calling Adtab, low to liner at the over-the-counter in Europe. So all of those new innovations are going to be a good part of driving to our 600 to 700. Then we get to the next big 4 innovation, Bovaer, the methane reducing cattle product we in-licensed from DSM. We expect that to be a path to approval in the first half of next year. And then we've got the 3 big pet products for the U.S.: derm, 2 products; broad spectrum parasiticide, path to first half approval and then expected 2 to 4 months from approval to launch.

And so let me push you a little bit there, Todd, because it's a perfect segue. That's literally what I had in front of me. So I think investors are getting excited, right? I mean you put up a good quarter. You raised -- you talked about cash flow getting better in '24 than '23. As some of these initiatives got behind you, that frees up your ability to pay down debt, and then you've got all these new products. But the confidence that these products, Bovaer, atopic derm JAK, monoclonal, the triple, all get approved in 1/8/24 when just like -- when you look back at what's recently taken place, BI has taken much longer for them to get NextGard Plus. Even Zoetis, it took them longer to get Librela. Maybe try to communicate to the investors why you have that level of confidence on those 4 getting across the goal line in 1H '24, where with the agency, some of these things just seem to be taking longer.

Well, we can't control the agencies. What we can control is the quality of our package, the quality of the data. We're having good interactions with the agencies. We've seen Bexacat get approved earlier than we expected. We've seen our parvovirus get approved conditionally but still approved generally in the time frame. We expect it was probably a month late. So we've got -- ZORBIUM got approved a little faster. Varenzin got conditional approval a little faster. So there are products that we have that are getting approved inside our time lines or a little quicker, understanding there's some other ones out in the industry that have had delays. So we've been clear to say we've got a path to first half approval. Doesn't mean it's a guaranteed first half approval. But right now, we're still on that path based off Ellen's team and the milestones they're hitting. If that changes, we'll update you and the rest of The Street on time lines.

Okay. And let's do the March from the $230 million in innovation this year, that's the midpoint, the $600 million to $700 million in 2025. Even if you hit your goals and a lot of these products are approved, I don't know, April, May, June, as you laid out, it's plus 2 to 4 months on the launch. So that's a really back-end weighted $600 million to $700 million. We should think $130 million going to $230 million, going to x sub-400, I would think. And then the rest of the true-up to $600 million to $700 million being the '24 to '25. Just approximately, is that the right way to think about it?

It's not the wrong way to think about it. We certainly...

That's what I aspired for.

Yes, exactly. Again, we've got the whole portfolio of products we've launched that are continuing to ramp and that we think we get scale on that, that have real value to driving that number. The new products are certainly essential to us hitting the number. We feel very good about those coming to market next year with Bovaer, broad spectrum parasiticide, JAK as well as a monoclonal antibody for dermatitis. So all of those things progressing well. We're very focused on the launches. We're focused on delivering '23, but also then the launches. The team is hitting on all cylinders right now. So excited to get those approved so we can deliver those revenue numbers.

And so a lot of the incremental of that $600 million to $700 million March is more '24 to '25 than '23 to '24. I would assume it's not too dissimilar from a margin perspective as well, right? Because when the products get out there, you said you're going to support them and you're going to spend, but it's after you launch. And so really, you launch, you got to spend a little bit behind it. The true contribution is more of a '25 phenomenon seemingly much more so than '24, is that...

Again, it will be a timing element, right? We would love to be investing behind all 4 products as early in the year as possible as I think everyone in this room would want. So overall, we think we're going to continue to grow. We've got the infrastructure built. We can handle a lot more topline revenue with the infrastructure. We're getting that more efficient. We're driving synergies. So there's a lot of positives that help offset some of the other costs that would get behind the investments to drive the revenue. So overall, again, we feel good about sort of how the business is trending, understanding that '23 is not a great year for us, and we've guided that with declining EBITDA in '23 and expecting that to improve as we get this innovation and launches going.

Okay. Well last quick exercise, and I'm sort of cheating and looking at the numbers, but I think this is a pretty good way to, I don't know, view things or walk it down. This year, the constant currency growth is negative 1% and innovation is an incremental $100 million in sales or 2%-plus growth contributor, right, the $100 million on the base. So the implied -- the 2023 implied base is negative 3%, negative 1%, just strip out the innovation, is negative 3%. And if I do that same calculation for 2022, the implied base was negative 4%. So the implied base was negative 4% in '22, negative 3% in '23. It probably shouldn't deviate much from that for next year, right? I mean, I know the innovation might be a little bit different. Do you see where I'm going with that like... Let's break that apart because I'm not probably where I should be. Admittedly, I'm higher than The Street next year and '24. But when I go through that exercise, is that base down LSD plus and then figure out what innovation is going to do when you can rive a total company?

Yes. I think the -- in that pair market, we were down about $100 million last year. We said we're going to be down similarly this year with also clearer competition as well as factoring in, competition in the pain market. So that's a big driver of your mAB on where it's down. Overall, there's still some farm animal generics coming in that are having those impacts. So again, we look forward to both stabilizing the base. We're doing that some with price, and that's been a positive contributor. We're then having good success in poultry and aqua. Swine has been a tougher species outside the U.S. A lot of that becomes China, as you talked about earlier, Jon. So overall, again, we're focusing on continuing to execute, get in front of our customers, getting products out there and bringing the innovation because the innovation is going to be the growth driver that's going to drive the EBITDA higher. That's going to be the cash we get to delever and get the benefit of both cash to pay down debt and higher EBITDA to reduce leverage on a twofer. So overall, we're better than we were 3 months ago, 6 months ago, a year ago, and we're just continuing to drive those improvements going forward.

That was great, Todd, and very helpful conversation. Just maybe I want to end with because it's been topical is the cash flow, right? The results were solid in 1Q. The cash flow lagged. I think some of us were surprised. I think you did a very good job laying out what happened and why, some AR dynamics. But should we expect that to normalize in the second quarter?

Certainly, the bridging stock that all got sold in late April with 60- to 90-day terms gets paid off here in Q2 and improves it. And then the nature of corporate bonuses where you accrue all year long, you pay it out in Q1. So it's a positive on cash flow, Q2, 3 and 4. It's a negative on Q1. And then the interest rate swap transactions we did a year ago to accelerate cash in, that puts a disconnect between our cash interest and our P&L interest. A lot of that is starting to play out. There's still some deltas there that will be negative on cash flow relative to what you see in the P&L. But yes, cash flow will improve. We're still at $100 million of net debt pay down for the year.

Okay. Fair enough. Todd, thanks very much. Appreciate it.

Thanks, Jon. Thank you.