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

All right. Great. Well, good afternoon, everyone, and thanks for joining this session with Elanco. We're very pleased to have Jeff Simmons, President and CEO, with us for a fireside chat today. I guess, Jeff, maybe to start, it's been about 2.5 years since the Analyst Day.

A lot changed from a macro standpoint, competitive landscape has changed. What you have in the pipeline. You've done some deals in that time. Could you maybe just talk about what's played out over those 2.5 years? And then when we think about the next 2 to 3 years, kind of what's your vision for what you want to see the company deliver over that period?

Sure. Thank you. Thanks for the opportunity, Nate, and great to be here at the Goldman Conference. So yes, I think in December 2020, we had just put together fresh off about 2 years into the IPO, we acquired Bayer Animal Health and had an Investor Day in December 2020 and really set a trajectory, laid out an algorithm, talked about 3% to 4% annual growth. And in that first year, we delivered about 5% on a constant currency growth and the strategy was playing out very well, and I'll come back. I think the vision of building an independent animal health company that can reach the world's animals, over 100 countries, 19 species of animals. The big thing with Bayer was to actually set up an IT system that we actually had to integrate just coming off from the[indiscernible] integration of the IT system. Bayer went on to [indiscernible] IT system, and we just completed that actually April here just recently last month. So look, I think over the course of the next year, so 2021 went just as planned, and we were integrating Bayer and things were going well. We were capturing our synergies. And as we went into 2022, I think the combination of African swine fever, COVID, extra COVID lockdowns in China, which is a key #2 market for us. Inflation, which took a lot of the productivity agenda off the table, a strong dollar, which took over $200 million of revenue out. When we got done really, when we step back and say, in a constant currency, we were down 3%, given everything that went on. And I think the recessionary impact on pet retail was probably something that was abnormally impacting on Elanco even versus the industry. So all of those things, I think, were factors. As we come into this year, though, as we're kind of 3 years now coming in since that Investor Day, what I would tell you is, we had a nice first quarter seeing sequential improvement. The ERP system is now complete. We are sitting on an extremely strong R&D leadership team led by Ellen De Brabander, that's had a lot of experience in the industry. And we're sitting here looking at 6 blockbusters with a path to approval by the first half of 2024. And we're preparing for launches. We've got 2 of the 6 approved, one in cattle and the parvovirus, our first monoclonal antibody set up to go. And I would say that we're very well positioned. We're returning to growth in our guidance in the second half of this year. And that really will start a trajectory of innovation, growth, better margins. And I think the last one, Nate, we'll get into it is our stand-up costs have been significant when you stand up and the integration and the IT systems over $1 billion during this window of time, we're going to go $140 million to $160 million this year. And that will drop to about $20 million next year, which will really help the free cash flow. So we're ready to go. This vision of an independent animal health company focused on products, longest-standing brand in the industry, reaching the world's animals is now here, just come off from 2 weeks as of this weekend, in Asia, and you see it firsthand, and Bayer has given us scale, size, pets, things we didn't have, we're ready to go.

Great. Maybe I'll start with the [indiscernible] business and then we can get into the innovation a little bit later. I guess again, kind of sticking long term, when you gave that 3% to 4% algorithm, the base business was expected to contribute about 1%. A lot's changed as you kind of just talked through. Do you still feel like that 1% contribution from the base business is achievable as you look at the business today?

Without question, some of the factors I mentioned from African swine fever and the swine business and some of the erosion, we even saw some antibiotic policy occur in Asia that decreased some of our core. We had not -- we did not deliver that core growth of 1% last year. That was no question of factor of a lot of the environmental factors we mentioned. I would say, as we look now today, I would say that there's no question that we see as we start to move into returning to growth in the second half, a stabilization of that core. We're seeing innovation, health, the portfolios that help the core. We save more than 2% price and we've got 5% in the first quarter. And again, portfolio innovation and I think geo expansion has all helped that core. So it's stabilizing. We're not giving guides by each segment of our portfolio, but we do see -- and also just relative to those maybe legacy products that we lost product on, their size is much smaller as well. So again, an algorithm is an average over time, but we do believe that stabilization -- we've seen a sequential improvement, we see it occurring and that will be a key factor going forward for us.

And you said the goal is to get back to revenue growth in the back half of this year. I guess when I look at the components of that, you mentioned price will be strong, I guess, at least 2%. Innovation probably contributes about 100 basis points of that based on the guidance. And so it implies a slight decline in volumes. I think volumes are kind of down mid- to high single digits in the first half. So do you start to see that volume inflect? And can you maybe just talk about what's changing from first half to second half that drives that volume?

Yes, I would say innovation, supply and environment a little bit in winning into certain environments and where we're leading. So I would just say that as we look at the second half, the key drivers outside of price, as you said, it will be, first of all, just innovation sales. So we've had Zorbium, a pain product, Bexacat, first SGLT2 approved in the U.S. by an animal company for diabetes in cats. That will be a driver, Experior or cattle product for ammonia reduction, that's growing nicely sequentially -- and there's 3 or 4 other products in there globally. We've got 4 OTC products that we have approved. All of that will be a driver to the second half growth. Second is supply. We had some vaccine supply outages. And I think through the COVID, we've seen a lot of those factors play. Supply will be a positive compare and incrementally a driver. And then lastly, will be just the environments. Look, I think the U.S. pet retail had a big impact on us, as I said, in the second half of 2022. We've seen sequential improvements in Q1. We see that sequentially getting better throughout the year. That will be a factor. Europe's recession, we predicted it would be much worse and it was really a tough situation second half [indiscernible] better this half -- this second half than it was last year. So those are -- and then look, I think China is a big driver for us, and we see incremental improvement. It's not a V-shaped recovery. It's definitely, the swine business is still a slow recovery, but pet and poultry are more robust. Those are the drivers of a second half return to growth.

Okay. Makes sense. And I guess, from an end market standpoint, any differences you're seeing between the vet channel? I think that traffic has been relatively stable, maybe hasn't continued to recover, but you're seeing pretty good demand. There's patient demand there versus like OTC, which I think has been a little bit more volatile. Could you maybe just give [indiscernible] those 2 parts of the market?

Yes. So I think, first of all, I think Elanco is as we look at the Bayer transaction, one of the elements, many elements we looked at with that transaction but was to be the omnichannel leader, remembering that globally, 1/3 of pet owners still don't go to the vet clinic. So whether that's Tractor Supply or Chewy, there's still a large percentage and we are leaders in that, and we've actually grown share in that segment. So -- and then 2/3 are vet clinic, and that's where a lot of our innovation has gone over the last year and where it's going to go over the next couple of years to be taking each one of those segments. What I would say is on the pet retail side, what we've done to really drive share is not just share of voice and campaigns on the DTC side but we're using physical availability. We brought in a lot of retail expertise. We've kept a lot of the Bayer retail expertise and the whole idea is more retailers, more shelves and more geo expansion. We're just -- when it comes to distribution touch points, it was up 17% in Q1. So that's a key driver. And then we're innovating as well in retail. So we're relaunching. We've launched 4 Advantage brands, a couple of from Elanco compounds. So that's on the retail side, and we believe we're well positioned there. That's still a market that we see growing and we see our leadership growing in that segment and a nice high-margin business. On the vet side, I think a couple of things we see trend-wise. Yes, visits have come down, but spend has been resilient. COVID, I really believe strongly when you look at the data, COVID has made the pet experience more convenient. From drop shipping to dropping the dog off at the curb to wellness programs, spend has been continuing to stay very strong. We're seeing that. I think our competitors are seeing that. And so what you need to do is have strong portfolios, enough share of voice, enough global reach, and you need to constantly be innovating into those. So vaccines, therapy and parasiticides, you need to be hitting each one of those with innovation, and that's what we're attempting to do, and we've launched 4 products already this year in those spaces.

And you went through the ERP cutover in March and into April that shifted some sales. I think you said that based on what you saw through April, you're kind of confident in your estimate for what that impact was. I guess outside of that, have you seen any inventory destocking in the vet channel that some of your peers have called out as a factor in terms of what the distributors are maybe holding relative to normal?

We've not. And I'd say we haven't had any campaigns or programs that I know others have noted that maybe they had. I mean our inventory levels with our distributors, so this is that we have buy-sell agreements with all the major U.S. retail or distributors, so they buy the product for us and hold their inventory levels have been very constant since middle of 2010 when we set up kind of the current distribution agreements we have. So there's really not been a change outside of the ERP that we mentioned. And again, ERP is working. That product has moved through the channel and all that's gone very well. There's a little pressure maybe on the farm animal side, just cost of capital, some of the farm animal, larger integrators, feed mills, some of those distributors is probably a little more tendency to try to keep inventory as low as possible, but it's again, nothing material, everything in our guide has calculated that in.

Got it. Okay. I wanted to ask [indiscernible] then get into the innovation. I guess I don't think we've heard anything official from the EPA at this point. I don't know if you've had any further communication with them. But I think you've recently said that you don't anticipate any change from the EPA would impact your ability to commercialize the product. I guess does that mean you have pretty good visibility in terms of what the kind of stewardship actions they're requesting from you will be and that, that won't impact your ability to sell Seresto on a go-forward basis in the U.S.

Yes. So I think this is very clear because this is, I think, a big factor in our story here. Seresto, a major product of ours. And what I would just emphasize is we've been very much in a good constructive dialogue with the EPA. They have announced that within weeks, they will actually finalize their review of this. It has been a science-based, databased approach. Remember, EPA is mostly plant, water, not a lot on animals. They regulate topicals and collars in the pet space. So this is not the core and they've counseled with the FDA, which we support as an industry for this, primarily around when we say stewardship, it's a lot around the pharmacovigilance, which we have a current infrastructure that's doing this for the majority of our products in the farm animal and pet vet side. So this is looking at products through kind of an FDA lens from a pharmacovigilance and oversight. We like this. It raises the bar in the whole category. It professionalizes it more. It makes it less vulnerable to claims against products and so we've been in close dialogue, I have myself, and we're confident from that dialogue that the outcomes are going to be good for the category, extremely good for Seresto and we stand today with as much confidence on the long-term registration of Seresto as possible as we ever have. I would also just say the products returning to growth in Q1, physical availability, all the things I just mentioned, there's been no hesitation if anything, expansion by the large retailers, the e-com players here in the U.S. and globally.

And I guess as we think -- once we get past this EPA review, we'll obviously see what's in it. But has your view of the long-term growth for Seresto changed at all? Do you think demand has been impacted by this process? Or that willingness to recommend the collar has been impacted by this review that would change the longer-term demand for Seresto?

Yes. There's no question there's been some overhang on the product. I think that there's still an awful lot of -- why we like this asset and we looked at it as Seresto users are loyal. There's over 90% return. That really -- that data hasn't changed. Our aggressive growth projections initially for the product were slowed, probably much more at a lower level by the PR issues, probably more so by the factor of just the economic recessionary impact, a pet retail customer, especially second half of last year, during the off season, during the fall and winter when the recession hit, Northern Europe and the U.S. pet buyers were not going in to buy a $60 collar. I mean that was -- that we have seen that pet retail customer come back strongly in Q1. So we do see strong opportunities globally for the product, but growth was impacted by this issue, but probably more so by the recessionary impact. But we're doing things. We just launched the largest advertising campaign we've had -- in the 4 years we've had the product that's going on now that's going well and the physical availability is very strong as well. So we're going to lean into the future growth of this product.

Great. On the innovation revenue. So you have a 2025 target for $600 million to $700 million. Based on the guidance for this year, that implies about an incremental $400 million over that period. You've highlighted 3 large pet health products [indiscernible] yet to get approval and launch. I guess when we think about now that the products are filed, is there feedback or updates that you expect to get from the FDA between now and that your kind of goal for approval in the first half of '24? And then are there updates that investors should expect from the company during that period?

Yes. So first of all, just from a high level is all the products we're talking about are FDA products with one exception, and that is the parvo product, the monoclonal antibodies are approved to the USDA -- so the Animal Drug User Fee Act, it's based off from PDUFA. It's called ADUFA. It's based on really with the FDA on average from the submission kind of period till approval, there's ranges in here. There's 3 major submissions, efficacy, safety and [indiscernible] about a year. So these are rolling iterative submissions and it's rolling an iterative and constant dialogue. I would say that we've had good constructive dialogue, high-quality packages, and we've got a predictable regulatory path. And that's what said that we've got a path to first half 2024. We've got, I think, a history here with Bexacat, Zorbium here recently of products that actually got approved ahead of time. We had the monoclonal antibody parvo a couple of months later. So you're going to have pushes and pulls. The good news is we've got 6 blockbuster products in major markets, 2 of the 6 are approved. And when we got that path for those approvals. So -- and I would say the 2 derm assets are also going in a very large $1 billion plus market that we don't have sales in. And I think it's a 2-product market, that has some dissatisfaction in it, and we see an opportunity to come in there and be an alternative and actually, it would be accretive sales in that derm market.

And so for the 2 derm products as well as for the triple combo parasiticide, I guess, can you talk about the commercial strategy and what that will be and maybe how it will be different between those 2 markets, para and derm and does it matter if you're second to market or third to market for those products in terms of how you're going to go to market?

Yes, many factors that come into play. The good news is any time innovation is introduced, if you look at the history, para, pain, derm markets grow, markets expand. We see that. So it is all about value. It's not about price. And I think that's just from the standpoint of bringing consumers, pet owners different, vets make money as well off this. So they're always looking for innovation. So a few things. There's one differentiation matters. So just to highlight, parvo is a new market, unserved -- and you've got a deadly virus over 90% of puppies that get this and die, and we had zero puppies die in the trial. So that's going to be a new market. If you look at the JAK1 inhibitor on derm, we've said it's differentiated to what's on the market today and that's a key factor and the broad spectrum parasiticide is differentiated. We haven't talked about the [indiscernible] competitive product. So differentiation matters. Then I think, Nate, it's a combination of a lot of levers. We brought in some of the best know-how industry know-how on launching, and we've brought them into our teams and hired them. So we got the know-how, but it's do you use distribution or not. Do you go to corporate clinics or the smaller clinics? Do you use DTC and digital? What kind of share of voice do you have for reps? Today, we would say we've got enough share of voice in the marketplace to go in and be very competitive and take share. Will we take that up? Will we use telesales? These are all the decisions that we'll be making as we're modeling and preparing. We've got a dedicated team, a center of excellence around launching that's focused on this now and is actually modeling and watching kind of real live launches going on right now with Zorbium, Bexacat and in the midst of a parvo launch as we speak. So -- and we are heavily concentrated right now on the U.S. pet health market.

And can you maybe talk about the level of investment that might be needed ahead of these launches and how investors should think about that?

Yes. We've said pretty openly and we said this on the last earnings call that we -- first of all, on approvals, once you get an approval, depending if you have to label the product or not, can you label ahead. It's 2 to 4 months, you're launching. And then typically, you're looking at any incremental added spend once you start to see the early clinic penetration would come after the launch. So as we look at the before, we would say today, we believe at this stage, we've got the right share of voice and we would do definitely trade-offs within because it's a U.S. concentrated market. We're already launching and most of the veterinarians already know about derm, already know about para. So it's not about awareness as much as about differentiation in some of these other levers I mentioned. There will be some incremental spend, but it won't be, we think, anything material until after the launches occur and they become a little bit self-funding.

And you kind of talked about you're launching into established markets, maybe with the exception of parvo. But there's pretty good, I think, awareness in terms of need and efficacy of these products. I guess -- does that -- how does that impact your view of like the uptake of these products maybe relative to a typical launch?

Yes. I think all the things I just mentioned, done with, yes, the right level of investment in the share of voice and the differentiation is key. You look at a derm market that's #1 reason pet owners go to the vet is because of a derm problem. The dog is self-diagnosed in itself with itching, is that continues to be a market where people are looking for alternatives. There's also portfolio plays to where today, maybe a competitor that has all of those has a little bit of a portfolio advantage. We'll be coming with a portfolio advantage or to be a lot more competitive as we've got a leading pain portfolio, one of the widest parasiticide portfolios, derm will be an additive impact to our portfolio, which will be a big part of the competitiveness going into this market. And we think compared to even other competitors will be one that actually has one of the largest across the 3 biggest markets, the 3 biggest dimensions when you go in.

And I guess when we think about the margin implications of these products ramping, I think people typically think pet health products higher than average margins, so you should see nice accretion. Is that sort of the case out of the gates? Or does it take time to kind of scale the manufacturing, leverage the commercial investment that you're making before you start to see that margin accretion on those products or those launches?

Yes. The starting point in U.S. pet health of these major markets is usually accretive and positive, but it will ramp, no question with more volume. I think on the monoclonal antibody side, as we've even mentioned with parvo, we're moving from a small-scale bioreactor to a higher scale, that margin will get a lot better, a lot quicker, very rapidly on the monoclonal antibody side, which our manufacturing plant has been approved, and we're making product. So that would be the one that I think you would see a quicker change. But yes, it starts in a good place, but it gets -- it will be a big driver to our margin expansion and free cash flow will be these pet health launches.

And then I guess it'd be great to get your perspective on just like where you kind of think innovation is going in these markets. Zoetis has talked about life cycle management that it's working on. How do you make sure that you kind of maintain your competitiveness in these markets as they continue to grow and evolve?

Well, first of all, best people. I think that's key. I mean you have stable, good, very good people. I believe Dr. Ellen de Brabander, she's had a lot of experience in the industry, and she's come in. She's taken a good blend between Kindred, Bayer and Elanco. And I think having the best people across early development all the way to regulatory, that's key, without question. I think know your markets -- and I think for us, we are very focused on products, and we want large products that can be big products and differentiated products in big markets. So we're laser-focused on that. We're not going to do adjacent areas. We're going to do just that. I think the other thing what Bayer's helped us do is, especially on the pet side is omnichannel. So we're leaders in pet retail. You can see us. We're innovating, faster innovation cycle in retail and it actually drives existing sales faster. And then over on the other side, as we've mentioned, we're targeted on the obvious pain and derm, which are big, growing the next 2 big markets. while leveraging our omnichannel and para and then looking at key markets. We see diabetes as being a big market for us as we go forward, not only from the heritage we came from, but the market that we're going into. And then being able to also continue another couple of big areas like parvo is new. Livestock sustainability is going to be the fastest, next biggest animal health market outside of even pet, about $2 billion. We've got the winning portfolio, but also the winning capability, being able to monetize and certify carbon for the livestock industry will be another monetary income stream for producers but it will also be something that we see as a major animal health. When you look at enteric methane, enteric ammonia reduction, we've got the leading portfolio for that as well.

I did want to ask on that, what is the 2 blockbusters we didn't really hit yet. So Experior, I think you've said, is now being used by several of the largest producers, maybe took a little bit longer to get to that point than you anticipated. Any kind of feedback or learnings from that launch as it relates to [indiscernible]? And have you been able to have kind of initial conversations with customers around [indiscernible] and maybe just give us a sense of what you think the appetite there is?

Yes. I mean Elanco's U.S. farm animal business and really global farm animal business as I studied it across Asia over the last couple of weeks. Look, we're growing. We have a very strong franchise. We're #1, #2 in most all categories and it takes a winning portfolio, but you've got to have a value beyond product as well. That's going to be really key. Why have we grown and really taken leadership in poultry, while we've got one of the largest databases that merges performance and health together that all the major integrators need. As we look at the cattle business, yes, the adoption has been a little slower but when people change their feeding systems for a new product, the stickiness of that product will stay, not for a year or two, but for a decade plus or even longer if it's done right. So we -- I think what our learning is, it's the #1 way to administer animal health products to livestock is through feed. We're leaders in that, being able to have micro ingredient machines, be able to have the nutritionists, to be able to formulate it to know what the residues are [indiscernible]. All of those are barriers to entry, but there are also sticking points to keep the product and hold. Experior is sticking. I think we're 100% people to use it, stay on it, keep using it. We see that even with [indiscernible] as it enters the market to reduce methane. It will become something that we believe will become part of feeding systems and new income streams to producers.

And the $2 billion opportunity, that's for the producers? Or is that the potential drug market size? Because you're talking about 2 blockbusters that could be $200 million plus?

Yes, that's kind of an assessment that DSM and Elanco has done as we look at global methane, really greenhouse gas reduction inside the animals, okay, not biodigesters and other things outside. That's what we see when you look at that as an animal health market that may be nutritional health and animal health together, which we're in both of those segments now.

Okay. A few ones kind of going down the P&L, and I want to hit cash flow as well. I guess the EBITDA guidance for this year, I think implies maybe a more balanced cadence between first and second half of what we normally see. Can you maybe just talk about what the factors are driving that maybe differential versus what we typically expect?

Yes. So for those kind of new to Elanco in the room after acquiring Bayer with a big pet health retail seasonal business, we saw Seresto an advantage, big margin drivers, 60%, 70% of sales in the first half. So what's happened in '23 to your question is, one, we saw a 2022 recessionary impact on pet retail have an impact in the second half of the year, but that was kind of the off-season. We're seeing that carry over into '23. That's what was in our guidance. And so that kind of lowered the first half numbers. The second half, actually, the kind of there's an equalizer, but you're going to continue to see better price and better innovation in the second half. So that, I think, made to your question, kind of equalize.

And on free cash flow, you guided to $100 million for this year. How should we think about that evolving into next year? I know a number of cash costs come down. I'd imagine there's maybe some EBITDA growth. I think net working capital is going to be flat. I guess can you think -- can you help us think about like order of magnitude on that, just as we think about kind of what trajectory you see the business being on into next year?

Yes. Look, I think the very first thing, obviously, we got a very durable business, durable cash flows. We paid off $500 million of debt last year -- as you mentioned, this is what we're guiding for this year and next year, we will start to increase that debt pay down as free cash flow. So we have, as we've said, spent a lot of money on stand-up. This year will be somewhere between $140 million to $160 million, that's going to go to less than $20 million next year. So the first is stand-up costs go away, free cash flow goes up in a pretty significant way. That's the ERP system, that's the stand-up cost. Second is EBITDA, EBITDA, EBITDA. I mean it is these new products, everything we're doing in terms of leveraging EBITDA. We have every employee on an [indiscernible] type basis incentive plan. So every employee, as we traveled around, net working cash flow sitting in affiliates talking about how they're changing terms, everyone is [indiscernible] to drive this and we're seeing the impact of that. So I think you're going to see an increment there as well. So those are going to be drivers. The other one is going to be internal inventory. So we've seen internal inventory grow a little bit, and that's really been driven a lot by a quick rapid supply-demand change last year. Some COVID supply chain concerns, making sure we had enough and those factors and then the ERP cutover caused inventories to go up. We're going to be decreasing those inventories. And over time, that will drive cash as well. But again, durable cash flows, debt -- we'll have a debt hold this year in August and then not until again in 2027.

I guess one just follow-up on free cash flow. I think the inventory has gone up pretty meaningfully. You kind of decided all the factors. How quickly can the organization work to bring that down and when we would -- when should investors start to see improvement there?

Yes. So I think I mentioned all the factors. I mean the first thing is to continue, as you start to see the business return to growth, you continue to manage it by affiliate level where we are. We've got updated one system, one set of data, forecasting, everything is a little bit live, faster, easier inside Elanco than it was pre April 1 when we had to cut over. So all of those factors drive a more efficient organization. And look, we're also going to be more intentionally saying, hey, where do you turn the plant down and where is demand rising and that's going to be something we're going to be very intentional on. Because look, cash -- free cash flow conversion, driving cash up is going to be probably second to launches and EBITDA growth. Those 2 things are going to what's going to bring our debt down in a pretty rapid way.

And just maybe wrapping up there. So you mentioned the 2027 maturity. I think a lot of investors are obviously focused on the leverage of the business. I guess how are you thinking about the options to address that in advance, either spreading maturities or looking at other avenues to maybe manage that debt burden?

Yes. We -- as you know, we've capped some of the rising rates, and we've done that in the short term. But I think the biggest thing here is because of the durability, it is going to be cash networking cash, free cash flow conversion, driving that first. And the biggest thing that can change our debt ratios is EBITDA and paying down cash and we plan to get back at that at a pretty aggressive way in 2024.

Great. All right. Jeff, thanks so much. Really appreciate the time today.

Thank you, Nate.