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

Hi. Good afternoon, everybody. My name is Erin Wright. I'm the lead health care services analyst at Morgan Stanley. We're happy to have with us today Elanco Animal Health. We have the management team here. We have Jeff Simmons, the CEO with us up on the podium here and then also Todd Young in the audience, the CFO; and IR, Katy Grissom as well, who leads up the IR effort there. So happy to have you. I'm glad you can come and welcome, I think I hand it to you for just some intro remarks, if you want to give those and then we can hop right into Q&A.

Great. Thank you, everybody. Thanks for the interest in Elanco. So I think the headline is we are at an inflection point as a company, second largest independent animal health company. Next year will be our 70th year as a company, longest-standing brand in front of farmers, vets and pet owners. And we really are coming into kind of a historical time. We set it up with a return to growth this second half coming off from a good couple of quarters of consistent delivery, beat and raise on the last quarter. And as we kind of turn, I think what excites us is not just a return to growth, but our strategy is working. And I'll start with innovation. Innovation, we have innovation launch since 2021, we've seen $210 million to $250 million of innovation driven by a couple of really great innovations, Experior and cattle. We'll see it a $60 million to $70 million run rate. Parvovirus, deadliest virus in puppies actually with a monoclonal antibody and a retail product called Adtab. So 3 to 4 nice products driving growth with 3 blockbusters that I can say today right now, even since our earnings call or all we believe the FDA has what they need set up on the Animal Drug User Fee Act that will be progressing towards a path for 3 blockbuster products in the first half of 2024. That is what will drive that inflection point to really drive increased growth and margins. Those being a broad spectrum parasiticide, Credelio, Quattro differentiated, a differentiated JAK inhibitor in atopic dermatitis and a $1.3 billion derm market. And Bovaer, a new market where it's actually methane reduction in cattle, which we can come back and talk about. So that's the innovation more we can talk through that. That will be the big, big driver and probably our most historical year ever and our 70th year around innovation. Secondly is just our portfolio, and I would say is we've seen sequential improvement on a more durable, diverse portfolio. We've had a lot of challenges in different parts of our portfolio. And what I'd say today is, we're seeing a lot more durability, more stabilizing in that portfolio, incremental improvement. You can really look at it as Farm, Pet International, U.S. and each one of those 4 segments, we see some of the best leadership we've had, best capabilities, best pricing and a lot of things that are driving even innovation in all 4 of those quadrants. And lastly is productivity. We had a big milestone in April where we've got 1 ERP system, standing up, coming out of Lilly, integrating Bayer. One IT system over $1 billion in investment to do all of that, that's complete. And I would say the last couple of months has really represented a simpler Elanco, a more stabilized and really a lot of levers to be able to get us more productivity. We're past the big share $120 million or so of onetime expenses and large expenses will go down to under $20 million. So again, I think our innovation, portfolio and productivity strategy reaching the world's animals is working and coming into probably a pretty big inflection point as a company. So that's we are.

Yes. So we're facing this unprecedented level of innovation at Elanco. And I think that that's important because that's been kind of a part of the thesis since you've been the IPO is that we wanted to see the innovation and start to see that come to fruition. We're now on the cusp of that. So you've shared with us the $600 million and $700 million of innovation contribution by 2025. Can you talk a little bit about that cadence, just more broadly, and then we can get into product-specific dynamics. But how should we think about the cadence of that? That's not a net number, but hopefully that that's all, to some extent, incremental.

Yes. So when we launched kind of Bayer plus Elanco in December of 2020, we said, hey, between that period and 2025 is actually $500 million to $600 million. We acquired Kindred, $600 million to $700 million. We've stayed consistent to that. So what's driven that has been some nice innovations around feline diabetes with Bexacat, a broadening growing pain portfolio, some non-antibiotic poultry products, and now we're starting to get to the more substantial ones, the blockbusters led by Experior, parvovirus, our first monoclonal antibody. So doing the math, this year, we'll have between $210 million to $250 million of new innovation since that starting point, January 2021. It was about $100 million a year ago. So we're seeing it ramp nicely. And we see over the next couple of years, we'll see that achieve that $600 million to $700 million. There will be some cannibalization in para, some in cattle with the beta agonist. But as a whole, we see that growing. And again, starting next year, we'll see the increased growth coming from Experior, parvo, things we already have combined with some of the new -- these new big blockbusters.

So let's start with atopic dermatitis. So for the JAK inhibitor, all the data is with the FDA for review, can you give us an update on that time line at this point, how comfortable you are with the visibility there? The strategy in terms of taking that to market? Will you establish those minimum volume commitments with distributors to enhance that visibility? Or how will you work with distribution or other partners to help capture share. Sorry, there's a lot in that.

Yes. So second largest market besides -- outside of parasiticides is derm, atopic dermatitis. It's about $1.3 billion, growing high single digits, been growing even double digit, but it's predicted to grow at high single digit. It only has 2 real compounds of significance there. One is a JAK and one is an atopic monoclonal antibody. What we would tell you is it's the #1 reason people take a dog to the vet is an itching dog and kind of self-diagnosed themself. Most of the labels show that's far from 100% effectiveness on the label today. So that kind of shows that there's an opportunity right there. And so we are bringing a JAK initially followed by our own IL-31 short-acting and long-acting compounds. So we've made the submission on a differentiated JAK to go into this marketplace. If you look at ADUFA, the Animal Drug User Fee Act, that's what gives you that 180 days a path towards a first half product approval. I would say that if you kind of step back and look at that market, they've had those products a while. And we believe that it's going to be, one, the level of differentiation. Two is really looking at the approach to the marketplace. So we've brought in some of the best know-how in animal health launching and pets with Tim Bettington that ran Zoetis U.S. and launched Simparica Trio and had Apoquel inside a point. We've also recently hired Shawn Hooker, the Head of Marketing for BI, probably one of the best marketing minds. And coming because of this portfolio, coming because of the culture. The launch strategy will involve everything from DTC and promotion but also share of voice. And I think the other thing, just to share since our earnings call is we've announced a 25% expansion in our U.S. pet health sales force. We'll add about 75 reps, should be one of the largest pet health sales forces now in the marketplace and in the top tier. And we're doing that because of what we see with the potential of this innovation and what we currently have. Share of voice will be a key factor in this launch.

And then what about differentiation? How should we think about it? You mentioned effectiveness, for instance, as being one area that could be addressed? Could it also be safety, particularly with the JAK in terms of what shows up in Apoquel and then also on the IL-31?

Yes. So we've talked about the differentiation in our parasiticide. I'll come to that in a minute. We've not given the specifics on our differentiation for competitive reasons until we get a little closer. But differentiation in our market either comes back to efficacy, safety or administration. And again, I think this market opens up to that. The other aspect, I think, is derm has been at one category as you look at the major players because you don't have it going into, whether it's corporate Vets or going into the offering to the marketplace, you got to have para, you got to have pain, you got to have therapy and bios. But without derm, you've had some loss of leverage. We'll be, we think, 1 of 2 companies now that have that portfolio that will also play in the ramp rate and the share taking in this marketplace as well.

And the IL-31 under the jurisdiction of the USDA, which is a little bit different. So it's a little bit -- time line was a little pushed out, but at the same time, it's usually quicker turnaround time net-net for USDA. What is -- what are they looking for? What's different?

Yes, that we've moved that at the earnings call. We said, first of all, that it is a differentiated product. So that's new information that we believe our IL-31 short-acting is differentiated again, not giving the specific details, but we're excited about that. And this is really a USDA requirement really for the monoclonal antibody class. They wanted more dogs, more doses. And so this was not anything we believe relative to our package, it was more around the platform class change.

And the new time line is 2025.

2025.

Okay. First half, second half, or...

We didn't have specifics on that.

That's fair. So now let's switch gears to parasiticide. So what's the time line for approval now and launch for Quattro? And as exciting you gave some more detail on the most recent call about the differentiation of that product. Can you give us a little bit of information -- a little bit more on how it stacks up relative to the competition and where it is in the time line?

Yes. So we've got good experience with broad spectrum parasiticides. We've got Credelio Plus outside the U.S., which provides a very strong portfolio. This is a submission made for in the U.S. So since the earnings call, we can say that, that submission has been completed. It's been going for a while with a staggered submission. So on an Animal Drug User Fee Act that gives you kind of that 180-day clock until our next update. So that gives us a path. What we highlighted with this product a little bit more differentiation. So Quattro as this is the first product in this class, in this area inside the vet clinic with 4 active ingredients. With those 4 active ingredients, we'll have flea and tick control like others, but we'll have differentiated coverage, especially in the intestinal worms. So heartworm, roundworm and tapeworm. So we'll see broader coverage. We think that will be important. It will be different. The other is that since our announcement even in the second quarter, we highlighted given that there's another product in the class that we intend from our data package and believe that we'll be able to have efficacy on heartworms in the first month. And some of the others takes 6 months. So we think that's another key factor around efficacy and differentiation.

And how are you thinking about sort of -- have you been -- or what's your initial take on the more recent competitor launch in the combination space? Has anything surprised you in terms of their approach or their tactics or anything that you can learn from as you launch yours?

Yes. I don't know if I'll get into those details other than to say that I think the -- what you do see in the pet market, and this is a common question from investors is when innovation comes and you see this in para and derm and pain, and it's been consistent. We see it even happening as this one is rolling out. You usually do not differentiate on price. Actually, you price to a premium. People like new stuff. So this product price to the premium in the market. Second thing you see is the market gets bigger. So actually, there's an interest. So everyone's driving compliance, driving new users. So we're going to see, I think, the market get bigger. That's the second factor. And then everyone starts to use different aspects of share of voice. Do you use distribution, how much DTC versus digital use and these are all the factors that I think will come into play.

And in thinking about sort of the time line here and your approach to launch and your limitations as well as opportunities around the FDA approval and the cycle there, will VMX 2024 be a very meaningful year for you? Or is that more so 2025?

I think 2024 will be a meaningful year. I don't know if it will need to be related directly to a convention or to a show, but I do believe that when you look at having a differentiated derm product and the second company into derm combined with broad spectrum parasiticide, I think we have a nice opportunity. At the same time, I'd really highlight too, Erin, that our parvo virus monoclonal antibody, you've got up to 900 dogs a day that get this deadly virus, and if they're not treated correctly, 91% die. And we've seen where we're 2 months kind of into this launch, it's been successful. But how this is actually helping us as an entree is it's taken us into many more clinics, 30,000 clinics in the U.S., many more clinics that maybe weren't normally seeing us because they now have the first treatment against this deadly virus. And I think that's been a big factor as well as we're now in feline diabetes, first-in-class, first SGLT2 and a really new novel pain product. So that's opening doors, that's testing the muscle of launch preparing and now we're increasing our sales force by 25%, all of these things attribute to, I think, proof points about what 2024 can be for Elanco.

Okay, great. And then also a little bit on 2024. You have an $80 million headwind associated with parasiticide competition in 2023. Like what then continues into 2024 on that front? Do you think some of that has already played out and you were kind of at a level of steady state to some extent? Or how should we think about that as you launch your product as well?

Yes. So we've given a number starting the year between $80 million and $100 million of really U.S. vet clinic competition that falls really in not just para and pain and the competition is coming there, but even in otitis, some of the generic players. We would say we're tracking to that or a little bit favorable, positive to the Elanco side on that competition. I think we're seeing our overall portfolio in the U.S. vet market stabilize. U.S. pet health returned to growth in the second quarter and a lot of that is attributed to the stability. So we see innovation and a stronger portfolio being something that we'll see some of these factors play but our guide that we have so far for the rest of '23 attributes to that competition that's coming.

And you mentioned the canine, parvo, mAB and your launch there, and that sounds exciting. And what are you learning about that type of market, that type of product, especially as you kind of go forward with or move forward with IL-31 as well?

Yes. We're supply limited right now. So we're in a smaller bioreactor in our monoclonal antibody facility, but we are ramping up and have said we'll be at a 10x increase. That's our intention by the fourth quarter of this year. So be able to roll in this year, we'll be small numbers, $5 million to $7 million initially. But our focus isn't necessarily on the numbers as much as ensuring positive experience making sure that efficacy protocol is tied very tightly and making sure that there's high awareness of parvovirus. It's a conditional approval. So awareness really matters. This is the only treatment for this virus. And then next year, it will be -- we believe it will be ramping. The thing I think that's the biggest thing we've learned, right now, vet clinic capacity is an issue. This product helps get dogs in and out faster, making efficiency a lot better for the clinics. And that's been -- and then being able to save puppy's lives creates a lot of brand loyalty to the Vet as well.

And then I wanted to ask on Bovaer, how you're thinking about -- how meaningful that could be in terms of timing and magnitude of contributions?

Yes. Bovaer is what we believe is the next major market in animal health. If we've got a $35 billion to $40 billion market, we believe that methane reduction -- enteric in the animal methane reduction is the next and up to $2 billion market. So we see Bovaer in the U.S. being as much as $200 million. And I think there's 4 kind of, I want to say, building blocks to make Bovaer successful even starting next year. And we're really building and shaping this market. So the first thing is -- and we're going to start in dairy farms. So this is a feed ingredient that will actually inhibit methane production inside the rumen of a cow. So there's 4 things that are needed. One is a dairy farmer needs to have the data and the data analytics to be able to capture and track what he's doing. We're loading dairy farmers on every week to be able to do that. Second is you got to have a certified protocol from SCS, an independent body, and we've -- we're working on not only getting Bovaer approved but other products in our portfolio. Then you need an independent company to monetize the carbon. We spun out a company this year. Tyson's funded it, DSM, the dairy industry has to where actually a Nestle or a Danone can actually buy the carbon. And that's the fourth thing, which is getting CPG companies to actually want to buy those carbon credits. Those 4 pieces are coming together nicely. We found a CMO to make the product before building a plant. And it's our intention. We're on a path to have the first kind of major FDA methane reduction product approved in the first half of 2024. So the key building blocks are in place. The submission is in and we're tracking for a first half 2024 approval.

So a lot is going on in the first half of 2024, to say the least. So let's talk a little bit about commercialization and just what investments need to be made at this point? And how do we think about that in terms of the timing of those investments? Are you front-loading a lot of that now? Or is there still a lot more to come in 2024?

Yes. So our guide for the second half, we had a strong second quarter, but the guide actually attributed some to actually increase in the sales force and some of the things that we're doing. So our plan is to do that so that they're in place, they're in their territories. They've got the relationships with their customers when we're getting ready to launch. So that's why we're doing some of that in the second half of this year. That's key. We're looking at all the key elements from our distribution relationships to the use of the digital technology that we're already launching these products on. That will be key and then how we actually approach the different segments of the market from the small clinics, the GPs to the corporate clinics. All of those are factors, Erin, that we'll be looking at as we go into the first half of the year. Look, it's going to be a tension for Elanco on we want to launch with no regrets. We want to take market share. We've got differentiated assets in the largest pet health markets and this new methane market. So we're not going to do this halfheartedly. That will be tension against our continued growth on the EBITDA line as we go into 2024. And again, we'll guide in February when we're into our launching of our '24 guidance. Those are the key aspects.

And so as we think about -- and I'll use your word, the tension into 2024. So what about like the manufacturing dynamics that you were mentioning in the most recent quarter? Does that continue? Just some of the dynamics be implied, I guess, what I'm trying to get at is implied second half EBITDA target was slightly curtailed on just mix manufacturing dynamics investments that you were talking about, what else continues into 2024?

Yes. So let me first just box the second half of 2023. We were significantly over kind of a beat and raise on all lines for the full year. In the second half, though, there was some take-back of EBITDA relative to the first half and the rest of '23. And that came really from the standpoint of, one, the increased sales force, two, these are strategic decisions, slowing down a couple of our plants, and that was to decrease kind of some internal active ingredient inventory to improve net working capital, which is something we wanted to do. And then there's just a little bit of some plays off from our last guide in that second half around more poultry, which is a lower mix and vaccine supply. Those are things in some increased operating expense. So that's what caused the second half EBITDA, some take-back of that this year. As to answer your specific question, going into 2024, I think it's going to be -- we're going to have less onetime cost, but we are going to see some increased investment, and we're going to continue to see lower manufacturing volumes in some plants that are going to actually impact margins playing off from the launch costs as well.

And switching to more of the top line in the second half, how should we think about the quarterly cadence there in terms of kind of what, I guess, you modestly increased that target for the year, but what does that imply, I guess, during the third and fourth quarter?

I think I would look at just the sequential improvement in the business by more durable portfolios. Second half last year, minus 5% as a company. First half this year, minus 1%, we're 0% to plus 3% in the second half, so midpoint 1.5%. And our intention really is that that's going to be driven by innovation growth, price growth, better vaccine supply will be a factor and poultry and aqua, they continue to remain strong.

And then longer term, I mean, you're doing a lot from an innovation perspective, both diversify the mix and add new innovative products, when does top line growth get to that more consistent state? And when do you reach the mid- to high single-digit long-term growth that's consistent with the industry?

Yes. I think if you look at Animal Health, what makes it attractive is durable portfolios. We've gone through a stage where we had some innovation gap. We need durable portfolios with constant innovation. We're coming into that era. I think, though, the industry has averaged more mid-single digit than high single digit unless you have a pop of some major innovation over a short period of time. So what I would say is we are setting Elanco up to be a solid mid-single-digit company that may have some seasons of higher growth, but that mid-single digit will be driven by a more durable portfolio, larger innovations than we've had in the past as well as incremental innovation. And probably a price capability and management that can get price like we've never had before either. We're tracking to better than 3% this year, and we believe that price capability will play a key role as we go forward. But again, the era we're coming into is major markets with differentiated major innovation, and that's why we will have -- our #1 focus is launch really, really well.

Yes, that's definitely why we wanted to start there, but I will end on fundamentals. If you could kind of give us a sense of what's going on from a companion animal perspective, we're still seeing pressure from a vet visit perspective, still seeing elevated pricing that's somewhat offsetting. So what -- how are you thinking about sort of the consumer experience at both the vet clinic level and at the retail level, what you're seeing in the market and just help with the overall companion animal space.

Yes. So maybe we split them, but I would say Elanco, again, the broadest company relative to inside the vet clinic. Outside the vet clinic, average numbers, about 1/3 of all pet owners don't go to the vet clinic. They're buying either online or buying in retail. And we're #1 in that category actually taking share. And what we've seen here is being in more shelves at more price points, physical availability, we're now in Lowe's and tractor supply in a lot of places, Bayer was not. We're adding innovation, price points that are low -- the low cost at Walmart to the higher kind of premium price in a Seresto. So that has paid off and increased share of voice through just bigger campaigns. So on the retail side, we've seen that market recover after 2022. We've seen people come back to that. It's a pretty seasonal market, but probably one of the best seasons we've seen in quite some time even since owning the Bayer asset. So I think a resilient market that wants innovation and wants many price points and wants to shop where they want to shop. Inside the vet clinic, a lot of talk about visits. Visits are bouncing around from kind of flat to minus plus over the last 6 months. What I would say is our energy really is on the spend, on the quality of the visit, every survey we take, expectation to spend more or continue to spend continues to remain consistent. So what you need to do is reach the pet owner with what they want. It's not as much of a price sensitive. It's being able to give them what they want. Bringing more innovation like diabetes and parvo helps continue to make that spend resilient.

And on the livestock side, what are you looking at in terms of fundamentals? And if you could speak to that globally to what's going on in China versus the U.S. and other markets as well?

Poultry and aqua, probably the most stable, most resilient markets. There's a lot of positive trends. There's pockets. Even here in the U.S., if you look at Tyson and others, there are some challenges in poultry. But we're leaders in poultry and leaders in salmon, a very resilient market, a lot of demand, a lot of movement of that protein around the world trades pretty open. So pretty durable, low single digit, pretty consistent growth. And again, protein demand overall animal protein continues to grow. On beef, mostly U.S. beef here, feedyard Australia, a few others, there's a shortage of beef, probably be a 3-year cycle where heads of cattle are down about 5%. So what they do to compensate is keep them in the feedyards longer. That plays well to our portfolio with feed additives that are used in the late stage of the cattle's life. Pigs, it's really 2 big markets. As Europe for us is less, U.S. and China, U.S., it's been, I would say, a challenging market in U.S. pigs, but we see that maybe stabilizing as we get into the 2024 period. China has been a U-shaped recovery, not a V-shaped recovery. Elanco China will grow kind of mid-single digits for the year. Pigs will be a slower recovery. It's just under $20 right now, that breakeven is around $20.

And then lastly, on capital deployment, you continue to tip away at the debt burden here. How do we think about that level now and then going into 2024. And obviously, things get better as the stand-up costs do come down as well. And then also just on that front, like 2 collaborations, licensing deals, maybe small M&A even, is that on your radar screen at this point? And then on the flip side of that divestiture?

A lot of energy, as we say we're focused on returning the company to growth this half all the innovation launches. And the third priority for all of us is and all of our compensation is tied to a little bit of an EVA structure is increasing free cash flow. And so -- and improving net working capital. You've heard Todd talk about this. So we're decreasing internal inventories, which are historically high for the industry. We're bringing those down kind of as much as we can to historical lower levels internally. And then we're looking across the board at everything from optimizing CapEx only really to the new product launches. And being as judice as we can with one IT system, as you say, a whole lot less standup cost you'll see a pretty significant material change from 2023 to 2024 in that area. So free cash flow will grow as we go into 2024.

And anything else that you think investors will better understand, I guess, over the next 18 months, I think it's kind of obvious, it's all on innovation and execution there on, right?

Yes. I think Elanco is a company that is now set up on one system. We have now just left -- we've left Lilly, we've acquired Bayer. We're now on one system. You have got a stabilized more simplified Elanco that can pull levers faster. Two is we're hiring the best know-how and talent probably the best leadership team that we've ever had with the years of experience when you look at Tim Bettington and what Bobby has done in Pet Health across the board. So we got the right team in place and the energy is all about growth and innovation. And we've got what we need. We're an execution story over the next 12 months to drive a lot of value.

Okay. Perfect. Thanks so much for your time.

Thank you, Erin.