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Edited Transcript of ELAN.N earnings conference call or presentation 9-May-19 12:00pm GMT

Q1 2019 Elanco Animal Health Inc Earnings Call

May 15, 2019 (Thomson StreetEvents) -- Edited Transcript of Elanco Animal Health Inc earnings conference call or presentation Thursday, May 9, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeffrey N. Simmons

Elanco Animal Health Incorporated - President, CEO & Director

* Jim Greffet

Elanco Animal Health Incorporated - Head of IR

* Todd S. Young

Elanco Animal Health Incorporated - Executive VP & CFO

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Conference Call Participants

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* David Reed Risinger

Morgan Stanley, Research Division - MD in Equity Research and United States Pharmaceuticals Analyst

* Ekaterina V. Knyazkova

JP Morgan Chase & Co, Research Division - Analyst

* Erin Elizabeth Wilson Wright

Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst

* Jonathan Marley Kaufman

William Blair & Company L.L.C., Research Division - Associate

* Kathleen Marie Miner

Cowen and Company, LLC, Research Division - VP

* Kevin Kim Ellich

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Michael Leonidovich Ryskin

BofA Merrill Lynch, Research Division - Associate

* Navin Cyriac Jacob

UBS Investment Bank, Research Division - Equity Research Analyst of Specialty Pharmaceuticals and Large Cap Pharmaceutic

* Umer Raffat

Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Analyst of Equity Research

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Presentation

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Operator [1]

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Good morning and welcome. My name is Susan, and I will be your conference operator today. At this time, I would like to welcome everyone to the Elanco Animal Health Q1 2019 Earnings Conference Call. (Operator Instructions) At this time, I would like to turn the meeting over to Jim Greffet, Head of Investor Relations. Please go ahead.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [2]

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Thanks, Susan. Good morning. Thank you for joining us Elanco Animal Health's Q1 2019 Earnings Call. I'm Jim Greffet, Head of Investor Relations. Joining me on today's call are Jeff Simmons, our President and Chief Executive Officer; Todd Young, our Chief Financial Officer; and Katy Grissom from Investor Relations.

During this conference call, we anticipate making projections and forward-looking statements based on our current expectations. Our actual results could differ materially due to a number of factors, including those listed on Slide 2 and those listed -- outlined in our latest forms 10-K and 10-Q filed with the Securities and Exchange Commission.

As a reminder, our financial statements for the first quarter of 2018 have been derived from the consolidated financial statements and accounting records of Eli Lilly and Company. The information we provide about our products and pipeline is for the benefit of the investment community. It's not intended to be promotional and is not sufficient for prescribing decisions. You can find our press release, the slides referenced on this call and an investor workbook on elanco.com. We will continue to use our site to distribute important and time-critical company information. The slides and the press release also contain further information about the non-GAAP financial measures that we discuss during today's call. After our prepared remarks, we'll be happy to take your questions.

I'll now turn the call over to Jeff to provide the highlights.

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [3]

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Thanks, Jim. Let me start by saying how much we appreciate your interest in our company and support through the Lilly exchange offer process. We were thrilled with the demand for Elanco shares in the exchange, which was nearly 8x oversubscribed. Elanco is now a fully independent company, focused and in execution mode on our innovation portfolio and productivity strategy.

Let's begin with the highlights on Slide 3. Our Q1 results show execution across the board. Profitability is improving. Our new products are growing. We're launching more presentations in more markets. We've augmented our pipeline with business development investments, and we are building the foundation for a fit-for-purpose independent Elanco.

Our sales results for the quarter again show the variability across categories that we've seen in prior quarters, and which is common in the animal health industry. It is important to understand the underlying trends in our business, and I will provide more details in a moment which demonstrate the strength of our fundamentals. In summary, our sales are in line with our expectations.

I would like to begin with our gross margin, which is a key element of our productivity and margin expansion agenda. We've taken many actions over the past several years to rationalize our infrastructure, reduce SKUs, consolidate contract manufacturing suppliers and implement lean manufacturing techniques across our operation, to name a few. You can now start to see the benefit of these actions in our income statement.

We are pleased with the 180 basis point improvement in adjusted gross margin this quarter to 52.9%. The margin improvement drives accelerated growth in our income. For example, our adjusted earnings before interest, taxes, depreciation and amortization grew 12% in the quarter. Our new products also continue to perform well. The portfolio of 11 newly launched products grew 59% and now represent 13% of our total sales. And we continue to expand in new geographies and offer additional presentations.

And as we announced last week, we have made important strategic investments with our intent to acquire Aratana and a commercial agreement with VetDC. These actions advance all 3 pillars of our innovation portfolio and productivity strategy. Our execution enabled us to deliver adjusted earnings per share of $0.25 for the quarter.

Now let's take a closer look at our sales performance on Slide 4. This quarter, I think it's particularly important to put our sales results into context. My key message is that the fundamentals of our business are strong, and we are tracking to our goals. A key variable here is African swine fever, which we will address more during the call. To reinforce our confidence in our portfolio approach, you'll see that we are maintaining our guidance at constant currency for the full year despite the African swine fever headwind.

The quarterly variability in sales is especially apparent this quarter. Taking a slightly longer view of performance provides what we believe is a more representative assessment of our trajectory. For example, while Companion Animal Disease Prevention declined 6% this quarter, the 6-month growth rate is 16% at constant exchange rates. Likewise, the 34% growth in Companion Animal Therapeutics this quarter is 19% over the 6-month window. This longer view normalizes for anomalies and purchasing pattern fluctuations that are common in this business and often impact a given quarter. The leading indicators of demand at the vet clinic are consistent with this longer-term sales trajectory. Todd will talk more about specific things impacting Q1 later in the call. Overall, we are pleased with our performance and are on track.

Now regarding African swine fever. Since our Q4 call, the situation in China has worsened, and the disease is spreading to other Asian nations. Herd losses are significant, with some industry analysts citing 25% to 35% reduction due to the epidemic. We estimate that African swine fever impacted our total sales approximately 1% in the first quarter or $7 million.

This is a fluid situation that will impact global protein markets. While increased swine production from other markets and increased global beef and poultry production may mitigate the supply gap, we're not projecting a full offset in the near term. Importantly, the underlying demand for protein persists. This bodes well for the longer-term recovery process in China and the prospects for swine, poultry and, to a lesser extent, beef production globally. We will continue to monitor the situation, and we'll support our customers as they work to contain the spread of the disease and rebuild herds.

Roughly 3% of our total company sales come from China. Our current estimate is that African swine fever may impact our international sales by approximately $25 million to $35 million for the full year. Our intent is to offset this headwind elsewhere in our portfolio. We will keep investors apprised of this evolving situation and the headwind we see to our business.

Slide 5 summarizes some of the main events since our last earnings call across the 3 pillars of our strategy. On the innovation front, as I mentioned, our portfolio of innovation launched since 2015 grew 59% over Q1 2018 to $98 million in revenue. You can see the growth trajectory of these products on Slide 15. We continue to expand our reach by launching these products in new geographies. We launched Galliprant for dogs in the EU and are seeing strong demand signals across the EU. Additionally, we received approval for Correlink in Brazil as well as other several smaller markets outside of the U.S.

On the portfolio, we delivered top line revenue of $731 million, an increase of 2% when excluding the impact of foreign exchange. Strategic Exits continue to decline as a proportion of the overall business, and our core revenue excluding these exits accounted for $709 million in sales, also growing 2% at constant exchange rates.

Our targeted growth categories, Companion Animal Disease Prevention, Companion Animal Therapeutics and Future Protein & Health, grew 4% in the quarter and represent nearly 60% of our sales. All Galliprant backorders from Q4 2018 have been cleared as of early April. In fact, in the first quarter of 2019, we've already manufactured more bulk batches of Galliprant than we did in the entire year of 2018. We continue to expand our offerings for Credelio. In the U.S. market, we now have a full suite available for dogs. And in the EU, we now have a full suite available for cats, after launching new presentations in the quarter.

Finally, in April, Elanco launched a direct-to-consumer television campaign for Credelio to drive awareness and continued growth. This complements our digital multi-channel approach for a number of companion animal brands. We are investing aggressively to maximize the value of these innovative products, with a bolus expected in Q2 and Q3.

Now turning to our third pillar, productivity. I discussed the improvements in our gross margin from the work our manufacturing organization has been doing for some time. The efforts continue in support of our long-term margin expansion goals.

In Q1, we completed the in-sourcing of the manufacturing process for our chewy platform and Cheristin product, driving cost reduction and better capacity utilization of several internal sites. Additionally, we established a new source of active pharmaceutical ingredient, API, for Credelio. And over the course of 2019, we'll begin to transition to the new site, which will result in a meaningful future reduction in API costs.

Finally, we've completed a number of technical improvements in our poultry vaccine manufacturing process, which have enhanced our ability to produce the products more reliable and consistently while reducing manufacturing cost for several vaccines.

On the SG&A side, we're executing on the decision to change the go-to-market model in 16 countries we announced last December. We've established agreements with various partners to provide commercial services in a number of markets and are now complete in 10 countries. Overall, our productivity agenda continues to progress and is delivering meaningful financial benefit.

Now I'll turn the call over to Todd to provide more color on our Q1 results and financial guidance for 2019.

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [4]

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Thanks, Jeff. Slide 6 summarizes our presentation of GAAP results, while Slide 7 describes the items considered in the adjusted financials. Slide 16 to 19 in the appendix provide a summary of the adjustments made to the GAAP results to arrive at our adjusted presentation. I'll focus my comments on our adjusted measures to provide insights into the underlying trends in our business. So please refer to today's earnings press release for a detailed description of the year-on-year changes in our first quarter GAAP results.

Looking at the adjusted measures on Slide 8. You'll see total Elanco revenue declined 1% in the quarter. On a constant currency basis, growth was 2%. As Jeff mentioned earlier, core revenue also increased 2% at constant exchange rates. Overall, revenue growth this quarter was driven by the continued uptake of our Companion Animal Therapeutics products, aqua, poultry vaccines and nutritional health products.

Gross margin as a percent of revenue was 52.9%, a significant improvement of 180 basis points over last year driven by our manufacturing productivity initiatives, offset slightly by product mix and the impact of foreign exchange rates.

Total operating expense was flat for the first quarter. Marketing, selling and administrative expense increased $1.1 million, reflecting incremental expenses as a result of operating as a public company partially offset by continued productivity initiatives, benefits from foreign exchange rates and cost control measures across the enterprise. This modest increase in expense despite the early separation from Lilly, the establishment of a full independent Board of Directors and strategic investments across the business, demonstrates our productivity agenda's impact throughout the company. Note also that we deferred some DTC investments originally planned in Q1 into Q2, which will also impact the quarterly spend trajectory.

R&D expense decreased 2% or $1.1 million, primarily driven by the project spend fluctuations and external innovation milestone payments in the first quarter of 2018, which created a favorable comparison for this quarter. The combination of sales growth, gross margin improvement and flat operating expenses produced an operating income increase of $10.5 million or 8% compared to the first quarter of 2018, resulting in an operating margin of roughly 19% for the quarter. Our effective tax rate was 21.2%. At the bottom line, Q1 adjusted net income was $92.9 million, a reduction compared to prior year, primarily driven by the interest expense we have in 2019 that we did not have in 2018.

Moving on to Slide 9. Let's take a look at the effect of price, rate and volume on revenue growth. As previously noted, the effect of foreign exchange on core revenue was a 3% headwind overall. Excluding this, our revenue growth on a constant exchange rate basis was 2%. Volume growth was 2%, while price was flat. On the slide, you can see the breakdown of revenue across our 4 categories. I will focus on the constant exchange rate growth.

Companion Animal Disease Prevention, which includes parasiticides and vaccines, declined 6% in the quarter: 3% from volume and 3% from price. Declines in older-generation parasiticides and companion animal vaccines were partially offset by continued growth in Credelio, Interceptor Plus and certain over-the-counter parasiticides. Volume declines largely reflect purchasing patterns, which impact the yearly comparison. Price changes are driven by a higher percentage of sales through alternative channels and a change in mix of dosage strengths, which offset list price increases. Alternative channels tend to have lower pricing, but similar overall profitability from more effective promotional effort.

Companion Animal Therapeutics increased 34% in the quarter, up 28% from volume and 6% from price. The increase is driven by continued uptake of Galliprant, the resolution of Q4 backorders and the launch of Galliprant in Europe. Overall, Galliprant sales were $23 million in Q1. Future Protein & Health grew 5% in the quarter: 2% from volume and 3% from price. Growth of our aqua portfolio driven by the continued uptake of Imvixa and Clynav, was offset by an unfavorable comparison for our poultry feed additives portfolio. Imvixa continues to drive value for salmon farmers in Chile and exceeded our expectations in Q1. Strong salmon prices provided a tailwind to that industry.

As we discussed on our Q4 call, our poultry portfolio benefited last quarter from international purchasing patterns ahead of anticipated price increases and the increased rotation to Elanco products in the fourth quarter of 2018. Our Q1 results reflect these buying patterns.

Ruminants & Swine was flat for the quarter. Price decreased 1%, offset by volume growth of about 1%. Our U.S. and international businesses largely offset each other in Q1. The U.S. cattle business benefited from the replenishment of the channel for Micotil after the stock outage in the fourth quarter of 2018 and purchasing patterns for Rumensin. Internationally, our swine antibiotics business, particularly in Asia, was negatively impacted by ASF, as Jeff mentioned earlier; continued implementation of antibiotic programs across the region; and product rationalization aligned with our productivity agenda.

Slide 10 provides the details of our performance in the U.S. and internationally. Overall growth in the quarter is driven from the U.S. International results were most significantly impacted by the softness in the swine business. International growth in Future Protein & Health and Companion Animal Therapeutics is offset by the declines in the other 2 categories.

Before discussing our financial guidance, I would like to cover 2 other topics: First, our intentions with respect to our dividend and our cash balance at the end of Q1. On the dividend agreement -- on the dividend -- excuse me, in our merger agreement, through our proposed acquisition of Aratana, we agreed that we would not pay a dividend until that transaction is closed, which we expect late in Q2 or early Q3. We have discussed the dividend with our new Board of Directors and have their support to pay a $0.06 per share dividend on a quarterly basis, as described in the S4 filed as part of the Lilly exchange offer. We will recommend this dividend to our Board at the first Board meeting after our Aratana acquisition is complete.

While we typically focus on the income statement during our earnings call, I wanted to provide context on our Q1 ending cash balance in advance of our 10-Q filing. Our unrestricted cash balance as of March 31 was roughly $200 million less than it was on December 31, 2018. This was primarily due to a large cash receivable from Lilly that was not remitted to Elanco in the quarter. Nearly all the amount has been collected as of today, and our cash balance and cash flow fundamentals remain strong and in line with our expectations. I wanted to be proactive and detail this in advance of the 10-Q filing.

Now turning to our financial guidance for the full year 2019 on Slide 11. We are updating our full year core revenue guidance to reflect the impact of foreign exchange. We now project full year core revenue to be between $3.02 billion to $3.08 billion, a reduction of $20 million in both the low end and high end of the range to reflect the FX challenges of a stronger dollar. We continue to expect Strategic Exit revenue to be approximately $0.06 billion. We are maintaining our guidance for earnings per share. We expect EPS on a GAAP basis to be between $0.36 and $0.48, and on an adjusted basis to be between $1.02 to $1.12. Keep in mind, the year-on-year EPS growth is impacted by the full year interest expense that Elanco has for 2019.

In summary, our results are in line with our expectation and illuminate the value of being a portfolio innovator. We are pleased with the trajectory of our margin expansion goals and remain committed to delivering our guidance.

This concludes our prepared remarks. Now I'll turn the call back over to Jim to moderate the Q&A session.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [5]

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Thanks, Todd. We'd like to take questions from as many callers as possible, so we ask that you limit your questions to 2 or a single question with 2 parts. Susan, can you please take the first question?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Chris Schott.

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Ekaterina V. Knyazkova, JP Morgan Chase & Co, Research Division - Analyst [2]

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This is actually Ekaterina on for Chris. So my first question is gross margins are clearly a focus of the story, and those performed very well this quarter. You touched on this a bit in your prepared remarks. But can you elaborate a bit more on what drove the strength in Q1? And then as we think about the trajectory for gross margins going forward, can you give us a sense of how much of the improvement that you expect will be coming from mix as Companion becomes a bigger part of the portfolio versus kind of these productivity initiatives that you're implementing? And what's the least to be done from an operation standpoint to drive your margin improvement?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [3]

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Great set of questions, Ekaterina. Todd?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [4]

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Thank you for the question. We're thrilled with the gross margin improvement. Over the last year, we've been very much focused on driving the productivity agenda throughout our manufacturing organization.

We worked hard to implement lean practices across the enterprise; to find more suppliers of lower-cost API, much like what we just announced with respect to Credelio; and these initiatives taking contract manufacturers lower, from down to 100 at the end of 2018. All of those efforts were driving value in the cost of our inventory, but you didn't see that in 2018, despite the efforts that occurred from 2016, '17 and '18. That inventory made at a lower cost now is coming through the P&L and driving the improvement you're seeing.

We have more initiatives underway. The Credelio API sourcing won't have an impact in 2019. That will allow the productivity agenda to continue to grow over the next few years as we continue to expand our gross margin.

With respect to gross margin in 2019, the percentage you saw today is probably the upper bound of what we would expect. These improvements are there. But over the course of the year, we don't expect to exceed this amount. We very much feel like the 52% to 53% range is where we'll land.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [5]

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Great. Susan, we have another question?

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Operator [6]

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Of course. Our next question comes from the line of Erin Wright.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [7]

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Great. A couple of questions here. First, on African swine fever, you alluded to potential offsets for that for the remainder of the year. Where would this potentially stem from? Is it increased exports from other markets and improvement in underlying trends across the U.S. or new product launches throughout the year? I'm just curious how we should be thinking about that quarterly cadence, particularly across that Ruminants & Swine business? And then on the Companion Animal Disease Prevention segment, you mentioned that stocking dynamics potentially hurt you in the quarter. I guess, how much did it help you in the fourth quarter? And how should we be thinking about the quarterly cadence there as well in terms of those distributor stocking dynamics?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [8]

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Jeff?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [9]

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Thanks, Erin, very much. Yes. So I would just want to highlight again that we've been talking about African swine fever since early in the year. And just want to really highlight again that I think this does need to be considered an endemic. There's challenges. There's spread now from China into Vietnam and Cambodia. And as we mentioned, losses of 25% to 35%. So when you look at that 1% or $7 million this quarter and the $25 million to $35 million we've talked about, it's going to be offset by -- I'll start with just the highlight of the portfolio approach, Erin, that we've been talking about, so portfolio of products, portfolio of therapeutic areas and portfolio of geographies.

So the first would be definitely coming from what's driving growth, our growth categories. I would highlight areas like poultry and aqua as well as the whole Companion Animal segment. And then I think innovation. When you look at products like Clynav, Galliprant and others, even our vaccine portfolio being up 59%, innovation now represent about 13% of our portfolio. So that's where we see the offset at this stage.

We'll continue quarter-to-quarter to give you updates as we see both the African swine fever evolve. The second point I would just say on Ruminants & Swine, yes, this is going to create, I believe, quite a shift in the protein markets, but it's going to take some time. As breed replacements, as animal numbers and trade all play into this, it's going to take some time for that I think, more in the medium term. We don't see that playing out in any materiality in 2019, but maybe later this year, but early next year.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [10]

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Todd, do you want to talk about some of the stocking dynamics in Companion Animal Disease Prevention?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [11]

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Certainly. I'll focus on Slide 4, where we showed the 16% growth on a 6-month over 6-month basis. We've done this to demonstrate that there is a lot of variability, especially between the Companion Animal Therapeutics, Companion Animal Disease Prevention. As I look at it, one of the key items is with respect to our distributors. They have incentives that are tied to entire Companion Animal products, not these 2 categories.

And so with the stock-out we had at the distributor level, not the vet clinic level, for Galliprant in Q4, there were some incentives for them to buy more vaccines and parasiticides to meet the tiering incentives in Q4. So they were pretty fully stocked on those, versus in Q1, the incentive was to buy Galliprant given we resolved all the backorders and had lots of production on that side.

In addition to that, there was a flush of inventory in Q4 of 2017. We've mentioned before that was a build back then in Q1 of 2018 that made for a tough comparison. But finally, I just want to emphasize, we feel very good about the underlying demand in the vet channel and feel like while the 16% to 19% is certainly not what we project for the full year, we do feel very good about where we're positioned with our Companion Animal portfolio for the rest of 2019.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [12]

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Thanks, Todd. Susan, do we have another question?

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Operator [13]

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Yes. Our next question is from the line of David Risinger.

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David Reed Risinger, Morgan Stanley, Research Division - MD in Equity Research and United States Pharmaceuticals Analyst [14]

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(technical difficulty)

but a couple of quick ones. First one is could you please update us on the specific cost reduction plan for calendar year 2019 and 2020? And what percentage of those represent cost avoidance? And the second question is, what was the extra Galliprant sales benefit in 1Q due to channel restocking following the 4Q supplier constraint? And will the 1Q Galliprant sales figure represent a tough comp for 2Q sequentially?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [15]

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Todd, do you want to start, and I can supplement if there's more detail that we need?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [16]

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Certainly. I'll start with the Galliprant. There was a restocking effort as we took care of all of our supply constraints. We think that was probably about $6 million to $8 million in the quarter. We're also very excited to have launched Galliprant in a number of European countries. Again, that expansion internationally, we expect to provide additional tailwind going forward. But given the $23 million in total sales in Q1, we'd agree that sequentially the Q2 comp is more difficult.

And then with respect to specific cost reduction efforts, a number that we've outlined, being taking our contract manufacturing organizations lower. We're at 100 at the end of last year. We've said we're targeting to be at 80 by the end of this year. As we continue to invest in lean, we see the benefits of the API at lower cost coming through on our inventory. All of these items continue to drive this productivity agenda. We're very much on track. The team there is doing a great job of identifying additional opportunities to allow us to continue to meet this upward trajectory over the years to come and feel great about how the team is delivering and really owning this area of improvement for us.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [17]

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Let me add just 2 clarifying points. I think it was the end of 2020 was our goal to get to the 80 contract manufacturing organizations. And then, one other thing that is also a theme for this call, from actions we've taken in the past, for example, facility exits, like the consolidation of our vaccine manufacturing plants, the action is taken and then you see the benefit through the income statement over time as we complete technical transfer and the costs finally dissipate down to 0. So the continued improvement in the gross margin will also be a function of just the completion of costs and the tail-off from actions already taken. So we're well on track to the gross margin goals.

Susan, can we continue?

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Operator [18]

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Of course. Not a problem. Our next question comes from the line of Umer Raffat.

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Umer Raffat, Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Analyst of Equity Research [19]

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I had 2, if I may. First, perhaps on gross margin. So the long-term gross margin expansion target of about 900 bps, I'm just trying to tease out how much of that is driven by the previously announced things like site shutdowns and the CMO and SKU rationalization -- and I know the first couple of hundred bps is kicking in -- versus some of the new initiatives announced today. Should we expect 50-50 or 70-30 kind of thing? It will be really helpful to understand that? And secondly, I know you have a policy of not disclosing pipeline. So my question is this. Without specifying any specific product, is it reasonable for investors to expect that you can file a $300 million-plus peak sales-type of a product within the next 12 to 18 months?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [20]

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Umer, you win the prize for the clever question of the day. Todd, do you want to talk maybe a little bit about gross margin? I can supplement. And then pipeline to you, Jeff.

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [21]

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Yes. Umer, as you know, we have signaled the 900 basis point improvement. As we previously stated, 85% of those actions have been identified and are underway. And as you see, a number of the ones that we've talked about executing over the last few years have come to fruition here in Q1. And as I said, we expect to generally hold this 52% to 53% range for the rest of this year.

As we move forward, a strong example is Credelio. As we mentioned earlier, mix was a slight headwind; two, gross margin. As Trifexis slows down, as older-generation parasiticides and Credelio comes up as a replacement in our portfolio -- Credelio is a lower margin right now because it doesn't have that historic efficiency of scale.

As we note, with the Credelio API becoming cheaper for future years, that will then offset and grow the gross margin that we've identified. So overall, I would say, most of what we've done, it's identified, as we said before, about 85%, and the other items we're quickly identifying here in the course of 2019.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [22]

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I'd say, just to reiterate some specifics that we provided, we had outlined about $215 million of both savings and cost avoidance. And the time window we had said there was mid-'18 out through the end of 2020 from a lot of the things that Todd had talked about already having been identified and we're on track there.

Post the 2020, I'd say there is another $100 million of ideas and targets that our manufacturing organization is looking after. We've been less specific on those things given that it's farther out in time. But the combination of those things gives us the outlook that really holding cost of products sold to be more flat in the face of growing sales would be the end game for the gross margin improvement. Todd, do you -- excuse me, Jeff do you want to talk about pipeline?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [23]

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Yes, absolutely. Thanks, Umer, for the question. So let me come back to you with 3 points that excite me, and I'll answer your question, I think, probably more indirectly, as you may expect. But 3 things that excite me about innovation: portfolio, our metrics and our leadership. One is, I think, you got to continue to see us with the portfolio of innovation. We're not dependent on anyone big product. That's a big part of the Elanco story.

And we like our shots on goal. We're always searching for additional products. And an example of that is VetDC and the Aratana situation. So again, now over 40 candidates. The second is just the metrics. When you look at, first of all, the innovation we have now, we have a high bar. There's an expectation every time we launch a product is, how does that become a blockbuster? As we made Interceptor Plus one last year, we got our eyes on a few more that we're launching. So it's just as important in this industry to launch as well as not just develop the products.

But when you look at 40 candidates now in development, 4 years in a row with 3 approvals a year, and I really believe that we're being known in the industry and working very hard that -- whether it's from funds to companies, to partnering late-stage licensing, we believe, that Elanco is set up to help the innovators that are out there in animal health be a partner as well.

And lastly, it's just overall leadership. I believe that we've got a leadership team that they're vested on this. Innovation is one of our 3 key incentive bonus metrics. And so everyone is totally focused on making sure this pipeline moves quickly. So those are 3 answers. I'm not going to answer the one specific question. But I think I would really highlight again portfolio, our track record and our leadership for the reasons why I'm very confident going forward.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [24]

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Susan, can we continue?

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Operator [25]

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Of course, gentlemen. (Operator Instructions) Our next question comes from the line of Michael Ryskin.

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Michael Leonidovich Ryskin, BofA Merrill Lynch, Research Division - Associate [26]

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I got a couple of quick ones, hopefully quick ones. One is, I think you appreciate all the focus on the moving pieces between the quarters, particularly in disease prevention. And I appreciate the clarity you provided in the slides on the 6-months growth year-over-year. But given that there were some weird inventory stocking going back to 3Q '17, 4Q '17 in disease prevention, I was hoping you could give us a little bit more the normalized underlying growth rate here. Looking at -- you did $186 million in the quarter. Is something in the $195 million range more appropriate to account for that stocking? And I'm just trying to parse apart some of the pull-forward to 4Q that you mentioned versus any actual underlying slowdown in the older-generation parasiticides that you called out. And then a follow-up question, if I could. You also called out some positive Rumensin purchasing patterns in the U.S. I was wondering if you had an update on the potential for generic competition and just sort of generally an update on Rumensin.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [27]

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Sure, Mike. Thanks. This is Jim. I'll take a shot at some more details on the first part. So to quantify a couple of things, and admittedly, there are moving parts here across years that we'd like to have be less of a discussion for the future, but we have these details for the moment. So in Companion Animal Disease Prevention, we think that the Q1 '18 compare is inflated by $15 million or so for that restocking of the prior channel flush.

And then the Q4 '18 to Q1 purchasing ahead for the overall distribution incentive that Todd talked about, that one's difficult to quantify because we don't get that level of communication. But in the low double-digits millions, we think, is a reasonable estimate there, just knowing what the backorders were for Galliprant as well as how the overall incentives might operate.

Then I can probably give less specifics on what the normalized run rate is. I guess, qualitatively, we're heading into the heart of flea and tick season. So traditionally you've seen Q2 is a step-up. When we look at the underlying trends, as we see pull-through to vet clinics out of distribution and the overall, what we think is a leading indicator of the demand for the product and how the flea and tick season is going, it looks to our expectations, it looks strong.

So we would expect to see an uptick in sales in the second quarter, consistent with those overall market themes. There still may be year-on-year comparison. So we'll try to focus on both absolute sequential growth in absolute sales produced in the period and then qualify things that result in strange compares across years. Jeff, do you want to provide any more macro comments, and certainly the generic Rumensin?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [28]

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Yes. I think just overall in this Companion Animal Prevention area, Michael, I think it's really important that, one, we look every day at that vet clinic demand. We feel very good about that. That's the lead indicator. And second is our portfolio approach. Yes, there are some pushes and pulls. But as we launched the company, we talk a lot about the next 5 years, how that portfolio will drive growth and the growth of the overall market.

Third thing is we're putting a lot of time on the channel, and the channel to not only drive demand in multiple channels but also compliance. And as we talk, compliance is, again, one of the greatest areas of opportunity in this space. And I will say in this last quarter, we see that continued opportunity to execute there.

And so I think those -- and then lastly, as Jim mentioned, we're leaning in, we're investing, and we're taking from areas that are maybe less strategically critical, like these countries that we moved out of, 10 that we executed in international, and rechanneling some of that investment. And that investment will increase in Q2.

As you look at generic Rumensin, good question. No change in our assumptions. We'll do that when we know information, like you. I will emphasize, again, we continue to innovate. We continue to grow this product. We continue to lean in, and this continues to be a very important value contributor to our customers. So we're going to continue to represent and drive this product. We have competed, as you know, Michael, against generic monensin in many markets. We're prepared and actually doing increasing things as we go forward over our long-range plans to continue to keep Rumensin as a very critical part of our cattle business globally.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [29]

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Thanks, Jeff. Susan, I think we have a few more in the queue, perhaps?

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Operator [30]

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Of course, we do. We have some (inaudible) right now. Our next question comes from the line of Kevin Ellich.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [31]

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Just a couple of questions. Jeff, I guess, starting off with the new API source for Credelio, I appreciate your comments and Todd's update that it won't really benefit you in 2019. But just wondering, how much savings should we expect going forward? And are there other products that you're looking at where you could find savings, some new API sources?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [32]

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Yes, Kevin, good question. This is part of our bigger agenda that Dave Urbanek and our manufacturing team and the finance team are working on. As we've talked about over the last 6 months pretty openly that procurement, active ingredients we've highlighted. Jim can maybe give a little bit more specifics if there's anything there on the overall procurement savings. But what I would say to you is, this is part of the agenda that we've had in place that will drive this gross margin trajectory over the next 5 years.

And we have that granularity. As we've mentioned, we've had over 85% that we've identified and are acting on, and this is part of that. I won't give specifics on an active ingredient for a specific product. But just to simply say why we feel very strongly about our trajectory and our belief in our margin expansion agenda is things like this that we're acting on, moving on, and they're lining up very much with our plans and our expectations.

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [33]

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Yes. I think on the procurement side itself, we've identified $100 million of savings. As Jim mentioned earlier, goal here is to keep manufacturing cost flat as we continue to grow the top line to have that enhanced margin, and these initiatives are clearly a huge contributor to that effort.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [34]

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Susan, can we proceed?

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Operator [35]

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Certainly. Our next question comes from the line of Kathy Miner.

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Kathleen Marie Miner, Cowen and Company, LLC, Research Division - VP [36]

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First, just a quick clarification, if I may, on the offset to the $25 million to $30 million on African swine fever this year. Do you consider the Aratana revenues as part of the eventual offset? Second question also on Aratana. Can you just please remind us of your current expectations for closing timing and also the impact on adjusted earnings, both this year and in 2020? And last question, Jeff, I wonder if you could give us some brief comments on your latest thinking on the U.S. trade dynamics and how that might be impacting your business? I know you've spoken on the cattle or the dairy impact in the past. And just wondered any other species or any other thoughts you may have.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [37]

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Great list, Kathy. There's a bit of an assortment there. Todd, do you want to talk about some of the Aratana financial items?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [38]

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Sure. So with respect to Aratana, we expect that to close still late Q2 into Q3. Team's working very diligently to get the S4 pulled together and to get that accomplished as well as working closely with the Aratana team on getting their shareholder vote complete to secure the merger. We have not included any financials in our 2019 numbers from Aratana. As mentioned on the call announcing the deal, we did say we don't expect it to be dilutive in '19, and we generally expect it to be modestly accretive going forward. This accretion is a function of the current Galliprant accounting. We basically recognize all of Galliprant through our income statement today. And so this is a very positive deal from a cash perspective, less P&L just as a result of how that accounting works.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [39]

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Good. Trade, Jeff?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [40]

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Yes. Great question, Kathy. So I'll just highlight a few things. I think the trade relationship between the U.S. and China, no question, has implications on the protein industry and how it's converging very timely with African swine fever and the significance in terms of the number of animals that are being impacted there. It will change some of the global protein dynamics, so I see an opportunity here.

When you think about animal health, really our focus right now is: one, continuing to emphasize the importance of trade and the movement of meat, milk and eggs globally to continue to meet this growing demand for protein that continues -- animal protein, shall I say. We need standards relative to feed ingredients to be more consistent, whether they're CODEX or anything else, where science and safety are in the forefront or the center of those standards.

So that will be our agenda. We are working as an industry. We're working collectively on this. And we think there is an opportunity here and the timeliness to be able to continue to move forward. But nothing specific new to report. As you know, they're dynamic and they're continuing, and we're working in alignment with not only the global side but the U.S. and even the Chinese side.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [41]

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Susan, I think, we have, perhaps, a couple more?

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Operator [42]

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We definitely do. We have our next question from the line of John Kreger.

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Jonathan Marley Kaufman, William Blair & Company L.L.C., Research Division - Associate [43]

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This is Jon Kaufman on for Kreger. I would like to dig into African swine fever in a little more detail. There's been some discussion on the part of the large poultry producers who say they're well positioned to take advantage of potential pork shortages. So looking out over the medium to long term, if poultry were to begin displacing swine as global food source, what does that mean for your business from a profitability standpoint? And can you remind us of your relative positioning in poultry and swine compared to some of the other major players?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [44]

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Thanks, Jon. Great question. Well, we've been very clear as we've launched the new company that we've got 3 growth categories, 2 in Companion Animal, but we talk a lot about Future Protein, which is poultry and aqua, and the nutritional health business, the antibiotic alternatives. We are a leader in many segments in poultry. It varies by country. But we're in the top 3 in most all segments of poultry. We've got a diversified portfolio, from feed additives that are key, to antibiotic replacements, to even a vaccine portfolio, as you know, in Salmonella and other preventative diseases, and a very nice pipeline.

So it's a priority area. It's an area of leadership. It's an area that is driving growth for us. And I would add, in addition to products, I believe there's 2 capabilities that Elanco has been working on for more than 15 years. One is the ability to work with corporate accounts. As you know, this is a pretty consolidated industry. But not just the ability with our people to do that, technical and sales, but also having the analytics and the value beyond product services, that also is a key driver as we've got a database that is almost 2 decades in age that is linked to health performance going forward. So again, I see continued ability to add increasing value to the poultry industry, to innovate in this space as it's a growth driver as we go. I would caution us that I think the dynamics will take some time, and I think the balancing of this as well as the trade aspects will all come into play, but we're very much aligned with our customers to continue to add value to them as it goes.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [45]

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One other item. We haven't quantified our sales by species, but at least in ordinal ranking, cattle is 1, poultry is 2, swine is 3 and salmon is 4. So you can see that even in our existing portfolio, poultry is a bigger piece of the pie. Susan, I think, maybe one more in the queue?

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Operator [46]

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Yes, please. You have one more. Our next question comes from the line of Navin Jacob.

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Navin Cyriac Jacob, UBS Investment Bank, Research Division - Equity Research Analyst of Specialty Pharmaceuticals and Large Cap Pharmaceutic [47]

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Just on Galliprant, been performing very well. Could you -- if you have any -- if you could provide any color on current market share for Galliprant? And where do you think that could potentially go in 2 to 3 years? And then second question, if possible, it seems like there were some purchasing pattern benefit for Ruminants & Swine. If you could help quantify that so that we can understand underlying demand, that would be helpful.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [48]

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Sure. Jeff, do have macro thoughts on Galliprant? I think, as we look at the overall space, there are a lot of various NSAID products there. As we look at our performance, Galliprant is the #1 prescribed branded NSAID. And there are a variety of products for different components of pain in the acute versus long term, early onset versus later needs. Macro wise, I think we feel good about the Galliprant profile, what it's bringing to the market. With that, there's opportunity there. We won't project market shares or talk in detail about where we are now, but we think there's upward potential.

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [49]

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Yes, and I think we'll just continue to look at pain and osteoarthritis through a portfolio approach. We're excited about even the potential of the Aratana transaction with Nocita, having another surgical pain product. And I would also say, and I think it's important that the actual segment is growing like some of the other Companion Animal Therapeutic areas. We highlighted oncology in our last call, and we're excited about the VetDC in addition to derm. As we all know, pain is evolving in the same space, where you got organic market growth and then you got entrance of innovation where innovation is heavily rewarded. So on Galliprant, our job right now is launch well, bring further SKUs. And right now, we're getting that full suite that we need, and then geographic expansion. So right now the lead indicators look very good, and we'll continue to not only support Galliprant but really become and build that pain leadership in that segment.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [50]

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Todd, do you have thoughts on purchasing patterns?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [51]

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Certainly. On Ruminants & Swine, obviously, it was a big quarter in the U.S., offset by a tough quarter internationally. With respect to Rumensin, we know we did pull some sales from -- expected in Q2 into Q1 that augmented that a bit. When we show you this year-over-year 6-month time frame, you can see negative 4% growth in that category. A lot of that is the antibiotic movement in Asia as well as African swine fever. The other bit with respect to the U.S. in Q1, we had a Micotil shortage in Q4. This product was replenished in Q1. And so that provided some additional benefit to the run rate for the Q1 Ruminants & Swine business. So overall, this category with African swine fever will continue to be tough, but overall in line with where we're headed.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [52]

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Great. I think that was all the questions. Jeff, do you want to offer some closing comments as we conclude?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [53]

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Absolutely. Thank you, again, for your time and support throughout the journey to Elanco become an independent public company. As you know, we're executing on our strategy. We're pleased that our efforts so far over the past several years are now delivering growth in profitability and accelerated income.

I want you to hear my confidence lies in: one, the value that is increasing that we're adding to our customers; two, I believe strongly that our strategy, our IPP strategy of innovation, portfolio and productivity, there's progress, and hopefully you've seen the proof points in today's results; three is the engagement and the ownership of our employees today is at a high that I haven't seen in a long time; and lastly is the business model of an independent Elanco is a stronger Elanco. We look forward to continuing to build a long-term relationship with all of you, our investors. If you have any additional questions, please feel free to reach out to both Jim and Katy. Have a great day.

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Operator [54]

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And this concludes today's conference call. You may now disconnect. Thank you very much.