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Edited Transcript of ELAN.N earnings conference call or presentation 13-Aug-19 12:00pm GMT

Q2 2019 Elanco Animal Health Inc Earnings Call

Aug 14, 2019 (Thomson StreetEvents) -- Edited Transcript of Elanco Animal Health Inc earnings conference call or presentation Tuesday, August 13, 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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* Christopher Thomas Schott

JP Morgan Chase & Co, Research Division - Senior Analyst

* David Michael Westenberg

Guggenheim Securities, LLC, Research Division - Analyst

* David Reed Risinger

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

* Erin Elizabeth Wilson Wright

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

* Gregory B. Gilbert

SunTrust Robinson Humphrey, Inc., Research Division - Analyst

* John Charles Kreger

William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst

* Kevin Kim Ellich

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

* Liav Abraham

Citigroup Inc, Research Division - Director

* 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

* Stephen Michael Scala

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* 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. My name is Adrian, and I will be your conference operator today. At this time, I would like to welcome everyone to the Elanco Animal Health Q2 2019 Earnings Call. (Operator Instructions)

Thank you. I would now like to turn the call over to your host, Jim Greffet. Please go ahead, sir.

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

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Thanks, Adrian. Good morning. Thank you for joining us for Elanco Animal Health's Q2 2019 Earnings Call. I'm Jim Greffet, the 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 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 second 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. 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 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. Good morning, everyone. This quarter marks Elanco's fourth quarter as a public company, and we're pleased to be delivering on the vision we set forth last fall. Our second quarter results are in line with our expectations and reflect a disciplined execution of our global team across our innovation, portfolio and productivity strategy. You will see that we're taking a nimble approach to executing our strategy in the face of some external events impacting our business. Let's begin with the highlights since our last call on Slide 3.

Our Q2 results demonstrate execution and focus. Our targeted growth categories are growing above the market on a constant currency basis. Fueled by new products and geographic expansion, our productivity agenda is delivering and driving improved profitability and we continue to demonstrate our position as a partner of choice with additional strategic relationships, all while building a fit-for-purpose independent company.

Our top line results represent the solid underlying demand for our products and the strength of our fundamentals. The 9% growth of our targeted growth categories is in line with our expectations.

Next, our margin expansion continues to unlock value. We're pleased with the improvement in adjusted gross margin, which continues to drive accelerated growth and profitability and cash flow as shown by the 29% growth in our adjusted EBITDA. We also continue to make important investments that strengthen our portfolio and pipeline. The acquisition of Prevtec Microbia and R&D collaboration with AgBiome advance Elanco's commitment to deliver a suite of alternatives to antibiotics, such as vaccines and nutritional health products like enzymes and probiotics.

Finally, we're delivering on our IPP strategy, while in parallel executing on our goals to stand up the independent Elanco. With half of the year complete, we're narrowing the range for both sales and EPS, which Todd will discuss later in the call.

Slide 4 summarizes some of the key events since our last earnings call across the 3 pillars of our strategy. First, our innovation strategy is built on launching with excellence, progressing our internal pipeline and complementing with external opportunities. Our new products and launch mode continue to fuel our growth, increasing 45% year-over-year. The group now represents 14% of our total sales. And you can see the growth trajectory of these products in constant currency on Slide 15. We continue to expand our reach by launching these products in new geographies. For example, Galliprant continues to launch in additional European countries and both Credelio and Galliprant were approved in Brazil since our last call.

As you'll remember, 60% of the innovation growth we expect between now and 2023 will come from these products already on the market. The near-term focus is on ensuring launches are flawlessly executed. Importantly, our internal pipeline continues to deliver as expected across every stage of development. We are meeting milestones and progressing development programs. We are pursuing best-in-class and first-in-class innovations with concentrated investments and large opportunity targets. We have a prioritized and focused internal investment approach and intend to fund acceleration where the science and risk allow.

Complementary external opportunities round out our innovation strategy. The R&D collaboration with AgBiome and our acquisition of Prevtec, which includes their R&D pipeline, are examples since our last call.

With the Aratana acquisition, which closed in July, the VetDC collaboration and now the Prevtec acquisition, we have added 7 development programs to our pipeline. We are launching well. We're progressing the internal pipeline, and we're complementing with external opportunities. Our strategy is on track to deliver a sustainable flow of innovation over the long term.

Now on the second pillar, portfolio. Our targeted growth categories delivered above-market growth of 9% and now represent about 62% of our total sales, an increase of 5 percentage points since our IPO. With the acquisition of Aratana now closed, we have completed the first phase of crosstraining on the products and have begun offering our integrated portfolio to our customers, both in the general practice vet clinics as well as the specialty clinics with Aratana's specialty field force.

Finally, the Prevtec acquisition gives Elanco full ownership of ColiProtec, a vaccine for swine, which Elanco currently markets in Europe and Canada. This agreement provides Elanco with a portfolio of solutions against E. coli, one of the greatest challenges for swine producers, and offers options as the market for antibiotic alternatives continues to expand.

Similar to our Aratana relationship, we have a progressive history with Prevtec, beginning with a licensing agreement, showcasing our partnering approach. By having full ownership, Elanco will

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position to grow ColiProtec, expand in more geographies and capture the full margin benefit.

Now turning to our third pillar, productivity. The efforts in our manufacturing organization continue in support of our long-term margin expansion goals. We are pleased to report that now 100% of the productivity initiatives are underway that are needed to deliver our expected cost savings through 2020. The team is now turning their focus to the next phase in the journey from 2021 to 2023 and beyond.

On the SG&A side, we've shifted our go-to-market model in 13 of the 16 international markets we announced last December and expect to complete the remaining 3 by the end of this year. Additionally, the independent company stand-up efforts are progressing well, aligned with our time line and cost expectations. While there -- our essential TSA is still active with Lilly, we've exited many ahead of schedule and continue to receive the support we need to ensure business continuity.

Finally, in the second quarter, we paid down $50 million on our term loan. This is coupled with our growth in adjusted EBITDA. It demonstrates progress towards our deleveraging goals. Overall, our productivity agenda continues to progress and is delivering meaningful financial benefit.

Now let's take a look at our sales performance on Slide 5. We are pleased with the results, especially in our targeted growth categories, which show solid growth in the quarter. Performance in the ruminant and swine category reflects 2 main external pressures. First, the impact of swine -- African swine fever on Asian markets continues to be the most significant headwind for our sales.

Since our last call, the situation has continued to worsen, with herd losses increasing in China and the disease spreading further throughout Asia. While we still believe there is opportunity for increased swine production from other markets and increased poultry and beef production to mitigate the swine loss in Asia, we do not believe there is a full offset in the near term for our business. Clearly, the underlying demand for protein persists and we believe this bodes well for our longer-term recovery in China and across Asia as well as the prospects for swine, poultry and, to a lesser extent, beef production globally.

While the situation is fluid, we continue to focus on supporting our customers around the world as they navigate these dynamic changes in the global protein markets. Additionally, there is a second external pressure in ruminant and swine that comes with production issues at a contract manufacturer had disrupted supply of certain injectable cattle products in the second quarter.

While we were working closely with this supplier to mitigate downside, we expect a continued disruption in supply in the second half of the year as these issues are resolved. Very importantly, without these headwinds, our core revenue growth is 5% on a constant currency basis demonstrating that our fundamentals remain strong and our IPP strategy is delivering.

Now I'll turn the call over to Todd to provide more color on our Q2 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 21 in the Appendix provide a summary of the adjustments made to the GAAP results to arrive at our adjusted presentation.

Today, I'll focus my comments on our adjusted measures to provide insights into the underlying trends in our business, so please refer to our press release for a detailed description of the year-on-year changes in our second quarter GAAP results.

Elanco delivered another strong quarter. Looking at the adjusted measures on Slide 8, you'll see total Elanco revenue increased 1% in the quarter. On a constant currency basis, growth was 4%. Gross margin as a percent of revenue was 54.6%, an improvement of 540 basis points over the last year driven by our manufacturing productivity initiatives and, to a lesser extent, price improvement and the favorable impact of foreign exchange rates on international inventories.

Our gross margin improvement is tracking to our plans in the first half of 2019. In the second half, due to the typical seasonality of our product mix and lower planned plant utilization, we expect a lower gross margin than in the first half. Thus we continue to expect adjusted gross margin for the full year to be between 52% and 53%.

Operating expense increased 7% in the second quarter. Marketing, selling and administrative expense increased 5% to $201 million reflecting increased direct-to-consumer marketing efforts for our companion animal portfolio and, to a lesser extent, incremental expenses as a result of operating as a public company, partially offset by the benefit from foreign exchange rates.

R&D expense increased 12% to $69 million or 8.8% of revenue due to the timing of spend within the year, increased project spend as a result of pipeline progression and increased costs as a result of operating as a stand-alone company. The combination of sales growth and gross margin improvement, partially offset by increased investments in our brand and R&D, produced an operating income increase of $30.7 million or 24% compared to the second quarter of 2018. The resulting operating margin is roughly 20% of sales in the second quarter of 2019.

At the bottom line, Q2 adjusted net income increased 3% to $101.6 million with an effective tax rate of 23.4%. Normalizing for the $20.7 million of interest expense we had in the quarter, which we did not have in 2018, adjusted net income increased 24%.

Moving to Slide 9, let's take a look at the effect of price, rate and volume on revenue growth. The effect of foreign exchange rates on core revenue was a 3% headwind overall. Price grew 2% while volume growth was 1%. On the slide, you can see the breakdown of revenue across our 4 categories. I will focus on constant currency growth. We are pleased that our business grew in the U.S. and in internationally in each category except international ruminants and swine.

Starting with Companion Animal Disease Prevention, which includes parasiticides and vaccines, revenue grew 6% in the quarter, 3% from volume and 3% from price. Growth is driven by the continued uptake of Interceptor Plus and Credelio partially offset the declines in certain older generation parasiticides.

Moving to Companion Animal Therapeutics, revenue increased 26% in the quarter, 21% from volume and 5% from price. The growth is driven by demand for products across the therapeutics portfolio, primarily the continued uptake for Galliprant in the U.S. and now a strong launch in Europe as well.

Turning to Future Protein and Health in our Food Animal portfolio, revenue grew 7% in the quarter, 4% from volume and 3% from price. Growth in this category is driven primarily by the continued uptake of our aqua portfolio as well as poultry and nutritional health products. Ruminants and swine revenue declined 6%, with flat price and a 6% volume decline. Growth in our U.S. business was more than offset by external factors impacting our international business. Our swine business in Asia continues to face headwinds due to the spread of ASF in the region. We estimate the impact in the second quarter was about $8 million. However, the increasing herd losses are expected to have a more significant downside in the second half of 2019.

Our international business was also impacted by the continued implementation of antimicrobial policies in Asia and product rationalizations aligned with our productivity and agenda.

The U.S. cattle business was negatively impacted by purchasing patterns for Rumensin, offset by favorable purchasing patterns in other cattle products, primarily Optaflexx. Finally, we estimate the disruption in the global supply of certain injectable cattle products reduced sales by $8 million in the quarter. ASF and the supply disruption provided a 500 basis point drag on our ruminants and swine performance.

Revenue from strategic exits increased 51% in the quarter driven by higher demand from our contract manufacturing arrangement with BI and from the production of human growth hormone for Lilly, a contract that was not put into place until the fourth quarter of 2018. These were partially offset by the continued year-over-year reduction in other strategic exit items. Aside from these 2 contract manufacturing agreements, all other strategic exits have been reduced to 0 as of this quarter.

Slide 10 provides our overall performance in the U.S. and internationally. The U.S. business continues to drive overall growth. Our international business returned to growth in the second quarter, with growth in all 3 targeted growth categories offset by the headwinds I just described in ruminants and swine.

Before discussing the financial guidance, I would like to provide an update on our dividend plans. With the significant cash flow we project over time, we expect a dividend will be an element of our value proposition to equity holders. However, we are postponing the initiation of our dividend as our management team and Board of Directors wants to maximize flexibility to use our cash in the most productive ways possible.

Now turning to our financial guidance for the full year 2019 on Slide 11. For revenue, we remain confident in the growth prospects of our targeted growth categories and our underlying ruminants and swine business. We expect a downside of $40 million to $50 million from the impact of African swine fever across Asia and $15 million to $25 million from the disruption in global supply for certain injectable cattle products for the full year 2019.

Our targeted growth categories, especially Companion Animal Therapeutics, aqua and poultry, paired with our business development efforts, will partially offset these temporal headwinds. In the second half of the year, we will benefit from the inclusion of sales from Entyce, Nocita and Tanovea. Additionally, we have revised our commercial agreement with Lilly for Posilac, which Elanco has continued to distribute since the separation.

Moving forward, Elanco will record the full income statement benefit from the sale of the remaining inventory of Posilac.

Based on these dynamics, we are updating full year guidance for revenue and EPS. For total revenue, we now expect a range of $3.08 billion to $3.12 billion, a reduction of $20 million from the top end of our previous range. We now project core revenue to be between $3 billion and $3.04 billion reflecting up to 4% core revenue growth, excluding the impact of foreign exchange rates. The updated revenue expectations also include a $20 million increase in strategic exit revenue due to the increased contract manufacturing demand from BI.

Finally, we are narrowing our range for expected earnings per share. We now expect EPS on a GAAP basis to be between $0.36 and $0.44 and on an adjusted basis to between $1.04 and $1.10. Keep in mind, the year-over-year EPS growth is impacted by the full year of interest expense that Elanco has in 2019.

In summary, our year-to-date results are in line with our expectations and illuminate the value of being a portfolio innovator. We are pleased with the trajectory of our margin expansion goals and confident in the underlying growth of our core business.

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 want 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. Adrian, we're ready for the questions. Can you take the first one, please?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of Erin Wright with Crédit Suisse.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [2]

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On the gross margin, it was seemingly better than your internal expectations or what you articulated last quarter. What were some of those factors that contributed to the better gross margin trend? How much of it was attributable to mix versus FX? And can you speak to how we should be thinking about the quarterly progression on the gross margin?

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

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Sure, Erin. Thanks for the question. Overall, we had utilization of our plants that was slightly higher than we expected that drove a portion of that margin expansion. As I mentioned, we don't expect that to happen in the back half of the year. FX was a slight positive overall due to the FX impact on international inventories. The biggest driver was the productivity initiatives that we've been executing against over the last few years and those continue to drive value.

And then finally, with slightly higher growth in the U.S., which is typically a higher margin geography for us as well as in the companion animal business, those were all contributors to first half margin expansion slightly ahead of our expectations.

In the back half, we don't have that plant utilization. There was also a seasonality of mix. If you look back at Q4 of 2018, it's a big quarter for us on our poultry business, which is primarily international and thus comes with a slightly lower margin than overall. So that's sort of the expectation of why we still believe for the full year we'll be in the 52% to 53% range.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [4]

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Okay.

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Operator [5]

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The next question comes from the line of Michael Ryskin with Bank of America Merrill Lynch.

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Michael Leonidovich Ryskin, BofA Merrill Lynch, Research Division - Associate [6]

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I'll squeeze in 2 really quick ones. One, there was a generic Rumensin approval in the U.S. in the quarter. Could you comment on how that reads in relative to your expectations? And any update on timing on generic Rumensin competition in the U.S?

And also your comments in the prepared remarks on the flexible use of cash. When you talk about suspending the dividend, obviously, you've seen a lot of press reports in recent weeks about a potential large M&A transaction. Could you remind us your outlook on leverage, cash utilization, opportunities of a larger size than -- for example, the acquisition of Aratana?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [7]

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Great. Thanks, Mike. Jeff?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [8]

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Yes, thank you, Michael. So on the generic monensin that is coming into the marketplace, just real quick, again I'll reiterate, we are prepared. It aligns with what our expectations were. They will continue to pursue combination clearances in beef and able to be in the dairy market. I want to emphasize that, again, this is a competitor that we know with Huvepharma. Our full year guidance incorporates all of the known dynamics right now that are impacting us and the industry, including this. So it aligns very much with our assumptions that we've had, both this year as well as next year. We'll keep you updated as we go forward.

I'll make one comment just briefly on capital allocation. As mentioned by Todd, our allocation decisions are made with the intent of using cash in the most productive ways possible and that's absolutely critical and clear in our strategy. And hopefully, just by the showing of our -- delivering of our results and 29% improvement in adjusted EBITDA shows the strength of the business and that will continue to be important as we go forward, that we'll invest cash appropriately for the most productive ways possible.

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [9]

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Michael, as you notice, we did pay down $50 million of debt on our term loan during the quarter, as well as utilized about $60 million of cash on the Prevtec acquisition, all in line with our IPP strategy.

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Operator [10]

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The next question comes from the line of Umer Raffat with Evercore.

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Umer Raffat, Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Analyst of Equity Research [11]

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Jeff, I know -- I realize what you guys can and can't say, but it's one of those periods where the stock was reacting very aggressively to the repeated press reports, the number of outlets they were in as well as the sheer specificity in those articles. So my question is as investors look for clarity, and I know you just mentioned IPP strategy stays on execution, is it fair to say that the core strategy remains smaller tuck-ins and not large deals? And are we at the stage where we're past any specific deals mentioned in the press?

And I had a quick one for Todd as well. Todd, on gross margins, I think it'd be really helpful, given how strong it's been coming in, if you could lay out a bridge from when you guys went public when the gross margin was at 50%, to the 54.6% reported today. So for example, it's 100 bps from onetimers, but if you could just lay out that for us, that would be really helpful.

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [12]

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Thanks, Umer. At a high level, I'm going to make sure that the energy of our organization is focused on executing our strategy, which I think you can see is working very well. It's the right strategy, a lot of proof points. And our stock price at any given time can be subject to many factors. And so I'm not going to comment on market rumors. As I've said very clearly in the past, we are a company in execution mode, and I think this is our fourth quarter as an independent company and it shows that. Our focus is on standing up as an independent company and delivering against this strategy. And it also -- I've said in the past, we're always assessing this industry, it's dynamic and this quarter represents that, with whether it's African swine fever or a contract manufacturer or a meat processing plant that had a fire this weekend. It's a dynamic industry, and we're always evaluating these vectors of risks and opportunity that are present in the industry and we'll be looking at those as we keep our focus on long-term sustainable value and growth for our investors.

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [13]

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And Umer, on the margin bridge, as we've communicated previously, we do expect to be able to add 1,000 basis points of gross margin from the 50% you referenced, up to approximately 60% by 2023. We've said that generally we will be on a linear basis. And so as we project a 52% to 53% gross margin here for 2019, it's generally in line with that. I will say that our swine business in Asia is typically a little bit of a lower margin business than our U.S. business. And thus, as you see some of that mix playing through, that is a factor in the gross margin in 2019 as well as the higher utilization of certain plants this year that just helps drive.

Our fundamentals with respect to our gross margin productivity efforts are fully underway. We're now 100% of the initiatives that we had planned to deliver the 2018 to 2020 gross margin story are all underway and are delivering and we've now turned to look to those next level of efforts to get us to '21 to '23. So overall, the manufacturing team across the Elanco footprint is really delivering on results and owning this effort to drive productivity forward.

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Operator [14]

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The next question comes from the line of David Westenberg with Guggenheim Securities.

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David Michael Westenberg, Guggenheim Securities, LLC, Research Division - Analyst [15]

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Great work on Galliprant internationally. When we talk to vets in the U.S., they love the label, the no lab work. Is that no lab work dynamic similarly popular in Europe? And do you see international as a more exciting opportunity than the U.S.?

And then my second question is on Rumensin or generic Rumensin. Some of the smaller competitors I talk to talk about how Rumensin is a great product for cross-selling, not even in the sense that it's usually sold in combination, but in the fact that you're the only one that has it and it really helps them -- really helps you sell other kinds of products, not necessarily just in combination.

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [16]

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Yes, great questions, David. So we're really excited about Galliprant. What it does, it ultimately, when you start with a pet owner and with a dog that is now living a longer life because of the advancements of the animal health industry and bringing in what we believe is the leading product for osteoarthritis, it all comes down to the pet owner wanting something that's easy to administer, that works and is safe. And so it starts there. And our entire focus is through the veterinarian just thinking about that pet owner. So, yes, we're seeing great interest and uptake in the international markets. We continue to globalize the product as we've shared, and we see the same interest as we globalize this product and see tremendous growth remaining in Galliprant and that marked a little bit of the rationale for the Aratana acquisition.

As you move to Rumensin, I say the second pillar of our strategy is portfolio and we are looking as we've shared out on the road, the biggest problems for our customers and how we offer a portfolio of solutions against those, whether it's salmonella in poultry or arthritis and pain in dogs, to the cattle, it's really everything from the ruminant to the respiratory and being able to offer a package of products. Rumensin is one of those, but we are looking at, again, the suite of products that we have as well as bringing new products on as we've talked about, with a new product that is coming like Experior that has an environmental claim. So, yes, we feel very good about this, and again, we're a portfolio company, not just a product company and Rumensin represents that.

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Operator [17]

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Next question comes from the line of David Risinger from Morgan Stanley.

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David Reed Risinger, Morgan Stanley, Research Division - MD in Equity Research and United States Pharmaceuticals Analyst [18]

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So I have 2 questions, please. First is strategic and second is on the exits. So on the first question, how would you assess a large transaction which enhances scale, but has uninspiring revenue growth prospects?

And second, with respect to your strategic exit revenue, it was $28 million in the quarter. That was more than double what we expected. And I think there was a comment about an additional $20 million in exit revenue, I'm not sure. I guess if you could just help us understand how to model the strategic exit revenue line over the next few quarters?

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [19]

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Jeff, do you want to talk a little bit about [PG]?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [20]

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Yes, I mean, I know this -- David, I appreciate the question. As I said, I'm not going to comment specifically on any of the market rumors or assets. And again, we're in execution mode. I think I would highlight a lot of what we're doing and what we have done in the first year. We're assessing opportunities that -- and optimizing our strategy through that. And I think examples of Prevtec and Aratana are examples, but I want to emphasize this is the one thing that is not changing in the lens that we look through, is this IPP strategy, innovation portfolio and productivity, and those key pillars around each one of those and the critical aspects of it. That's the lens we look through. A heavy focus on execution, a heavy focus on standing up as an independent company and delivering on this strategy, that's the lens that we'll look through as we look into the marketplace.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [21]

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Todd, do you want -- so Todd, do you want to talk about strategic exits, or I can?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [22]

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Yes, Jim, why don't you go ahead and handle it. David, just -- we've got 2 things going on still with strategic exits. The BI contract manufacturing revenue that we're doing for the M1 vaccines and then human growth hormone for Lilly. But I'll leave it to Jim on the time lines.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [23]

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You can probably solve for it, Dave. So in our updated guidance, we do give a separate number for strategic exits. We've raised it to $80 million for the full year. It was $60 million. And I think that's roughly split between Q3 and Q4. Q2 was a pop because of increased production, especially for the Boehringer Ingelheim vaccines and just the volume that they require. We think that comes back down to the run rate that was closer to what we saw in Q1 and then those 2 -- the HGH for Lilly and the BI vaccines, those will continue to dissipate as we complete those contracts.

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Operator [24]

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The next question comes from the line of Chris Schott with JPMorgan.

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Christopher Thomas Schott, JP Morgan Chase & Co, Research Division - Senior Analyst [25]

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This, the first one here I'd just be interested in your views on the parasiticide market in light of the pending Simperica Trio launch. I think there's been quite a bit of debate of what that means for your flea and tick business. So just be interested in any comments you might have about how you see the market evolving? And how Elanco kind of plays in that evolution?

Second question was just coming back to the comments on business development and focus on execution. Maybe regardless of size, can you just talk a little bit about the capacity the organization has at this point from a bandwidth perspective? Do you have bandwidth at this point to consider further transactions that we think about standing at the company, the Aratana deal, et cetera, and the work that's being -- that's going on there? Maybe just for some context of just how stretched is the organization right now?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [26]

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Thanks, Chris. We feel, and very clearly, nothing new since -- with the news on additional innovation coming in. As we've shared very openly in the IPO, this was expected. We shared that we would likely not be first-in-class. We're working on elements of best-in-class in our pipeline. Don't talk as openly about this given that our pipelines are not quite as transparent as the pharmaceutical industry, but I'll emphasize we're tracking very nicely internally on our prospects in this area. We most importantly, and as you saw with the new products, Chris, we're tracking very well relative to our portfolio of parasiticide products that we're offering to the market today. We offer the broadest solution to the 7 main parasites today between the 2 products of Credelio and Interceptor Plus. We also have different niches, in segments both in the vet market as well as the retail market, that we offer. So we like our current portfolio. Assumptions are not new, and our pipeline is progressing. So we overall feel very good about it.

I come back on capacity of the organization. We look at execution and engagement scores quarterly. I will tell you that they are -- they've grown significantly since the start of the IPO, making our employees owners. The engagement is high. We look at execution scores quarterly as well. And what I would tell you is we've narrowed the focus as a company. As we've moved from being a division to an independent company, the clarity is high. And I believe that the supervisors that we have around the world are crystal clear in this IPP strategy. So to me, I start there and I don't say it lightly when I say we're a company in execution mode, we're serious in what we're doing. We know the job we have to do and that's, Chris, I would say my answer to you is, it's something that is front and center in the way I lead and it is something that I monitor on a quarterly basis. And I feel very good about the state of Elanco right now.

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Operator [27]

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Kevin Ellich with Craig-Hallum.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [28]

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I guess, wanted to start off with the underlying organic growth for the business. You have a lot of moving pieces, with your Aratana acquisition, Prevtec, generic Rumensin coming into play here. Could you walk us through kind of where the true underlying organic growth for the business is? And then, Jeff, just wanted your thoughts on the use of different distribution channels for Companion Animal products, online versus distributors? It seems like more people are opening up [Pet] Chewy and 1-800-PetMeds?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [29]

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Great. Underlying growth, Jeff...

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [30]

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Yes, I just think the underlying growth, I want to really emphasize one key number that's important is when you take out the events, which is African swine fever and the contract manufacturing impact in the ruminant and swine segment, we're growing the underlying demand for core revenue on constant currency is at 5%. I think the other point that was stated by Todd is 7 of the 8 categories, when you look at our 4 market categories and U.S. and international, 7 of the 8 are growing. So when I look at this, and we look at things such as the placements and the demand pull-through in vet clinics, when we look at market share in these key segments, we feel very good about the fundamentals. And again, you understand that when we talked about the fundamentals of animal health continue, and I think the diversity of our industry and the global aspects of it and many therapeutic classes, this year is an example, that diversity creates sustainability of growth. So that's important. Second question was...

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [31]

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Distribution channel.

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

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Yes, distribution channel. Great question. So just since the launch of our IPO, I mean a continued dynamic of change, both in distribution and retail and corporate vet clinics and specialty clinics, to me, the multi-channel approach to reach a pet owner globally continues to be more and more dynamic. It's something that we've got our eyes on, it's something we've got to be very conscious of. And what I would say is I feel very good today about where we stand, but it's something that we need to continue to monitor and assess. As I talk about looking at vectors of risks and opportunity, this is one that we'll continue to look at. Probably a good example since the start of this year with Aratana, and I'll reiterate a comment I made, we've cross-trained our sales force. We've got Aratana's sales force is now part of the Elanco team. They've been trained. They're focused on those specialty clinics in the U.S., while our core team is selling Aratana products back to the general vet clinic. And we've got a retail group and a corporate vet clinic group. So those are examples that where we have teams in place and will continue to monitor some of these other changes that are occurring. But it is something I think we need to keep our eyes on as we move forward in the global pet market.

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Operator [33]

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The next question comes from the line of Steve Scala with Cowen.

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Stephen Michael Scala, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [34]

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A couple of questions. Regarding postponing the initiation of the dividend, is there any clarity on when it might be initiated? And apologies if I missed it, but can you speculate on what cash -- or can you be specific on what cash needs are taking priority over initiating the dividend?

And then secondly, the Novartis acquisition several years ago was a greater challenge and more disruptive to integrate than many had expected. So just philosophically, what factors would the company consider before going down that road again?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [35]

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Todd?

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Todd S. Young, Elanco Animal Health Incorporated - Executive VP & CFO [36]

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Yes, Steve, thanks for the question on the dividend. We have not stated when we expect to initiate a dividend. We do think over time that our business is going to generate a significant amount of cash and that we'll be able to pay a substantial dividend in the future.

In the near term, obviously, we pay down the term loan as we had planned. What was unplanned was this nice opportunity with Prevtec, and where that's $60 million of cash utilization that really, we think, drives value in antibiotic alternatives as we get a vaccine for swine producers, proposed weaning diarrhea on E. coli and that's a sort of opportunity we're excited to invest in for the long-term value proposition that Elanco brings.

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [37]

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Yes, let me share, Steve, just at a very high level. I think it's important to note on Novartis and we did this when we were out on the roadshow when we launched the company, that the challenges faced between 2015 and 2017 were heavily dependent on 2 events that occurred more to our organic Elanco business. And I think that impacted the external results between 2015 and '17. One was the emergence of some new Companion Animal innovations. Since then, we've launched Interceptor Plus and Credelio. And the second was the whole clean food movement, where it impacted both our antibiotic franchise and some of our productivity products. Again, those were on the actual business. I think when we look at Novartis, synergies, new products, the capabilities that brought the global nature of the business, it actually -- we felt good that was not really a distraction as much as the 2 external events impacting our results. But we learned a lot of things that were helpful for us as we go forward in running our existing business.

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Operator [38]

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John Kreger with William Blair.

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John Charles Kreger, William Blair & Company L.L.C., Research Division - Partner & Healthcare Services Analyst [39]

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Jeff, what's your latest view on how the ASF issue in Asia will play out for the business? Sounds like the impact is getting a little bit worse, but do you have a view about whether or not that will likely become a bigger headwind in '20? Or perhaps could it flip to be more neutral or positive as other producers and other regions start to increase capacity, just curious what your views are.

And also a kind of a similar question, the global supply disruptions that you mentioned, from your perspective, when might those be resolved?

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

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Yes, let me take your second question first, which is, this is related, let me be clear, to this contract manufacturing issue where we're working very closely with this company. This is directly related to the Micotil outage that we had in the past. So it's the same contract manufacturer. The problems are contained. They are known. It's really more of the resupply and the pathway back to resupply. It is our intention that these are issues that should be resolved by the end of the year and not be issues going into 2020. We'll keep you updated on that, but I feel good about that.

I think relative to African swine fever, there is a lot that we've learned, but there is a lot we still don't know. It's significant. It's like nothing I've seen in my 30 years. These are large numbers. It's moved from China to the Asian countries. There are some early emerging cases still unknown, relative to what they are in some of the emerging Eastern European countries. But I would say, we need to keep our eye on it. There is no question. The dynamics we need to look for is, one, I think you'll see poultry within Asia benefit the most initially. And then I think trade will be the second factor, is the ability to move pork into diets that will not and won't want to change as fast, and that pork demand will be there as the ability to supply from other areas.

I do think that on the ground, the biosecurity measures that are being taken are the right thing, but it could just take time. So I think it's the leveling off will be poultry locally, maybe poultry globally. And then I do think keep our eyes on trade as we start to look at other parts of the world that want to feed this demand, it's important. As you look at swine economics here in the U.S., we went from last quarter them making money, to they're moving closer to breakeven. And a lot of that is simply because of the inability to trade pork and that's something to watch. So I think it's something we need to continue to monitor as we go through 2020. I do think some of these upsides will, I think, balance out some of the local downside. And I think innovation still quite a ways off. So those are my thoughts at this stage. More to come. I think this is one of these quarter-by-quarter, we'll learn and put more of this puzzle together.

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Operator [41]

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The next question comes from the line of Liav Abraham with Citi.

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Liav Abraham, Citigroup Inc, Research Division - Director [42]

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A follow-up question on generic Rumensin. What do you consider a fully generic market in terms of number of generic players? And how many generic players do you ultimately assume will play in this market?

And then secondly, perhaps a couple of comments on pricing from your end. Pricing across your portfolio remained quite strong in the second quarter and in the first half. So can you just comment on the sustainability of the pricing trends that we've seen across your portfolio?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [43]

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Great question. So I always come back on the generic. This industry has had a high percentage of generics. Monensin is an example. It's been generic from more than 20 years in many other markets that are similar to the U.S., like Canada. Again, it comes back to a few key fundamentals that are important. The total portfolio, the continued innovation that comes with life cycle management, I think the pure economics, this is a cash market and our Rumensin like any other products are -- it's a small cost. It's pennies per pound in terms of the cost. So that comes into play where you add share voice, value beyond product and a portfolio of products. That is really -- it's not about the number of generics as much as the total value proposition. And we really like where we are relative to our total portfolio in cattle. And examples of that is an Experior that is coming as a product as well as even as we look at a deal that we've done earlier with Novozymes as we continue to build out and give that beef producer more value and total offering.

I think pricing, when you look at the underlying fundamentals of demand, we feel good about pricing. We've said our industry in the past has averaged about 2% in terms of price. We predicted that or a little less going forward, and we continue to monitor carefully. But we see nothing that would change that going forward.

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Operator [44]

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The next question comes from the line of Navin Jacob with UBS.

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Navin Cyriac Jacob, UBS Investment Bank, Research Division - Equity Research Analyst of Specialty Pharmaceuticals and Large Cap Pharmaceutic [45]

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Just a couple on gross margins, if I can. Very nice progression here. But if you could help us understand how much of a benefit -- I'm sorry if I missed this in the prepared remarks or during the questions, but how much of a benefit FX had this quarter? And then just broadly speaking on that same point, could you help us how -- understand how it flows through going forward, just so we know how to model it? So if it's a negative impact on revenues, it's a positive impact on gross margins, is that always the case? Any color there would be helpful. And then if I didn't mention this Posilac, if you could help us explain that impact, please, that would be very helpful.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [46]

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Navin, it's Jim. I've spent a lot of quality time with our accountants and gross margin. So for Q2, as Todd mentioned, overall our gross margin -- foreign exchange was a benefit to our gross margin, about 80 basis points. That's the combination of 2 things. Operational FX. So just as we had the 3 percentage point headwind to sales, we have a residual headwind on our gross margin from just the operational change in foreign currency. I think that was roughly 80 or -- 50 or so basis points, [15] basis points of headwind, then we have this other issue that if anybody follows Lilly, it's similar to the FX impact on foreign international inventories. And that can be somewhat counterintuitive depending on when rates move, where they move and the inventory turns.

For this quarter, that was actually a tailwind of 130 basis points or so. And that's why Todd phrased his language as it did. I'd say, if you parse those 2 things apart, generally as we see rates move and create a headwind or tailwind to sales, you would see a similar level -- a reduction, of course, because of the marginal impact, but you'd see a resulting impact on gross margin. Then we'll do our best period-to-period to talk about this other effects on international inventories because it can be discrete and at times counterintuitive, as it is this quarter. So we'll do our best to be clear on that. Jeff, do you want to talk about Posilac?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [47]

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Yes, on Posilac just real quick. I mean, again, we've been representing this product in the U.S. and international markets for the remaining inventory owned by Lilly as Todd stated. This was just really a transactional decision. It made more sense for us to have the inventory on our books, and it links a little bit to my portfolio approach. As we work through the inventory, we will be selling this in the portfolios that we have in the dairy industry.

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Operator [48]

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(Operator Instructions) The next question comes from the line of Kevin Ellich with Craig-Hallum.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [49]

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Jeff, just had a quick follow-ups. So the U.S. cattle market, seems like with the wet summer we've had, cattle are staying on pasture longer, they're heavier when they go into feedlots. You guys called out Optaflexx as the driver this quarter, wondering what's really driving that. And are you still seeing competition from generic Ractopamine, sorry. And then also want your view on the mid-alternative plant-based market and the longer-term implication on your food animal business?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [50]

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Yes, great questions. I'll say this. If you just look at the basic fundamentals of each one of the segments of protein, cattle on feed in most major U.S. feedlots continue to run about 2% ahead of last year's pace. The demand continues to be quite strong there. They've got their pressures, but I think as a whole, there is nothing that U.S. pasture and range conditions overall are in good conditions allowing cattle to be on grass longer. And so as a whole, beef is in a good place. Dairy continues to struggle, as we've shared.

And as the combination of Optaflexx as we've talked, Rumensin and some of our other even respiratory therapeutic products, soon nutritional health products, it does allow us to have a portfolio approach that offers value. And I think it's a representative example of the earlier question relative to the importance of portfolio overall.

On protein alternatives, something I speak on and talk about quite often and our team looks at, no question, we're monitoring right now the alternative meat, but I will say this. We have a bigger challenge internally. If you just put the numbers to this, they've predicted that the alternative meat industry will be about $6.5 billion by 2023. When you have $1 trillion industry growing 1% to 2%, we're growing $10 billion to $20 billion a year. So we're growing on an annual basis what the alternative market will be totally in 2023.

With that said, we've got our own challenges and this is where animal health, I believe it's so critical right now, with whether it's environmental and the challenges there, to trade, to an African swine fever. The importance of, I believe, mortality, morbidity, the health and the well-being of animals, animal health is in the center of this, which is what we kind of call one health, sustaining supply, sustaining economics, the health of the animal, the quality of the food really gets back to the impact not just on the animal, but the environment and the person. So a lot of interest in alternative proteins, it's something we've got our eyes on, but the bigger is really the shifting diet, more protein as well as, of course, increased population and more GNP. So that's -- those are some of my thoughts and why the importance and the priority of animal health in the center of this animal protein dynamic has never been as critical as it is today, I believe.

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Operator [51]

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The final question comes from the line of Gregg Gilbert with SunTrust.

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Gregory B. Gilbert, SunTrust Robinson Humphrey, Inc., Research Division - Analyst [52]

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Jeff, can you comment on your geographic mix, and are you content with where it exists now? Are there any markets you're looking to add to or enhance via organic efforts?

And then secondly, curious on your longer-term view on cats and the opportunity to increase medicalization rates for cats? And how your pipeline is aligned for that?

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

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Great questions, Gregg. No question, we're much more global than we've ever been, we're as diversified as we've ever been, but we're not enough. I think that as I look at a few spots, no question, a more global companion animal market is going to be critical for us. We've got a good, strong U.S. business, as you know, and a pretty good European and Japanese business. But as you can see, the emerging market companion animal market is critical. We've got a nice global poultry market overall, but I think as we look at being opportunistic, as we build a swine portfolio with ColiProtec and Prevacent and our cattle portfolio, we're going to want to continue to be opportunistic, and where our productivity agenda allows, to continue to expand overall.

The feline market, Gregg, is -- as you know, continues to be very attractive. It's not talked about probably enough. An example of that is our Credelio cat launch in Europe and the success of that is showing the importance of this segment, innovating there, the administration to a cat becomes even new innovation in itself. And as you know, there is a couple big areas of opportunity there like renal failure, et cetera. So we're excited about that. Our pipeline is lined up and going after those targets as well. So as a whole, we're in a good place.

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Jim Greffet, Elanco Animal Health Incorporated - Head of IR [54]

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Jeff, we have just a couple of seconds left. Do you want to offer closing comments?

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Jeffrey N. Simmons, Elanco Animal Health Incorporated - President, CEO & Director [55]

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Yes, I want to thank you for joining us today. I hope the second quarter represents clearly our IPP strategy, innovation portfolio and productivity is working as you look at the growth of the business, the impact of innovation on our business and the progress in our pipeline and one of the biggest quarters here, our fourth quarter as an independent company, in the area of productivity. And our ability with the guidance that we've given to continue to deliver in that range. Thank you for your interest in Elanco, and I want to assure you that Elanco employees around the world, we're invested, we are engaged, we are acting like owners and we're delivering on the strategy. Thank you for your time, and have a great day.

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Operator [56]

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You may now disconnect.