Elanco Animal Health Incorporated (NYSE:ELAN) Q3 2023 Earnings Call Transcript
Elanco Animal Health Incorporated (NYSE:ELAN) Q3 2023 Earnings Call Transcript November 7, 2023
Elanco Animal Health Incorporated beats earnings expectations. Reported EPS is $0.18, expectations were $0.12.
Operator: Good morning. My name is Krista, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Elanco Third Quarter 2023 Earnings Call. [Operator Instructions] Thank you. I would now like to turn the conference over to Katy Grissom, Head of Investor Relations, you may begin your conference.
Katy Grissom: Good morning. Thank you for joining us on Elanco Animal Health's third quarter 2023 earnings call. I'm Katy Grissom, 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 Scott Purucker, from Investor Relations. The slides referenced during today's call are available on the Investor Relations section of elanco.com. Today's discussion will include forward-looking statements. These statements are based on our current assumptions and expectations and are subject to risks and uncertainties that could cause actual results to differ materially from our forecast. For more information, see the risk factors in today's earnings press release as well as in our latest Form 10-K and 10-Q filed with the SEC.
We do not undertake any duty to update any forward-looking statements. Our remarks today will focus on our non-GAAP financial measures. Reconciliations of these non-GAAP measures are included in the appendix of today's slides and in the earnings press release. After our prepared remarks, we'll be happy to take your questions. I'll now turn the call over to Jeff.
Jeff Simmons: Thanks, Katy. Good morning, everyone. Elanco reported a strong third quarter, delivering topline adjusted EBITDA and adjusted EPS growth. We exceeded our expectations on all key non-GAAP metrics, while weathering the unfavorable strengthening of the U.S. dollar that occurred late in the quarter. Constant currency revenue growth of 5% was driven by accelerating contribution from innovation, stabilizing core volumes and price growth. Along with the improving market conditions, constant currency revenue growth of 6% for pet health and 4% for farm animal was enabled by our differentiated global omnichannel approach, strategic leverage of our diverse portfolio and our enhanced capabilities and leadership. We believe this provides the framework for continued topline growth for Elanco in the fourth quarter and in 2024.
Starting on Slide 4. In the third quarter, price growth of 4% and sequential improvement in year-over-year volume growth was driven by both Pet Health and Farm Animal leading to adjusted EBITDA growth of 5% and adjusted EPS growth of 6%. We made significant progress on innovation in the third quarter completing FDA submissions for three late-stage potential blockbuster products, all with a path towards approval in the first half of 2024. Improving cash generation and reducing leverage remain priorities for Elanco. In the quarter, operating cash flow was $198 million and we repaid $156 million of debt as we continue to advance efforts to improve net working capital and operating cash flow. As we look to the fourth quarter, we are tightening our full year guidance ranges to reflect third quarter outperformance and incremental headwinds from the strengthening U.S. dollar since our August call.
We are raising the midpoint of our constant currency revenue growth guidance, now expecting flat to 1% growth for the year and raising the midpoint for both adjusted EBITDA and adjusted EPS guidance despite increasing FX headwinds. Moving to Slide 5. Our 5% constant currency revenue growth for the quarter was driven primarily by our international business. In line with our expectations, the global business benefited from price, stabilizing core volumes, innovation and improved supply. In the third quarter, U.S. Pet Health revenue was flat as execution across share of voice, physical availability, innovation, price and improved supply for vaccines was offset by competitive pressure and a softer vet clinic end market later in the quarter. As the industry continues to track the impact of lower vet visits, we highlight that only about 18% of our total global business is sold to the U.S. vet clinic, isolating our sensitivity to visit trends to a subset of our portfolio.
Outside of the vet clinic, our leadership in the OTC business provides the diversity of channels and price points desired by many pet owners. Our recent innovation and broad OTC portfolio allow us to take advantage of the resiliency we have seen in the OTC market, particularly with value and treatment offerings, leading to year-to-date growth of 10% for OTC products in retail channels. We continue to see the growth in e-commerce for both OTC and prescription products outpace other channels, where greater enrollment in subscription programs is resulting in higher compliance rates. Overall, we believe our differentiated omnichannel approach across both prescription and OTC products as well as vet clinic and retail channels positions us well in Pet Health in the U.S. and globally.
Moving to international Pet Health. The 16% constant currency revenue growth was driven by better economic environment in Europe as compared to the third quarter of last year and expanded commercial capabilities, contributing to double digit growth for both Seresto and the Advantage family outside of the U.S. Additionally, new products led by Credelio Plus and AdTab contributed to growth. Next, international Farm Animal. The largest revenue contributor of our four quadrants delivered 5% constant currency revenue growth, primarily driven by price, cattle and poultry where growth was enabled by strong underlying markets, share growth and key markets like the U.K. and increased supply capacity. Finally, our U.S. Farm Animal business returned to growth at 2% after several quarters of decline.
Growth was driven by innovation primarily Experior, partially offset by timing of poultry rotations and regulatory changes impacting certain cattle products. We are encouraged by experienced progress and remain confident in the expected annualized run rate of approximately $60 million to $70 million of revenue for the product as we exit 2023. Moving to Slide 6. I'd like to highlight several key drivers of our innovation portfolio and productivity strategy since our last call. Starting with productivity. We are very focused on improving cash conversion to enable debt pay down. While margin expansion remains important, we are broadly prioritizing cash generation acknowledging the leverage we currently carry. The company-wide focus is supported in part by our shift to Elanco Cash earnings, our EVA like bonus metric.
Importantly, we have nearly completed the cash outlay necessary for project cost to support our systems integration earlier this year. With this project behind us and our continued efforts on improving net working capital, we expect improved operating cash flow next year. Moving to portfolio. Price growth was 4% in the quarter with 4% in Pet Health and 3% in Farm Animal. We continue to expect at least 3% for the full year. Importantly, in the third quarter, we saw volume growth in both Pet Health and Farm Animal. Contributing to this, our manufacturing and quality organization delivered improved supply for vaccines in Cattle and Pet Health and expanded capacity in poultry contributing to growth. Overall, we see our core portfolio volumes stabilizing with increased competitiveness of the overall portfolio, driven by first stronger commercial capabilities and then our global omnichannel approach.
And then with the complement of adding innovation into our total portfolio. Now on innovation. Our already launched products continue to gain momentum, led by Experior NutriQuest on the Farm Animal side and Credelio Plus and OTC retail innovations on the Pet Health side with lifecycle management contributing across both. We continue to expect $210 million to $250 million of revenue contribution from these new innovations this year. Our canine parvovirus monoclonal antibody remains on track for supply constraints sales of $5 million to $7 million in 2023. And we expect increased supply availability from our expanded capacity in early 2024, allowing the product to be a key contributor to innovation growth next year. On the late-stage pipeline, we have completed FDA submissions for Credelio Quattro, Bovaer and our JAK inhibitor for canine dermatology which upon approval will be known as Zenrelia.
These three potential blockbusters continue to have a path towards U.S. approval in the first half of 2024. Additionally, we initiated globalization of Zenrelia with submissions in Canada and Japan. We've updated our innovation chart on Slide 7 of today's presentation. This is an exciting time at Elanco as we returned to revenue growth as a company. We are entering a new era of opportunity in Pet Health and in the emerging space of livestock sustainability. We believe these areas will be the drivers of sustainable growth going forward. So let me share a few specifics on our progress in each area. For Pet Health, we are focused on increasing our commercial competitiveness and have previously highlighted the strategic enablers of enhancing our share of voice, expanding physical availability, optimizing pricing and leveraging innovation.
To enhance our share of voice, we're expanding our U.S. Pet Health sales team to deepen relationships with veterinary clinics. We are targeting a 25% expansion, approximately 75 professionals across our veterinarian sales team. There is strong interest from experienced animal health professionals bringing with them relationships and expertise. For our veterinary clinic facing team, the expansion will create smaller territories allowing for more time with clinics and this is expected to drive increased penetration and reorder rates. Next in the share of voice area. Over the last several years, we've transformed our commercial model using data analytics and digital tools to more efficiently and effectively reach veterinary clinics through multi-channel approach.
Through connected touch points, we can reach over 80% of our priority clinics via two or more channels, creating an integrated online and offline experience. When implementing this optimized experience with Zorbium, our post-operative pain product for cats, we saw a 2x increase in sales. Next we have developed an AI-based recommendation engine enhancing our ability of our sales force to deliver the right message at the right time to our customers, leading to increased sales in a pilot earlier this year. We rolled out this Virtual Assistant Platform broadly enabling reps to better prioritize and personalized engagements, deepen relationships and improve conversion. With these enhancements, our sales force is simply more efficient. Products launched using this multi-channel approach and analytics and form engagement strategy reduce the average time to purchase after launch by 28%.
On the OTC side in the area of physical availability, our U.S. Pet Health retail team leveraging their CPG experience has reimagined the opportunity for our OTC parasiticides portfolio. For context, today OTC flea and tick pet products are sold in about 75% of brick and mortar universe in the U.S. However, Elanco products are only sold in about 25% of those distribution points, creating meaningful opportunities to expand physical availability of our products. We are targeting expanded points of distribution in channels like grocery, dollar stores, warehouse clubs and pharmacy with many already secured for next year. Paired with the opportunity to expand with existing customers, this is expected to be a volume growth driver next year and beyond.
Now transitioning to progress we are helping to shape in the livestock sustainability market. Last week Athian in which Elanco provided seed funding announce they have established a first of its kind voluntary livestock carbon inset marketplace, creating the opportunity for a new value stream for farmers by using validated science-based protocols for product interventions like our Rumensin, producers can now monetize third party verified greenhouse gas emissions reductions. Athian has verified its first farms -- creating, certifying and selling carbon credits within the dairy supply chain. Since last week's announcement, a leading dairy processor has committed to purchase the first credits and we're excited about the robust demand we see from leading food companies.
On Slide 8, we provide an overview of the emerging ecosystem and note the importance of food manufacturers, restaurants and retailers within the dairy supply chain who have committed to approximately 100 million metric tons of greenhouse gas emissions reductions. We see this carbon inset market place coming to life and expect to create significant food chain and farmer value that would enable livestock sustainability to become the next $1 billion to $2 billion global market in Animal Health, fueling Elanco's next era of Farm Animal growth. With that, I'll turn it over to Todd.
Todd Young: Thank you, Jeff. And good morning, everyone. Today, I'll focus my comments on our third quarter adjusted measures. So please refer to today's earnings press release for a detailed description of the year-over-year changes in our reported results. We reported a strong quarter with growth in revenue, adjusted EBITDA and adjusted EPS. Starting on Slide 10. We delivered $1.068 billion in revenue, representing 4% reported growth or 5% in constant currency. Foreign exchange rates represented a headwind of $5 million compared to the third quarter of 2022. In our August guidance, we expected a $10 million year-over-year benefit in reported results that did not materialize given the dollar strength. Price contributed 4% and volume growth was 1% in the quarter.
Slide 11 provides revenue by the four quadrants of our business in the quarter. Total Pet Health revenue grew 6% in the third quarter with price growth of 4%. Our U.S. business was flat with growth from price, innovation sales and the return on supply for vaccines offset by competitive pressures in the veterinary clinic. Based on our current view, we assume our retail partners will broadly work down inventories in the fourth quarter in line with last year while continuing to benefit from retail volumes performing much better for us in 2023 even during our current flea and tick off-season. In international Pet Health, constant currency growth of 16% or $27 million significantly contributed to the company's overperformance in the third quarter compared to our August guidance.
Improved market conditions year-over-year specifically in Europe, our differentiated omnichannel approach and innovation drove growth. In the fourth quarter, we expect year-over-year market improvement and the ramp of Credelio Plus and AdTab to contribute to growth. Moving to Farm Animal. Total global revenue grew 4% in constant currency year-over-year. International Farm Animal revenue grew 5% in constant currency, primarily driven by poultry and strength in cattle parasiticides partially offset by slight declines in swine and aqua. U.S. Farm Animal revenue grew 2%, primarily driven by the continued ramp of Experior. Cattle vaccines grew slightly in the quarter and we expect continued improvement in the fourth quarter. Poultry declined as customer rotations onto our products were strong in the third quarter of last year.
We expect improvement in poultry in the fourth quarter as a result of confirmed rotations onto Elanco products including Tyson's reintroduction of animal-only antibiotics or ionophores into their poultry supply chain. Finally, we expect Farm Animal distributors to reduce their purchases in the fourth quarter as they manage their working capital. Continuing down the income statement on Slide 12, gross margin increased 50 basis points to 54.5% of revenue. Price growth and productivity were partially offset by higher inflation, losses, and an approximate 120 basis point headwind from reduced throughput at our manufacturing plants. This headwind is expected to accelerate in the fourth quarter and throughout 2024, but is a key lever as we work to reduce balance sheet inventory and improve net working capital.
Operating expense increased by 6% in the third quarter, driven by increased investments supporting our Pet Health business, higher project spend in R&D and increased people-related expenses. Our increased investment in the business presents a near-term EBITDA headwind, but we expect it will contribute to sustainable top line growth by accelerating innovation contribution and helping to stabilize core volumes. Interest expense was $72 million, an increase of $14 million year-over-year as a result of higher interest rates. Our debt is approximately 76% fixed and interest expense was $8 million below our expectations for the quarter as a result of lower gross debt in capital market transactions that we executed in the quarter, which I will elaborate on shortly.
Adjusted EBITDA was $214 million in the quarter, an increase of 5% compared to the third quarter of 2022. Adjusted EPS was $0.18, an increase of 6% in the quarter. On Slide 13, we include bridge of third quarter results compared to our August guidance. Now let me offer a few words on our cash, working capital and debt on Slide 14. Cash provided by operations was $198 million in the quarter. While inventory was a use of cash in the quarter, performance was better than the third quarter of last year. This was partially offset by a larger benefit from interest rate swaps settlements with $75 million last year compared to $57 million this year. We continue to prioritize efforts to manage our balance sheet inventory, including slowing production at certain manufacturing sites assessing safety stock levels by product and identifying supply chain opportunities to manage API and raw material inputs.
These efforts are expected to deliver benefits to the balance sheet gradually overtime as we implement changes while also prioritizing new product launch supply needs. We've updated Slides 25 and 26 in the appendix to reflect updates to our key debt information. In September, we restructured $3 billion of our interest rate swaps, provide a cash benefit in the quarter that will unwind over the next 12 quarters. And we extended the tenders of the swaps by a year, which will reduce our exposure to interest rate changes until August of 2026. At the same time, we entered into a net investment hedge, which is expected to reduce both our income statement and cash interest expense over the next three years. Based on our third quarter debt pay down in these transactions, we now expect that income statement, interest expense of approximately $280 million in cash interest between $380 million and $385 million in 2023.
If we assume flat interest rates throughout 2024, no more fed rate adjustments. We expect 2024 income statement interest expense of $280 million to $295 million and cash interest between $340 million and $355 million. As Jeff mentioned, year-to-date, we've completed about 90% of the cash outlay supporting our system integration in 2023 and continue to expect a meaningful reduction in project cash costs beginning in 2024. In the third quarter, we paid down $156 million of debt and net leverage declined to 5.7 times from 5.9 times at the end of the second quarter. We remain confident in our full-year debt pay down expectations of $50 million and expect year-end leverage to be between 5.5 and 5.8 times. In the quarter, we recorded a non-cash pretax goodwill impairment charge impacting reported EPS by $2.10, which was excluded from our non-GAAP results.
The accounting charge was primarily driven by the sharp increase in long-term treasury rates used in our goodwill impairment analysis while the expectations for our long-range plans remain consistent. Finally, let's move to guidance on Slide 16. The outlook for our underlying business is above our expectations in the second half of 2023. However, the U.S. dollar has strengthened since August. Today, we are tightening our guidance ranges while reflecting an increase to the midpoint of our expectations for constant currency revenue growth, adjusted EBITDA and adjusted EPS. For the top line, we now expect a headwind of approximately $70 million for the full year or a $40 million increase from our August guidance using foreign exchange rates as of early November.
We expect full-year revenue between $4.36 billion and $4.4 billion representing flat to 1% constant currency growth compared to our previous guidance of 1% decline to 1% growth. We expect adjusted EBITDA of $965 million to $1 billion and adjusted EPS between $0.88 and $0.94 for the full year. As detailed on Slide 17, compared to our August guidance adjusted EPS is increasing more than adjusted EBITDA as we reduce interest expense expectations based on entering the net investment hedge and restructuring our interest rate swaps. We are also reducing our effective tax rate expectations to adjust for lower expected foreign income tax inclusions in 2023 aligned with the actual results in our 2022 U.S. federal income tax return that we filed last month.
Our fourth quarter guidance is detailed on Slide 18. We remain confident in the return to growth for the second half of the year with 2% constant currency growth at the midpoint for the fourth quarter. As detailed on Slide 19, we expect the innovation sales ramp, price, improved supply and improved EU pet retail market and growth in poultry to be the key drivers of growth, partially offset by anticipated competition in the U.S. vet clinic and expected working capital optimization for distributors, providing a headwind in the quarter. Now, I'll hand it back to Jeff for closing comments.
Jeff Simmons: Thanks, Todd. Our continued sequential improvement in performance thus far in 2023 demonstrates our strategy is working, as we are laying the groundwork for a return to sustainable revenue growth. As we looked at 2024, I want to provide some early considerations on Slide 20. First, on the headwinds. Well-known competitive pressure in the U.S. vet clinic remains in 2024, while our commercial efforts are helping to stabilize our base volumes. On the Farm Animal side, we're watching generic competition and continued low U.S. cattle numbers. Beyond the top line, we expect to continue to manage our internal inventory and make investments in sales and marketing for the launches. While these will create tension on margins, they are expected to deliver long-term value.
Finally, using early November foreign exchange rates, we anticipate that the headwind from the U.S. dollar strength will continue into next year. As we think about the tailwinds in 2024, we're confident in constant currency revenue growth for our business next year. Contributions from innovation will accelerate with the ramp of existing products. Experior, our parvovirus monoclonal antibody, Credelio Plus and AdTab, with 2024 launches expected to contribute to growth, primarily in the second half of 2024. Strategic price growth and stabilizing core volumes will be enabled by our differentiated global omnichannel approach and strategic leverage of our diverse portfolio. All underpinned by our enhanced capabilities and leadership. Elanco has momentum going into the fourth quarter, with exciting expectations for innovation contribution and growth in 2024.
We believe the external environment is manageable, and we are building a portfolio and capabilities to sustain a positive trajectory going forward. With that, I'll turn it over to Katy to moderate the Q&A.
Katy Grissom: Thanks, Jeff. We'd like to take questions from as many callers as possible. So we ask that you limit yourself to one question and one follow up. Operator, please provide the instructions for the Q&A session. And then we'll take the first caller.
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