We are lowering our rating on Elanco Animal Health Inc. (NYSE: ELAN), a leading animal health company, to HOLD from BUY. The company, a September 2018 spinoff from Eli Lilly, makes health and nutrition products for both companion and food animals. Elanco acquired Bayer’s animal health business for $6.89 billion in early August in a deal that management expects will benefit the company’s position in the Companion Animal market. It views the deal as a way to benefit from Bayer’s e-commerce and retail leadership and R&D platform, while also keeping the business out of the hands of competitors. However, while management expects to achieve $275-$300 million in synergies by 2025, the deal has significantly increased the company’s leverage and weighed on margins. Elanco also faces pressure from the COVID-19 pandemic, particularly in the Farm Animal market amid declining demand for protein. While the pandemic-related challenges now appear to be subsiding, it will likely take several quarters before the company is able to outperform peers. As such, given the challenges of integrating the Bayer business and the increase in debt, as well as the continued impact of the pandemic, we believe that a HOLD rating is now appropriate. We would consider an upgrade on signs of sustained margin improvement, a stronger balance sheet, or a return to growth in the protein market.
The beta on ELAN is 0.98.
The company completed its acquisition of Bayer’s animal health business on August 3. The deal, valued at $6.89 billion, was funded by $5.17 billion in cash and ELAN common stock. According to the Wall Street Journal, it was spurred in part by Bayer’s decision to divest certain assets amid ‘mounting liabilities’ from Roundup herbicide lawsuits. As Elanco had sufficient financing to complete the acquisition, it viewed the deal as a way to benefit from the Bayer unit’s e-commerce and retail leadership and R&D platform, while also keeping the business out of the hands of competitors. In order to meet antitrust requirements for the acquisition, Elanco divested four products, representing $120-$140 million in annual revenue. The deal has expanded the scope of Elanco’s Companion Animal business and is expected to deliver $275-$300 million in synergies by 2025, with roughly $100 million expected to be realized by 2H21 and two-thirds expected in the first 30 months after the closing.
Due to the pandemic, Elanco’s distribution partners have faced liquidity and working capital issues amid signs of slower end-user demand, leading Elanco to make changes in its distributor relationships. Historically, the distributors would fill out their inventory levels, buying significant quantities of Elanco products in order to be prepared for any level of demand. They would also provide additional sales support alongside Elanco’s own sales team. However, Elanco has now shifted to a leaner approach, restocking distributors’ channel inventories only when supplies begin to deplete. Nevertheless, management noted that this issue has now been resolved, leading to no further expense in the third quarter.
Beyond the pressures on distributors, management discussed other effects of the pandemic on its business. During the third quarter, the company’s faced a $35 million headwind from the pandemic, toward the low end of its guidance of $30-$50 million, with roughly a quarter of the impact felt domestically, primarily in swine products. Management expects to record a $20-$30 million COVID-19-related impact in 4Q20. Management noted that the pandemic continues to pressure global protein markets, notably poultry and seafood, although conditions have begun to improve in the companion animal market.
On November 6, Elanco reported 3Q20 results that beat analyst expectations for earnings, but missed on revenue. Third-quarter adjusted earnings fell 57% to $0.13 per share, but beat the consensus estimate of $0.12. Revenue grew 15% as reported, or 16% in constant currency, to $890 million, but missed the consensus forecast by $28 million. Excluding contract manufacturing, constant-currency revenue rose 17% to $874 million. In the first three quarters of the year, earnings fell 58% to $0.35 per share, while revenue fell 7% to $2.13 billion.
The company expects to generate $1.02-$1.06 billion in total revenue. Core revenue.
EARNINGS & GROWTH ANALYSIS
Elanco generates revenue mainly from its Farm Animals segment (53% of total 3Q revenue) and its Pet Health segment (45%). In 3Q, it generated the remaining 2% of revenue from contract manufacturing, formerly Strategic Exits. Third-quarter segment results are summarized below.
The Farm Animal segment saw revenue grow 3% to $473 million.
The Pet Health business offered stronger performance in the third quarter, generating revenue of $400 million, up 36% from the prior year.
Management typically keeps a close eye on expenses. The 3Q20 non-GAAP gross margin was 54.2%, up 90 basis points from 3Q19, driven by the inclusion of Bayer’s higher-margin business, favorable pricing, continued productivity gains, and an absorption benefit in advance of the launch of a new independent Elanco ERP system in 1Q21. The increase in the adjusted gross margin was partially offset by headwinds from the legacy Elanco business and less favorable fixed-cost leverage.
Elanco’s ‘three-pillar’ growth strategy focuses on portfolio development, innovation, and productivity improvements. With regard to its portfolio, management noted that its acquisition of Bayer’s animal health business provides the company with greater scale and an expanded geographic scope, particularly in Pet Health.
Looking ahead, the company has five launch-equivalent products in its pipeline that it expects to launch by the end of 2021, of which four have already received approval, and 25 that it expects to launch by 2024.
On the productivity front, Elanco continues to improve its business processes. Despite the COVID-19 pandemic, the company was able to advance its manufacturing productivity, independent company stand-up, and ERP development initiatives.
FINANCIAL STRENGTH & DIVIDEND
We view average levels as 50%-55%. The substantial increase in debt stemmed primarily from Elanco’s use of a $4.275 billion term loan B debt financing commitment, which became effective following the Bayer acquisition.
Our view of an average interest coverage ratio is 10-12. The adjusted profit margin was 6.8%, down from 14.5% in 3Q19. Moody’s downgraded the company’s debt to Ba1/stable from Baa3/rating under review on January 27, 2020. S&P downgraded its debt to BB/stable from BB+/creditwatch negative on August 5, 2020 following the Bayer acquisition.
Elanco does not have a dividend or share buyback program.
MANAGEMENT & RISKS
He joined former parent company Eli Lilly in 1989 and became president of Elanco in 2008. CFO Todd Young joined the company in November 2018. He previously served as CFO at ACADIA Pharmaceuticals.
Investors in ELAN shares face risks. The company faces intense competition and could be hurt by unexpected changes in veterinary medical practices and animal health technologies, as well as by adverse government regulation. As a global company, Elanco also faces currency and trade risks. The acquisition of Bayer’s animal health business has also substantially increased the company’s leverage. It could also be impacted by changes in consumer preferences that lower demand for beef, pork, and poultry, such as the rise of plant-based meat alternatives, or by changes in animal health trends, such as the emergence of African swine fever, which could lower supply.
The COVID-19 pandemic has created risks for Elanco. These risks include a decline in revenue from consumers not making trips to veterinarians and challenges for meat producers due to reduced restaurant dining. The COVID-19 pandemic has also caused ELAN’s distribution partners to reduce inventories and cut back on purchases. Additionally, restrictions on travel have increased costs associated with the integration of Bayer’s animal health unit.
Elanco Animal Health, based in Greenfield, Indiana, provides products for both companion and food animals. It is currently the second-largest animal health company in the world following its acquisition of Bayer’s animal health business. Founded in 1954 as part of Eli Lilly, it was spun off from Lilly through an IPO on September 24, 2018. Elanco sells its products in more than 90 countries and has a market capitalization of approximately $10.3 billion. The company has 6,080 full-time employees.
It then fell sharply in the coronavirus selloff. While the stock has largely recovered from this plunge, rising above its January 2020 highs to its latest 12-month high in October, the shares have lately returned to their long-term pattern of decline, stalling out before reaching their highs of June and July 2019. The stock is currently trading about 18% above its 200-day moving average but about 2% below its 50-day.
However, given the challenges of integrating the Bayer animal health business and the increase in debt, as well as the continued impact of the pandemic, we believe that a HOLD rating is now appropriate. We would consider an upgrade on signs of sustained margin improvement, a stronger balance sheet, or a return to growth in the protein market.
On December 8, HOLD-rated ELAN closed at $29.79, up $0.44.