Description

Elanco Animal Health Inc (ticker: ELAN, or “the Company”) was last written up in January 2020 by Flaum. Quick background is probably warranted but want to point VIC members back to Flaum’s write up for an overview of the attractive dynamics in the Animal Health industry along with a more detailed overview of the Company.

Elanco is one of the top 4 global providers of pharmaceutical products to the Companion Animal (pets) and Farm Animal (livestock, poultry, swine) industries. These businesses are generally high margin and high multiple given incumbent providers have major competitive advantages. Elanco trades at a wide discount to both public company peers and recent precedent transaction multiples in the industry.

Since Flaum’s 2020 write up, Elanco has been on a wild ride culminating with the stock being down ~50% since early 2020. The sequence of events that has transpired since then are listed below:

1. Covid Pandemic
2. Completion of the Bayer Animal Health transaction (August 2020)
3. Investor day (December 2020)
4. Activist engagement from Sachem Head (December 2020)
5. FY 2022 - Consistently missing / lowering guidance, disappointing street and investors (2022) while levered equities were beaten to death in a rising interest rate environment (2022)
6. Major standup / integration spend (~$1b) from IPO and Bayer acquisition that impacted cash conversion (2019-2023)
7. Failure to achieve any financial targets set out at the IPO/Post-Bayer completion/Investor Day (2018-Present)
8. Peak to trough drop of ~75% in Elanco’s stock price (2020-2023) which has rebounded to being down ~50% at today’s levels

Taken together these events / issues resulted in a total capitulation in the stock price over the last several years. Below I attempt to decompose the events that I believe were the leading causes of the drop in the stock price:

1. Bayer Acquisition
   1. Positives - transaction represented good industrial logic on paper, enabled Elanco to gain much needed scale as a standalone company, shifted portfolio mix to ~50/50 companion animal vs farm animal (much more similar to Zoetis), and catapulted Elanco to the #2 player in the space behind Zoetis.
   2. Negative – transaction was ~$8b, Elanco paid ~18x LTM EBITDA, and levered the balance sheet to ~7x EBITDA at the time of closing the transaction in August 2020.
2. Investor Day 2020
   1. Positives - Elanco held an investor day in December 2020 where management highlighted a path to above industry average revenue growth, ~400bps of gross margin expansion (56% to 60%), ~1,000bps of EBITDA margin expansion (low-20%s to low-30%s), Operating Free Cash Flow north of $1b, and leverage declining to sub-3x by 2023.
   2. Negatives – Elanco has failed to achieve any of the financial targets they set at the investor day as we enter 2024. Consensus estimates for Gross and EBITDA margins are 56.5% and 21.8% and leverage is north of 5x net debt to EBITDA.
3. Fiscal 2022
   1. It is difficult to find any positives for Elanco in 2022 as the stock was crushed on the back of missing and lowering guidance all 4 quarters in 2022 and coming to market with a lower outlook for 2023. To make matters worse, after stubbing their toe every quarter in 2022, levered equities were smoked given the rising rate environment which resulted in Elanco’s interest expense increasing +40% from 2022 to 2023 due to the Company variable rate exposure.
4. Major Standup / Integration costs
   1. Positives – IPO and Bayer integrating costs are finally behind the company and should be next to nothing in 2024 and moving forward
   2. Negatives – ~$1 billion of project costs materially masked FCF generation and limited Elanco’s ability to delever the balance sheet.
5. Failure to achieve any of the financial targets mentioned above
   1. Managements failure to achieve any of the margin, FCF, or leverage targets damaged their credibility with shareholders considering management pushed out the achievement of these targets to a date TBD on the Q2 earnings call in 2022.  
6. Major value destruction
   1. Peak to trough drop of ~75% in Elanco’s stock price (2020-2023). Stock has rebounded some over the last 4 months – given better than feared Q3 results in 2023 and momentum exiting FY 2023.

So where do we go from here and why is Elanco interesting at these levels after what has transpired over the last several years? Elanco is still a top 4 global player in the animal health industry, has an ~$8 billion market cap (remember they paid ~$8b for Bayer), and is trading at a wide discount to public peers and precedent transaction multiples at 13.6x and 12.7x 2024 and 2025 EBITDA. I believe the Company has / is turning the corner on driving meaningful value for shareholders after posting a better-than-expected Q3 2023 earnings release in November 2023.

As we enter 2024 the narrative around the Company is entirely about execution related to its product pipeline. Elanco has several blockbuster products in various stages of approval and commercialization as indicated by the graphic below. There products represent potential blockbuster opportunities (+$100mm in sales) for Elanco and are expected to drive meaningful topline growth while also dropping to the bottom line at high incremental margins (well north of current consolidated margins).

Three of the four products are expected to achieve regulatory approvals in 1H 2024 with commercialization in 2H 2024 with the remaining blockbuster slated to be approved in early 2025. If the current management team can execute on the product pipeline over the next 12-24 months, then I estimate Elanco is set to see its valuation expand into the mid-teens on an EBITDA multiple basis. Elanco is forecasting $600-$700mm in innovation pipeline revenue in 2025 as referenced by the graphic below:

Additionally, FCF has not lived up to expectations because of the failure to improve margins and drive down project costs. Given the leverage profile, many shareholders have waited to see the inflection in FCF to get interested in the story. We anticipate FCF will improve meaningfully as we move through 2024 and into 2025 due to the large project costs wrapping up exiting FY 2023. This should enable the Company to begin delevering the balance sheet over the next coupe of years.

Two other points to mention as we wrap up the investment pitch. In December 2023 there was a Bloomberg report than activist Ancora was targeting Elanco with replacing the CEO and refreshing the board (https://www.bloomberg.com/news/articles/2023-12-14/activist-ancora-said-to-push-for-changes-at-elanco-animal-health). I believe any pressure from shareholders would be well received by a frustrated shareholder base but also estimate this could prove to be a lightning rod for the incumbent management team to start making the appropriate decisions to drive value. Dovetailing from the activist rumors to value creation initiatives, the Company did announce yesterday a sale of its Aqua business to Merck Animal Health for $1.3 billion (https://www.prnewswire.com/news-releases/elanco-announces-sale-of-aqua-business-for-1-3-billion-302053143.html). Elanco commented the business segment was non-core looking forward, that the after tax proceeds ($1.1b) would be used to reduce debt, and that the approval path for the three blockbuster products remained on track causing a 10% jump in the stock.

Pulling this all together, I believe Elanco has turned the corner, the last 4 years are finally behind the company, and the prospects for Elanco are much brighter now if the management team can execute. Delivery of the innovation pipeline, improved FCF conversion and margin expansion should yield a much higher trading multiple for Elanco. Based on 2025 consensus EBITDA, a 15x EBITDA multiple, and two years of delevering with FCF I believe Elanco can trade in the low-mid $20s ($22-$25) representing 40-50% upside from current levels. Activist pressure helps hold the Company accountable to deliver on their promises over the next 18 months and I believe Elanco could achieve a much higher return if management achieves targeted margin levels post FY 2025.

Catalyst

• Execution on innovation pipeline - getting 3 blockbsuter approvals across the finishline in 1H 2024 with clear path to commercialization in 2H2024 
• Management to reestablished credibility with investors and the street
• Stable to lower interest rate environment 
• Continued value creation initiatives by the Company
• Actist pressure results in meaningful changes to BoD, management, strategy 
• FCF and asset sale proceeds to delever balance sheet to reseasonable levels