Elanco Animal Health Incorporated

into vet clinics and alternative channels was up mid-single digits in the third quarter, in line with our reported U.S. pet health revenue trends after adjusting for last year's benefit from the initial stock in at a large retailer and this year's divestitures. We continue to closely manage inventory in the distribution channel to stay at target levels, and we exited the third quarter with inventory levels consistent with the second quarter. Moving to our farm animal business, COVID-19 pressures are lessening in the U.S., while the pandemic was a greater factor in certain international animal health subsectors in the quarter. Globally, we estimate that COVID represented a $35 million headwind to legacy of land goal revenue in the quarter, in line with our guidance. About a quarter of that impact was felt domestically, primarily in swine. These challenges on the U.S. protein supply chain and on our business eased sequentially through the period. We've been encouraged by the higher cattle on feed numbers and the diminishing pork processing backlog, allowing for improved producer margins in both cattle and swine since the summer slows. While the momentum is promising, we do expect the timeline for industry normalization to still extend into 2021. For Reminson, we see sustained commercial strength, despite generic disruption. Our market share assumptions are tracking better than originally planned after 12 months of competitive entry, as our team is successfully demonstrating the product's meaningful therapeutic and quality differences to customers. In our international business, let me start with pet health, where markets around the world appear to have broadly stabilized in the quarter. with some variances by country. Credelio was a growth driver in the quarter outside of the U.S., driven by market expansion and uptake of Credelio for cats in Europe. On the farm side, our international future protein and health portfolio was negatively affected by unfavorable macroeconomic conditions and reduced consumption trends. As a result, the industry has seen pressured prices and producer profitability across species, most notably poultry and aqua markets. In the global poultry market, we've seen acute production declines and reduced export opportunity in certain regions, particularly Central America, the Middle East, and India, which more than offset growth in markets like China and Vietnam. Poultry prices have dropped to an outsized degree due to relatively high dependence on food service sales, including restaurants and wholesale markets. Balancing local supply with volatile demand has proven challenging for global producers. Production growth estimates this year vary widely, from up 15% in China compared to declines of 8% and 10% in Thailand and India, respectively. We believe these near-term industry headwinds have impacted Elanco more acutely as a result of our unique portfolio composition, which is weighted towards premium price feed additives. As poultry producers experience greater economic pressure, we see trade-out of performance, food safety, and premium products, while biologics and disease treatment products tend to remain more stable. Transitioning to aqua, we've seen severe macro-related shocks to the industry, with salmon prices down 40% since the start of the year. These adverse economic conditions have impacted producers' use of premium solutions like Clinapp. However, we expect aqua to still provide growth for 2020 in total, and we see the potential for a return to robust sales growth and market share gains next year. This volatile international backdrop and future protein in health is likely to persist in 2021, but we continue to view both species as important growth drivers for a length over time. Although our international ruminant and swine portfolio was pressured by macroeconomic conditions and decreased producer profitability, our Asia swine business provided a partial offset. This business experienced healthy growth in the quarter as the recovery continues compared to last year's African swine fever headwinds. Both Legacy Atlanco and Legacy Bayer China swine sales were up robustly year over year, and both also saw a more than 30% improvement compared to the third quarter of 2018. Finally, let's discuss Bayer Animal Health's side of our newly combined organization. For July, Bayer reported animal health revenues of €166 million or approximately $191 million. As I mentioned earlier, Legacy Bayer contributed €196 million in the remainder of the quarter for Elanco, totaling about €387 million combined for Q3. This represents approximately 3% growth for the quarter, excluding the impact of divestitures. the Bayer business experienced robust growth in the first seven months of the year, driven by retailer stock in to support higher demand as a result of COVID and the blackout period ahead of the deal close. In the third quarter, we observed some unwind of this inventory pull from retailers. But overall, we believe the Bayer business remains in line with the 4% to 5% underlying growth that we estimated in the first half. The strength reflects Seresto, now our largest single product on a pro forma basis, which added nearly $20 million to Elanco's revenues for the quarter. Advantage family revenue was $55 million, and performance for both in the quarter was impacted by seasonality, the unwind of retailer stock-in, and system cutovers. In just our first few short months together, I'm encouraged by how well the integration is progressing. Our team is managing the complexities of an acquisition of this size while still completing our stand-up to be fully independent from Lilly. As I mentioned earlier, we are moving with speed as evidenced by our initial restructuring announcement. We remain on track for $275 to $300 million in total synergies, including the first two-thirds in the first 30 months. Our combined team is focused on commercial competitiveness, delivering innovation, and realizing synergies, especially as we continue to navigate a challenging macro environment. We have the right plans in place, the right people to execute them with strong momentum into the balance of the year and beyond. Moving to slide six, we continue to see strong progress against our IPP strategy. Let's look at a few of the key milestones and achievements on the strategy during the quarter. Starting with innovation, we received two new approvals since our last earnings call. The first is the European Commission approval for INCREXA, a product for bovine and swine respiratory disease, which will be a valuable complement to our farm animal portfolio. In October, we also received U.S. FDA approval for Allura, a weight loss management treatment for cats with chronic kidney disease. With these two products alongside Xperia and Kosa Body, we remain on track towards at least five launches by the end of 2021 and 25 by the end of 2024. Bigger picture, we're taking a holistic approach to innovation. Many shots on goal, including differentiated efforts in large addressable markets. I'm excited about our pipeline potential, which will fuel a part of our growth algorithm over the long term. We look forward to sharing more at our investor day on December 15th. On the portfolio front, we have a solid group of focus brands that drive our growth. The 14 legacy Elanco products launched or acquired since 2015 grew 18% in the quarter. Excluding divestitures and adjusting for last year's initial stock in at a new retailer is shown on slide 17. Through Bayer, we have an enhanced portfolio and capabilities to serve customers across all channels globally. Bayer tripled the size of our international pet health business, where Seresto and Advantage still have a long runway ahead, especially in markets like China. On the U.S. side, the combined Elanco is now a leader in the flea, tick, and heartworm retail market and outgrew the industry in these alternative channels in the quarter. Finally, on productivity, we remain relentless on operating expense and cash management in the quarter and layered on incremental savings from reduced travel and related expenses. We also continue to drive manufacturing efficiencies and are on track to realize the $215 million in savings and cost avoidance as planned from 2018 through the end of the year. We expect to share more on our next phase during our December investor meeting. Additionally, we maintain price discipline in the quarter, up over 2% for legacy Elanco. Price and productivity contributed to our 54.2% gross margin performance, which Todd will detail in a moment. As I look to next year and beyond, our IPP strategy has uniquely positioned Elanco within the animal health sector. Our strategic actions since the IPO have set the stage for meaningful value creation for all of our stakeholders moving forward. With that, I'll turn the call over to Todd to provide more color on our results and outlook.

Thanks, Jeff. Slide 7 summarizes our presentation of GAAP results, while slide 8 describes the items considered in the adjusted financials. Slides 18 to 21 in the appendix provide a summary of the adjustments made to the GAAP results to arrive at our adjusted presentation. I'll focus my comments on our adjusted measures in order to provide insights on the underlying trends in our business, so please refer to today's earnings press release for a detailed description of the year-over-year changes in our third quarter GAAP results. I'll also remind you that our third quarter 2020 results include two months with bear animal health. Looking at the adjusted measures on slide 9, you'll see that total Elanco revenue increased 15% of the quarter on a reported basis. Foreign exchange had a 1% negative impact. I'll break down the effect of Bayer on our revenue growth in further detail in a moment. Gross margin as a percent of revenue was 54.2%, an increase of 90 basis points compared to the third quarter of last year. The improvement was driven by the inclusion of Bayer's higher margin business, positive price on Elanco's legacy portfolio, continued productivity gains, and an absorption benefit in advance of our go-live on our new independent Elanco ERP system in the first quarter of 2021. Partly offset by legacy Elanco mix headwinds, as well as the cost of our fixed manufacturing footprint spread over lower total sales at our legacy business. Total operating expense increased 40% in the third quarter, including the addition of the Bayer Animal Health business in August and September. As a percent of sales, operating expense increased from 34% in the year-ago period to 41% in this period, reflecting the impact of cutovers in August, as Bayer's costs hit our P&L on day one, while sales experienced a blackout period of about two weeks. At Legacy Elanco, operating expense continued to reflect cost management as many parts of our business are still operating virtually. Operating income decreased 22%. At the bottom line, Q3 adjusted net income decreased 46% to $60.3 million. The Q3 effective tax rate was 9.7%, reflecting the decrease in international income that was subject to the GILTI tax, which was introduced through U.S. tax reform in 2017. Our adjusted EBITDA margin was 16.6%. On slide 10, you can see the effect of price, rate, and volume on our revenue performance. The benefit of the bear acquisition is reflected in volume. As is typical with acquisitions, we will continue to report the addition of the Bayer business in volume for the next four quarters. For the legacy Elanco business, price was up 2% for the quarter, demonstrating the value of our innovation and the ongoing discipline we are applying despite competitive pressures. Slide 11 provides more detail on our overall performance in the U.S. and internationally, both of which were impacted by COVID, but also benefited from the addition of Bayer. In the U.S., total revenue increased 9%, and international revenues grew 23%. We expect to file our 10Q shortly, but moving to slide 12, let me now provide an update on working capital, cash, and our debt leverage, including our recent term loan paydown. As we have discussed, working capital is an area of focus for us. In the U.S., consistent with Q2, we held all distributors at 60-day payment terms. In the third quarter, day sales outstanding continued to improve sequentially, standing at 67 days versus the peak of 103 days in the first quarter of 2020. We ended the third quarter with $660 million in cash and equivalents on our balance sheet. As announced at the end of the quarter, we repaid $100 million on our term loan that funded the Bayer Animal Health acquisition. We will continue to repay debt from our operating cash flow in 2021 with a focus on our $500 million note, which is due in August of 2021. Our net debt leverage ratio stood at 6.4 times at the end of Q3. During October, we borrowed $250 million on our revolver to fund local country asset purchases as part of the Bayer acquisition. Once the purchases are complete, Bayer AG will pay Elanco the $250 million purchase price back, which we will use to repay the revolver. This circular transaction should be completed this year. 2020 remains a uniquely cash-heavy year, given the stand-up of the independent Elanco ERP system and IT infrastructure, the execution of the acquisition, and the build of the requisite ERP infrastructure for the Bayer business. we now estimate total cash costs for the independent company stand-up to be in the range of $280 to $320 million net of certain offsets. The increase versus the prior range of $240 to $290 million primarily reflects higher costs to execute local country IT infrastructure deployment and transitions as a result of the COVID-19 pandemic-related travel restrictions and protocols, as well as increased site cutover and additional scope costs. The vast majority of our global team are now operating in the Elanco IT infrastructure environment, and we remain confident in completing the stand-up of the independent Elanco with the Elanco ERP cutover in Q1 of 2021. The completion of the ERP transition will drive the culmination of the remaining Lilly Transitional Services Agreements. Additionally, as we shared in the pro forma financials in the October 15 8K filing, I want to note that Elanco capitalized approximately $72 million for the ERP infrastructure supporting the Bayer business. Now I will transition to our outlook on slide 13. For the fourth quarter of 2020, we expect Elanco total revenue to be between $1.02 billion and $1.06 billion. Our fourth quarter guidance includes an estimate of approximately $20 to $30 million of COVID-related headwinds, primarily in our farm animal business. We are also monitoring the potential impact of another phase of broad shutdowns, including actions currently being taken in Europe. However, our guidance does not reflect a broad U.S. or international shutdown as we saw earlier this year. On the bear side of our global pet health business, the fourth quarter will reflect an estimated $10 million of continued reversal of revenue pull forward due to COVID and IT cutovers. For the full year, we believe that retailers are holding an additional $25 million of inventory compared to 2019, and that this incremental balance is appropriate to match bear's larger sales base and strong underlying trends in recent periods. as well as the larger trend across consumer packaged goods, with retailers reacting to the ongoing COVID backdrop and rising case counts. Additionally, fourth quarter revenue guidance incorporates a number of other discrete headwinds to growth, including divestitures as part of executing the bear trend acquisition, lapping sales of POSLAC inventory, awaiting regulatory clearance in India, and the impact of deferring the typical January 1st price increases at bear to our February timeframe. The treatment of certain trade funds as SG&A under IFRS versus a sales reduction under our U.S. GAAP accounting also reduces legacy bear sales compared to all prior periods. Importantly, however, our outlook is grounded in underlying growth trends on both sides of the business that are in line with our fundamentals year-to-date, including continued 4% to 5% underlying growth for Bayer's global portfolio. We are not introducing EPS guidance at this time, given the volatile macroeconomic backdrop and the unpredictability of potential future effects from COVID-19. We expect to provide more details on the fourth quarter at our investor day in addition to 2021 guidance. In the meanwhile, let me offer some commentary on operating metrics. We anticipate a sequential deceleration in gross margin from the third quarter's result, reflecting our normal seasonality step-down as a result of plant maintenance and shutdowns, sales seasonality for Soresto and the Advantage family, and the reversal of the absorption benefit in advance of Elanco ERP cutovers in January, as well as ongoing mixed headwinds and fixed costy leverage. We expect to continue to capture productivity efficiencies and remain disciplined on price. Furthermore, the quarter will include three months of bears higher margin business. With respect to operating expenses, we anticipate year-over-year declines for both Legacy Elanco and Legacy Bear relative to the pro forma expenses provided in our October 15th 8K filing. Our outlook reflects benefits from the continued cost management initiatives and ongoing reductions in travel expenses. Value capture actions are on track, but we remain very early on the curve to realizing benefits. Now I'll hand it back to Jeff for closing comments.

Thanks, Todd. Let me summarize. We closed the third quarter as a stronger enterprise, seeing positive progress from key strategic decisions with the inclusion of Bayer and the distribution model shift. We are executing with discipline and urgency to deliver on our stated expectations for the quarter, achieving results at the high end of our guidance. We are gaining share with key pet health products and entering the balance of the year with momentum. We are moving quickly on the integration and making the tough decisions necessary to capture value. The final phase of our independent stand-up is underway and on track for completion in early 2021. Our IPP strategy is working with a combined stronger portfolio, greater access to the world's animals, and through a pipeline that is progressing, and with a productivity agenda that continues to enhance margin growth. I want to end today on slide 14, highlighting the 2030 Elanco Healthy Purpose Sustainability Commitments we unveiled last week. These decade-long commitments support the United Nations Sustainable Development Goals and are a first of its kind in the animal health industry. Our protein, planet, and pet pledges aim to provide improved access to nutritious protein, reduce the company's and our customers' footprint on the planet, and increase the health of the pet to support people's well-being. We outline these pledges in detail on our website at elanco.com. But it all starts with a healthy and strong enterprise driven by the growth, innovation, and margin expansion agenda against which we are executing. Through these efforts, Elanco is focused on creating value for our customers, employees, shareholders, and society as a whole. With that, I'll turn it over to Tiffany to moderate the Q&A.