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.

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. Michelle, please provide the instructions for the Q&A session, and then we'll take the first caller.

Okay. So at this time, if anybody would like to ask a question, please press star 1 on your telephone keypad. Again, that is star 1 on your telephone keypad. Your first question comes from Michael Riskin from Bank of America. Your line is open. Thanks.

I'll just ask one to make sure everyone gets enough time. I want to focus on the livestock business in the quarter. I mean, I recognize some of your comments and prepared remarks, Jeff, but if we just look at what some of the peers were able to accomplish, you know, Merck Animal Health Livestock was up 8%, Zoetis Livestock was up 9%, Fibro Livestock was up 5%. And it looks like the legacy Alonco business declined pretty meaningfully in the quarter. You know, if we try to back out Bayer's contribution, I'm getting something like a double-digit decline. So can you go into that in a little bit more detail? What's the discrepancy here? You know, is it anything by species, by geography, sort of what sticks out? And then how do we think about that in 4Q? You know, despite COVID headwinds, it seems like other businesses are able to work through them and benefit from some timing impacts in cattle. You know, when can we expect that to start showing up for Alonco?

Yeah, thanks, Michael. I think, first of all, differences in portfolio in places where the business is. I think, first of all, we feel very good about the fundamentals and the improvement, as I've said, in cattle and swine in the markets. I mean, the markets are improving post-COVID. Plant capacity, the diminishing backlog, as I mentioned, in pigs. And I see that being a positive. I think overall, and I would stay on some of the positives, again, strong swine recovery from African swine fever. So, these are just some of the key, I would say, pushes, and then I'll share some of the differences that you outlined. I think on the positive side, we see strong swine growth, even relative to 2018. as I said, both on the Bayer side and the Elanco side in the Asian area. That is the positive. We continue to see what we would say is strong, positive fundamentals in our overall business when you look at the U.S., What I think are some of the differences is, one, you know, we've got finishing one year in relative to generic reminiscence, and that is a – we're doing well relative to our expectations, but there is a decline there. And then the highlight to me is really poultry and aqua. We continue – they've been major growth drivers for us as future protein and health. They will continue to be. But what we've seen is, one, the salmon industry, which is a big part of our growth – and a big part of our plans this year that has been impacted by industry dynamics, not by market share, not by where our products sit, but just actually by the economics of the industry and its impact on pulling away from use of animal health products. Second is international poultry. Again, a pretty significant 75% to 80% of our future protein and health is poultry and a big international poultry business. And that's been impacted as well by, again, the impact of kind of the lingering effects of COVID and the pulling back of usage on certain animal health products. Again, as we look going into 21, there's no question some of these trends will persist a little bit in the COVID impact. But as I look even into 21, one, introduction of new products. Two, the fundamentals of where our share are. And poultry and aqua recovery, we continue to see them as key growth drivers. And the future of protein and health being a key growth contributor starting in 2021. Okay, so I would say as a whole, we feel very good relative to our expectations. There's just been a setback a little bit relative to international poultry and aqua.

I will take the next caller, please. And your next question will come from Nathan Rich from Goldman Sachs. Your line is open.

Good morning. Thanks for the questions. Jeff, I wanted to ask on the pipeline. Obviously, bringing new drugs to market and having that flow of innovation is a key piece of the revenue outlook. This is an industry, obviously, where visibility on the pipeline has been pretty limited. You talked about sharing more details at the analyst day. Can you talk about the type of disclosures we're maybe likely to get there, and what you see at a high level as the most attractive market opportunities? And just a quick follow-up, you talked about the four recent approvals. Any details you can provide on the timing of those launches as well as the potential market opportunity would also be helpful. Thank you.

Yeah, thank you, Nathan. So, real quick, I would just say at a very high level, we feel very good about where our pipeline is, as I've shared, at a high level, and we'll get into some of the detail. We have 25 new products, five from Bayer, 20 from Elanco. We see that as our starting point. That's what we'll highlight and talk about at the investor conference. At least, as I mentioned, five between now and the end of 2021 with four approvals. I'll look for Pet Health to contribute beyond in the remainder of the approvals here for this next year. And I think what you're seeing this year, you're going to see going forward, one, a mix of bigger, more significant products and bigger, more material markets, as well as strong innovations that can play an added contribution in our overall portfolio. So, a constant flow of innovation. We see this constant over this next five-year period. a contributing factor. What we're going to do at the investor conference is to highlight the markets, the market spaces we're going into, parasiticides, pain, therapy, aging dog and cat therapy on the pet side, antibiotic replacements, and continued therapy on the livestock side. We're going to talk about what we see in those markets and how our innovations will contribute into those, all while balancing the competitive exposure to this. But what I would say to you is I feel very good. about the portfolio we have. I feel very good about Bayer's contribution that they bring relative to pipeline and capability and size and scale and a constant flow of innovation that'll be the lead growth driver in our algorithm of growth that we'll talk about at the investor conference.

Next question, please. And your next question comes from Erin Wright from Credit Space. Your line is open.

Great, thanks. I wanted to clarify, what does the fourth quarter guidance assume in terms of the underlying growth for Bayer and Alonco, separately excluding divestitures? And if there's any, what sort of major destocking, stocking dynamics we should be aware of in the fourth quarter? And even into 2021, if there's some moving pieces we should be aware of there. I think you mentioned the $25 million in inventory in the channel. Is that companion animal or production animal? And then a follow-up question on the advantage business. Can you give us an update on the long-term assumptions for that business, at least how it's shaping up from a competitive standpoint, how it's playing into that alternative channel as well? That would be helpful. Thanks.

Aaron, it's Todd. Thank you for the question. Overall for Q4, we've not separated out Bear versus Elanco as part of the guidance. We have pointed out a number of the one year-over-year items that are in play, including, you know, Registration in India hasn't happened yet, so we get the economic benefits, but we don't get the sales. We do think retailers are still holding a little more Bayer product in the U.S. pet health retail chain, and that's about $10 million unwind in Q4. uh with respect to the 25 million you mentioned we that's also u.s pet retail we think that's just growth that happened this year because of the underlying growth and the bear business in those channels as the demand for the seresto collar for a family all have gone very well that's contributing to what we think is a strong underlying four to five percent growth for the total bear business But the double-digit growth they experienced in the first half of the year definitely had those effects. So, we're expecting, again, to get there. We think inventory and the channels will be appropriate across our entire portfolio, farm animal and pet health, by the end of this year. And that's all playing out well for us, as we're excited to have this higher growth bear business. With respect to the A family, again, it's been very good this year. They've had a very nice run, especially in China, and we're pleased as people continue to use those products and they do well in the retail and online channels with it. Originally, when we did the deal, we were expecting a low single-digit decline on a family going forward, and we'll be talking more about it at the investor conference as we refresh our total growth portfolio at that point.

Next question, please.

Your next question will come from Chris Short from J.P. Morgan. Your line is open.

Great. Thanks so much for the questions. Just two for me. First, I want to talk about 4Q sales levels. I think these are about $100 million below consensus. X the COVID headwinds, X that Bayer inventory you laid out. Do you consider 4Q a normalized sales number? I know you're going to have some first half seasonality with a new mix, but I'm trying to get a sense as we're trying to build a baseline sales level, how normalized we should think about 4Q being. My second question was just an update on longer-term margin targets you laid out with the deal. I guess, what's your confidence in hitting those estimates and particularly the timelines? How quickly can we think about this being achieved? Thanks so much.

Chris, thanks for the question. With respect to the second question, we're still confident in our ability to get to a 60% plus gross margin and over 30% EBITDA margins. As we've spoken before on calls, those have been pushed out. We are seeing more competitive pressure than we were in August of 2019 on the legacy Elanco portfolio, and we've been seeing that in some of our fundamental organic growth. At the same time, COVID is having these different impacts that are affecting us. That being said, we're confident in the overall portfolio for the long term and our ability to deliver on a 60% gross margin and a 30-plus percent EBITDA. With respect to Q4, there are a number of discrete items that we have tried to call out here today on the call. The price increase on bear products being pushed out to February versus happening in January does impact sales in the quarter. on a year-over-year comp basis. This adjustment for accounting where trade funds previously had been down in SG&A, those are moving up under GAAP reporting, and those were in our numbers in Q3 and will be in Q4 and going forward. That is a decline in sales relative to historic times for Bayer, but no change at the EBITDAs. It's just a movement amongst the P&L. The other bit to mention is we think divestiture impact is about $20 million on the legacy Elanco portfolio and just around $10 million on the legacy Bayer portfolio. Those are all items that are affecting the absolute quantity of sales in Q4 relative to what a pro forma without those items would have been a year ago.

I would emphasize, too, Chris, I think the underlying demand, again, for the Bayer business and the Elanco, especially U.S. pet health business, we continue to grow share. We continue to see, as I highlighted, the 14 focus products of Elanco up 18%. We'll be adding five more to that going forward. But I would emphasize, again, we feel very good about no change in the underlying demand sequentially coming from Q3 into Q4. A lot of this is the adjustments that Todd highlighted. Thank you.

We'll take the next question, please. The next question comes from David Rissinger from Morgan Stanley. Your line is open.

Yes. Thanks very much. And congrats on the corporate progress. So I have, I guess, a couple questions here. First, you know, clearly various moving parts are precluding Elanco from providing earnings guidance for the fourth quarter. But given that uncertainty, How is the company going to be able to provide earnings guidance for the full year of 2021 on December 15th? Second, with respect to the launches, so five launches by the end of 2021 and 25 by 2024, could you just please quantify how many of those I'm assuming none of the five would have blockbuster or greater than 100 million revenue potential in terms of the five that are launching by the end of 2021. But for the 25 that are launching by the 2024 period, how many of those would have blockbuster or greater than 100 million revenue potential? Thanks very much.

Let me take the first question, Dave, and I'll let Jeff answer the second one. With respect to the earnings, it's a great question, a very fair one. We do expect to provide greater detail in the investor day on December 15th with respect to how we project Q4 to come out. Clearly, with two weeks to go in the quarter, you'd expect us to be able to do that, and we'll do that to help provide that baseline then to give a 2021 guidance. Jeff?

Yeah, real quick, David. On the pipeline, first of all, I think I want to reiterate, nice mix between pet health and farm animal, a constant flow of approvals throughout that entire five-year period. We will get into more of these specifics in terms of spaces. and what areas that we will be launching in. We have been very clear. Areas like broad-spectrum parasiticide will be in there. Derm will be in there. More pet therapy, antibiotic replacement, and farm animal, and some additional kind of first-in-class, best-in-class, like products like Xperia, for instance. So what I would say when you ask about numbers, we're looking through a different lens with a higher bar. With it being a larger company, we need larger numbers. faster kind of adoption rates on new products. So I would say that these products are looking through that lens of an Elanco plus Bayer, you know, needing more materiality. And we've got a significant number of those that we believe with the right market creation, launch, and competitive commercialness, commercial ability, that they'll be blockbusters. So I would say that there will be a series of them in there. And again, a linear line and a nice blend between pet health and and farm animal. So feeling very good about our pipeline, feeling very good about the ability with Bayer plus Elanco, capability, size, and Bayer's contributions. We're stronger with innovation than we were before the Bayer transaction. And looking forward to you know, starting that with these launches. And I keep reiterating, too, a lot of runway with the 14 products that we have that are focused products. We're going to add into that Seresto and Claro as other products with a lot more growth potential. And then you add on five this year, and then the series of launches beyond. So we like our algorithm of growth. We like our pipeline. And there will be some nice blockbusters within that. Thank you.

Next question, please.

next question will come from john krieger from william blair your line is open hi thanks i just wanted to clarify your comments about stocking unwinding for bear in the fourth quarter that 10 million do you think that finishes the necessary unwind or should we expect more needed in uh 21 and then the follow-up todd i think you rattled off a number of puts and takes on gross margin can you just kind of Expand on that a little bit more. Can we think about gross margin as having kind of a normalized improvement trajectory in 21, or will that take a little bit longer given those items? Thanks.

Sure, John. Yes, we think that the retailer inventory levels for US Pet on the historic bear business will be at the appropriate level given the growth we've seen on dispensing data for those products in 2020 and that we won't have that. To the extent there was an inventory growth in 2020, that's something that'll be a headwind to growth in 2021 for us. But fundamental underlying growth of U.S. pet products and bear, we're really pleased with as dispensing growth continues to track very nicely on those products for the last 15 months. On the margin side, that's something that just, as a reminder, we have a step down on legacy Elanco business. It was stepped down more than 500 basis points in Q4 of 2019 versus Q3 of 2019. That's a part of how our mix plays out and something we wanted to highlight. The higher margin bear business certainly helps our overall gross margin, but as you know, the seasonality of the U.S. parasiticide business makes Q4 a lower level than what it looks like in Q1 and Q2. So, overall, we're very pleased with our initiatives on the gross margin. Aside from a productivity, the team continues to take costs out and take costs out on an absolute basis with respect to reducing compensation and benefit costs, reducing the cost of API through our initiatives on sourcing, and those are on track. The mixed headwinds we've seen, as called out earlier with the legacy Elanco business and ruminants and swine, does impact that gross margin. So we'll continue to provide greater guidance on it, but we wanted to clarify that we do expect a margin step down in Q4 versus the one we just had here in Q3. Great. Thank you.

Next question. Your next question will come from Balaji Prashant from Berkeley. Your line is open.

Hi, thanks for paying the questions. So I just wanted to call and comment on the sustainability goals introduced. Post that, I would like to get your thoughts around the past site market. Your peers spoke of a six-person gain in parasiticides. You're commenting on price growth and volume growth in the market, too. So are there some dynamics which are happening which we are not probably figuring out? Is the market growing faster than what you or we are anticipating? And so if so, what are the factors? Secondly, is it fair to assume that your share of this market will stay intact or even increase with the new launches which are expected to come out over the next one to two years? Thanks.

Yeah, so let me start first on the first question, and that is, yes, we feel very good about the overall, I think, pet health market. I'll start there. I think we know that COVID has increased the attention to the pet, the compliance. We've seen a V-shaped recovery. We've seen both growth nicely in the vet clinic market. We also are seeing very strong growth, as you know, in the retail market as well. Yes, on parasiticides, as you see, we've seen nice growth across all sectors, price growth in parasiticides. We also believe that there is continued offering, and when we look at marketing all the way to the pet owner, you know, understanding things, you know, more clearly by reaching that direct pet owner and pulling them into the vet clinic. And I would note our pairing of Credelio plus Interceptor Plus is an example of that. Pairing is increasing, growth is significant, and a lot of that can be attributed by a marketing approach that reaches pet owners, taking them into the vet clinic, and there's a knowledge and an awareness of that message. That is a big driver in this. And then, yeah, we believe attention and compliance helps drive volume, but it also helps drive price as well.

But one thing to note there, Balaji, we are seeing a decline in Trifexis, our historic product. And so, as Jeff mentioned, you're managing that within our expectations, but that is a decline in the parasiticide market.

Thanks, Doc. Yeah, we think that too. Thanks. Just to follow up on livestock side with rumensin. So you said that it's faring better than what you anticipated. So what is the current market share or what is the impact of the generic version? And you called out poultry under pressure. Could you identify the factors, what's driving this in LATAM and India? Thanks.

There's no question that there's a lot of moving parts from the earlier question on ruminants. We feel good about the increased number of days cattle on feed. There's been a talk about, yes, there was a cattle run in Q3, a little premature, a little sooner than normal. That puts more cattle on feed as you go into Q4. That's positive. When you look at actually the generic, we see our ability to differentiate and hold although, you know, there was a market size change from COVID from earlier this year. So when we back up and look at our assumptions of holding in year one 20% total value loss or less, we're feeling good relative to that, you know, in relative terms to a market that has actually changed in size. So, again, doing very well competitively, and I attribute a lot of this to portfolio and product differentiation.

And then the second part of the question about the fact that driving lower market growth in poultry in Latin America and India.

yeah i mean it's very clear that the covet impact has been a little bit linger a little bit later and it's lingered a little bit longer relative to this and a lot of this distributed attributed international poultry markets are more dependent on food service and restaurants and we know the impact of that and now we're starting to see that that impact we see it returning quickly um and and but this will persist as we go into 2021. thank you

Thanks.

We'll take the next question. And your next question will come from Kathy Miner from Cohen. Your line is open.

Thank you. Good morning. Just a first one quick follow up on your guidance or your expectation for 20 to 30 million COVID headwind in Q4. Is that mostly on the US or is that an outside of the US expectation? Second of all, could you comment on your swine business in China and if that's returning to growth and how you see that developing going forward? And if you could, just at least a brief comment on the channel trends in the third quarter. That's certainly a big part of the Bayer transition and just curious whether that was continuing to grow through Q3. Thank you.

Sure. So, with respect to the swine business in China, I think our first question was?

Start with COVID headwind.

Oh, sorry. The COVID headwind was primarily continuing international farm animal markets, the poultry impact, Middle East, Latin America, India. We do see those continuing. It'll be some impact in the U.S., but that's not It's a bigger quantity. That's why we're seeing it come down quarter over quarter. We'll let Jeff jump in on the swine side.

Yeah, so we've seen very good growth both in the Elanco and Bayer, and I'll even go back to using a comparison of 2018, so before the African swine fever effect. So we're seeing stronger prices. We're seeing more industrial farms. Those are two really positive trends. And then, you know, I think multinational product use. So when you put those things together, we're seeing over a 30% growth in both the Elanco business, back to pre-COVID comparisons in 2018, both on the Elanco and Bayer side. And again, I would put those three factors as the big drivers. Strong economics. We see that growing. you know that tailwind uh benefiting as we go into 2021 and we'll talk some about that at the investor conference um let me just highlight on distribution be very clearly just to make sure it's real clear that you know on on our legacy lanco business the overall business um our inventory levels are the the same in in q3 as they are in q2 they're at the right levels we're at 60-day terms That strategy is working. Our relationships are very strong with the four remaining distributors that we have, and it's paid off, as I've shared, relative to demand creation. We're growing market share. We've got better improved receivables and cash conversion and pricing within that, and the distribution strategy, we think, is working extremely well. And I would highlight, you know, that that is a heavy focus. You know, in addition, there's the retail business that Todd has talked about, and we would really highlight, you know, what drove that retail bear business was much more retailers. Distributors are not involved in that, so there's no inventory issues there at all. And that buy-ahead a little bit was driven by both the cutover and the COVID concerns But again, underlying business remains very strong on both retail and the vet clinic business for our pet business.

Next question, please. Your next question comes from David Westenberg from Guggenheim. Your line is open.

Hi, thanks for taking my question. So, can you talk about caporalin in cats? You know, we've seen a lot of off-label usage of entice for a number of years now. Do you see the cat market as larger than the dog market, just given the health consequences for weight in cats is much worse? And, you know, this is a small market, but it's an opportunity to pioneer into maybe a $50 million product. Is that fair to say? And then, secondly, can you talk about retail channel mix? We've seen Just an OTC pet and dramatic acceleration in the shift to online from pet specialty and box retailers. Do you think that's to your advantage there in terms particularly around the bear animal health products? Thank you.

Yes, let me just highlight again, Allura, we believe first and best in class relative to what we have here relative to an oral treatment. And again, the mode of action, you're exactly right. We believe this is a market creation archetype for us. It's an opportunity. As you know, chronic kidney disease may affect right now. The numbers are 1% to 3%. We think that can be higher, but a much higher incidence in older cats, you know, intensified. But we're seeing, you know, a cat that can be, you know, 12, 15 years old, it can be estimated at 30% to 50%. the cats are affected. So we like this segment. We like the market creation opportunity, which gets back to a big part of our innovation strategy, bringing first, best-in-class, unique mode of action here with a liquid oral solution. And so we see this being a an opportunity to create a really nice product. I won't get into exactly how much, but we will say that our intention is to lean in heavily here. And again, we continue to increase our portfolio, and we'll talk some about that in the feline market, which is a really strong market, highlighted even by our success with Cordelia-owned cats in Europe. So, we feel very good. And yes, there is some pairing and some opportunity within Tice that is a similar product in dogs. And then, yes, on retail, look, I would highlight we are a retail leader. We are the retail leader right now with the combination of Bayer plus Elanco. flea tick, heartworm, there is no question you need that capability and a portfolio, both a scripted and an unscripted OTC portfolio like Seresto and Advantage to win. And we feel very good about the Bayer capabilities in this space, our leadership position, and our innovation and our ability to grow in this space. So yes, we see these trends persisting that came through COVID.

Next question, please. The next question comes from Elliott Wilbur from Raymond James. Your line is open.

Thanks. Maybe just real quickly for Jeff. Give us perspective or color on sort of the emerging ASF cases that we're seeing in Europe, obviously negative for some markets and positive for others, but maybe just how that impacts Lanco's business, if at all, and for Todd, with respect to, obviously, a lot of focus on cash flow and leverage position. Anything you could say at this point that could help us in terms of thinking about a longer-term framework with respect to cash conversion metrics?

Yeah, so let me start with ASF. Again, there still is, you know, spotted cases that have popped up in industrialized operations in Asia. You know, for instance, as some noted here in South Korea. But again, I want to emphasize no material effect. on ASF that we see really anywhere in the world, but especially in Asia. And you're seeing again the positive fundamentals of the recovery in China. That again will be a tailwind for us as we go into 2021. The cases in Europe again, mostly in Germany and East Europe, We do not see at this point in time a risk to any commercial pig production. It's mostly been in the wild boar market. And so we've not seen anything in no material effect that we're assuming at this point in time for our European pig business.

Elliot, with respect to cash conversion, we feel good about the working capital discipline we've instilled over the last few months, bringing DSOs down considerably since the Q1 timeframe. We are continuing to look at working capital needs across our business. I would say one of the things about operating two different systems is we need multiple bank accounts in countries in order to efficiently process the payments on both sides of the business. That does chew up a little bit more of cash on the balance sheet, but something that we're working through and trying to manage. We're also focused on inventory levels. We did grow inventory on our own balance sheet here in Q3 as a result of the IT cutover we will have to go on to our separate ERP system in Q1. So, do expect to have better inventory numbers in 2021 as we get past a lot of these IT-related items. So, again, we'll get into more on EBITDA growth expectations on the investor day in December.

next question please the next question will come from umar rafik from evercore your line is open hi guys thanks for squeezing me in um i wanted to focus on the distribution strategy xus and could you remind us what exactly is the distribution strategy for international livestock and how many months of product did these international distributors have as of end of june versus end of September. And I'm trying to understand if that had anything to do with the tightening of day sales outstanding, which drove the livestock issues at QS. Thank you.

Yeah, most of that is directly with Large protein producers are mostly our customers internationally. No factor at all. Again, as I shared, international and U.S. and globally, Lanco inventory and distribution was at the levels we wanted coming out of Q2, remained the same in Q3, and was not a factor at all in our results.

Jeff, do they buy additional ahead-of-quarter clothes if they're incentives that exist, these large protein makers?

very very little to none um you know once in a while when a price increase program is in place sometimes there's an allowance of some buy ahead um but again that is we've moved those out mostly across the globe from q q4 into q1 to prevent any of that any change but no that that is not the case and again i want to re-emphasize uh inventory levels same in q3 as they were in q2 were at the right levels and feel very good about those changes Not a fact, very much. Thank you very much.

Next question. And your next question will come from Navin Jacob from UBS. Your line is open.

Yes, thanks, Navin Jacob, UBS. I appreciate you putting me in. So I just want to expand on Omar's question around inventory. If you could provide very simply how many days on hand or weeks on hand or months on hand you have for companion animal in the U.S. and for livestock, as well as for not just your portfolio, but for the buyer portfolio, because it seems, you know, you had called out the reduction in buyer inventory. I just want to try and understand so we don't have any more, you know, surprises, quote unquote, around inventory and quarters forward, where exactly your inventory levels stand, both on the companion side of things Livestock side of things, Elanco standalone, buyer standalone, please. Thank you very much.

David, as we said, the inventory issue we put behind us at the end of Q2. Inventories are consistent in Q3 versus Q2. If there is a material change in inventories that drives an impact on revenue, we will disclose that and we'll be upfront about it. With respect to the bear side, as we talked and tried to be very clear on the retailer side, which is not distribution, right? We're not talking about the co-veterans and NWIs and those that aren't on our side, but rather, you know, the Amazons and Walmarts that, given COVID, as well as continued uptake in the Soresto and the Danish products, they did hold more inventory. As we said, we think that's about a $25 million increase in 2020 compared to 2019. That's after another $10 million comes out of that here in Q4. And so going into 2021, we feel very good about inventory levels across our business, across the Bayer business, and that they're set up to grow as we keep it. We've changed the strategy. in the earlier part of this year and talked about it extensively on the Q2 call and feel very good about both our relationships with our distributors in the U.S., the international business and how it's operating, as well as the retail relationships that we had before but now get enhanced with the broader OTC product portfolio that Bayer brings.

That's very clear. Thank you very much.

With that, we'll wrap it up today. Thank you for joining us for a Lenco Animal Health third quarter conference call.

Thank you, everyone. This will conclude today's conference call. You may now disconnect.

THE END