Elanco Animal Health Incorporated

Hello and thank you for standing by. My name is Regina and I will be your conference operator today. At this time, I would like to welcome everyone to the Elanco Animal Health Second Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you'd like to withdraw your question, press star one again. I would now like to turn the conference over to Katie Grissom, head of investor relations. Please go ahead.

Good morning. Thank you for joining us for our Lanco Animal Health second quarter 2022 earnings call. I'm Katie Grissom, head of investor relations. Joining me on today's call are Jeff Simmons, our president and chief executive officer, and Todd Young, our chief financial officer. Today, we're missing Scott Perucker from investor relations, who's enjoying paternity leave after the birth of his daughter in July. Congrats, Scott. The slides referenced during this call are available on the Investor Relations section of elenco.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 discussed in today's earnings press release, as well as our latest Form 10-K and 10-Q filed with the SEC. We do not undertake any duty to update any forward looking statement. 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.

Thanks, Katie. Good morning, everyone. Elanco continues to execute our innovation, productivity, and portfolio strategy while delivering in the second quarter. In particular, our company-wide productivity agenda continued to deliver, and we are pleased with the progress on our innovation pipeline. While we now expect some challenges, mostly macro environmental challenges, to our top-line performance over the remainder of the year, we expect to return to constant currency sales growth in the fourth quarter of this year. Our company-wide productivity efforts continue to drive margin expansion. Our pipeline progress is laying groundwork for future growth, and our commercial teams continue to help customers around the globe treat animals with our diversified global portfolio. In the second quarter, I'm proud of the Elanco team for increasing adjusted EBITDA 3% and adjusted EPS 29%, despite the revenue decline of 4% in constant currency, which was in line with our May guidance. Elanco's focus over the last year on productivity efforts to reduce costs by streamlining our sales and marketing organizations, prioritizing resources in R&D, and across our manufacturing footprint, allowed us to exceed our top end of our second quarter guidance range with adjusted EPS of 36 cents and adjusted EBITDA of 300 million. Additionally, we delivered strong operating cash flow in the quarter and reduced our net leverage ratio to 5.3 times, down from 5.6 times at the end of the first quarter. Today, we are updating our revenue outlook for 2022 to account for economic, environmental, and company-specific factors that accelerated and intensified in the quarter. We are taking a measured and balanced approach to this environment and this forecast. Given these dynamics, we are also adjusting the timeline by which we expect to achieve our longer-term margin targets laid out at our December 2020 Investor Day. Despite today's reduction in our sales expectations for 2022, we expect to expand both gross margin and EBITDA margin this year and expect that to continue in 2023 and 2024. We remain committed to 60% gross margin and 31% adjusted EBITDA margin and will provide an update on timing in 2023. Moving to slide four, let's start with our second quarter sales results. We reported revenue of $1.177 billion, a decline of 8% in reported revenue or 4% in constant currency. We delivered 3% constant currency growth in farm animal, driven by 6% growth in the U.S., led by Zoeshield in poultry and Remenson in cattle. Our international farm animal business grew 1% in constant currency as strength in ruminant, including sheep, was partially offset by softness and our swine business in China, and to a lesser extent, Europe. Although a notionally smaller business, we continued to see strong performance in aqua with 5% constant currency growth, despite the $10 million of phasing into the first quarter we discussed in May, which drove Q1 growth of 96%. Pet health declined in Q2 by 7% in constant currency. Our U.S. business declined 11% driven by competitive pressure on our vet-based parasiticides, including Trifexis and Interceptor Plus, and declines across our retail portfolio. We do not believe this level of sales decline is indicative of the underlying quality of our U.S. pet health business as supply and other discrete issues impacted the business in the quarter. We are confident it will improve as we move forward through the back half of the year. International pet health was flat in the quarter. In China, our pet health business was also flat in the quarter, driven by the impact of two months of COVID lockdowns. These results are in contrast to the significant double-digit growth the team delivered in 2021 and the first quarter of 2022. Additionally, I'd like to address our second quarter price growth of 1%. Price growth in pet health was below our initial expectations, but reflects an intentional shift in our U.S. retail business. We invested further in promotional investments, or trade funds, with our retail partners to drive demand that increased our gross to net spend, thus reducing net sales from price. This trade fund investment was a shift in spend from marketing operating expense and created a net positive contribution to EBITDA. Price growth in farm animal was driven by our international business. In U.S. farm animal, price was lower than our expectations, driven by competitive dynamics and the pricing actions in the bovine respiratory disease market impacting INCREXA. Mid-year price increases have been taken across both pet health and farm animal portfolios, and we expect to see accelerating contribution in the second half, with full-year price growth more in line with our historical 2 percent levels. Moving to slide five, we are reducing our full-year sales guidance from an expected constant currency growth of 2 to 3 percent to now flat to minus 2 percent. Compared to our May guidance, this is a $220 million reduction at the midpoint of the range to reflect our current assumptions that can be grouped into three areas. First, approximately $65 million from the unfavorable impact of foreign exchange rates. We now expect a total headwind of $205 million from dollar strength compared to $140 million we expected in early May. Secondly, 100 to 120 million from macro environmental factors, including the pace of recovery from China's COVID lockdown, disruptions in the global supply chain, and pressure from the expected economic slowdown around the world. And finally, a net 40 to 50 million or one percentage point drag on growth from performance headwinds relating primarily to pricing realization, innovation ramp, and U.S. pet health parasiticides. Regarding the $100 to $120 million reduction from macro environmental factors, let's start with China, which is $60 to $65 million of that reduction. We've been expecting our China business to grow by 22% at constant currency and to provide about a percentage point of growth from totally lanko this year, as it did in 2021. With this revenue change, we now expect China to decline by approximately 1% this year in constant currency. For pet health, as the major population centers in China were under strict lockdowns, our assumption in May was for a rebound in pet up demand starting in June that would result in a V-shaped recovery similar to what we saw in the U.S. in 2020. While we saw some improvement through June and into July, it does not appear the second half bounce back will materialize as expected. And we now see a more tempered pace of growth in the second half than we did in May. In the first quarter of the year, Elanco's strong team in China grew market share six percentage points in the parasiticide market through its commercial capabilities and strong portfolio that has just been enhanced with the approval of Cordelio. While we don't expect to recapture our lost sales from Q2 as we projected in May, we still expect our China pet health business to grow double digits in the second half of the year. Moving to farm animal in China, Swine prices are improving, but are expected to remain volatile. The large industrial swine producers have a higher cost base coming out of the African swine fever, impacting their ability to invest in our products as current prices remain below their break-even levels. Additionally, the lower protein demand overall from the COVID lockdowns and competition from cheaper pork is also impacting our poultry business, where prices have been depressed and tracking blower expectations for the year. Despite the current environmental headwinds in China, we believe we are very well positioned in both pet health and farm animal to take advantage of the recoveries as they occur and believe China will be a growth driver for Elanco in 2023 and years to come. Next, moving to the supply chain disruption, which represents 30 to 35 million of our sales reduction from macro environmental factors. While the paper and packaging challenges from the first half are largely behind us, freight and logistics remains dynamic and a number of our suppliers and CMOs are experiencing ongoing input sourcing challenges and labor shortages. We expect these issues to negatively impact our ability to meet demand for a number of smaller products, primarily in our international farm animal business. We continue to seek alternative sources of raw materials, and other inputs to drive more reliable supply performance in 2023. Lastly, we expect the reality of the economic slowdowns across the world will create a 10 to 20 million downside in our global business. Finally, we are reducing our revenue guidance by approximately $40 to $50 million to reflect our lowered expectations for innovation sales ramp, price growth, and performance of our U.S. pet health parasiticide business. which will more than offset better-than-expected performance in poultry, aqua, and contract manufacturing. While I covered price earlier for innovation sales, we're lowering our expectations by $20 to $30 million to $100 to $130 million for the full year, as a result of our updated expectations for Xperia and Crexa and Credelio+. For Xperia, we are very pleased with the customer experience feedback we are receiving as the number of customers using the product and the number of head on Xperia continues to increase. However, the feed yard adoption curve is behind our expectations from May. Important to point out, twice the number of cattle started on Xperia in the second quarter than in Q1, and more cattle started in July than we saw in all of Q2. We continue to expect Xperia to become a blockbuster and industry feedback in recent months has only strengthened this belief. Given the current strong ramp in cattle on the product, we expect Xperia to be a major growth driver and a creative to gross margin in 2023. Finally, as we evaluated the results of this year's flea and tick season, we think the competitive pressure across the portfolio will likely be closer to 75 or 80 million dollars rather than our previous 60 million assumption. We see the majority of the additional pressure on dog products as growth in Seresto and Cordelio for cats is strong. While these headwinds in innovation, pricing, and parasiticides create a net negative on our sales expectations, the strength in our aqua and poultry business and higher contract manufacturing sales are expected to provide a positive offset. Our commercial teams continue to deliver in areas where our portfolio has competitive strength. Later, Todd will take you through the adjusted EBITDA and adjusted EPS from the changes in the top-line guidance. Now I'd like to transition to provide more information on Soresto and our progress on innovation. In the second quarter, Soresto declined approximately 6% in constant currency and was below our expectations. The decline was driven by a softer season in the U.S. and Europe, lower retail inventory levels, and competitive dynamics. For the first half, the brand grew approximately 2% in constant currency with total sales of $273 million. In June, I appeared before the House Subcommittee on Economic and Consumer Policy in support of Soresto, defending its strong safety profile and the importance of protecting dogs and cats against disease carrying fleas and ticks. During my testimony, I reiterated our commitment to work with EPA supporting science-based evaluations of the product. We continue to provide additional data and analysis that supports Soresto's strong safety profile. While Soresto has been challenged in the U.S. the last two years, it has generally performed in line with our expectations across the rest of the world. Aligned with historical data, in July, our U.S. consumer research shows repurchase intent of 95% for Soresto, demonstrating high customer loyalty. We see Soresto as a resilient, affordable brand that meets unique market needs and are very focused on driving brand growth in years to come. Transitioning to slide six, the most important driver of future growth for Elanco is our innovation portfolio. We continue to expect the products launched in 2021 and beyond to contribute $600 to $700 million of revenue by 2025. The leadership of Dr. Ellen DeBrabander and the disciplined execution of her experienced team over the last nine months have increased our confidence in the next era of innovation coming from new platforms and spaces, including monoclonal antibodies, sustainable protein, and pet therapeutics, as well as pet parasiticides. Since our last earnings call in May, we continue to advance our late-stage pipeline, delivering approvals and increasing probabilities. Within the next two to four months, we intend to make regulatory submissions for our broad spectrum parasiticide product and one of our late stage dermatology products. The submissions will start the regulatory review process, which is iterative and rolling in nature, with approval timing dependent on the regulatory body involved. With FDA, we typically expect a 12 to 18 month review cycle from initial submission to approval, while the USDA and the European authorities are often shorter. For our parasiticide product, we believe we have crossed the so-called heartworm threshold, a challenge we faced several years ago with Cordelio Plus in the U.S. development program. We believe our late-stage assets are differentiated from the current market offerings and will continue to update you on any material developments. We remain on track for seven approvals in 2022, with six of the seven expected approvals in major markets now received. These portfolio-enhancing products are primarily in pet health, including Credelio in China, Credelio Plus in Canada, and Advantage XD for cats in the U.S. Additionally, our parvovirus treatment for dogs continues to advance, with USDA approval expected late this year or early 2023. Finally, we continue to build a leading feline portfolio that we believe will improve the standard of cat care. In July, we launched Zorbium. a long-acting postoperative transdermal pain product which is gaining traction in vet clinics. Its innovative delivery mechanism makes postoperative care easier on cats and their owners, delivering value to veterinarians as evidenced by 5,000 clinic placements in the first month. We're also pleased to announce today that we've licensed a revolutionary first-in-class product for feline diabetes care. The product introduces a new mechanism of action for veterinarians with a needle-free, easy-to-give daily oral medication to treat this chronic condition. The product is under FDA regulatory review and expected to be approved within the next 12 months. In addition to these, near-term innovations such as canine influenza and parvovirus demonstrate Elanco's commitment to bringing novel and differentiated innovations, and will serve as important relationship builders with veterinarians ahead of our expected broad-spectrum parasiticide and multiple dermatology products coming to the market. We plan to have Ellen join our third quarter earnings call in November to provide further updates on innovation efforts and portfolio progress. Before I turn the call over to Todd, I'd like to thank the Elanco team for all of their productivity efforts over the last few years. Our introduction of an EVA-like performance metric into our short-term compensation, which we call Elanco Cash Earnings, is driving a company-wide ownership mindset and intensifying our focus on delivering capital optimization. I believe this mindset and ownership culture will drive value for all stakeholders over the long term. Now I'll hand it over to Todd.

Thank you, Jeff, and good morning, everyone. Today I'll focus my comments on our second 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. Starting on slide 8, we delivered $1.177 billion in revenue, an 8% decline or 4% decline in constant currency, with price growing 1%. Foreign exchange rates represented a headwind of $56 million in the quarter, or 4%, slightly above our expectations. Slide 9 breaks down our revenue performance by species and slide 10 provides revenue by region in the quarter. For pet health, we declined 7% in constant currency for the quarter with our international business flat in constant currency and our U.S. business declining 11%. The Advantage family of products contributed $137 million, representing a 7% decline on a reported basis or a 3% decline in constant currency driven by supply challenges and softness in Europe. Soresto contributed $113 million, representing a 12% decline on a reported basis, or a 6% decline in constant currency, with softness in the U.S. and Central Europe, where the Russian invasion of Ukraine negatively impacted our business, partially offset by growth in Western Europe. More broadly, Cordelio grew double digits globally, vaccines remained steady, growing dispensing within a market growing mid single digits and on a year-to-date basis Gallup Grant grew double digits in the US while weathering competition in Europe. Our farm animal business grew 3% at constant currency including 2% from price primarily driven by our international business. Volume growth was primarily driven by the international ruminant business notably sheep products. Additionally the quarter benefited from a shift in timing for generic defense programs for Reminson ahead of a mid-year price increase, shifting sales expected in the third quarter of 2022 into the second. Growth was offset by pressured economics for swine and poultry producers in China and a decline for swine in Europe. Slide 11 further summarizes our financial performance for the second quarter. Despite the decrease in reported sales, gross margin improved 190 basis points to 58.9%, primarily driven by continued improvements in manufacturing productivity, a weaker euro and price, partially offset by inflation and input costs, freight and conversion costs, and an unfavorable mix from lower sales in pet health. Operating expenses for the quarter were $425 million, a reduction of 11% year over year. The impact of FX on expenses was approximately $14 million favorable in the second quarter, or a 3% benefit year over year. This improvement highlights our disciplined execution and demonstrates our ability to sustain synergies and cost savings from our restructuring actions, while more than offsetting inflation and continuing to invest in key strategic priorities. Our R&D spend was in line with expectations as we concentrated investments going into this year and prioritized our pet health blockbuster development pipeline. Interest expense was $50 million in the quarter, a year-over-year decline of 17% driven by the repayment of our 2021 senior notes last August. The non-GAAP effective tax rate was 18% for the quarter, which provided a benefit of 3 cents per share above our expectations. This lower Q2 rate was driven by the jurisdictional mix of Elanco profits and discrete items. We still expect our full year tax rate to be approximately 25 to 26% despite the lower Q2 rate. Adjusted net income was $177 million and adjusted EPS was 36 cents for the quarter, reflecting growth of 31% and 29% respectively. Adjusted EBITDA was $300 million in the quarter, or about $40 million better than the midpoint of our guidance. We expect to file our 10Q in the coming days, but let's move to the balance sheet and cash flow metrics on slide 12. We ended the quarter with $5.63 billion in net debt, a reduction compared to the first quarter of 2022 of $240 million. Our net debt to adjusted EBITDA ratio at the end of Q2 was 5.3 times which improved from 5.6 times at the end of Q1. We expect the net debt to adjusted EBITDA ratio to continue to improve in the second half and expect to finish the year at approximately five times. In the second quarter, our operating cash flow was $312 million, reflecting the lower reported net loss in the quarter year over year and a one-time benefit of net $124 million from a cash interest rate swap settlement. The swap settlement provides a cash benefit in the second quarter that will create a headwind in operating cash flow over the next four years as this cash acceleration reverses. Excluding the swap benefit, operating cash would have increased 21% over the second quarter of 2021. Next, let's transition to our updated outlook for 2022 on slide 14. For the full year, we now expect revenue to be between 4.465 and $4.55 billion were flat to down 2% year-over-year in constant currency, reflecting the details Jeff has already provided on sales. The bridge from the May guidance can be found on slide 15. While in the second quarter, our productivity initiatives allowed us to deliver higher adjusted EBITDA and adjusted EPS than our guidance projected, despite sales only at the midpoint of guidance, we do not expect that to be the case in the second half of this year. We continue to see higher inflation negatively impacting our manufacturing and supply chain networks, and wage inflation is now negatively impacting our business as well. For the full year, we expect inflation to impact our manufacturing costs by $140 million, or $20 million more than we projected in May. As you can see in the bridge on slide 16, we now expect adjusted EBITDA between $1.06 billion and $1.1 billion for 2022, which is a $65 million reduction from the midpoint of the range provided in May. The stronger U.S. dollar drives approximately $20 million of the change, while the other $45 million is driven by the approximate $55 million of overachievement in adjusted EBITDA in the first two quarters of the year, more than offset by the gross profit drop-through from the sales reduction in the second half and incremental inflation. We now expect adjusted diluted EPS of $1.06 to $1.13 for 2022, which is a reduction of $0.08 versus the midpoint of the range provided in May. The stronger US dollar is driving approximately $0.03 of the reduction. The other $0.05 is driven by the sales reduction, partially offset by a smaller amount of increased productivity and the operational overachievement in the second quarter. Finally, we are introducing guidance for the third quarter of 2022 on slide 17 we expect revenue of 1.01 billion to $1.06 billion adjusted EBITDA between 175 million and $215 million and adjusted EPS between 12 cents and 18 cents. The constant currency projected revenue decline of 3% at the midpoint is driven by expected declines in ruminants, swine, and contract manufacturing partially offset by expected growth in poultry and aqua. We expect pet health to be generally flat. While we aren't guiding to the fourth quarter explicitly, growth at the midpoint of the implied range is 2%. Moving to slide 18. As Jeff mentioned earlier, we are extending the timeline for the achievement of our 60% gross margin and 31% adjusted EBITDA margin from 2023 and 2024, respectively. This change is driven primarily by the degradation in the global macro environment since we established these targets in December of 2020 with respect to inflation, supply chain disruptions, and the longer recovery in China from COVID lockdowns. as well as the unfavorable impact of sales mix on gross margin. While these factors have accelerated and intensified since May, we had not changed the timeline before today because our productivity initiatives had continued to deliver ahead of our expectations. Although it's hard to adjust for just one factor, when you reduce our cost of goods sold in 2022 by approximately $100 million to reflect the incremental inflation compared to what we had expected during the December 2020 investor day, we would project a 60% gross margin this year. That incremental $100 million of gross profit would have also increased our adjusted EBITDA margin by over 200 basis points, which would have had us tracking to our 31% target for 2024. Our reality is different, and the things we have described are causing us to change the timing of achieving these targets, but not changing our expectation that we will continue to expand our margins in 2023 and 2024. As we noted in February, our value capture expectations are ahead of schedule and the integration of the Bayer ERP system and business processes is on track. We still expect this integration to deliver $50 to $60 million of adjusted EBITDA savings in 2024. Moreover, as China recovers, Xperia ramps, supply chains improve, and we continue to capture price, all of our productivity measures over the last few years will drive continued margin expansion. We plan to update the timeline for achieving our 60% and 31% targets in 2023. With that, I'll hand it back to Jeff for closing comments.

Thanks, Todd. At Elanco, we are building a long-term sustainable company. Over the past two years, we've created a stronger, more durable, and diverse company. Our efforts to streamline and drive efficiency are delivering significant productivity, improving profitability and cash generation, allowing us to pay down debt and continue investing in the business. The team has executed beyond our expectations and are progressing on our next significant initiative, which is integrating the Bayer Animal Health business into our systems and processes. While we are in a challenged environment this quarter, demonstrates our strategy is working and we are better positioned to weather these challenges as a result of our company transformation. Fundamentally, animal health remains an attractive industry that has underlying macro growth drivers in both pets and protein, is resilient through challenges, and it rewards innovation. We are accelerating progress on our innovation with opportunities to bring best-in-class solutions to address unmet needs and revolutionize care. As the pipeline delivers, we expect to leverage our established cost base to fuel more margin expansion. Beginning with our Pet Health Blockbuster submissions in the next two to four months, this opens the door to our next era of innovation and growth that will deliver increased value to customers and shareholders. With that, I'll turn it over to Katie 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. Operator, please provide the instructions for the Q&A session, and then we'll take the first caller.

At this time, if you'd like to ask a question, simply press star followed by the number one on your telephone keypad. Again, that is star one. Our first question will come from the line of Erin Wright with Morgan Stanley. Please go ahead.

Great, thanks. So first on 2022 guidance, Can you speak to some of the company-specific factors you called out? So first on incremental price headwinds embedded in your guidance, is that tied to the dynamics at the retail pet product level? And then also on the slower innovation ramp that's now implied, is that parvovirus or is there something else that's contributing to the lower innovation contribution for this year? And then I have a separate question just on innovation. You mentioned USDA and FDA timelines as it relates to your DERM product. candidate in pet health, and does that mean you have both the JAK inhibitor and the IL-31 products around similar timeframes? Could you have both products launched by 2024? And if you do, in fact, launch the IL-31 product first, what would be extending the timeline for the JAK if that's still a candidate for you? Thanks.

Thanks, Erin. Great questions. Jeff, you want to start on the 22 guide and some of the company-specific factors, and then we'll move to innovation.

Yeah, thanks, Erin. You know, I just want to emphasize again that, as we've said, we're taking a measured and balanced approach. Many factors, Erin, that we expected to drive this accelerated growth in the second half changed significantly in the last three months. FX, as we mentioned, most of these, of course, being macro. There's a high dependency on China, as we know, for growth, and a lot has changed, as we mentioned in our comments. CMOs unable to supply, and then just the overall economic slowdown we see. Yes, as you look at specifically your question on price, we had anticipated a greater than historical level of 2% price We did expect that to be back-end loaded. We took price increases in the first half. We've taken additional price increases here mid-year for the second half and do expect to step up. But two drivers, Erin, that caused the price to be lower, one was on the farm animal side in the generic markets, especially bovine respiratory disease. That was greater than anticipated with new market entries in that market. The second was, yes, in U.S. pet para. On the retail side, under Bobby's leadership and a lot of great things that are happening on our pet retail business, we made a decision to channel some of the price increase dollars, as I mentioned, to trade dollars to drive demand. We will assess that as we go into this third quarter. This lowered price, but it actually increased gross to net and drove positive EBITDA. As we step back and look at price, we continue to see price as a lever. We continue to see price stepping up this half. This will also be a contributor to growth as we lap into 2023, lapping against these price increases and continuing. We see elasticity to take more price, Pat, and even in protein on our differentiated products.

I'm going to talk about innovation, just what's driving this lower ramp, and then we'll get into sort of the timeline piece.

Yeah, Erin, you know, first of all, I would say probably in all my time in animal health, I've not seen, as I mentioned in my comments, as much progress what Ellen has done and really a call out to the R&D team. And, you know, probabilities are up, speed is up, new spaces are up as we look at now feline diabetes, methane. You know, reduction last quarter, DERM late last year with Kindred. So just as I step back, you know, Elanco is building, I believe, a world-class innovation engine in animal health under Ellen's leadership. And I look forward to her coming in November to talk more about it. On the ramp, yes, we've taken the ramp down a little bit. I would point to some of the INCREXA in that BRD market that I mentioned. would also point to experia and i want to just emphasize i think it's important maybe to just call out um experia briefly that you know this is not a matter of um the the the value or the the compelling value proposition the product it's really just a shift in the ramp by one quarter uh without question we you know we missed this ramp timing why it's really the complexity to try the product then transition to full feeding coordinating with the packers but we do again see this trajectory cattle doubled in q2 versus q1 more cattle started on in july we believe we're still very committed to the six to seven hundred million and we believe that the leading driver of that will be experia as a blockbuster and again experia will be another key growth driver in 2023. Then relative to DERM, what we would say is yes, one of the two submissions we'll make in the next two to four months is DERM. I will say that we haven't articulated which asset is Which one, I will say though that the DERM portfolio continues to progress nicely, both the IL-31 as well as the JAK and the assets behind that that came from Kindred as well as our own pipeline. And Ellen will articulate a little bit more of that when we get into the November call. Thanks. We'll take the next caller.

Your next question will come from the line of Michael Riskin with Bank of America. Please go ahead.

Great. Thanks for taking the question. I want to pick up on something you were just talking about, innovation and some of the newer products. Given some of the things you just called out in Krax and Xperia, and given what you're seeing for some of the other more recent launches, do you think maybe it'd be prudent to reconsider the $600 to $700 million target by 2025? I guess I'm getting at is that given a slower start to that, Do you see incremental risk to getting those numbers over the next couple of years? And then I'll throw out the follow-up question at the same time. The delay to the long-term margin target for gross margins and adjusted EBITDA, there's a lot of inflation macro factors impacting that, but you also have some company offsets in terms of pricing power and some things that have done better. One is, do you have the ability to potentially continue to use those levers to offset those? And two is, and kind of related to that, is what if inflation doesn't improve? What if the supply chain factors don't improve? What if China lockdowns seem to persist? How much risk does that put on over the next 12 to, let's say, 24 months for long-term performance if the macro factors that are causing the delay of that don't see any improvement? Thanks.

Yeah, thanks, Mike. Jeff, let's start with the innovation, $600 to $700 million, and then we'll talk margin targets.

Yeah, Michael, right question, absolutely. But I would emphasize that, again, the adjustment innovation is driven a lot by potentially the ramp of Xperia, which we're extremely confident in, even more so this quarter than a quarter ago, and it's really just been a matter of a shift. And we see that this will become a blockbuster franchise, a lot like the Reminson did in the days that it was launched. That's the kind of standard. That will be an accelerator. We're also, as you know, last year, about a half a dozen portfolio enhancing innovations. We're doing that again this year. That will play as well. And then, you know, I think the most important, as you know, is the ramping of the pet health blockbusters that are in the pipeline and the probability of those going up. And, you know, we had a probability-based number, and that's 600 to 700 million. The probabilities, as I've mentioned, have gone up materially. And given that, you know, our confidence goes up and they more than make up for a slower ramp in the innovation. So again, a robust pipeline, heavier participation by pet, more pet blockbusters, and we're also bringing in new spaces, as we've mentioned, that also will supplement like feline diabetes that we brought in that will be a contributor as it's under regulatory review. Then, you know, maybe I'll move just quickly to the guidance and give it to, or the margin targets and give it to Todd, maybe for some of the levers, Michael. But I want to really emphasize a few things in these margin targets. First of all, we remain committed. We're adjusting the timing, but we're not changing the commitments. and we're not changing our annual progression of margin we're committed to margin growth in 22 and 23 and 24 going forward our productivity is working there's no question we face some headwinds the environment has caused us to make an adjustment in the timing not in a change in the commitment and as todd mentioned in his comments We were on track to actually exceed them, especially on the gross margin side, and I want to emphasize that. There are some levers that we have in addition. You know, I would start with the organization with an EVO-like ownership mindset. We're finding opportunities every quarter beyond what we thought. There's a lot of synergies between Bayer, but maybe, Todd, you want to highlight a little bit on just some of the approaches we're taking and some of the balance that Michael's challenging us on.

Sure, Jeff, and thanks for the question, Mike. You're right, we have taken some price, but we're still running at the 2% historical level we'd expected back at our investor day. We do foresee increasing price and we've called that out as a driver in the back half of this year as we return to growth in Q4 with key biggest lever. individually is certainly the integration of the bear systems and processes into elanco as we noted back in february that's 50 to 60 million of incremental savings on eva da that we'll get as that annualizes in 24 and on track for the middle of 2023 Your question about inflation continue to be hot, China not coming back, certainly those are big parts of our business. The team's done a very good job of offsetting significant amount of inflation. That's why we're in the face of having mixed challenges this year, our pet health business down, poultry up. We're expanding gross margin. We think we've got levers yet to go there, especially through the EVA-like metric Jeff mentioned and the ownership mindset. But it is something we have to continue to do and aren't getting the lift we'd get without that. And then the FX component, certainly $55 million of EBITDA we've lost in 2022 versus 2021 based off the current expectations for foreign exchange rates.

Great. Thanks. We'll move to the next question.

Your next question will come from the line of Chris Schott with J.P. Morgan. Please go ahead.

Great. Thanks so much for the questions. My first one was just, I'm still trying to get my hands around kind of bridging from the two key results we saw printed today to the three key guidance, and it seems like The headwinds you're referring to were, you know, were in place in 2Q. They're obviously continuing or strengthening into 3Q. But we are seeing a pretty big step down in sales and even a bigger step down in margin. So I'm going to try to fully understand that issue. And then my second question was just on Seresto. And just talk a little bit about, as you think about the U.S. business there, what it's going to take to get back to maybe a more normalized kind of run rate for that business. Thank you.

Thanks, Chris. Let's start with Todd for the kind of more full-year guidance question, and then we'll go to Jeff on Seresto.

Chris, thank you for the question. On slide 15, you can see the bridge on the change in our guidance. FX clear using rates as of early August, and that's the $65 million headwind. As we think about the impacts in the back half, we had said in May we expected China to have a V-shaped recovery in pet health and to get back all the lost hills in Q2 in the back half of the year. That isn't happening the way the recovery is going in China. Pork prices continue to ramp, but not at the same pace, and our customers' break-evens are running even higher than we realized. And then finally, on the poultry side, we've seen a big impact on our poultry business that wasn't visible in May in China. The supply chain disruption, this is a lot of small items that are finally catching up to us on end-user demand. We've been mitigating a number of supply challenges over the last year. But we're finally at a point where we just don't have a mitigation to those. These are, you know, 10, $3 million to $4 million items across the globe to serve everything from poultry to pet health to cattle to sheep, all, you know, small items that are adding up that just – you know, are impacting us in a way that we have to call it out now as we go into the back half of the year. And then just general softness. We've got 16 of 22 international kind of affiliate groupings that are growing the top and bottom line. But all of those have started to slow as we went into June and July. And that's what we're representing with this economic slowdown. I don't have a specific item, but it's clear we're seeing a softness across our business that we want to reflect. So then, again, para-competition that we do see happening in the vet clinic in the second half, the innovation ramp, the Xperia, Increxa, Crudelio Plus, those are all back-up items versus what we saw in May, offset by continued good growth in aqua and then poultry. So those are the drivers and ones we wanted to be clear on today.

Yeah, and just Soresto, getting back to normal growth.

Chris, great, great question. Thank you. Again, a lot of belief in Soresto. I come back to some of the fundamentals, and I can share a little bit on the quarter. You know, Soresto serves an important market, you know, an eight-month coverage, affordable, it's convenient, it doesn't require a vet visit, there's a large market out there. As we study the data, we did this quarter a, you know, customer, you know, consumer research, and we saw 95% repurchase intent, so a lot of loyalty, just what we found in the diligence, a lot of return users. but also low awareness, overall awareness. So our digital capabilities to grow awareness is important. So a resilient brand and it's differentiated. Some discrete items I would point out, Chris, that maybe as we look at dispensing a little stronger than maybe the decline in sales, We saw a softer season. Remember, retail, it takes the warm weather to get people activated to go buy their collar. So in April, that cooler weather did have an impact. We have a very big business in Central East Europe that's been impacted some by the war. Again, a strong business in Central East Europe for Seresto. And then we saw some lower retail inventories where the retailers took their inventories down. When you take and normalize that, yes, there was some increased competition, but I think those discrete items balance that. The brand grew 2% year to date. And again, as we look going forward, Chris, it's one, it's, One, more geography without question. International is growing very nicely for Seresto. Two, it's with digital, growing more awareness to that segment that doesn't see the veterinarian, and then lifecycle management. All of those things will be critical as we look at growing this brand, which is our intent, that this brand will continue to grow. And more than 50% outside the U.S., we see a lot of runway for growth with Seresto.

Great, thanks.

Your next question will come from the line of John Block with Stiefel. Please go ahead.

Great, guys. Thanks. Good morning. Jeff, I think I heard you right. You talked about gross margin EBITDA expansion continuing to 2023. And, you know, I'm guessing that has to be predicated on some top-line numbers. So just any thoughts or commitments for revenue growth in 2023, you know, again, some of the key products it looks like might not be on the table until 2024. And then just longer term, when you get some of those key products across the goal, and let's focus on the triple, just talk to us about, you know, the impact that you think it may or might not have on advantage on Seresto, you know, the way that you're going to attack the market. So call it, it's more incremental in nature rather than cannibalistic. Thanks guys.

The margin expansion and then thinking about the new innovation.

John, I thank you for the question. Look, when we look at our IPP strategy, productivity is working, margin expansion, pipelines progression on the innovation side. Our portfolio, when we step back and look at the algorithm of new products followed by focus brands and even doing better on defend brands, as a whole, we still believe that strategy works. you know, as a whole, it's going to play out nicely over now to 2025. But growth is a focus. So let me emphasize, we do expect our business returning to growth in Q4. That includes our pet health business, again, with a backdrop of the assumptions that we have today. We will assess 2023, but remember, even Even looking at the importance of things that we see on our focus brands or innovation, we see China coming back. I mean, what's happening in the second half of 22, we see playing positively in 23. The CMOs that Todd mentioned were adding suppliers. We don't see that being a long problem. The price lapping, the increasing of innovation led by Xperia, and then the adding of products like Parvo that we expect their approval late this year, early next. and the approvals. And then when I step back, John, and see, hey, farm animal, we in a lot of markets are taking share. Poultry, aqua, we have a leadership position. Pet therapy, the non-para business is getting to be a higher percentage of Elanco overall. And international, a statistic I would share, 16 of our 22 clusters of countries are are growing both top line and bottom line here even in the second quarter. So I think a durable international business. So growth is a focus. We do have durable, diverse geography and portfolio. No question the second quarter was challenged. And then as you look at moving now to the pipeline and para, what I would emphasize is, first of all, we are looking at para holistically. We are looking at both first omni-channel in and outside the vet clinic. And then we're looking at the differences between the international and the U.S. businesses. Without question, you know, first to class is always, you know, a charge, but best in class is equally as important. And so when we start to see, hey, we've got differentiated offerings with this new pair of asset that we believe as we look at, hey, how can it capture share? It is the leverage of our channel, the leverage of, you know, new puppy starts, the leverage of being able to complement what we have. The legacy brands, like a Trifexis, will continue to erode, but that's what we expected in our algorithm. But I think when you step back and say the breadth of our portfolio, the breadth of the channel, and now bringing new innovation in, we see it being net-net, nicely accretive between now and 2025. Thanks.

We'll take the next question.

Your next question will come from the line of Uma Ravith with Evercore ISI. Please go ahead.

Hi, guys. This is Mike Cicciori in for Omer. Thanks so much for taking my question. Just two for me. Number one, on guidance, how much conservatism would you say is baked into the second-half guidance? I'm saying this because on the 1Q call, you implied that the second-half guidance suggested a strong second-half rebound. Obviously, things have changed. Just wondering if going forward, there's a strong element of conservatism baked in the back half of the year. And the second question is just more on livestock. In Q1, you said that pricing has held up well for producers and that they wanted to keep buying along those products to get the most out of feed. I'm wondering if that's still the case and if you could provide any color along those lines. Thank you.

Great. Let's start with Todd just on the guidance, and then we'll move to Jeff on livestock.

Mike, thanks for the question. We feel good about the guidance we're providing today. We don't feel good about the change relative to May, but as we look forward and have conversations with all of our key leaders across the company, we're trying to reflect the best view of the current reality. We factored in this kind of global slowdown and are very focused on continuing to drive change. positive growth in EBITDA as well as returning to growth on the top line in Q4 for all the reasons we've already mentioned. So, Jeff, on livestock?

Yeah, again, a good quarter for our farm animal business overall, international in both U.S., growing nicely. I think that comes from some of the diversity and some of the fundamentals that you mentioned, Mike. You know, the The demand for protein remains. There are some price pressures that we're seeing that are starting to get where prices with some of the economic slowdown, it's starting to slow slightly. I would point to a couple. I think poultry is very positive. The demand is very strong globally because it's a more affordable protein. Our leadership position in poultry turning higher cost grains into more protein there will be strong. Same with aqua. I think on the swine market, it's everything that Todd just mentioned. It's really, for us, swines all driven by China. And, you know, that's more of a balancing of demand and supply and economics prices coming back. We're seeing prices coming back in July, but again, not to our expectations, but, you know, hope for a recovery. And then beef, I think the dynamic I would just highlight, you hear about the droughts and everything that's happening. What I see here is more cattle coming out of the farmer feeder calves going into the feed yards. So we'll see in the second half of the year, Mike, a higher number of cattle on feed because of the drought and the movement of getting them back into the yards, probably for more days because they'll come in at lighter weights. But our population of the herd, especially in the US beef market, is down. It'll probably take a couple years. So you'll start to see a little bit of a slowdown, I think, in herd rebuild. and 23 and 24. But net-net, farm animal business pretty resilient here. A lot of it is because of the conversion of higher cost feed into protein from our products and animal health.

Great, thanks. We'll take the next question, please.

Your next question will come from the line of Nathan Rich with Goldman Sachs. Please go ahead.

Hi, good morning. Thanks for taking the questions. A couple on parasiticides. I guess first, Jeff, you talked about The data on the broad-spectrum parasiticide crossing the heartworm threshold, the product that's on the market today I think has 100% efficacy against the development of heartworm. I guess, do you see your product as competitive to that? And then secondly, I wanted to ask about the shift to more trade funds instead of marketing dollars, and I think you called that out as a net positive, to EBITDA. Could you maybe talk about the rationale for making that shift in the commercial strategy and how it impacts your view of growth for that category going forward?

Yeah, great question, Nate. So just real quick to start on our – On our pair of assets, again, we look through a lens of things that can be differentiated, but also the critical thresholds to get the product to market. As we looked at Crudelio Plus as an example, not having that 100% heartworm was a restrictor and has been a restrictor for innovations across many companies. You know, significant news today that we believe we've passed the threshold necessary to bring a broad spectrum next generation product to market. Beyond that, so, you know, matching absolutely. Then beyond that, we are looking at and won't articulate great detail now, but, you know, we believe that what we have bringing to market at the stage it's in, is differentiated from what is on the market today, even considering the best in class. Again, more work to be done and the label finalized with the FDA, but at this stage, we do see that. And Ellen will share a little bit more of those details in November as well. And then, you know, on the retail side, again, we believe we've got a great portfolio. The retail market, you know, has its ebbs and flows, but we've got a leadership position here. We've got leadership brands with a Seresto advantage. We're innovating against those brands, like with Advantage XD. And I want to just highlight, I mean, Bobby Mody coming in with his team, with some of the Bayer expertise we have. we believe we're well-suited to continue to grow. There's a lot of positive trends for retail and the ease of meeting pet owners where they want to shop and maybe even a more affordable way in these inflationary times. We made a decision to go ahead and to work closely with our retailers and put more trade dollars in to increase awareness and increase you know, shelf space and share a voice in the retailers. We'll see how that plays out. As we saw a slower start in April with the cooler weather, this was one of the moves we made late in the quarter. More to come on that. But again, confidence in our team and our capability and our portfolio and our innovation in the retail space and continue to see this omnichannel is critical.

Great. Thanks. We'll take the next question.

Our final question will come from the line of Christine Raines with William Blair. Please go ahead.

Good morning and thanks for taking the question. Can you give me some more details on your feline diabetes drug? What do you anticipate the market opportunity to be here? And also same question for Dorbium. And then in general, how are you marketing these feline products given that sort of, as we all know, cats are medicalized at a much lower rate? And then just for my second question, it's going to be about what your expectations and goals are for the pipeline Parvo buyers product you have. Thanks.

Yeah, let me try to tie those together. First of all, I think feline, there's no question. So, you know, under-medicalized, you know, not coming to the vet as much as maybe they should, we see a real opportunity with Crudelio Cat last year, Advantage XD coming. We've got, you know, Zorbium that we've launched here, and then we've got this new product that we're bringing in. We continue to see expanding feline diabetes. We're also, and a real credit to our team and the digital team in Elanco, that actually in one month, I don't know if I've seen this fast of adoption in any other product, 5,000 clinics in one month. grabbing a hold of Zorbium because of not only the product, but I believe also a digital strategy that's working, and that will be a capability that we'll use for feline as well as even new products that we're getting ready to launch. This feline diabetes product, again, some of the challenges that you see is You know, being able to get to needle free novel first in class a new mechanism of action. You know, a daily medication that's really easy to give really opens up an opportunity to show that hey diabetes can be easily treated. And this market, you know, we're going to continue to size this market and assess this market. But again, a product. that is a new mode of action and under regulatory review and expecting that we'll be launching that product as we go into 2023 as another contributor to growth. And then on Parvo, yes, Parvo continues to track nicely, will be a market as we look at about in the U.S., you know, somewhere in that 400,000 to 500,000 dogs a year, puppies a year, that we're going to be able to be vital to every vet clinic on something that's untreatable today. We are working through all the final milestones and hope to bring that product into an approval by late this year, early next. Again, another contributor to growth and innovation as we go into 2023.

So maybe it would... Yep, thanks for the last question, and Jeff, I'll turn it over to you to close.

Yeah, I just thank you, everyone, for joining this morning. In closing, I just want to reemphasize... you know, some of the key points that are most important. Elanco delivered a strong second quarter, a credit to the Elanco team, continuing to focus on expanding margins, growing EBITDA, generating cash, and delivering efforts despite the sales pressure and the challenging environment here in Q2. We're confident in long-term growth. the durability of our business and particularly pleased with the significant pipeline progress so far this year and in the next two to four months as I emphasized we will begin the submissions that will really open up the next era of innovation and growth and opportunity for Elanco and this will ultimately lead to increasing value for our customers and our team and our stakeholders and I again want to thank you for your interest in Elanco we look forward to continuing to engage with you as we go through the rest of this quarter

Ladies and gentlemen, that will conclude today's call. Thank you all for joining. You may now disconnect.