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.