Elanco Animal Health Incorporated

Good morning and welcome to Elanco Animal Health's first quarter 2023 earnings call. All participants are in a listen-only mode. After the speaker's presentation, we will conduct a question and answer session. To ask a question, you'll need to press star, follow the number one on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the call over to Katie Grissom, Head of Investor Relations. Thank you. Please go ahead.

Good morning. Thank you for joining us for Elanco Animal Health's first quarter 2023 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, Todd Young, our chief financial officer, and Scott Perucker from investor relations. The slides referenced during this call are available on the investor relations section of elanco.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 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. As we open 2023, we're encouraged by our improving business results this quarter. We saw sequential improvement in many leading indicators of underlying demand and easing environmental factors that pressured our business in 2022. While we expect macro factors to persist, Elanco is making the necessary disciplined decisions to stabilize the business and progress our innovation pipeline, while focusing on improving our cash flow generation and returning to constant currency sales growth in the second half of this year. Beginning on slide four, this year is off to an encouraging start. Improvement in our underlying business, notably in pet health, increases our confidence in the outlook for the first half and full year of 2023, allowing us to raise the bottom end of the guidance range for our key metrics. We progressed important operational and pipeline milestones and reduced uncertainty in key areas, including the completion of the Bayer ERP system integration and the positive collaboration and progress with the EPA on Soresto. The pipeline continued to advance with conditional approval of our parvovirus product and initial submission of our IL-31 monoclonal antibody for dermatology. Overall, our pipeline is in an even better position than it was just two months ago. Additionally, we remain confident in our liquidity and the business's ability to generate cash throughout the year. While our operating cash flow was seasonally lower in the first quarter, we continue to expect improvement throughout the year, leading to approximately $100 million of cash available for debt pay down this year. We remain confident in our position relative to our financial debt covenants and our ability to reduce debt and leverage over time. Finally, while our executive leadership and global team remain committed to near-term delivery, we're also actively planning for the expected launches of our potential blockbuster innovation. At the end of the call, I will share some considerations for our encouraging yet balanced outlook as we expect to see an inflection point in 2024 as we receive approvals and begin launching our potential blockbusters. Moving to slide five. In the first quarter, Elanco delivered revenue of $1.257 billion, a reported growth of 3%, and constant currency growth of 6%. In April, we completed our global systems integration, bringing the legacy global Bayer animal health business into the Elanco ERP environment. As a part of our system cutover preparation, we proactively communicated to our customers our expectations of a two to four week shipping blackout periods for Legacy Bear Animal Health products that would occur in April. Our February guidance assumed that customers would likely shift purchases of Legacy Bear products from the second quarter into the first quarter to ensure continuity of supply in the market. Our best estimate, based on our results, analysis of individual markets, and customer conversations, results in a benefit from the ERP blackout in the range of $90 to $110 million, or a 7 to 9 percentage point benefit to growth. Excluding the ERP blackout, revenue performance in the first quarter was largely in line with our expectations and represents a sequential improvement for both pet health and farm animal compared to our fourth quarter, 2022. In pet health, the U.S. market remains strong overall. despite the continued low single-digit declines in U.S. vet clinic visits. Excluding the benefit from the ERP blackout, our pet health business was approximately flat, representing an improvement from the high single-digit and low double-digit declines we reported over the last several quarters. Bobby Mody, our Executive Vice President of U.S. Pet Health, and his team have refined the strategy and improved execution in our largest and highest margin business area, leading to improved performance in four key areas, share of voice, physical availability, pricing, and innovation. We have increased our share of voice in three ways. We are driving more efficient and targeted conversations with clinics through digital tools, leveraging innovation to gain more mind share from vets, and adding inside sales reps to provide broader and more frequent engagement with Elanco. As an example of our expanding digital efforts total touch points with that care professionals was up 15% year over year in the first quarter, resulting in greater and faster clinic lead generation. Next we're expanding physical availability of our products more total distribution points across retailers and clinic shelves more meaningful locations in stores and new channels contributing to improve dispensing across our portfolio. In the first quarter, we expanded total distribution points for our retail portfolio by 17%, which contributed to the U.S. Seresto and Advantage family growth in the quarter. Regarding price, we significantly upgraded our capabilities in this space. We're taking a disciplined approach to maximizing revenue via list price increases and trade promotion optimization. U.S. pet health grew price more in the first quarter than any quarter in the last year, which contributed to the global pet health price growth of 5%. Finally, we're capturing additional sales from innovation and product refreshes with six products approved or launched in U.S. pet health the last six months as we are building a launch excellent muscle through improved capabilities. Our retail category management efforts on the Advantage family are driving higher velocity and lower cannibalization than we expected for our value-oriented relaunch of canine Advantix. Overall, in the first quarter, we believe these actions help the U.S. pet health business to outpace the overall category in OTC dispensing and drive year-over-year growth in Elanco Rx product sales from distributors out to the veterinary clinic, despite continued pressure from competitive innovation. Additionally, we likely benefited from the macro factors, including improved consumer conditions and a potentially earlier parasiticide season. We are pleased with the positive outcomes from the actions we've taken to strengthen our position in U.S. pet health market, but acknowledge there's still a lot to play out this year with uncertainty around the economy, retailer pricing, and competitive actions. We look forward to continued progression to improve this business. Now a few comments about our pet health business internationally. In Europe, the economic environment has been better than expected, but our performance was pressured in the quarter compared to the very strong start in the first quarter of 2022. While the pet health market and Elanco's sellout data for available countries in Europe is improving sequentially, we still expect continued environmental pressure on the business in the second quarter. In farm animal, the underlying business benefited from the strength in Europe and Asia led by poultry, offset by decline in the U.S. related to vaccine supply and competition in select product categories. Despite this, we remain encouraged by the growth opportunity for Xperia this year. Six of the largest U.S. cattle feeding organizations have moved to commercial adoption of Xperia with broad acceptance by the beef processors. Xperia adoption continues to strengthen the value of our overall cattle portfolio offering, including ramensin. Finally, in China, while poultry is improving, swine prices were pressured to start the year. We're cautiously monitoring progress in this market and assume gradual improvement throughout the year. Across our pet and farm animal businesses, we continue to expect year-over-year environmental and competitive pressure. However, the successful completion of our ERP system integration, our innovation progress, and positive indicators in our business, notably in U.S. pet health and international poultry, support our decision to raise the bottom end of guidance on our key metrics for both the first half and the full year. Next, moving to slide six and the IPP milestones we achieved over the last few months. Starting with productivity, we are pleased with the completion of the ERP integration the last major milestone associated with the Bayer Animal Health transaction. I am proud of the team's preparation, their leadership, and the execution to advance us into this new phase. We look forward to the flexibility, the simplicity, and the optionality of operating this business now on one consolidated system. Moving to portfolio, we continue to collaborate with the EPA as they near completion of their review of Soresto, which included expert counsel, from the FDA in the process. We appreciate the EPA's approach and diligence during the science-based review process. Elanco continues to align with the EPA on their recommended stewardship actions, supporting the continued registration of the product. We expect the formal results to be communicated by the EPA as they are finalized in the coming weeks. As a leader in animal health, we are committed to the well-being of pets and welcome the opportunity to work with EPA on these stewardship actions that we believe will raise the bar and support the continued safety of Seresto to protect pets from fleas and ticks and the deadly diseases they can carry. Slide 7 details our progress towards unlocking Elanco's next era of growth and value through innovation. The pipeline continues to strengthen with advances and all key programs in line with our expectations. Since February, we launched four new products, received three approvals in major markets, and initiated the submission of our sixth new potential Blockbuster product. The R&D organization is executing with excellence while driving partnership across manufacturing and commercial. In mid-March, we began shipping Bexacat, our once daily oral SGLT2 inhibitor, diabetes product for cats in the U.S. Earlier this month, we received FDA conditional approval For varenzin, CA1, a daily oral treatment for the control of anemia associated with chronic kidney disease in cats. These portfolio-enhancing products are both first-in-class feline innovations, and we view them as market creation opportunities. Next, the USDA approved our Elwood, Kansas monoclonal antibody manufacturing site and granted conditional approval for our canine parvovirus treatment. As our first monoclonal antibody, this approval represents a significant milestone in our journey to advance this important platform. With a total addressable market in the U.S. of approximately 330,000 canine parvovirus cases per year, the conditional approval highlights the value and need for this unique treatment. We already have a strong interest from the veterinary community for this potential blockbuster product. We expect to begin shipping in the coming weeks as we finalize state approvals. Important to understand, the conditional approvals for our parvovirus treatment and varenzin are a reflection of agreed-upon approval pathways with the regulatory agencies to allow for accelerated market access, given both these products address significant unmet needs. For both, we plan to continue to progress towards full approval and do not expect the current status to be commercially limited. On the pet health OTC side, we've expanded our OTC R&D capability to enhance our efforts here. Since our last call, we launched Canine Advantix, a flea and tick preventative for dogs, and Advantage, a flea preventative for cats, at a small subset of U.S. retailers. These value offerings are a cornerstone of our good, better, and best approach to flea and tick retail category management. Additionally, we're pleased to announce the approval and launch of AdTab in several EU markets, our third OTC introduction this year. Leveraging the Advantage brand name, AdTab is an oral monthly flea and tick product for both dogs and cats. This addition establishes Elanco in the emerging OTC oral parasiticide market in Europe. Finally, in March, we completed the initial technical submission to the USDA for our IL-31 monoclonal antibody for canine dermatology. Each of our potential blockbusters is progressing as planned with a path towards approval by the first half of 2024. Xperia, Bovair, and our Parvo product are novel, first-in-class products, while our broad-spectrum parasiticide and JAK inhibitor dermatology asset are expected to be differentiated from the current products in these large and growing markets. Now I'll pass it to Todd to provide more on the first quarter results and financial guidance.

Thank you, Jeff, and good morning, everyone. Today, I will focus my comments on our first 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 9, in the first quarter, we delivered $1.257 billion of revenue, reported growth of 3%, or growth of 6% in constant currency. Price contributed 5% in the quarter. As Jeff referenced, We believe our ERP system integration led to a shift in sales from the second quarter to the first. In February, we assumed this shift would benefit first quarter revenue by $40 to $80 million. However, we now estimate the shift to be approximately $90 million to $110 million. A few factors drove the revised estimate of the customer-initiated demand shift. First, we believe our customers demonstrated a higher level of sensitivity than we anticipated related to the potential for extended disruption from the system cutover and general supply chain concerns. Additionally, we believe sequentially stronger dispensing at our retail partners contributed to the magnitude of purchases in the U.S. pet health business. We believe estimating the benefit of the shifted sales resulting from the ERP blackout provides important context to better understand the trends in our underlying business performance. Therefore, on slide 10, we provide our revenue results by business area on a reported and a constant currency basis, as well as our estimate for the benefit in the quarter from the ERP blackout. For pet health, constant currency growth was 8%, with an estimated benefit of 10 to 12 percentage points from the ERP blackout. In the US, pet health revenue grew 12%, including an estimated 12 percentage point benefit from the ERP blackout. The approximately flat underlying business performance was driven by innovation and growth in our OTC parasiticide portfolio, offset by supply disruption for certain vaccines and continued pressure on legacy parasiticide products. Recent retail dispensing data indicates improving dynamics in the OTC flea and tick market, with Elanco maintaining our market leadership position. Seresto and the Advantage family both grew in the quarter in the U.S., benefiting from an improving macro environment and the commercial efforts Jeff described. In the first quarter, we temporarily suspended our minimum advertised price or MAP policy to avoid potential extended interruptions in product availability in the retail channel before or after our ERP blackout period. During the MAP suspension, a number of retailers offered lower prices to consumers primarily on Seresto. Elanco did not materially change our trade promotion strategy with customers in the quarter, helping to drive the 5% price increase in global pet health. We believe some of the Seresto dispensing strength in the first quarter may be a result of this dynamic and anticipate potential softening and dispensing trends throughout the remainder of the season as prices move higher as a result of the reimplementation of our MAP policy at the end of April. We believe maintaining MAP pricing is an important component of protecting the value of our brands long-term. Outside the U.S., last year's robust start to the year creates a difficult comparison in the first quarter. International pet health grew 5% in constant currency with an estimated benefit of 11 percentage points from the ERP blackout. China was negatively impacted by the post-lockdown COVID outbreaks in the first quarter. However, we are encouraged by the latest data in these markets pointing to improving in-market demand starting as early as March. Globally, our farm animal business grew 5% in constant currency, with an estimated benefit of 4 to 5 percentage points from the ERP blackout. In the U.S., our farm business declined 6%, with an estimated benefit of approximately 2 percentage points from the ERP blackout. The decline in the underlying business was driven by vaccine supply disruptions, poultry customers rotating off of Elanco products, and lower demand for our cattle implants. These headwinds were partially offset by the continued ramp of our innovation portfolio, mainly Xperia, and our new nutritional health products. Outside the U.S., constant currency growth was 10%, with an estimated benefit of approximately 6 percentage points from the ERP blackout. The growth in the underlying business was driven by strength in Europe and Asia, led by poultry, and price, partially offset by timing of purchases in the aqua business. Continuing down the income statement on slide 11, gross margin increased 230 basis points to 60.8%. Gross margin benefited from the ERP blackout by an estimated 130 to 170 basis points as more sales of higher margin legacy bear animal health products were realized in the first quarter. Additionally, the improvement was driven by price growth and continued productivity gains across our manufacturing network partially offset by inflation. Operating expenses increased 1% year-over-year in the quarter, with R&D expenses flat at $81 million and SG&A expenses up 1%, primarily driven by employee-related expenses partially offset by the favorable impact of foreign exchange rates. Interest expense was $64 million compared to $52 million last year, in line with our expectations. Adjusted EBITDA was $379 million, or growth of 12%. with an estimated $70 to $90 million of benefit from the ERP blackout. Adjusted EBITDA margin was 30.2%, an increase of 260 basis points, with an estimated 370 to 460 basis point benefit from the ERP blackout. Adjusted EPS was $0.45 in the quarter, with an estimated benefit of approximately $0.11 to $0.14 from the ERP blackout, assuming a corporate consolidated tax rate of 21.9%. Before moving to our guidance, let me offer a few words on our cash, debt, and working capital on slide 12. Cash used for operations was $145 million in the quarter. The year-over-year decline in the first quarter operating cash flow reflects higher cash interest and a lower reported net income, excluding the impact from the ERP integration. Historically, the first quarter is our lowest cash-generating quarter, with accounts receivable increasing due to the sequential increase of sales from the fourth quarter to the first quarter, and the timing of our corporate bonus payout in March. Additionally, inventory increased in the quarter, with pet health inventory declining slightly and farm animal inventory growing, largely driven by the pressured sales volume over the last several quarters. We have established a cross-functional team focused on improving our network and capital performance, especially as it relates to inventory on our balance sheet. We have begun implementing plans to reduce throughput in certain manufacturing facilities to help manage our balance sheet inventory levels down. With the post-COVID stabilization of global supply chains and our ERP integration complete, we believe we can start to improve this area of our business. We ended the quarter with net debt of $5.8 billion as we drew $200 million on our revolver to offset the typical seasonality of cash flow in line with our expectations. At the end of March, our net leverage ratio was 5.4 times, slightly lower than the 5.5 times at the end of 2022. With our tighter EBITDA guidance and our continued expectations of $100 million of free cash flow available for debt pay down, we now anticipate our year-end net leverage ratio to be between 5.3 and 5.8 times. Given the recent volatility in the banking sector and increased investor focus on liquidity, Slide 19 in the appendix provides the latest view of our debt position. In March, we took advantage of volatility in the SOFR forward curve to lock in interest rates through the second quarter of 2025 for the $1 billion of swaps that were set to roll off in October of this year. This will keep our fixed rate debt at between 65% and 70% of total debt through 2023 and 2024. Importantly, we continue to expect durable cash flows from our business and are confident in our ability to service our debt with our current liquidity position. Now, let's move to our financial guidance, starting on slide 14. As Jeff said, we are raising the bottom end of our guidance range across all key metrics, driven by the successful completion of the ERP system integration, our innovation progress, and the positive indicators in our base business, notably in U.S. pet health and international poultry. For the full year, we are raising the bottom end of our guidance by $30 million and now expect revenue to be between $4.31 billion and $4.4 billion or approximately flat to a 2% constant currency decline. For adjusted EBITDA, we are raising the bottom end of our guidance by $20 million and now expect $940 million to $1 billion. Finally, we anticipate adjusted EPS of 76 to 83 cents an increase of two cents on the bottom compared to our February guidance. Slide 21 in the appendix provides updates to several of our additional assumptions. On slide 15, we provide our updated financial guidance for the first half of the year and the second quarter. We reflected the raised bottom end of the full year guidance in the first half guidance. While we're encouraged by the positive leading indicators, we continue to expect a decline in the top line for the first half of 2023 of approximately 2% to 4% driven primarily by environmental and competitive factors and supply constraints in our U.S. farm business. As shown on slide 16, we expect the $90 to $110 million of estimated benefit from the ERP blackout in the first quarter will unwind, negatively impacting revenue growth by approximately 8 to 9 percentage points in the second quarter. Excluding the estimated impact of the ERP blackout, we expect the decline in the base businesses will be largely in line with the first quarter. The shift is also expected to negatively impact adjusted EBITDA and adjusted EPS in the second quarter, as shown on slides 22 and 23. In line with our initial guidance in February, adjusted EPS is also impacted by year-over-year headwinds from higher interest, taxes, unfavorable FX rates, and additional operating expense investments. Finally, moving to slide 17, for the full year, consistent with our initial outlook from February, Our implied second half guidance for this year represents flat to 2% constant currency growth. Our guidance reflects sequential improvement in growth in both the first and second half of this year. We are confident in the second half of 2023 expected return to growth for several reasons. First, we expect our innovation portfolio will continue to ramp as existing innovation products grow and new products are launched. Second, we assume an improvement in vaccine supply will occur starting in the third quarter. Price is off to a strong start, and we continue to expect contribution of more than 2% for the full year. Finally, we see improving macro conditions in China, Europe, and the U.S. compared to the significant pressure we experienced in the second half of 2022. Now I'll hand it back to Jeff for closing comments.

Thanks, Todd. While our team is focused on delivering in 2023, we acknowledge the desire to better understand the opportunity for Elanco in 2024 and beyond. We are not giving guidance beyond 2023 today, but I want to provide you with some context on how we're thinking about the future. First, our portfolio outlook is balanced. We expect continued competitive and generic pressure, but also anticipate improved supply and stabilization in our base pet health business. Regarding innovation, we expect our parvovirus treatment, Xperia, our new OTC products, and others will continue to ramp, delivering incremental innovation revenue in 2024 on the path towards 600 to 700 million by 2025. For our four other late stage assets with blockbuster potential, we're confident in a path towards first half 2024 approvals. However, as we know, regulatory timelines are subject to many factors, and the competitive landscape is uncertain. We are focused on progressing what is in our control, timely, quality, and comprehensive submissions. With that said, we are actively reviewing our launch plans and are focused on speed to market post approval. Based on recent experience with Zorbium, Bexacat, and Parvovirus, we expect launches to be around two to four months post approval. We have not finalized our launch investment plans. However, we expect more limited incremental spending ahead of launches with consideration for more significant investment post-launch. The team is working closely to optimize these U.S. launches and will take a thoughtful approach to staging investment. Finally, with the completion of our ERP integration, we continue to expect to drive additional synergies and reduce project cash needs to less than 20 million next year. contributing to expected improved operating cash flow. We hope this additional context is helpful as you consider the opportunity for Elanco in 2024 and beyond. We are encouraged by the milestones achieved, reduced uncertainty, and positive leading indicators, and have a balanced outlook for expected progress in the medium term. 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.

Thank you. As a reminder, to ask a question, please press star followed by the number one on your telephone keypad. Our first question comes from Chris Schott from JP Morgan. Please go ahead. Your line is open.

Hi. This is Ekaterina on for Chris. Thank you so much for taking your questions. So first on ERP, I think you mentioned the magnitude of the ERP dynamic was greater than you were expecting in the quarter. Can you just elaborate a bit more on how you know that that was all ERP and maybe not strong underlying kind of demand than you were expecting? How are you approaching, I guess, separating out the ERP piece from just like demand? And then the second question is on channel inventory levels in the quarter. So some of your competitors had mentioned distributors lowering inventory levels in Q1. So if you take out all that happened with the ERP piece for the Bayer product, is this something that you also saw for the Elanco business? And then maybe how did that impact Q1? Thank you so much.

Thanks for the question, Katerina. With respect to the $90 to $110 million estimate we've provided for the bridging stock ordered by our customers, We've done a lot of analysis with respect to both, you know, specific orders from our customers and conversations with them, understanding what sales have been in historic periods, and then also just looking at underlying demand trends for dispensing data and inventory levels. You know, this number is our best estimate. I've also got the benefit of having already seen April sales, so we feel very good about this 90 to 110. It is a timing issue. This is why we made the decision in February to guide to the first half, understanding that this would be a little noisier than we'd ideally like. But net-net, we feel very good about that, though we are pleased with underlying demand. We think it was higher. than what our original estimate was, as our customers probably were more concerned they'd be out of product longer than our confidence in the execution we would have. Great news for us, execution was on the money, and we had the U.S. up and running by April 10th. The rest of the country staged over the course of April. We're up, we're running, we're shipping product, we're billing, we're collecting. So really pleased with how the team executed this ERP cutover. And then with the question on channel inventory, the first part to note, Most of the U.S. sales for the Bayer legacy products go directly to our retail customers, so there's not much impact on that distributor levels or in the farm channel. Overall, those levels have been consistent with what we have had since the end of Q2 of 2020, but we are attuned to distributors with higher cost of capital focusing on inventory levels, and so we've factored that into our forward guidance as well.

Our next question comes from Erin Wright from Morgan Stanley. Please go ahead, your line is open.

Great, thanks. As you think about the three companion animal blockbuster products in 2024, so the parasiticide and the derm launches, is the timeline still on track? Has there been any changes there? Is there any possibility of expediting those launches? And how are you thinking about your conversations with the FDA, just given delays across certain competitor products? with the FDA specifically? And what investments, and you kind of touched on this, I think, at the very end, Jeff, but what kind of investments do you need to make from a commercial perspective to roll these out? How should we think about that incremental commercial investment that you need to make in 2024? And can you talk about the strategy around distribution, pricing across parasiticides in Durham? Thanks.

Thanks, Erin. It's the right question to ask relative to the timing. What I would say is kind of as we step back and look at the pipeline position, I'd say the following things. And as I mentioned, we're controlling what we can control. First, I think quality of the team. What Ellen has done with her and her team, the quality of our regulatory team. Second is the quality of the packages, which we're very confident in. The dialogue with the regulators. I can point to proof points, you know, three approvals here recently, Parvo, USDA, ADTAB, EU, and Varenza and FDA. I think the track record and recent success is an example of this team and what they're capable of. I also think we're going into some new spaces, Aaron, maybe for us, but not new spaces for regulatory. So Durham with a jack or an IL-31 short acting or a para, these are new areas. Delays that typically come, like we saw with Parvo, in new areas. So I would say our confidence level is on that. The size of pipeline and the size of shots on goal in major markets to us, we sit in a very strong position relative to the number that we do have. Relative to the investment, that's why we wanted to highlight a little bit to give you perspective on 24 is count on, you know, as we've seen with these recent approvals for us, you know, launching two to four months after approval. And we believe today we've got, and you're seeing it, all the things we're doing to drive today's demand are going to help. So the physical availability, the share of voice, the launch capabilities with digital technology. We believe ahead of the launches, we don't see a major step up, Erin. We'll see that major step up coming after the approvals, and we'll model that accordingly. So that's the update. Again, a lot of progress in the pipeline and a much stronger position than even two months ago with everything that happened this quarter.

Thanks. We'll take the next caller. Our next question comes from Balaji Prasad from Barclays. Please go ahead. Your line is open.

Good morning, everyone. So a couple of questions on Seresto. If you could maybe elaborate on more with what your discussions with the EPA entail and have you been able to reconcile your safety methodology with that of the EPA? On the same topic, could you also speak about the covenants and both on the interest rate and the interest coverage and the net leverage ratio and see if there's any kind of situation where Seresto withdrawal, if it comes to it, would impact this governance. Thank you.

Thanks, Balaji. On Soresto, yes, we've made nice progress from our last update in February, and we'll share that, as I mentioned, we are very pleased with this progress. We align with the EPA on EPA's recommendations, which link to stewardship actions, all supporting the continued registration of Soresto. We do expect, Laji, formal results to be communicated by the EPA in the coming weeks. Again, we're confident in the safety, the profile of the product. We're also, you know, appreciative of the raising of the bar for the category overall. You know, I'll just highlight a little bit on Seresto because it's so important to us. We saw sequential improvement in the quarter. We saw the U.S., after you calculate out for the cutover, the U.S. return to growth. Some of that may be attributed to an earlier season, people coming back to retail, but I also think this increased physical availability, you know, was a factor. OUS was down a little bit. It was a strong quarter a year ago, as well as some of the inventory management. I kind of step back and say we sold more than half of our 2022 Seresto in the first three months. So we like what we see. Again, there's a lot of the season remaining. The engagement with the EPA is positive progress and we'll wait for the formal results here in the coming weeks.

Balaji, with respect to the debt covenants, we feel very comfortable with our liquidity position, our overall cash flow, and how we see the business progressing over the next eight quarters. With that, we don't think there's any covenant risk whatsoever. We've laid out all the debt-related metrics on slide nine in the appendix of the deck so that if anyone has questions, you can find all the information there on towers and the like. So I feel very good about where we stand.

Good to hear that. Thanks.

Thanks. We'll take the next caller.

Our next question comes from Umar Rafat from Evercore ISI. Please go ahead. Your line is open.

Hi, guys. It looks like the base business is tracking better, but then I'm just really confused around some of the free cash flow and inventory stuff. So let me be more specific. If base business tracked well and there was another $100 million in revenues pulled forward, then why is free cash flow minus $145 million? Because it should have driven EBITDA as well. And then secondly, on inventory, something about the disclosures makes me uncomfortable. Tal, you said Bayer goes straight to retail partners, so no inventory. But the 10K says, ahead of Bayer ERP blackout, there was an additional inventory build as of December 31st, and it was further increased in one queue. So I guess I don't understand what the magnitude of this inventory is, and to what extent is it driving the performance we're seeing right now?

Thanks for the question. With respect to the free cash flow, you'll see that the accounts receivable balance is increased significantly given most of these 90 to 110 million of sales would have happened in the last couple of weeks of the quarter, and so there wouldn't have been cash flow coming in from those collections, but there is the EBITDA that comes from that revenue being recognized in the quarter. So that's the main driver. And then let's talk about the difference between inventory on our balance sheet and inventory at Retail Partners. Again, as we communicated, inventory at Retail Partners was low at the end of last year. That's something that was a headwind for our business. Here, there's certainly more inventory there because of our ERP blackout and the purchases made in the US on that. Then let's talk about inventory on our balance sheet. So again, we had volumes down on farm. We got 5% price. So with the underlying base business still in decline but having more price, that's lower volume. When you think about the split on inventory between pet health and farm animal, pet health is generally higher margin, which means its inventory balance on the balance sheet is lower because the costs of goods sold are lower. On the farm side, again, the flip-flop occurs, lower gross margin, higher COPS value. So we've got struggles in our farm animal volumes in the US that's driving for the increase in inventory on the balance sheet. You'll see we had pet health inventories actually did reduce. That's in line with the expectations of greater sales of the bear product in the first quarter. That happened. Foreign animal inventories are up. The other item to note is foreign exchange rates. We have a lot of inventory that sits outside the U.S. in Europe with our manufacturing footprint there. As the dollar weakened in the quarter, the balance sheet value of that inventory increased because it's in Europe. Again, hopefully we've separated inventory on our balance sheet, inventory at retailers from the numbers, and again, operating cash flow generally in line with where we expected to be in Q1. We still expect $100 million of free cash flow this year to pay down debt.

Thanks. We'll take the next question. Our next question comes from Michael Riskin from Bank of America. Please go ahead. Your line is open.

Great. Thanks for taking the question, guys. First, I want to ask about your comments on price. I think you indicated, you know, 5% in the first quarter balanced between companion and lifestyle. But I think you said for the year, only 2% or more than 2%. That implies very little price for the rest of the year. I'm just wondering what's driving that. Is that cycling up on comps? Is that the, you know, negative impact in 2Q because of the ERP? Is that tied to the MAP suspension? And then I've got a follow-up. Thanks.

Sure, Mike. You're right. We've said we'll get more than 2% price for the full year. It was a good first quarter, recognizing 5%. We did get a benefit from those Bayer legacy products where we've taken more price this year, coming more in the first quarter. So there would be an expectation to be less in the second quarter.

Any follow-up? Okay, thanks. And then the follow-up, it goes back to the blockbuster product launches for next year. Jeff, I appreciate your comments towards the end of the prepared remarks. That was really helpful, but I wanted to go a little bit deeper. You know, you talk about first half 24. Obviously, you know, January's first half. June is also first half. So given that, you know, we're still early in 23, you don't have that clarity. I'm just wondering, you know, your point on anticipating launching coming – two to four months post-approval. If you've got a scenario where you've got a June approval, two to four months puts you much later in the year. Does that change a little bit in terms of your thoughts on ramping, especially for something like the broad spectrum parasiticide, where you expect pretty major seasonality in the market? You want to be on the market on the first half of the year. So is there any consideration of doing sort of like an at-risk ramp in volumes in manufacturing to be ready to launch the day after approval. Is that a possibility or is there just limited wiggle room there? Thanks.

That's the right question, Michael. We are putting a lot of time, as you know, we've invested in talent capabilities in this area. We're using each one of these launches Zorbeam, Vexicat, now Parvo to really test all of these capabilities. We brought in Tim Bennington. So there's a lot of concentrated effort on all these scenarios. What I would say is I just highlight a couple things that are key, I think, as you look at 24. The ramping of all of these approvals we just mentioned. I'll point to Parvo, Xperia, Xperia's ramping. Those are our first two of the six blockbusters we've talked about. They'll be critical out of the gate. I even point to AdTab, which is a $50 to $100 million oral OTC space. That's what we see as potential over time with this product. So ramping first will be the most important critical thing as we go into 24. And then, look, we're trying to be balanced and pragmatic here because there's a lot of dynamics. The good news is we've got four shots on goal, all kind of going into different major markets with Bovair, the two Derm products, and Para. I would say specifically to Para, seasonality has become less of a factor. When you start looking at drop shipping, increased compliance, there's less of a spring pop as much as if you can get this into a program, it becomes a lot more of less seasonal. We will launch. We will launch better and with more excellence than we ever have in the company history with the right resources given the market potential. What I try to do today, though, is to say most of that investment will come after the that two to four months after an approval. That's the setup. But be assured, we've got a lot of interest and focus on this, and we'll keep you updated as we progress. Thanks. We'll take the next question.

Our next question comes from Nathan Rich from Goldman Sachs. Please go ahead. Your line is open.

Great. Good morning. Thanks for the questions. Jeff, maybe going back to Seresto, could you elaborate on what you meant by stewardship actions from the EPA? Well, I think it sounds like you expect continued registration for Seresta. Would there be any changes in how you are able to market the product going forward? And then a quick follow-up, if I could, on the MAP holiday, how are you thinking about the impact that that had on the pet health sales in the quarter? And is that impact contemplated in the $90 to $110 million range when thinking about the 1Q to 2Q shift?

Yeah, thanks for the question, Nate. You know, we won't elaborate much further other than to say, as I mentioned on Soresto and EPA, great productive dialogue. A lot that's happened here recently. Formal results will come in the coming weeks. A lot of, you know, I would say sequential improvement, demand and interest in Soresto. We see no, you know, no change of anything as sequential step up. As I mentioned, it's nice to see the U.S. come back to growth. And that's driven, that's why I took a little time on U.S. Pet Health, what Bobby's done with increasing retail expertise and capability. When we look at, you know, just our overall physical availability going up 17%, we're taking price and we're seeing a lot of loyalty from both the e-com sector as well as the brick and mortar. So look for more to come. But again, I'll reemphasize the most important point. We're pleased with You know, the EPA's recommended stewardship actions. We won't get into those details now, but we believe they're the right thing for the category for our product and others in collars to support the continued registration of Soresto and raise the bar on the category. That's key. As you look at MAP pricing, you know, I kind of want to step back a little bit. This is minimized advertised pricing. This is used commonly in CPG and retail and been in animal health for a long time. It protects the long-term value of the brand. We extended a MAP holiday or held off on MAP to avoid extended disruptions in supply during the cutover. Yes, we did see, you know, retailers compete on price, like products like Soresto. And even despite that, you know, Bilenco still achieved our 5% price in pet health. Really important, I would say. So, yeah, I do think it was a factor. But we reinstated our MAP policy at the end of April. I can highlight that we are back up to normal operating environment, and we'll continue to, you know, stay on a map policy as we go through the rest of this year.

And, Nate, with respect to the 9110, you know, again, we think there may have been a little more underlying dispensing in Q1. That's why we had our... Less, you know, more than our 40 to 80 we'd estimated in February. We do expect it reverses, as you saw in Q2, maps back in play, and, you know, we'll continue to execute the underlying fundamentals that'll drive this category.

Thank you.

Our next question comes from John Block from CIFL. Please go ahead. Your line is open.

Thanks, guys. Good morning. Jeff, just on the innovation sales, is the 210 to 250, sorry, 210 to 250 million still the right number for this year? I might have just missed that. And is there a number for the quarter? And then, Jeff, Soresto, I think, was down 9% normalized for the quarter. Do you still expect that to grow this year? And just maybe just a quick tack on Todd, the updated expectations of price more than two. So if it's 3%, just throw out a number. It sort of implies volumes came down very modestly since the initial guide because the bottom end of the range came up 30 mil, the top end was left unchanged. You know, is that a fair way to frame it? And if so, was that more of a pet health thing or a farm animal thing from your perspective? Thanks, guys.

Thanks, John. No change to our innovation sales as we highlight. You know, drivers to that will be pet therapeutics, Xperia, the OTC products. You know, now we'll have Parvo coming in here. We'll be shipping that product in the next couple weeks. So everything stays the course. And, again, those will all be drivers as we ramp going forward. Yes, Soresto is down. You know, we're still not globally where we want to be in full recovery here with Soresto. As I highlighted in International, a couple factors, a big 11% growth quarter here. first quarter last year. So there's a challenging compare. And we saw internationally, again, the retailer inventory oversight management, they had lower inventory. So those were factors. So again, all the things that we highlighted, we are leaning in with a pretty significant campaign on Soresto here that kicked off in April in the second quarter. And some of the increased operating expense is an investment. to build on the demand that we've seen pick up on Soresto in Q1. So we'll keep you updated as we go forward.

And then, John, with respect to your question on price, overall, we've captured price pretty well across our business. The one area where there was softness was U.S. Farm, where generic competition continues to be a place where price is more challenging to capture. We felt like we retired a lot of risk in Q1, BRP system up, running, and executed with no glitches, continued improvement sequentially in the pet health business and just environment stabilization. So that was the big drivers of raising the bottom end of our guidance. Yeah, if we get more price, that would be obviously a positive, and we'd be happy to have it. But a lot of different factors between volumes and price across our global business that are embedded in our guidance. We feel good about where we sit in the start to the year.

Thanks. We'll take the next question. Our next question comes from David Westenberg from Piper Sandler. Please go ahead. Your line is open.

Hi. Thank you for taking the question. And congrats. ERPs are hard. So I'll just put that out there right away. Can you talk about the methodology in terms of calculating the benefit in ERP? And can you kind of get into details on what exactly is happening for us Wall Street idiots that really don't know what's going on in the industry from a nuts and bolts level? It's going to distributors. It's going to the main warehouses of vets. I mean, just kind of Help us bridge what exactly is happening to get to that 90 to 110 calculation for us. And then I just have a quick second question in terms of the guidance. Are you factoring anything competitively with Librella now that it got approval or, you know, BI's triple I think is actually now maybe a little bit behind schedule. So any of the pushes and pulls in the guidance with the competitive factors? Thank you very much.

Yeah, with respect to the 90 to 110, this is an estimate based off talking to our customers, looking at historic sales data, and looking at underlying trends with inventory levels and pullout. When you think about it, it's in terms of we have our customers that order product every week. And so we went out and told U.S., customers, both on the farm and pet side, but we'll focus on that because it's the bigger notional number. So we went and told a big online retailer, we will be not selling you product for the next 10 days, but you'll be back up and running and ordering product on April 10th. that retailer has to make a decision. Do I trust I'll have that? I need to make my sales. I need to make my cash flows to the corner. And so they're evaluating, do they buy enough product for 10 days because they trust us? Do they buy it for 15 days because they're concerned? So that sort of evaluation is happening. If you think about, you know, a distributor in, you know, let's say Mexico, and we went to them and said, you're going to be the 35th country to come up on our ERP implementation, and you're going to be blacked out with no ability to buy product for the next, you know, 26 days. The question there is, do they buy a month's worth of product? Do they buy six weeks? Those sorts of things. So, you know, we get into, we were confident in our execution. That's why we were at 40 to 80. We think they probably took a little more conservative approach. That's how you get to the 90 to 110. Again, we gave first half guidance back in February because we knew this would be complicated and we're increasing the bottom end of that first half guidance because the good start we're off due to the year.

Yeah, on the guidance, just to build, David, on your second question, yes, we have in our assumptions the competitors from February, that guidance hasn't changed, and nothing's changed relative to even the recent news on new approvals coming in.

Okay, we'll take the next question. Our next question comes from Brandon Vasquez from William Blair. Please go ahead. Your line is open.

Hi, everyone. Thanks for taking the question. A lot of product-specific questions that have already been asked. So I guess one that kind of struck or got my attention was, if I heard you correctly, I think you said macro trends are kind of improving globally. And as you look through the back half theory, you kind of expect them to continue improving. Just kind of curious if you could talk a little bit about that, because I think there's a lot of concern from investors, not just in health, but in general, that macro can kind of deteriorate in the back half. So what are you guys seeing there? And then maybe the follow-up to that is, What's your confidence in being able to kind of keep the pricing benefits you're talking about now if there is a worsening macro environment? Thanks.

Sure. Thanks, Brandon. Recall, the back half of last year for us was really ugly. The environment was really tough. We saw lots of pressure across Europe. You had the COVID lockdowns in China that really negatively impacted our business in 2022. So when we talk about the improving conditions, our question going into this year was, was there going to be this sequential improvement? Where are we going to see customers coming back to the OTC channels for pet health products? We've seen that, we feel good about that, and that's what we speak to with respect to improving macro environment. We've got challenges here in our underlying business as we guide that to down two to four in Q2. So we're clearly not calling a massive great recovery, but rather just greater stabilization than we had last year. With respect to the question on pricing, again, the teams have done a very good job of executing price increases to start the year. That's demonstrated in the 5% we received in Q1. There continues to be a lot of competition in the marketplace and a lot of underlying dynamics we're focused on. That's why we've said more than 2% for the full year, and the teams continue to do well to ensure they're capturing as much of that as they can.

Thanks. We'll take the next question.

Our next question comes from Steve Scala from TD Cowan. Please go ahead. Your line is open.

Hi, this is Chris. I'm for Steve. I have two questions, both on power virus. So first, do you expect any capacity constraints on the U.S. march? And then second, what is the timeline for ex-U.S. marches, and how should we think about the U.S. versus ex-U.S. split behind your $100 million guide on that product? Thank you.

Yeah, Chris, thank you. We're excited about the Parvo launch. We'll be shipping products in the next couple weeks. We expect about 70%. We need state approvals now that will follow this federal conditional approval. We expect about 70% of the states to be in the first month. So we'll be shipping in the next couple weeks as states come on. Yes, excited about having our first monoclonal antibody plant now with Kansas approved and would emphasize that we will plan to – to be, you know, ramping, but as we move from a smaller leader to a higher leader capacity, that will happen throughout the second half of the year. So the launch will be limited initially by capacity. The vet interest is high. I also want to just take this moment to highlight, you know, this is a conditional approval. This will not be at all commercial limiting to us. It really comes as a regulatory body like the USDA in this case sees a, you know, 330,000 cases a year of parvovirus of 90% plus mortality from this virus and zero dogs dying in our trial, let's accelerate this product in the market. We'll continue with full approval, but there's really no restrictions here with the conditional approval other than there's a high need, there's a high vet interest. We will ramp throughout the second half and be in a really strong supply situation as we end this year. With that, I will just make a couple quick closing comments. Thank you for great questions today and continued investor interest. You know, Elanco looks at this quarter and say, we're doing this one quarter at a time. We're not where we want to be yet, but I think this quarter showed necessary actions, disciplined decisions, a lot of progress, and proof points as we look at the overall business and what's critical. Overall engagement, Elanco is growing on the inside. Our focus is high. And I would say the headline here is we're tracking to our expectation. We're seeing nice sequential improvement coming out of Q4, areas that are stabilizing, some areas returning to grow. I would point specifically that, you know, the retiring of risk that we saw, not only in the first three months, but the first four months around the stand-up of our IT system, around Soresto, and the overall management of the business, as well as the market that matters most to us is U.S. Pet Health. The lead indicators are driving the lag indicators that's going to set this business up for long-term success, as well as then Ellen's area in innovation, launching four products, having three approvals, two of our six blockbusters now in the marketplace, and our last major blockbuster initial submission made. So we still have a challenge here in Q2. We expect to return to growth in the second half, and be assured we're focused right now on what we can control, and that is execution across this company. We look forward to fielding questions throughout the quarter from all of you. Thank you for your continued interest. Penny Lanco, have a great day.

This concludes today's conference call. Thank you for your participation. You may now disconnect.