Elanco Animal Health Inc (ELAN) Q2 2021 Earnings Call Transcript

Ladies and gentlemen, thank you for standing by and welcome to the Elanco Animal Health, Inc. Q2 2021 Earnings Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. I would now like to hand the conference over to your speaker today, Tiffany Kanaga. Thank you, you may begin.

Good morning. Thank you for joining us for Elanco Animal Health's second quarter 2021 earnings call. I am Tiffany Kanaga, 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 Katy Grissom from Investor Relations. As always, during this conference call, we anticipate making projections and forward-looking statements based on our current expectations. Our actual results could differ materially due to a number of factors, including those listed on Slide 2 and those outlined in our latest Forms 10-K and 10-Q filed with the Securities and Exchange Commission. The information we provide about our products and pipeline is for the benefit of the investment community. It is not intended to be promotional and is not sufficient for prescribing decisions. You can find our press release and the slides referenced on this call in the Investors section of elanco.com. The slides and press release also contain further information about the non-GAAP financial measures that we will discuss today during this call. After our prepared remarks, we will be happy to take your questions. I will now turn the call over to Jeff to provide the highlights.

Thanks, Tiffany. Good morning, everyone. As I reflect on our progress and the nearly eight months since our investor day, we see evidence that our transformation is creating sustainable, long-term value for our customers, our shareholders and our globally Elanco team. Our results demonstrate we are executing against the strategy we laid out in December. Our second quarter revenue, EBITDA and EPS on Slide 4 were all above our expectations, continuing to build on the strong momentum our business has shown since closing the Bayer acquisition a year ago. Revenue of $1.279 billion surpassed the midpoint of our guidance range by nearly $40 million. Our performance in both sides are now relatively balanced business between pet health and farm animal. Our adjusted EPS of $0.28 was $0.04 above the midpoint of guidance, including an approximately $0.03 headwind from discrete items in the quarter that pushed our tax rate to nearly 30%, more than offset by approximately $0.07 of operating improvement. Adjusted EBITDA of $291 million was $29 million above the midpoint demonstrating good flow-through and showing significant headway toward our long-term margin targets. Today, we're raising our 2021 full-year revenue guidance for the third time by $15 million at the midpoint to $4.68 billion to $4.73 billion. The business is delivering beyond our long-term growth algorithm, providing total revenue up 5% to 7%. This includes approximately 4% to 5% for underlying business, with a reduced innovation range entirely due to external challenges for ZoaShield, which I'll discuss later, that is more than offset by portfolio gains in a good industry backdrop. While we exit the second quarter with strong momentum, we're taking a balanced approach to the rest of the year, factoring in many moving pieces including seasonality, moderation and pandemic-driven health tailwinds in the vet clinic, and ongoing competitive dynamics. During the second quarter, we made two strategic moves with some near-term implications and important medium and long-term benefits. First, we announced the bolt-on acquisition of Kindred Bio, which contributes three potential blockbusters alongside our own dermatology assets, and more quickly builds a presence in this essential part of the industry. The transaction also provides attractive shots on goal and other therapeutic fields including securing full ownership of the Canine Parvovirus Therapy. We've completed antitrust review and expect the transaction to close this month. Second, we announced the exit of three manufacturing sites. In further streamlining our footprint, we're accelerating our gross margin efforts, reducing annual CapEx and improving working capital. Todd will provide details on how these two decisions impact our revenue, EBITDA and EPS in 2021. Both strategic moves are examples of Elanco's increasing position of strength from continued transformation, driving value creation. We're taking the next steps in our journey to build a global independent fit-for-purpose Animal Health leader with consistent double-digit adjusted EBITDA and adjusted EPS growth in a durable industry. Moving now to overall pet health for the quarter on Slide 5, the global business drove approximately two-thirds of the upside versus the midpoint of the guidance, reaching $685 million in revenue for the quarter with continued good execution and a competitive but favorable pet industry. As you know, pet spending has many structural tailwinds, which were amplified during the pandemic. Industry research shows that the number of US pet-owning households surged by nearly 6% in 2020, versus the slightly positive pre-COVID run rate. This trend is not isolated to America, with 3.2 million UK households having acquired a pet since the start of the pandemic, and a 2020 survey by the Japan Pet Food Association showing a 15% increase in dog and cat ownership. This increased pet ownership also drove greater vet clinic traffic in the second quarter. Trends were most robust in April, up strong double digits against last year's quarantine impacts. Our pet health vaccine business was a standout in the quarter in this beneficial vet clinic backdrop. Vaccines were a key driver of Elanco's 2% improvement in price, reinforcing that our channel strategy is working and creating real demand. Our aggregate channel inventory levels at distribution remain consistent with prior quarters in the US and across the global business. Turning to parasiticide. Second quarter global Seresto revenue was $129 million, down 1% year-over-year, and global family revenue was $148 million down 3%. Both faced similar dynamics with a tough comparison against last year's retailer-driven stocking, and Seresto also lapping a meaningful increase in points of distribution at certain major retailers. Additionally, cooler and wetter weather in May across many parts of the US impacted seasonal traffic in the broader OTC channel as seen in the Nielsen data. Seresto and Advantage family trends rebounded in June alongside the industry with more favorable weather. Moreover, both achieved gains outside the US in the quarter, leading our overall performance in international pet health. We remain on track for full-year expectations for Seresto. The brand's resilient performance demonstrates high levels of confidence among consumers and veterinarians. Let me add that the EPA's 60-day public comment period which opened July 13, following an NGO petition is a standard and expected practice. We have full confidence in Seresto's strong safety profile, which is supported by registrations from more than 80 regulatory bodies around the world and our robust pharmacovigilance process. We continue to see a long runway to grow this trusted brand. The Credelio franchise drove healthy growth across its combined platform of US vet clinics, retail and international, along with the launches of both Credelio Plus and Credelio Cat. In the US market, Credelio maintained robust double-digit EDI growth in the second quarter, representing outbound sales into the vet clinics or alternative channels, and trends remained especially strong at retail. This focused brand is performing well in light of industry innovation, which is driving greater than anticipated share erosion from our older defense brand Trifexis. We will continue to maximize profitability with target investments across our portfolio and grow revenue through new innovation as we compete for greater share of the expanding global parasiticide market. Our combined international portfolio is highly competitive in both parasiticide and therapeutics, bolstered by outperformance from new innovation like Credelio Plus. Finally, in therapeutics, Galliprant continued its global expansion and also posted double-digit VDI growth in the second quarter with year-to-date share gains in the branded US inset market according to the Kinetic data. While we exceeded second quarter guidance and exit the quarter with good momentum, we head into the remainder of the year with a number of variables to consider. We believe pet health is recalibrating back towards normalcy against tougher comparisons and with a natural moderation of tailwinds from the puppy boom. We're watching vet clinic trends in light of the limited practice capacity and labor constraints. We're monitoring pet ownership trends as the economy opens up, offset by potential impacts in the Delta and other variants. Additionally, we recognize the increasing competitive nature of the industry, especially in the US and Depo parasiticide. In balance, our pet health strategy is tracking to overall expectations. Innovation is performing ahead of plan, driving growth alongside focused brand contributions. We have established omnichannel leadership and digital initiatives to generate long-term growth, with expansion in new regions like China, all supporting our full-year outlook and more consistent and competitive levels of pet health growth over time. Turning now to our farm animal business, in the second quarter, we saw a demand-driven improvement in our US cattle and swine businesses with protein benefiting from a return to food service. The first half of 2021 also benefited from higher numbers of cattle on feed. Elevated and volatile feed costs continue to pressure producer economics, likely extending to the back half of the year. However, they enhanced the value proposition for efficiency products like Skycis, Optaflexx and Rumensin, which all outperformed our forecasts in the quarter. In China, swine we experienced impacts from the reemergence of African swine fever. Hog prices ended the quarter down about 65% since the start of the year, severely pressuring profitability for Chinese producers. The sow herd reduction is likely to also impact the third quarter. But overall, we still expect our China business to deliver at least a percentage point of growth to total linked revenue in 2021. Finally, international poultry and aqua remain negatively affected by unfavorable macroeconomic conditions and reduced consumption as expected, but are exhibiting green shoots of industry improvement. We're seeing easing pressure on Quinav as salmon prices improve averaging up double digits year-over-year during the quarter. Quinav is also beginning to benefit from our recently published phase four study demonstrating superior ROI versus alternatives. Q2 also saw a very robust lift from the timing of ACO orders shifting into the period from the third quarter. While we do remain cautious around these businesses, we anticipate overall improvement ahead against a soft COVID-driven comparison. As you will see on Slide 6, our second quarter outperformance is driven by disciplined execution against our strengthened and expanded IPP strategy. I'd like to share more on our innovation progress on Slide 7 with details around the eight launches planned this year. Pet health innovation is running above expectations and I'm pleased with the global team's commercial execution around each of these three launches. Credelio Plus is exceeding plan in Japan and Europe and is on track to launch in Australia in Q3 in time for the local parasiticide season. While different thresholds around heartworm protection prevent us from bringing this product to the US, Credelio Plus is proving to be very competitive in the $1.5 billion international market. Meanwhile, Credelio Cat and Allura are growing our feline portfolio. In Farm Animal, Increxxa is faring well in a competitive and unprecedented market dynamic. It remains early days for Experior but we're making important strides towards achieving packer ecosystem integration with continued potential for blockbuster status. The Experior value proposition is being validated in the field and packer acceptance is growing now reaching seven packers versus one at the end of Q1. The first Experior customers have now reordered product and expanded use. Finally, ZoaShield, which we sourced externally to build our portfolio in the raised without antibiotics space. ZoaShield is currently facing greater than anticipated market supply of the leading competitive product. As a result, we're taking a proven approach to total pipeline forecasts in 2021, reducing our innovation revenue outlook by $15 million to $65 million to $85 million; however, we remain confident in the value contributions of ZoaShield to our poultry portfolio. It's important to understand that this year's reduction does not impact 2025 total innovation potential of $600 million to $700 million, which we raised in mid-June with the announcement of the Kindred Bio acquisition. Before I turn the call over, let me say a few words on the regulatory item. On July 1, Elanco received a subpoena from the SEC relating to our channel inventory and sales practices prior to mid-2020. We've cooperated and provided documents and information, and the SEC will continue to do so. We believe strongly that our actions were appropriate. Finally, I'd like to just stop and thank our entire global team for continued diligent execution and focus during these unprecedented times. From our South Africa colleagues determining how to reach customers amid riots to those in Vietnam, sleeping in our plant to ensure supply amid another COVID lockdown, their commitment to our purpose is unwavering and inspiring. With that, I'll hand it over to Todd to provide more color on our results and our outlook.

Thanks, Jeff. Slide 8 summarizes our financial performance highlights, including our reported net income and earnings per share. Slide 31 to 40 in the appendix you can find the summary of the adjustments made to the reported results to arrive at our adjusted presentation. I'll focus my comments on our second quarter adjusted measures in order to provide insights on the underlying trends in our business. So please refer to today's earnings press release for a detailed description of the year-over-year changes in our reported results. Looking at the adjusted measures on Slide 9, you will see the total annual revenue increased 118% in the quarter on a reported basis with five points of benefit from foreign exchange for legacy Elanco. Our second quarter revenue on a pro forma combined company basis would have represented growth of approximately 10%, assuming that their acquisition had happened at the start of the year and adjusting for the impact of strategic distribution changes. On Slide 10, there's a visual representation of our revenue outperformance versus the guidance range we provided in May. The key drivers in order of magnitude were commercial execution in our international pet health business, continued improvement in US cattle and swine currency tailwinds and order phasing in Aqua. Adjusted gross margin as a percent of revenue was 57% and the increase of 750 basis points compared to the second quarter of last year. The year-over-year improvement reflects the Bayer acquisition that dramatically increased our exposure to the rapidly growing pet health segment. Remember also that this higher margin portfolio is first half weighted due to the Northern Hemisphere's flea and tick season. Additionally, we saw the benefit of positive price and volume on Elanco's legacy portfolio and continued productivity gains. The sequential deceleration of 220 basis points versus the first quarter includes impact from a temporary plant shutdown due to a weather-induced power outage logistics cost, and the shift of some expenses into the second quarter with the legacy Elanco ERP cutover as discussed last quarter. Total operating expense increased 116% in the second quarter, driven by the addition of the Bayer Animal Health business. At $475 million, the amount was $42 million above the first quarter and includes the previously identified approximately $30 million shift of investment into the second quarter. There's delayed expenses included more optimistic and effective phasing for direct to consumer and digital advertising. Operating income increased 268% reflecting the Bayer Animal Health acquisition, our top-line execution, expense leveraging discipline and efficient execution. The sequential step down of $47 million from the first quarter is attributable to the sequential gross margin and shifting investment impacts I just described. Our adjusted EBITDA was $291 million, and our adjusted EBITDA margin for the quarter was 22.8%. At the bottom line, Q2 adjusted net income increased 274% to $135 million, reflecting our effective tax rate of 29.6%. Two discrete items primarily drove our rates above our prior full-year forecast of 21% to 22%. First, tax rate changes in several jurisdictions required the remeasurement of our deferred tax assets and liabilities within net impact adding nearly $5 million to our Q2 tax expense. The largest impact was in the UK, where the tax rate increased from 19% to 25%, resulting in $3 million in additional tax expense. This impact will not repeat. Second, we finalized the number of international tax returns to provision and transfer price adjustments then increased our expense by nearly $4 million. For the back half of the year, we anticipate an effective tax rate in the 22% to 23% range. Now let's discuss our revenue performance more closely. On Slide 11, you will see a breakdown of the contribution from legacy Elanco and legacy Bayer portfolios by category. Legacy Bayer products contributed $529 million in the quarter; pet health drove $685 million of revenue, or 54% of total Elanco. Cattle contributed $231 million, or 18% of total Elanco revenue in the quarter, with all three adding $179 million representing 14%, swine $113 million, or 9%, and aqua $44 million, or 3%. On Slide 12, you can see the effective price, rate and volume on our revenue performance. The benefit of the Bayer acquisition is reflected in volume. We will continue to report the addition of the Bayer business in volume to the third quarter of 2021 when we lap the transaction close. For the legacy Elanco business, price was up 2% for the quarter, led by puzzle vaccines and demonstrated the value of our innovation, the discipline we're applying despite competitive pressures, and enhanced commercial execution, all continued evidence that our channel strategy is working. Foreign metal price was flat in the quarter, reflecting competitive dynamics in US cattle and swine. We continue to target a 2% increase for the total business in 2021 with revenue management in focus as we're observing some inflationary pressures in areas such as transportation costs. Slide 13 provides a breakdown of our overall performance between US and our international operations. We further outline our geographic performance by pet health, farm animal, as well as contract manufacturing, all benefiting from the addition of Bayer. We expect to file our 10-Q shortly. So moving to Slide 14, let me offer a few words on working capital, operating cash flow and debt pay down. In the US, consistent with the prior four quarters, we held all distributors at 60-day payment terms. In the second quarter, day sales outstanding stood at 75 days, up from 69 in the first quarter as our average accounts receivable throughout Q2 was higher as a result of Q1 revenue being significantly higher than Q4 revenue. We ended the second quarter with $580 million in cash and equivalents on our balance sheet. We have secured a commitment for additional pre-payable floating rate bank debt of $500 million to refinance our $500 million of senior notes that come due on August 27. We will use cash from our balance sheet and draw on our revolving credit facility to fund the Kindred Bio acquisition. Consequently, we expect net leverage of 5.5 times at the end of 2021 in line with our original projection from December 2020. Before I discuss our guidance, I'd like to remind everyone of the 2021 financial impacts from streamlining our manufacturing footprint announced June 9. We closed the sale of the Shawnee Kansas site on August 1, removing $10 million to $20 million of associated contract manufacturing revenue in the last five months of this year. This impact was reflected in the guidance we confirmed when we announced the Kindred Bio acquisition on June 16. We do not expect an impact to adjusted EPS from the sale. We do anticipate a $5 million to $10 million EBITDA headwind in 2021, including an effect on depreciation. Please refer to our press release this morning for the GAAP impact for the second-quarter results from this divestment. With respect to the Kindred Bio acquisition, we expect slight dilution to both reported and adjusted EPS for the full year 2021 and approximately a $10 million impact of net loss and approximately a $10 million impact to EBITDA as we continue to execute against Kindred Bio's R&D programs. Now I will transition to a full year and third quarter 2021 outlook starting on Slide 16. We are raising our full-year 2021 guidance for total revenue and updating EBITDA and EPS for a number of factors, including our second-quarter outperformance. We now anticipate 2021 revenue of $4.68 billion to $4.73 billion, including the loss of $10 million to $20 million of contract manufacturing revenue from the Shawnee facility exit. To walk from our last update in June on Slide 17, our increased outlook flows through the approximately $40 million outperformance in the second quarter, partly offset by a reduced outlook this year for social and the impact of Aqua order phasing. Slide 18 provides a refresh view of the bridge from our 2020 combined company revenue for 2021 guidance. In comparison to our May update, we now expect innovation to contribute $65 million to $85 million in new revenue. This reduced range is offset by growth in our base portfolio. As a result, we anticipate approximately 4% to 5% underlying growth for the year and 5% to 7% total growth. Moving to Slide 19, we expect adjusted EBITDA of $1.035 billion to $1.075 billion based on adjusted gross margin at 56.75% to 57.37% and OpEx of $1.78 billion to $1.8 billion. For gross margin rate has been negatively impacted by increased logistics expense and inflationary pressures on our supply chain. The $20 million reduction to the adjusted EBITDA range also reflects the change in our depreciation assumption, including the impact of our manufacturing assets and expenses associated with Kindred Bio, mostly offset by our Q2 outperformance of nearly $39 million. Our full-year spend continues to incorporate strategic investments and commercial growth opportunities. Slide 20 provides the moving pieces informing our update adjusted and reported EPS guidance range. Our adjusted EPS outlook which is $0.03 lower than the range discussed in May factors in $0.02 dilution for Kindred Bio, $0.02 of impact from the ZoaShield and Aqua phasing, $0.03 from logistics inflation, and $0.03 from the discrete tax items affecting Q2. We are flowing through the $0.07 of operational execution and outperformance from Q2 to arrive at a revised 2021 guidance of $0.97 to $1.03. Our outlook demonstrates the underlying fundamentals of our business remain strong in the balance of the year. The reported EPS bridge likewise flows through the second quarter outperformance and the aforementioned items as well as the $0.46 write down by Allies from the manufacturing streamlining announcement. The impact to reported earnings from integration stand-up is sequentially decreasing in magnitude from approximately $80 million in the first quarter of 2021 to approximately $20 million this quarter. Moving to Slide 21, we're providing guidance for the third quarter of 2021. We expect revenue of $1.075 billion to $1.1 billion, adjusted EBITDA of $195 million to $220 million, and adjusted EPS of $0.15 to $0.19. Our outlook, which is a sequential step down from the first half of the year reflects the seasonality of our combined company and the resulting quarterly cadence as detailed in our call in May. Remember, just over 70% of Seresto revenue in just under 60% of the Advantage family revenue occurs in the first half of the year on average. Given the relative scale of these products and our margin contribution, the revenue timing translates to an outsized first half contribution to EPS as well.

Thanks, Todd. To summarize, Elanco is moving through 2021 with strong results extending our track record of execution since acquiring Bayer animal health and driving long-term strategic actions with the expected acquisition of Kindred Bio, further streamlining our manufacturing footprint and delivering on our vision of food companionship and routine life. We head into the back half of the year with confidence in our ability to drive sustainable double-digit adjusted EBITDA and adjusted EPS growth, anchored by steady growth on the top line. Our fundamentals are helping with our core R&D pipeline tracking to plan and robust portfolio growth resulting in above-algorithm revenue velocity in 2021. Our productivity agenda continues to deliver with rapid action towards synergy capture. Finally, I'd like to express a heartfelt thank you to Katy Grissom as she transitions to a new role in global marketing finance. Katie has been an instrumental part of the IR team during our journey since the IPO, and I look forward to the impact of her contributions in our commercial organization. With that, I'll turn it over to Tiffany to moderate the Q&A.

Your first question is from Michael Ryskin with Bank of America.

Hi, thanks for taking the question this morning. I want to start on sort of the guide methodology and the rationale from early in the year. And I think Slide 15 in your deck summarizes really well. You read the guide a number of times early this year, most recently in May. And now one situation where you're lowering it on adjusted EBITDA or adjusted EPS despite the solid second quarter. Obviously, that's a little disappointing. So I'm just wondering, given all the moving pieces in the big old and the new pieces in the underlying market, you know, it'd be more prudent to take a more conservative approach with more wiggle room for things like the digital issue and update and some of the logistics costs and the inflationary pressures?

Mike, I appreciate the question. We've been trying to get the most consistent and best information we have at the time when providing guidance. You know, when we did the Kindred deal, as well as the streamlining of our manufacturing, those did have impacts on EPS as well as EBITDA, we provided the bridges in the slides to try to clearly show that those are the key items we've had the overperformance from Q2 that we've factored in, plus this tax rate impact in Q2 that despite the tax rate cost us about $0.03 of EPS as a result of the law changes in the UK, as well as some return to provision adjustments. So overall, we've been very pleased with the underlying growth in our business. You know, as noted, the portfolio contribution from our products is growing faster now than we had previously communicated, which we view as a very big positive. The one-off with the associated supply. Again, that's something that we thought would play out differently at the start of the year. We're still confident in our raised without antibiotic portfolio going forward. So overall, we're trying to be as clear on the moving pieces. And again, the second half is very much in line or slightly better on our total Elanco portfolio than we expected back in May offset by some of the inflationary jumps on the logistics side of teams managing.

Your next question is from Umer Raffat with Evercore ISI.

Hi, guys, thanks so much for taking my question. Jeff, in your prepared remarks, you mentioned SEC is looking into the inventory practices. Could you expand on that a bit more? What specifically are they alleging? And do you expect this to be a multiyear process before any sort of resolution comes at least as to what's been the observation with similar investigations SEC has done on other companies in the past?

Yeah, thank you Umer for the question. Let me just reiterate. Yes, on July 1 of this year, our company received a subpoena from the US SEC. It was relating to our channel inventory and sales practices prior to the mid-2020 period. And the company has cooperated in providing the documents and information to the SEC at this stage, and will continue to do so. And as I stated, management, starting with myself, believes strongly that our actions were appropriate. And when we're maybe to put this in proper context, that I think is important in what you're asking for. First, to continue to keep with the theme of transparency to ensure continued transparency that is very important to us. And that's why we chose to voluntarily disclose the subpoena we received from the SEC last month. I think secondly, as I discussed today, the scope of the subpoena is related to our channel inventory and sales practices prior to the middle of last year after we reduced channel inventory and changed our distribution strategy. And you can appreciate this that I'm not able to provide more details since we don't comment on litigation or regulatory investigations, but I can say we're cooperating with the SEC, and we believe our actions were appropriate. We remain confident in our business strategy and all the decisions to make a change in our distribution channel strategy. And our teams will continue to be highly focused on executing against our outlook in 2021 and driving long-term shareholder value, which I think we demonstrated with consistent business performance at or above expectations over the past year. And as much as I appreciate the desire for more details that comes with this transparency at this current time, we do not intend to provide further comment, except when in compliance with security laws.

Your next question is from Nathan Rich with Goldman Sachs.

Hi, good morning. Thanks for the questions. Just two on the revenue outlook for the back half of the year, the change in the expectations for the ZoaShield led to a pretty large reduction in the guidance for new products that $15 million reduction that you called out, especially with pet health running ahead of your expectation with the new launches there. So could you just maybe talk about your updated assumptions for the ZoaShield and maybe how we should think about additional variability in the back half of the year? And then if I could also just ask on the competition in parasiticide Jeff, that you called out with some of the changing dynamics you've seen? Are you still expecting that $15 million revenue headwind from competition this year? Thank you.

Let me just anchor back on some important points for first time ZoaShield. You know, it's an externally sourced product to build up a raised without antibiotic portfolio. As Todd highlighted, we believe strongly that this portfolio is well positioned to be competitive in the medium and long term. So this is an alternative toxicity stat, and fits nicely as the portfolio play. It's currently facing greater than anticipated market supply of a leading competitive product. In other words, there's currently more supply from this competitive product than we anticipated as we go into these health program rotations with poultry integrators. So this dynamic is, discrete, maybe a little bit more short-term in nature, leading to a reduced innovation outlook for this product. We remain confident in the overall value contributions we see from ZoaShield and our policy portfolio and more so I want to reiterate and no change to our 2025 innovation revenue target of the $600 million to $700 million range that we updated in June with the Kindred bio and more to come. I would pivot to the two critical platforms of new products in that portfolio of eight that matter the most: Credelio platform, again, Credelio plus, Credelio cat exceeding expectations, and Experior tracking very nicely on that track to be a blockbuster that we've talked about. Relative Nathan to the parasiticide competition, it's playing out as expected. And as we've even talked about it, new innovation is impacting some of the older brands across the industry, ours and others. Innovation is driving and expanding the parasiticide market; it is growing nicely as an overall segment. So, you know, the impact has come to our Trifexis a little bit more. But when I step back, Nathan, and I look at the pushes and pulls of our global parasiticide strategy, the proof points are pretty evident that things are tracking and we're in a very strong position. We see the Credelio franchise here in the US and globally growing, driven by vet clinic traffic and a good industry backdrop, as well as growth in EDI sales, Credelio plus, Credelio cat as I mentioned, new products. Retail is continuing to do well, and then when I brought it out even a little further, we're seeing nice growth in international markets. Advantage is doing well in Asia, as we've mentioned, again, exceeding expectations, and Seresto is on track to meet our 2021 expectations. So pushes and pulls, pipeline progressing are in a good place overall with the global parasiticide.

Your next question is from Chris Schott with JP Morgan.

Great, thanks so much for the questions. I just had two here. I think you mentioned in the opening remarks that there was some moderation in full pet health trends reflected in the second half guidance. I'm just hoping you could elaborate a little bit on is that something that you're seeing already or expecting? I'm sure it gives us a view of what's kind of leading to that expectation. And then second question was on, I think you mentioned weather impacting the LTC business in May, can you just help us quantify a little bit of what you saw there? I'm just getting a sense of if we think about the Q2 key results overall, how much of an impact that is, which I think about more of a normalized result from the quarter? Thanks so much.

Chris, I would say overall, I want to highlight a few things in these trends. I think that it's a little early to say what's going to stick post-pandemic. But as we highlighted, and I think other companies have noted, the trends are significant that numbers of pets have gone up globally, pet visits have gone up globally, US and international. We do believe, I mean, our simple headline here is we believe that the 2020 growth that came from COVID will lessen. But the direction of the trends and the market changes will not reverse; they will stick. We've seen a rising of the overall level of the marketplace, which is positive. We though, when we look at what's really driving the ultimate growth, that clinic traffic, we believe will start to go more to that two-year average versus where we are today. So moving from double-digit growth and that clinic traffic to seeing moved to maybe more low single-digit. That is what we're predicting. And assuming we're seeing that from the standpoint of just the ability to sustain this we think is a challenge. I think retail purchasing as well has had a significant growth, especially e-commerce, the fastest growing segment; we see that lessening a little bit as well. Two things happened; one activity goes back up in the household; and two is innovation in the pet market is also driving some move to the pet market. I think Elanco is well positioned with omnichannel portfolio and geo expansion. Relative to your second question, yes, we saw a cooler May, and we saw a rebound in June. I don't know if we're going to quantify that at this time. But again, what we believe is that the message we would say is relative to the tough compares, Advantage and Seresto are tracking to our overall expectations for the year.

Your next question is from Jon Block with Stifel Financial.

Great, thanks. Good morning, everyone. Todd, let's start with the innovation segment. It seems that the $15 million ZoaShield might be more of a push than a loss. Considering the growth of the innovation sector in the upcoming year, would you agree that the contribution in the second year is greater than in the first year when we focus on the revenue impact of the innovation segment? Jeff, regarding Seresto, my understanding is that Seresto saw a 35% increase from the first quarter of 2021 to the first quarter of 2019, based on some information you provided last quarter. Additionally, it appears that Q2 grew by 5%. I know you mentioned improvements in June. Could you elaborate on the reasons for this variation while maintaining confidence that it aligns with your 2021 projections? More generally, why do you believe that this situation is more influenced by weather conditions rather than market factors? Thanks, everyone.

Sure, Jon. Thanks for the question. You know, we're not getting into 2022 guidance. But as we noted previously, the innovation portfolio, we expected it to be growing faster in the second half from the contribution in '21 than it would do in the first half of '21. You can then assume that that ramp would continue in the course of 2022, as you experience something, we'll continue to lay the groundwork on getting the packer integration in the life but then once that becomes your standard feeding protocol in the feed yards, that becomes just standard course that continues to grow. So I think it is a reasonable assumption to assume that backup contribution would have been a better ramp into 2022.

Jon, great question on Seresto. Let me just highlight. I think at the highest level, you're exactly right on the trends, reiterate that we're tracking overall with the expectations we have, we did know that the ramp that came from COVID was unusual and higher than normal. Here's the things we're looking at: First of all, you know, probably no more work has been done in a four or five-month period than the last four or five months on Seresto. And what we would tell you is one, you know we stand behind the safety of the product. The proprietary research that we've done shows the belief in the product from pet owners and veterinarians. We've increased the advocacy by the veterinarian as well to this product. It serves a niche and a need when you look at duration and cost and economics that's important. We've increased our capabilities on digital and then I think most importantly is the global kind of focus, especially in international with our increased dedicated investments and capabilities like digital and omnichannel. So with these, as we look at overall good strong IP protections, stronger capabilities as an independent Elanco, maybe versus Bayer. Again, we see this as a product with a long runway of value that can help drive overall growth as a key focus brand for our company.

Next caller, please?

Next question is from Steve Galla.

You mentioned the higher tax rate is due in part to higher corporate tax rates in the UK, that doesn't the UK tax rate increase from 19% to 25% as of April of 2023? If yes, then why is the impact occurring now? And the second question is one of just curiosity. If Elanco delivers full-year earnings at the midpoint of the range, then 65% of earnings would be delivered in the first half. In 2018 and '19, about 50% earnings were delivered in the first half that was also true of 2020 that was an unusual year. We noted a handful of temporary factors but I'm wondering if there's any permanent factors that will drive this trend into the future? Thank you.

Sure. Steve, thanks for the question. The remeasurement of the UK is really driven by the deferred tax assets and liabilities of the balance sheet that are longer-term in nature. And so we've got to take that entire accumulated balance into effect at one time when the tax law rate changes enacted. And so that's the reason that's happening now versus later as on those longer-term assets. Then with respect to the EPS, this is the fundamental change that has happened with the Bayer acquisition, with Seresto historically, about 70% of its sales is in the first half of the year; Advantage is close to 60% in the first half of the year. So that dives into about a $250 million difference in the first half versus the second half from those two products. And with that, you get a substantially larger EPS impact. Just from the timing of those revenue numbers, we expect that will persist clearly as we get growth in different aspects of our business over time that can affect the mix. But here in '21 that was expected. That's why when we've given guidance, both for Q1 and Q2, we've called it out; always a little bit of timing, it's just between quarters. So if we looked at, you know, a first half aspect of $0.65 of EPS, you know, that's about the right percentage, as you know, for the dollar as the midpoint for the full year. And then, you know, as we go into 2022, we'd expect a similar seasonality to occur. As I mentioned, you know, we called out some phasing of expenses, or Aqua sales, you know, those things are always going to happen in a broad-based global business like we have, that the seasonality will certainly continue and then live without we've been guiding since December of last year.

And then I think the normalization, Steve, you know, as you look at a Kindred portfolio coming on, we moved to non-parasiticide growth in pet health, as well as Experior and our farm animal business, cattle and poultry. We see this over time with innovation normalizing, but at this point in time, yes, the seasonality is real and overall beneficial to Elanco.

We'll move to the next caller.

Your next question is from Balaji Prasad from Barclays.

Hi, good morning. Firstly, two-part questions from me. Firstly, on ASF just want to call out some recent developments, especially the outbreak of ASF in the Dominican Republic, and inquire whether this could pose a risk to swine oil for the industry and do maybe some specific commentary around the possibilities around ASF entering the US from this region. And secondly, you called out reemerging ASF pressure with falling home prices. I'm not sure I got the full connection there, could you comment on that and expectations on the strength? Thanks.

Yes, good, great questions. So just at a high level as we noted in our comments, you know, African swine fever did have an impact, as we've talked about in the first half just overall to the Chinese industry. Pig industry slaughter rates were, you know, unexpectedly high in Q2, and that pushed pork production of the sudden supply increase impacted some supply-demand dynamics. We saw again, about a decline of about 65% since the start of the as I mentioned. We were going to monitor this going forward, our overall business continues to be very strong in China. But there was this surge we saw in the first quarter that will lessen as we go into the second half. If I look at African swine fever, specifically, even in the Dominican, I believe that all the right measures are being taken in place by the US and Mexican industries, biosecurity is at a different place than it was in China when the virus hit in China. And I'm confident that at this point in time first it doesn't have any impact on our material impact on our business in Latin America. And I do believe that the industry has the right things in place as we go forward.

Your next question is from Elliot Wilbur with Raymond James.

Good morning, I just want to ask a question around synergy target progression and cash cost spending against that. I presume your 2021 synergy targets are in fact intact, but specifically wanted to focus more on the cash costs associated with realizing those synergies? I think it was previously $160 million just in light of some of the inflationary pressures that we're seeing sort of across markets. And then follow up question for Todd, can you just talk a little bit about operating cash flow in the quarter, just what that number was, and I know it's still sort of early days in the integration here lots of moving parts on the working capital side. But there's anything that you could give us at this point to sort of help us think about conversion, operating cash flow conversion relative to adjusted net or adjusted EBITDA, any help there in sort of trying to model operating cash flow going forward? Thanks.

Sure, Elliot. Thanks for the question. Synergy tracking is going very well; teams deliver all the productivity initiatives; our manufacturing team continues to overdeliver in this area of finding opportunities to reduce the number of heads needed to drive our manufacturing facilities, and continuing to capture that. A large part of the cash cost to capitalize those synergies related to the layoffs we did with the restructuring analysis from September of last year, and then in January, the inflationary pressure bit has less of an impact. And then we're also doing a lot of combination of purchasing, especially with media spend and other agency-related costs. We are fighting against some inflationary pressure there, but we have better buying power now as a combined company with Bayer. So overall feel good about how that is tracking. As we look at the cost to both integrate Bayer as well as the setup for our separate ERP system, you know, we're pleased that we went from $80 million of cash spend in Q1 to only $20 million in Q2. And that's with us going live on the ERP system. In Q1, most of the integration from Bayer being completed that is getting lower. Now a lot of work to be done; a lot of great work by our global team to use the new system transition to new processes and the like, we are continuing to stabilize the system and then we'll be looking towards how do we integrate the DCS system that we had with Bayer's businesses being run on versus our SAP for HANA system, we're operating our business on to integrate those in to drive additional savings in the back half of the 2025 timeframe we've talked about. So all those things in play, with respect to operating cash flow, we will be filing the 10-Q shortly. As a reminder, in Q1 with $22 million of operating cash flow in Q2, operating cash flow jumped to $149 million. And again, that's a continued execution on these items of integration popping up and then just continued cash conversion on our working capital goals and the like. So overall tracking very well on all those items as we move through 2021.

Our last question is from the line of Nivan with Citi.

Hi, good morning. Can you comment on the higher cost? I think you mentioned higher transportation product that company-specific or otherwise, and then a follow-up on the last few unable to comment on the supply and also the demand dynamic? And what did you expect? And what has differed from your expectation? Thank you.

For the question, I think overall, the logistics cost, just the global freight and the mechanisms to get product moved across the world continue to be more disrupted by the COVID and the bounce back from labor issues that I think we expected. And then we're seeing some inflation playing in there as well, teams opening up different trade routes, we're dealing with this in a very proactive manner, but we are seeing those costs come through. One of the highlights from a pricing standpoint, we continue to think we will get a 2% price improvement across our portfolio in 2021. And we look for opportunities engrossed in that or other ways to continue to be sure we're not missing out on opportunities in from our own level. With respect to the question on ZoaShield, as we've mentioned, this was a dynamic of supply in the market already, as poultry producers in the non-antibiotic space look at how they want to operate. This is something that we are focused on. Again, overall $15 million or $4.68 billion to $4.73 billion revenue is a small percentage; we're looking across. I'm very pleased that our other innovation is tracking ahead of expectations. And we'll continue to do that as we look at the business going forward. So that's where we land at the moment. And we'll continue to update over the course of 2021. I'll close by thanking all of you for your interest and the questions today. I look forward to working and engaging with you in the second half. Again, good, strong fundamentals in the marketplace. The strategy is working, execution is extremely strong in Elanco. Good momentum is highlighted and exceeding our expectations and raising guidance for the third time and look forward to again engaging with you as we go forward. Thank you for your time today.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.