Elanco Animal Health Inc (ELAN) Q2 2022 Earnings Call Transcript

Hello and thank you for standing by. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Elanco Animal Health Second Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. I would now like to turn the conference over to Katy Grissom, Head of Investor Relations. Please, go ahead.

Good morning. Thank you for joining us for Elanco Animal Health's second quarter 2022 earnings call. I'm Katy Grissom, Head of Investor Relations. Joining me on today's call are Jeff Simmons, our President and Chief Executive Officer; and Todd Young, our Chief Financial Officer. Today, we're missing Scott Purucker from Investor Relations. He’s enjoying paternity leave after the birth of his daughter in July. Congrats, Scott. The slides referenced during this call are available on the Investor Relations section of 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 our non-GAAP financial measures. Reconciliations of these non-GAAP measures are included in the appendix of today's slides and in the earnings press release. After our prepared remarks, we'll be happy to take your questions. I'll now turn the call over to Jeff.

Thanks, Katy. Good morning, everyone. Elanco continues to execute our innovation, productivity and portfolio strategy, while delivering in the second quarter. In particular, our company-wide productivity agenda continued to deliver, and we are pleased with the progress on our innovation pipeline. While we now expect some challenges, mostly macro environmental challenges to our top line performance over the remainder of the year, we expect to return to constant currency sales growth in the fourth quarter of this year. Our company-wide productivity efforts continue to drive margin expansion. Our pipeline progress is laying groundwork for future growth and our commercial teams continue to help customers around the globe treat animals with our diversified global portfolio. In the second quarter, I'm proud of the Elanco team for increasing adjusted EBITDA 3% and adjusted EPS 29%, despite the revenue decline of 4% in constant currency, which was in line with our May guidance. Elanco's focus over the last year on productivity efforts to reduce costs by streamlining our sales and marketing organizations, prioritizing resources in R&D and across our manufacturing footprint allowed us to exceed the top end of our second quarter guidance range with adjusted EPS of $0.36 and adjusted EBITDA of $300 million. Additionally, we delivered strong operating cash flow in the quarter and reduced our net leverage ratio to 5.3 times, down from 5.6 times at the end of the first quarter. Today, we are updating our revenue outlook for 2022 to account for economic, environmental and company-specific factors that accelerated and intensified in the quarter. We are taking a measured and balanced approach to this environment and this forecast. Given these dynamics, we are also adjusting the time line by which we expect to achieve our longer-term margin targets laid out at our December 2020 Investor Day. Despite today's reduction in our sales expectations for 2022, we expect to expand both gross margin and EBITDA margin this year and expect that to continue in 2023 and 2024. We remain committed to 60% gross margin and 31% adjusted EBITDA margin, and we'll provide an update on timing in 2023. Moving to slide four, let's start with our second quarter sales results. We reported revenue of $1.177 billion, a decline of 8% in reported revenue or 4% in constant currency. We delivered 3% constant currency growth in farm animal driven by 6% growth in the US, led by ZoaShield in poultry and Rumensin in cattle. Our international Farm Animal business grew 1% constant currency as strength in Rumensin, including sheep, was partially offset by softness in our swine business in China and to a lesser extent, Europe. Although a notionally smaller business, we continue to see strong performance in Aqua with 5% constant currency growth despite the $10 million of phasing into the first quarter, we discussed in May, which drove Q1 growth of 96%. Pet Health declined in Q2 by 7% in constant currency. Our US business declined 11%, driven by competitive pressure on our vet-based parasiticide, including Trifexis and Interceptor Plus and declines across our retail portfolio. We do not believe this level of sales decline is indicative of the underlying quality of our US Pet Health business as supply and other discrete issues impacted the business in the quarter. We are confident it will improve as we move forward through the back half of the year. International Pet Health was flat in the quarter. In China, our Pet Health business was also flat in the quarter, driven by the impact of two months of COVID lockdowns. These results are in contrast to the significant double-digit growth the team delivered in 2021 and the first quarter of 2022. Additionally, I'd like to address our second quarter price growth of 1%. Price growth in Pet Health was below our initial expectations, but reflects an intentional shift in our US retail business. We invested further in promotional investments or trade funds with our retail partners to drive demand that increased our gross-to-net spend thus reducing net sales. This trade fund investment was a shift in spend from marketing and operating expense and created a net positive contribution to EBITDA. Price growth in Farm Animal was driven by our international business. In US Farm Animal, price was lower than our expectations, driven by competitive dynamics and the pricing actions in the bovine respiratory disease market impacting Increxxa. Mid-year price increases have been taken across both Pet Health and Farm Animal portfolios, and we expect to see accelerating contribution in the second half, with full year price growth more in line with our historical 2% levels. Moving to slide five, we are reducing our full year sales guidance from an expected constant currency growth of 2% to 3% to now flat to minus 2%. Compared to our May guidance, this is a $220 million reduction at the midpoint of the range to reflect our current assumptions that can be grouped into three areas; first, approximately $65 million from the unfavorable impact of foreign exchange rates. We now expect a total headwind of $205 million from dollar strength compared to $140 million we expected in early May. Secondly, $100 million to $120 million from macro environmental factors, including the pace of recovery from China's COVID lockdown, disruptions in the global supply chain, and pressure from the expected economic slowdown around the world. And finally, a net $40 million to $50 million or one percentage point drag on growth from performance headwinds relating primarily to pricing realization, innovation ramp and US pet health parasiticides. Regarding the $100 million to $120 million reduction from macro environmental factors, let's start with China, which is $60 million to $65 million of that reduction. We've been expecting our China business to grow by 22% at constant currency and to provide about one percentage point of growth from total Elanco this year as it did in 2021. With this revenue change, we now expect China to decline by approximately 1% this year in constant currency. For pet health, as the major population centers in China were under strict lockdowns, our assumption in May was for a rebound in pent-up demand starting in June that would result in a V-shaped recovery similar to what we saw in the US in 2020. While we saw some improvement through June and into July, it does not appear the second half bounce-back will materialize as expected and we now see a more tempered pace of growth in the second half than we did in May. In the first quarter of the year, Elanco's strong team in China grew market share six percentage points in the parasiticide market through its commercial capabilities and strong portfolio that has just been enhanced with the approval of Credelio, while we don't expect to recapture our lost sales from Q2 as we projected in May, we still expect our China pet health business to grow double digits in the second half of the year. Moving to farm animal in China, swine prices are improving but are expected to remain volatile. The large industrial swine producers have a higher cost base coming out of the African swine fever, impacting their ability to invest in our products as current prices remain below their breakeven levels. Additionally, the lower protein demand overall from the COVID lockdowns and competition from cheaper pork is also impacting our poultry business, where prices have been depressed and tracking below our expectations for the year. Despite the current environmental headwinds in China, we believe we are very well-positioned in both pet health and farm animal to take advantage of the recoveries as they occur and believe China will be a growth driver for Elanco in 2023 and years to come. Next, moving to the supply chain disruption, which represents $30 million to $35 million of our sales reduction from macro environmental factors, while the paper and packaging challenges from the first half are largely behind us, freight and logistics remains dynamic and a number of our suppliers and CMOs are experiencing ongoing input sourcing challenges and labor shortages. We expect these issues to negatively impact our ability to meet demand for a number of smaller products, primarily in our international farm animal business. We continue to seek alternative sources of raw materials and other inputs to drive more reliable supply performance in 2023. Lastly, we expect the reality of the economic slowdowns across the world will create a $10 million to $20 million downside in our global business. Finally, we are reducing our revenue guidance by approximately $40 million to $50 million to reflect our lowered expectations for our innovation sales ramp, price growth and performance of our US pet health parasiticide business, which will more than offset better than expected performance in poultry, aqua and contract manufacturing. While I covered price earlier for innovation sales, we're lowering our expectations by $20 million to $30 million to $100 million to $130 million for the full year as a result of our updated expectations for Experior, Increxxa and Credelio Plus. For Experior, we are very pleased with the customer experience feedback we are receiving as the number of customers using the product and the number of cattle on Experior continues to increase. However, the feedyard adoption curve is behind our expectations from May. It's important to point out that twice the number of cattle started on Experior in the second quarter than in Q1, and more cattle started in July than we saw in all of Q2. We continue to expect Experior to become a blockbuster and industry feedback in recent months has only strengthened this belief. Given the current strong ramp in cattle on the product, we expect Experior to be a major growth driver and accretive to gross margin in 2023. Finally, as we evaluate the results of this year's flea and tick season, we think the competitive pressure across the portfolio will likely be closer to $75 million or $80 million rather than our previous $60 million assumption. We see the majority of the additional pressure on dog products as growth in Seresto and Credelio for cats is strong. While these headwinds in innovation, pricing in parasiticides create a net negative on our sales expectations, the strength in our Aqua and Poultry business and higher contract manufacturing sales are expected to provide a positive offset. Our commercial teams continue to deliver in areas where our portfolio has competitive strength. Later, Todd will take you through the adjusted EBITDA and adjusted EPS from the changes in the top line guidance. Now I'd like to transition to provide more information on Seresto and our progress on innovation. In the second quarter, Seresto declined approximately 6% in constant currency and was below our expectations. The decline was driven by a softer season in the US and Europe, lower retail inventory levels and competitive dynamics. For the first half, the brand grew approximately 2% in constant currency with total sales of $273 million. In June, I appeared before the House Subcommittee on economic and consumer policy in support of Seresto, defending its strong safety profile and the importance of protecting dogs and cats against disease carrying fleas and ticks. During my testimony, I reiterated our commitment to work with the EPA, supporting science-based evaluations of the product. We continue to provide additional data and analysis that supports Seresto's strong safety profile. While Seresto has been challenged in the US the last two years, it has generally performed in line with our expectations across the rest of the world. Aligned with historical data, in July, our US consumer research shows repurchase intent of 95% for Seresto, demonstrating high customer loyalty. We see Seresto as a resilient, affordable brand that meets unique market needs and are very focused on driving brand growth in the years to come. Transitioning to Slide 6. The most important driver of future growth for Elanco is our innovation portfolio. We continue to expect the products launched in 2021 and beyond to contribute $600 million to $700 million of revenue by 2025. The leadership of Dr. Ellen De Brabander, and the disciplined execution of our experienced team over the last nine months have increased our confidence in the next era of innovation coming from new platforms and spaces, including monoclonal antibodies, sustainable protein and pet therapeutics as well as pet parasiticides. Since our last earnings call in May, we continue to advance our late-stage pipeline, delivering approvals and increasing probabilities. Within the next two to four months, we intend to make regulatory submissions for a broad spectrum parasiticide product and one of our late-stage dermatology products. The submissions will start the regulatory review process, which is iterative and rolling in nature with approval timing dependent on the regulatory body involved. With the FDA, we typically expect a 12 to 18 month review cycle from initial submission to approval, while the USDA and the European authorities are often shorter. For our parasiticide product, we believe we have crossed the so-called heartworm threshold, a challenge we faced several years ago with Credelio Plus in the US development program. We believe our late-stage assets are differentiated from the current market offerings, and we'll continue to update you on any material developments. We remain on track for seven approvals in 2022. And with six of the seven expected approvals in major markets now received. These portfolio-enhancing products are primarily in Pet Health, including Credelio in China; Credelio Plus in Canada; and Advantage XD for cats in the US. Additionally, our parvovirus treatment for dogs continues to advance with USDA approval expected late this year or early 2023. Finally, we continue to build a leading feline portfolio that we believe will improve the standard of cat care. In July, we launched ZORBIUM, a long-acting postoperative transdermal pain product which is gaining traction in vet clinics. Its innovative delivery mechanism makes postoperative care easier on cats and their owners, delivering value to veterinarians as evidenced by 5,000 clinic placements in the first month. We're also pleased to announce today that we've licensed a revolutionary first-in-class product for feline Diabetes Care. The product introduces a new mechanism of action for veterinarians with a needle-free easy to give daily oral medication to treat this chronic condition. The product is under FDA regulatory review and expected to be approved within the next 12 months. In addition to these near-term innovations such as canine influenza and parvovirus demonstrate Elanco's commitment to bringing novel and differentiated innovations and will serve as important relationship builders with veterinarians ahead of our expected broad spectrum parasiticide and multiple dermatology products coming to market. We plan to have Ellen joining our third quarter earnings call in November to provide further updates on innovation efforts and portfolio progress. Before I turn the call over to Todd, I'd like to thank the Elanco team for all of their productivities over the last few years. Our introduction of an EVA-like performance metric into our short-term compensation, which we call Elanco Cash earnings is driving a company-wide ownership mindset and intensifying our focus on delivering capital optimization. I believe this mindset and ownership culture will drive value for all stakeholders over the long term. Now I'll hand it over to Todd.

Thank you, Jeff, and good morning, everyone. Today, I'll focus my comments on our second quarter adjusted measures, so please refer to today's earnings press release for a detailed description of the year-over-year changes in our reported results. Starting on Slide 8, we delivered $1.177 billion in revenue, an 8% decline or 4% decline in constant currency with price growing 1%. Foreign exchange rates represented a headwind of $56 million in the quarter or 4%, slightly above our expectations. Slide 9 breaks down our revenue performance by species and Slide 10 provides revenue by region in the quarter. For Pet Health, we declined 7% in constant currency for the quarter with our international business flat in constant currency and our US business declining 11%. The Advantage family of products contributed $137 million, representing a 7% decline on a reported basis or a 3% decline in constant currency driven by supply challenges and softness in Europe. Seresto contributed $113 million, representing a 12% decline on a reported basis or a 6% decline in constant currency with softness in the US and Central Europe, where the Russian invasion of Ukraine negatively impacted our business, partially offset by growth in Western Europe. More broadly, Credelio grew double-digits globally. Vaccines remain steady, growing dispensing within a market growing mid-single-digits and on a year-to-date basis, Galliprant grew double digits in the US, while weathering competition in Europe. Our Farm Animal business grew 3% at constant currency, including 2% from price, primarily driven by our international business. Volume growth was primarily driven by the international Ruminant business, notably sheet products. Additionally, the quarter benefited from a shift in timing for generic defense programs for Rumensin ahead of a mid-year price increase, shifting sales expected in the third quarter of 2022 into the second. Growth was offset by pressured economics for swine and poultry producers in China and a decline for swine in Europe. Slide 11 further summarizes our financial performance for the second quarter. Despite the decrease in reported sales, gross margin improved 190 basis points to 58.9%, primarily driven by continued improvements in manufacturing productivity, a weaker euro and price, partially offset by inflation and input costs, freight, and conversion costs and an unfavorable mix from lower sales in Pet Health. Operating expenses for the quarter were $425 million, a reduction of 11% year-over-year. The impact of FX on expenses was approximately $14 million favorable in the second quarter or a 3% benefit year-over-year. This improvement highlights our disciplined execution and demonstrates our ability to sustain synergies and cost savings from our restructuring actions, while more than offsetting inflation and continuing to invest in key strategic priorities. Our R&D spend was in line with expectations as we concentrated investments going into this year and prioritized our Pet Health blockbuster development pipeline. Interest expense was $50 million in the quarter, a year-over-year decline of 17%, driven by the repayment of our 2021 senior notes last August. The non-GAAP effective tax rate was 18% for the quarter, which provided the benefit of $0.03 per share above our expectations. This lower Q2 rate was driven by the jurisdictional mix of Elanco profits and discrete items. We still expect our full year tax rate to be approximately 25% to 26%, despite the lower Q2 rate. Adjusted net income was $177 million and adjusted EPS was $0.36 for the quarter, reflecting growth of 31% and 29%, respectively. Adjusted EBITDA was $300 million in the quarter or about $40 million better than the midpoint of our guidance. We expect to file our 10-Q in the coming days, but let's move to the balance sheet and cash flow metrics on slide 12. We ended the quarter with $5.63 billion in net debt, a reduction compared to the first quarter of 2022 of $240 million. Our net debt to adjusted EBITDA ratio at the end of Q2 was 5.3 times, which improved from 5.6 times at the end of Q1. We expect the net debt to adjusted EBITDA ratio to continue to improve in the second half and expect to finish the year at approximately five times. In the second quarter, our operating cash flow was $312 million, reflecting the lower reported net loss in the quarter year-over-year and a one-time benefit of net $124 million from a cash interest rate swap settlement, which provides a cash benefit in the second quarter that will create a headwind in operating cash flow over the next four years as this cash acceleration reverses. Excluding the swap benefit, operating cash flow would have increased 21% over the second quarter of 2021. Next, let's transition to our updated outlook for 2022 on slide 14. For the full year, we now expect revenue to be between $4.465 billion and $4.550 billion or flat to down 2% year-over-year in constant currency, reflecting the details Jeff has already provided on sales. The bridge from the May guidance can be found on slide 15. While in the second quarter, our productivity initiatives allowed us to deliver higher adjusted EBITDA and adjusted EPS than our guidance projected despite sales only at the midpoint of guidance, we do not expect that to be the case in the second half of this year. We continue to see higher inflation impacting our manufacturing and supply chain networks and wage inflation is now negatively impacting our business as well. For the full year, we expect inflation to impact our manufacturing cost by $140 million or $20 million more than we projected in May. As you can see in the bridge on slide 16, we now expect adjusted EBITDA between $1.06 billion and $1.1 billion for 2022, which is a $65 million reduction from the midpoint of the range provided in May. The stronger US dollar drives approximately $20 million of the change, while the other $45 million is driven by the approximate $55 million of overachievement and adjusted EBITDA in the first two quarters of the year more than offset by the gross profit drop-through from the sales reduction in the second half and incremental inflation. We now expect adjusted diluted EPS of $1.06 to $1.13 for 2022, which is a reduction of $0.08 versus the midpoint of the range provided in May. The stronger US dollar is driving approximately $0.03 of the reduction. The other $0.05 was driven by the sales reduction, partially offset by a smaller amount of increased productivity and the operational overachievement in the second quarter. Finally, we are introducing guidance for the third quarter of 2022 on slide 17. We expect revenue of $1.01 billion to $1.06 billion, adjusted EBITDA between $175 million and $215 million, and adjusted EPS between $0.12 and $0.18. The constant currency projected revenue decline of 3% at the midpoint is driven by expected declines in ruminants, swine and contract manufacturing, partially offset by expected growth in poultry and aqua. We expect pet health to be generally flat. While we aren't guiding to the fourth quarter explicitly, growth at the midpoint of the implied range is 2%. Moving to slide 18. As Jeff mentioned earlier, we are extending the timeline for the achievement of our 60% gross margin and 31% adjusted EBITDA margin from 2023 and 2024, respectively. This change is driven primarily by the degradation in the global macro environment since we established these targets in December of 2020 with respect to inflation, supply chain disruptions and the longer recovery in China from COVID lockdowns, as well as the unfavorable impact of sales mix on gross margin. While these factors have accelerated and intensified since May, we had not changed the timeline before today because our productivity initiatives have continued to deliver ahead of our expectations. Although it's hard to adjust for just one factor, when you reduce our cost of goods sold in 2022 by approximately $100 million to reflect the incremental inflation compared to what we had expected during the December 2020 Investor Day, we would project a 60% gross margin this year. That incremental $100 million of gross profit would have also increased our adjusted EBITDA margin by over 200 basis points, which would have had us tracking to our 31% target for 2024. Our reality is different and the things we have described are causing us to change the timing of achieving these targets, but not changing our expectation that we will continue to expand our margins in 2023 and 2024. As we noted in February, our value capture expectations are ahead of schedule and the integration of the Bayer ERP system and business processes is on track. We still expect this integration to deliver $50 million to $60 million of adjusted EBITDA savings in 2024. Moreover, as China recovers, Experior ramps supply chain improves and we continue to capture price, all of our productivity measures over the last few years will drive continued margin expansion. We plan to update the timeline for achieving our 60% and 31% targets in 2023. With that, I'll hand it back to Jeff for closing comments.

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

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

Thanks, Erin. Great questions. Jeff, you want to start on the 2022 guide and some of the company-specific factors, and then we'll move to innovation.

Thank you, Erin. I want to reiterate that we are adopting a careful and balanced strategy. Several factors that we expected to drive accelerated growth in the second half have changed significantly over the past three months, particularly related to foreign exchange, which is largely influenced by macroeconomic trends. Our growth is highly dependent on China, which has experienced many changes, as mentioned earlier. Additionally, issues with CMOs' supply and the overall economic slowdown have impacted us. Specifically regarding your question on pricing, we anticipated a price increase greater than the historical 2%, though we expected it to be more pronounced in the latter part of the year. We implemented price increases in the first half and have added more mid-year for the second half, expecting a rise. However, two key factors led to lower prices. The first was in the Farm Animal sector, where market entries in the bovine respiratory disease area exceeded our expectations. The second factor is related to the US pet market. Under Bobby's leadership, we decided to allocate some of the pricing increase to trade dollars to boost demand in our pet retail business. We will evaluate this strategy as we enter the third quarter. While this resulted in lower prices, it did improve our gross-to-net figures and positively impacted EBITDA. Looking at prices more broadly, we see it as a valuable tool and expect further price increases this half, which will contribute to growth as we compare results against 2023 while maintaining flexibility to implement additional price increases in our differentiated protein products.

Going to talk about innovation, just what's driving the slower ramp and then we'll get into sort of the time line piece questions.

Yes, Erin. Throughout my career in animal health, I have not witnessed as much progress as what Ellen and the R&D team have achieved. We are seeing increased probabilities, faster speeds, and new areas of focus, such as feline diabetes and methane reduction last quarter, along with developments in derm from last year with Kindred. Looking at Elanco, I believe we are building a world-class innovation engine in Animal Health under Alan's leadership, and I look forward to discussing this further in November. Regarding the ramp, we have slightly adjusted our expectations. I would highlight the Increxxa in the BRD market and also Experior. It's important to note that this is not an issue of the product's value, but simply a shift in the ramp timeline by one quarter. We missed the ramp timing due to the complexities involved in trying the product and moving to full feeding while coordinating with the packers. However, we do see a positive trajectory, as cattle numbers doubled in Q2 compared to Q1, with more starting in July. We remain committed to the $600 million to $700 million target, with Experior anticipated to be a key blockbuster driving that growth. Additionally, regarding derm, we plan to make one of the two submissions in the next two to four months. We have not specified which asset this will be, but our derm portfolio is progressing well, including the IL-31, JAK, and other assets from Kindred as well as our own pipeline. Alan will provide more details during the November call.

Thanks. We’d like to take the next caller.

Thank you for taking my question. I'd like to revisit the topic of innovation and some of the new products you mentioned. Considering what you've highlighted with Cracks and Experior and the results from other recent launches, do you think it might be wise to adjust the $600 million to $700 million target downward by $25 million? Given the slower start, do you perceive any additional risks in achieving those numbers over the next couple of years? Also, regarding the delay in the long-term margin targets for gross margins and adjusted EBITDA, I recognize there are several inflationary macro factors at play, but you also have company-specific strengths like pricing power. Can you continue to leverage those to offset the challenges? Additionally, if inflation fails to improve, the supply chain issues persist, and the China lockdowns continue, how much risk does that present for Elanco's performance in the next 12 to 24 months if these macro issues are causing delays without any sign of improvement? Thank you.

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

Michael, that's a great question. I want to emphasize that the adjustment in innovation is largely influenced by the anticipated success of Experior, which we feel more confident about this quarter compared to the previous one. We believe it has the potential to become a blockbuster franchise, similar to how Rumensin performed when it launched. This will serve as a significant driver for us. Additionally, as you know, last year we introduced about six portfolio-enhancing innovations, and we're planning to do the same this year, which will also contribute positively. Most importantly, we are seeing increased potential for our pet health blockbusters that are in development, with their probabilities significantly improving. We previously estimated their value at $600 million to $700 million, and those probabilities have increased considerably. This renewed confidence more than offsets a slower ramp in our innovation pipeline. Therefore, we have a strong pipeline with increased participation from pet health blockbusters, and we're also exploring new areas, like feline diabetes, which is currently under regulatory review and will be an additional contributor. Now, regarding the guidance and margin targets, I want to address some key points. We remain committed to our margin growth targets for 2022, 2023, and 2024. Although we've had to adjust the timing due to certain challenges, our commitment to improving margins remains unchanged. There's no doubt that we're facing some headwinds, but our productivity efforts are still effective. As Todd noted, we were expecting to surpass our targets, particularly regarding gross margins, which I want to stress. We have additional levers to utilize, starting with fostering an ownership mentality within the organization. We are discovering new opportunities each quarter that exceed our expectations, and there are significant synergies with Bayer. Todd, perhaps you can elaborate on some of our initiatives and the balance that Michael has raised.

Sure Jeff. And thanks for the question, Mike. You're right, we have taken some price, We're still running at the 2% historical level we had expected back at our Investor Day, we do foresee increasing price, and we've called that out as a driver in the back half of this year as we were to growth in Q4 with key biggest lever individually is certainly the integration of the Bayer systems and processes into Elanco. As we noted back in February, that's $50 million to $60 million of incremental savings on EBITDA that we'll get as that annualizes in 2024 and on track for the middle of 2023. Your question about inflation continue to be high. China is not coming back. Certainly, those are big parts of our business. The team has done a very offsetting significant amount of inflation. That's why we're in the face of having mix challenges this year. Our Pet Health business down; poultry, up. We're expanding gross margin. We think we've got levers yet to go there, especially through the EVA-like metric Jeff mentioned in the ownership mindset, but it is something we have to continue to do and aren't getting the lift we get without that. And then the FX component, certainly $55 million of EBITDA we've lost in 2022 versus 2021, based off the current expectations for foreign exchange rates.

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

Thank you for the question. I'm trying to understand how to connect the two key results you reported today with the guidance. It appears that the challenges you mentioned were present in the second quarter and seem to be continuing or worsening into the third quarter. However, there is a significant decline that I need to comprehend. My question is about Seresto and what factors might help the U.S. business return to a more typical operating rate. Thank you.

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

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

Yes, Jeff. And just Seresto, getting back to normal growth.

Yes, Chris. That's a great question, thank you. I have a lot of confidence in Seresto and I'd like to share some insights about this quarter. Seresto addresses an important market with its eight-month coverage, affordability, and convenience since it doesn't necessitate a vet visit. The market potential is substantial. In our recent consumer research, we observed a 95% intent for repurchase, indicating high loyalty and many returning users; however, overall brand awareness remains low. Thus, enhancing our digital awareness capabilities is crucial. The brand is resilient and differentiated. I should mention that while dispensing has been somewhat stronger than the decline in sales, we did encounter a softer season. Typically, warmer weather prompts customers to purchase their collars, and the cooler temperatures in April affected that. We have a significant market presence in Central Eastern Europe, which has faced some challenges due to the ongoing war, although Seresto continues to perform well there. Additionally, we saw some retailers reduce their inventories. When we normalize for that, there was some increased competition, but I believe these specific factors balanced each other out. The brand has grown 2% year-to-date. Looking ahead, international growth will be significant for Seresto, and enhancing digital awareness for segments that do not visit veterinarians, along with lifecycle management, will be critical to the brand's development. We see substantial growth potential for Seresto, with over 50% of sales coming from outside the US.

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

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

Right. Jeff, do you want to step on the margin expansion and then thinking about the new innovation?

Thank you for the question, Jon. In examining our IPP strategy, our focus is on productivity and margin expansion. The pipeline is progressing in terms of innovation. When we review our portfolio, we see a promising algorithm of new products complemented by focused brands and improved performance in our defend brands. We remain confident that this strategy will yield positive results as we move toward 2025, with growth being a key priority. I want to stress that we anticipate our business will return to growth in Q4, including our pet health segment, based on our current assumptions. We will evaluate our performance in 2023, but it’s important to highlight that our focused brands and innovations are crucial. We are observing a recovery in China, and the trends we noted in the second half of 2022 are positively impacting the CMOs mentioned by Todd. We're increasing our supplier base and do not foresee prolonged pricing issues. Our innovations, especially through Experior, are growing, along with new products like parvo that we expect to approve late this year or early next, in addition to the ED approval. Looking at our farm animal market, we are gaining share in sectors like poultry and aqua, securing a leadership position. The non-para business in pet therapy is becoming a larger segment of Elanco overall, and it's noteworthy that 16 of our 22 clusters of countries are experiencing growth in both revenue and profits even in the second quarter. This indicates a resilient international business. While the second quarter presented challenges, I would like to highlight that we are analyzing our para pipeline thoroughly, focusing on both omni-channel strategies within and outside of veterinary clinics, and recognizing the distinctions between our international and U.S. operations. Best-in-class offerings are crucial alongside our first-class efforts. As we assess our new para asset, we are optimistic about its potential to capture market share by leveraging our channels and new puppy starts, while also complementing our existing products. We expect the legacy brands like Trifexis to naturally decline, which aligns with our expected forecasts. Overall, considering the extent of our portfolio and channel diversity, combined with upcoming innovations, we foresee positive contributions leading up to 2025.

Thanks. We’ll take the next question.

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

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

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

Yes. Again, a good quarter for our Farm Animal business overall, International and both US growing nicely. I think that comes from some of the diversity and some of the fundamentals that you mentioned, Mike. The demand for protein remains. There are some price pressures that we're seeing that are starting to get where prices with some of the economic slowdown. It's starting to slow slightly. I would point to a couple. I think poultry is very positive. The demand is very strong globally because it's a more affordable protein. Our leadership position in poultry turning higher cost grains into more protein there will be strong, same with Aqua. I think on the swine market, it's everything that Todd just mentioned. It's really for us. Swine is all driven by China. And that's more of a balancing of demand and supply and economics, prices coming back. We're seeing prices coming back in July, but again, not to our expectations but I hope for a recovery. And then beef, I think the dynamic I would just highlight, you hear about the drought and everything that's happening. What I see here is more cattle coming out of the farmer feeder caps going into the feed yards. So we'll see in the second half of the year, Mike, a higher number of cattle on feed because of the drought and the movement of getting them back into the yards probably for more days because they'll come in at lighter weights. But our population of the herd, especially in the US beef market is down. It will probably take a couple of years. So you'll start to see a little bit of a slowdown, I think, in herd rebuild in 2023 and 2024. But net-net, Farm Animal business is pretty resilient here. A lot of it is because of the conversion of higher cost feed into protein from our products in Animal Health.

Great. Thanks. We’ll take the next question please.

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

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

Thanks. We’ll take the next question.

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

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

That's your last question. Jeff, I'll turn it over to you to close.

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

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