Elanco Animal Health Inc (ELAN) Q3 2022 Earnings Call Transcript

Good morning. My name is Rob, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Elanco Animal Health's Third 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. Thank you. Katy Grissom, Head of Investor Relations, you may begin your conference.

Good morning. Thank you for joining us for Elanco Animal Health's third 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; Todd Young, our Chief Financial Officer; Ellen de Brabander, our Executive Vice President of Innovation and Regulatory Affairs; and Scott Purucker, from Investor Relations. The slides referenced during this call are available on the Investor Relations section of elanco.com. Today's discussion will include forward-looking statements. These statements are based on our current assumptions and expectations and are subject to risks and uncertainties that could cause actual results to differ materially from our forecast. For more information, see the risk factors discussed in today's earnings press release, as well as our latest Form 10-K and 10-Q filed with the SEC. We do not undertake any duty to update any forward-looking statement. Our remarks today will focus on 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. In the third quarter, the Elanco team executed well on the controllable aspects of our business. Starting on slide four, we continue to drive progress on our innovation, portfolio and productivity, or IPP strategy, demonstrated by the momentum in our pipeline and the productivity we delivered. Through relentless execution on our productivity agenda, we delivered 5% growth in adjusted EPS and expanded adjusted EBITDA margin by 120 basis points, despite a 4% constant currency sales decline in the third quarter. Adjusted EPS and adjusted EBITDA were both above the midpoint of our guidance. However, in the quarter, we saw most of the same macro concerns we called out in August, worsened compared to our expectations. The US dollar continued to strengthen, China's COVID lockdowns did not improve in the quarter, and the global economic slowdown accelerated, impacting Europe and the US pet retail OTC markets. Despite these macro pressures, Elanco progressed the controllable initiatives that will drive our future growth and value. On the R&D front, we initiated the submission to the FDA for our broad spectrum parasiticides, are finalizing a submission for our JAK inhibitor dermatology product expected before the end of the year, and are advancing our IL-31 short-acting monoclonal antibody in dermatology toward a submission in the first half of 2023. With these three products, plus our parvovirus monoclonal antibody and Experior, we see a path towards having five potential blockbuster products approved in the US by the first half of 2024. Additionally, we expect approval for at least three new OTC pet retail products in 2023. On the debt side, we paid back nearly $170 million of gross debt in the third quarter, with gross debt paydown of $500 million to $525 million expected for the full year. Finally, we've accelerated our plans to go live on the Bayer Systems integration by the end of Q1 to early Q2 2023. Our pipeline and productivity efforts exceeded expectations this year. Importantly, Elanco's held market share in line with our expectations in certain markets. Pricing increased in the third quarter, with 4% growth in Pet Health and 3% growth in Farm Animal. We expect two points of topline growth from price for the full year. We believe price growth and sustained market share are key during challenging environmental conditions, and Elanco is executing on these. Despite our success on the controllable aspects of our business, the worsening economic conditions and less-than-expected improvement in China has led us to reduce our financial guidance for 2022. You can see the drivers detailed on slide six, and Todd will provide more information later in the call. Before turning the call to Ellen and Todd, I want to address Seresto. Since the initial story about the product was published in USA TODAY about 18 months ago, Elanco has worked vigorously using a science-based approach to address and defend the safety profile of Seresto. Numerous studies, detailed pharmacovigilance data analysis, and expert evaluations overwhelmingly support the safety of the product. We know the EPA is finalizing their review of data and analysis for Seresto. We look forward to collaborating on brand stewardship and oversight for Seresto as the product provides a safe and affordable solution to protect pets from fleas and ticks, which can transmit diseases to both pets and people. Elanco is in active communication with the EPA on brand stewardship and oversight opportunities. Elanco is as confident as ever in the continued registration of the product. While the routine registration reviews of the active ingredients in Seresto remain ongoing, we do not believe these evaluations will result in any changes in pet product uses. Given the sustained value and efficacy provided, we expect Seresto to stabilize in 2023 and continue to be Elanco's largest individual product.

Thank you, Jeff. I'm pleased to join the call today. We have made tremendous progress, advancing the One Elanco R&D organization, moving past the integration of the legacy organizations and now entering a more stable phase. Our intent is to consistently deliver high-impact innovation through differentiated and portfolio-enhancing new products and through life cycle management of our key brands. We have a strong innovation pipeline, striking the right balance between research and development projects and between Pet Health and Farm Animal projects. Personally, I'm very pleased with the progress we have made in the last year and the potential I see for this organization to deliver consistent innovation fueling growth for Elanco. Elanco's next era of innovation is truly exciting. Recently, we expanded the pipeline with robust entries from research into development, where we have established proof of concept in the target species for several products that we believe are first-in-class or best-in-class opportunities. We have also expanded the pipeline via strategic partnerships like our exclusive licensing rights for Bovaer for methane reduction in cattle in the US and other early stage opportunities in targeted areas. I believe these differentiated assets, combined with our enhanced technical capabilities, will drive sustained growth from innovation beyond our current late-stage pipeline. Today, I will provide an update on five late-stage development programs we are pursuing for the US Pet Health veterinary market, of which four are already in the submission or approval phase. First, an update on Bexacat, the feline diabetes product we announced in our August call. This product is expected to be the first SGLT2 inhibitor to be introduced in the US animal health markets. The regulatory process has progressed faster than anticipated, and we now expect FDA approval before year-end with our US Pet Health team preparing for an early 2023 launch. Moving to our parvovirus treatment. Elanco and the USDA recently agreed to focus on conditional approval to expedite product availability in the market, confirming the significant unmet customer needs to address this deadly disease in puppies and dogs. We expect the conditional federal approval late this year or in early 2023, with the US launch planned in the first half of next year, after state approvals are completed. Given the unmet need, the unique value proposition and opportunity for expansion to international markets, we believe this product could be a global blockbuster. The parvovirus treatment is Elanco's first monoclonal antibody and will be internally manufactured. This facility is also expected to manufacture our future monoclonal antibody products, including the IL-31 for dermatology. We strongly believe in the significant potential for monoclonal antibodies in animal health, given their specificity and selectivity, and we will continue to build out and enhance this platform across Elanco. Transitioning now to our three key late-stage development products in parasiticide and dermatology. First, in parasiticides, I am pleased to share that we have initiated the submission of our combination flea, tick, heartworm and other intestinal parasites prevention product to the FDA. The expected product will demonstrate positive differentiation compared to the combination ectoparasiticides products available already on the market today. In dermatology, we plan to initiate the submission to the FDA for our JAK inhibitor before the end of this year. We expect the product to demonstrate positive differentiation compared to the current market incumbent. Additionally, we are pleased with the progression of our other dermatology asset, IL-31 short-acting, our second monoclonal antibody, and we expect to initiate its submission to the USDA in the first half of 2023. We believe the parasiticide in both dermatology products are blockbuster potential innovations with a path towards approval in the US by the first half of 2024.

Thank you, Ellen, and good morning, everyone. Today, I'll focus my comments on our third 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 nine, we delivered $1.028 billion in revenue, a 9% decline or a 4% decline in constant currency, with 3% growth in price. Foreign exchange rates represented a headwind of $61 million in the quarter or 5%, in line with our expectations in August guidance. Slide 10 breaks down our revenue performance by species and slide 11 provides revenue by region in the quarter. For Pet Health, we declined 7% in constant currency for the quarter, with volume declines in our parasiticides portfolio, partially offset by 4% price growth and growth in our pain portfolio. Our US business declined 8% compared to last year, primarily due to competitive and overall retail channel pressure. Our international business declined 5% in constant currency, primarily driven by the economic slowdown in Europe. While the overall 7% decline in constant currency was in line with our second quarter performance, it was significantly lower than our August expectations of approximately flat globally year-over-year for the quarter. The underperformance to our guidance was driven by the accelerating global macro-driven impacts from the economic slowdown in Europe and the continuation of restrictions in China as well as macro pressures impacting the US retail channel. In the third quarter, the Advantage family of products and Seresto declined 13% and 14% in constant currency, respectively, or $15 million and $8 million. In the US, available market data shows the OTC retail market down for the parasiticides overall. We believe there are three key trends driving this; economic-driven consumer behavior moving from prevention to treatment and to lower-cost options; retailer inventory management across categories; and broader competition from prescription options. Outside the US, we believe the year-over-year decline is driven by the economic slowdown that has emerged, primarily in Europe from higher energy costs and consumer inflation. On a constant currency basis, we expect stabilization going into 2023 for both Seresto and the Advantage family, driven by price improvement, return of supply from the paper and packaging issues we remediated earlier this year, opportunities for expanded physical availability, and introduction of innovations like Advantage XD for cats. We will continue to monitor and respond to the macro dynamics in these important markets. While the pet retail market is experiencing pressure, we believe meeting customers where they want to shop with effective products at multiple price points provides us the opportunity for long-term growth and profitability to complement our core business in vet clinics. Our best estimates suggest that manufacturer sales into US retail for OTC products is about a $1 billion market annually, which is approximately 25% of the total US parasiticide market. In the US and globally, we expect prescription products to remain the largest part of our overall Pet Health portfolio, with tailwinds over time from the products Ellen mentioned earlier. On a year-to-date basis, the global Pet Health business declined 4% in constant currency. And while the parasiticides business remains challenged overall, the global Credelio franchise across dog, cat, and Credelio Plus grew 16%. Our pain portfolio grew 11% year-to-date, driven by Galliprant dispensing, outgrowing the market in the US in combination with ZORBIUM's continued strong launch. For the quarter, our farm animal business was flat at constant currency, with 3% price growth. Increased demand for poultry products and strength in the aqua portfolio was offset by supply constraints for certain cattle vaccines in the US and a continued decline in swine in Asia. Both our US and international farm animal businesses were flat in the quarter. Overall, Ruminants outperformed our expectations, primarily driven by Rumensin in cattle and a continued strong season for sheep in Australia. Poultry and Aqua also outperformed expectations on a constant currency basis, helping to offset continued challenges in swine in Asia. On a year-to-date basis, Elanco's global Farm Animal business grew 1% in constant currency, with growth in poultry, aqua, and cattle, and US swine, partially offset by the double-digit decline in international swine, primarily in Asia. Overall, in farm animal globally, Elanco is holding or gaining market share in line with our expectations. Our innovation sales continue to track towards our August expectations of between $100 million and $130 million for the full year. Experior sales more than doubled sequentially in the third quarter compared with the second, and all leading metrics related to commercial uptake, reorder rates, and customer negotiations remain positive. In line with the decrease in reported sales, gross margin declined 160 basis points to 54.1%, primarily driven by inflation in input costs, freight and conversion costs, and unfavorable product mix. These were partially offset by productivity efforts across our manufacturing footprint and improved price. Operating expenses for the quarter were $376 million, a reduction of 14% year-over-year or $60 million. The impact of FX on expenses was approximately $20 million favorable in the third quarter or a 5% benefit year-over-year. Our R&D spend continues to be in a reasonably tight range of about $80 million per quarter this year. With respect to SG&A, we are pleased with the productivity mindset demonstrated by our team as synergies from integration and restructuring actions continued to deliver above expectations. Our execution on the integration of the legacy Bayer Animal Health business into Elanco's own ERP system, business processes and shared service centers is progressing well, and we accelerated the timing of our go-live to early in the second quarter of 2023 from the middle of the year. Adjusted interest expense was $58 million in the quarter, a year-over-year decline of $2 million. The sequential increase from the second quarter of this year was $8 million, driven by higher interest rates on our floating rate debt. The non-GAAP effective tax rate was 16.7% for the quarter, lower than our expectations, resulting from multiple discrete benefits in the quarter. We now expect the full year non-GAAP effective tax rate to be between 23% and 24%. Adjusted net income was $96 million and adjusted EPS was $0.20 for the quarter. The $3 million increase in our adjusted net income was driven by the execution of our productivity agenda, more than offsetting the negative impact of a lower topline and stronger dollar as you move down the income statement, plus the lower tax rate. As a reminder, approximately 25% of the $61 million in topline foreign exchange headwinds in the quarter, or approximately $15 million falls through to impact net income. Adjusted EBITDA was $205 million in the quarter, or about $10 million better than the midpoint of our guidance, with margin expansion of 120 basis points. In the third quarter, our productivity initiatives across Elanco helped our adjusted EBITDA to decline just 3% despite a 9% decline in reported sales and a 12% decline in gross profit. Gross profit declined more than sales as a result of the unfavorable revenue mix from the lower Pet Health sales and higher inflation that we had faced over the last year on cost of goods sold. We believe inflation has stabilized in the third quarter, and we continue to expect it to be in line with the $140 million we shared in August. Now, let's transition to our updated outlook for 2022 on slide 14. As part of our guidance in August, we expect that the fourth quarter would represent a reversal of the constant currency sales decline from the last two quarters. However, because of the worsening macro environmental factors impacting Europe and our US Pet Health retail business, continued COVID lockdowns in China, and the strength of the US dollar, we are reducing our full year revenue guidance by approximately $100 million. The bridge from the August guidance can be found on slide 15, but let me provide context on the pressures that have intensified. In Europe, our business increased 1% in the first half of 2022, but declined 9% in the third quarter as a result of the economic slowdown in the region. We have seen similar sellout data across the Pet Health market in several of our top countries in the region, generally in line with Elanco's results. In August, we expected China to decline 1% for the full year. However, despite a deceleration of the decline of the swine business in the third quarter compared to the first half of the year, the continued COVID-19 lockdowns, and protein producer profitability pressures are impacting our China business more than our August expectations in the second half, leading us to update our outlook for China to be a 16% to 18% decline for the full year. Finally, in US flea and tick over-the-counter retail channels, available data shows the market, overall, has experienced an accelerated decline year-over-year in the third quarter as consumers have reduced basket sizes and shifted to lower-cost treatment options. The rest of our assumptions from our August guidance update remain largely intact. And for the full year, we now expect revenue to be between $4.385 billion and $4.43 billion, reflecting an expected 3% constant currency decline year-over-year at the midpoint. As you can see from the bridge on slide 16, we now expect adjusted EBITDA to be between $1.01 billion and $1.045 billion for 2022, or approximately a $53 million reduction from the midpoint of the range from our August guidance. The stronger US dollar drives approximately $6 million of the reduction, while the rest of the reduction is the net of our third-quarter overachievement, offset with the gross margin drop-through from lower expected fourth-quarter revenue and operating expense favorability. We now expect adjusted diluted EPS of $1.01 to $1.07 for 2022, which is a $0.06 reduction compared to the midpoint of the range from our August guidance. The stronger US dollar is driving approximately $0.01 of the reduction, while the other $0.05 is driven by the sales reduction, partially offset by a small amount of productivity and the operational overachievement in the third quarter. Our fourth quarter guidance is detailed on slide 17. Finally, we expect to file our 10-Q in the coming days, but let's move to the cash flow and balance sheet metrics on slide 19. In the third quarter, our operating cash flow was $189 million, reflecting the lower reported net loss in the quarter year-over-year and a benefit of a net $73 million from a cash interest rate swap settlement. The swap settlement provides a cash benefit in the third quarter that will create a headwind in operating cash flow over the next four years as this cash acceleration reverses. The volatility in interest rates in both the second and third quarters allowed us to take advantage of our floating to fixed interest rate swaps being in the money to restructure the swaps and accelerate the cash benefit of the financial position, which allowed for greater debt paydown than the third quarter. Excluding the swap benefit, operating cash increased $27 million over the third quarter of 2021. We ended the quarter with $5.51 billion in net debt, a reduction of $121 million compared to the second quarter of 2022. Our net debt to adjusted EBITDA ratio at the end of the third quarter was 5.2 times. On slide 20, you can find detail on our current debt profile and interest rate swap positions. On debt paydown, reducing debt is expected to remain our primary capital allocation priority. This year, we expect to repay approximately $500 million to $525 million in gross debt and improve our net debt position by approximately $350 million. Our net leverage is expected to be 5.2 to 5.3 times at the end of this year, down from 5.5 times adjusted EBITDA at the end of 2021. The impact of the stronger dollar has reduced our net cash balance by $49 million compared to the year-end 2021. In 2023, we have roughly $400 million in debt maturities, with limited additional obligations until 2027. We remain confident in the durability and cash generation of the business and our ability to continue to reduce debt and meet our obligations. With that, I'll hand it back to Jeff.

Thanks, Todd. Elanco's relentless focus on the key controllable aspects of our business is evident in our productivity, improved contribution from pricing, and operating expense control, allowing us to guide to expanding EBITDA margins and additional debt pay down for the full year. We are advancing our pipeline, accelerating our systems integration, and holding market share in line with our expectations. All these set Elanco up for the next era of innovation and growth. As we look to 2023, I want to provide our early considerations on slide 21. The macro environment across the world continues to be uncertain, with likely continued pressure in Europe and US Pet retail markets, a competitive marketplace, increasing interest rates, and volatile foreign currency markets. Offsetting these headwinds, Elanco's ability to reach the world's animals and competitive portfolio are well positioned. We are holding share in line with our expectations and expect to see improvement aligned with global macro conditions. Second, we see stabilization as we continue to capture value from pricing actions. Tailwinds from more consistent supply and our market position in China sets us up well for when COVID-related pressures subside. Third, as you heard from Ellen, we are making great strides in advancing our pipeline. We expect to continue to ramp the launch of innovative products like Experior, ZORBIUM, and Advantage XD for cats while expecting to introduce Vaccicat, our parvovirus treatment and several other over-the-counter and prescription portfolio enhancing innovations. We believe there is a path to have five potential blockbuster products approved between now and the first half of 2024. Experior, our parvovirus product globally, broad spectrum parasiticide, and the JAK inhibitor, and IL-31 dermatology products. Fourth, our continued productivity efforts and the expected decrease in inflationary pressures on our manufacturing costs, as well as our systems integration will be important for our continued margin expansion efforts. And finally, next year, the organization will prepare for the expected launches of our late-stage pet health blockbusters in the industry's largest markets, US parasiticide and dermatology. We will achieve this by making the right investments in R&D, manufacturing in our systems, and in our launch capabilities. The Elanco team is focused on controlling the controllables, advancing our capabilities in manufacturing, marketing and sales execution, while delivering new products from our pipeline. This team is embracing the opportunities in front of us and looking forward to this next era of growth. With that, I'll turn it over to Katy to moderate the Q&A.

Thank you, Jeff. We would like to take questions from as many callers as we can. Operator, please provide the instructions for the Q&A session, and then we will take the first caller.

Your first question comes from Mike Ryskin from Bank of America. Your line is open.

Thank you, Jeff. For my first question, I want to discuss the core portfolio in the third quarter and for the year. You keep mentioning that you're maintaining your market share and not experiencing significant losses. Most of the reduction in your fiscal year guidance seems tied to macroeconomic conditions. However, we’re not observing the same level of economic impact on some of your competitors, both private and public. Is it possible that there is a notable shift in market share from OTC to prescription and into veterinary clinics, especially where some competing products are being launched? If that's the case, it may not reverse as the economy improves. I’d like to hear more about what’s happening in the parasiticides sector, since your comments on maintaining share suggest there could be losses. Any insights you could provide would be appreciated.

Thank you, Mike. That's an important question, and we've invested considerable effort in our analysis. We want to highlight that our market share aligns with our expectations. At a high level, we are observing deteriorating economic conditions in the EU and pet retail, which are impacting sales, along with unfavorable developments in China due to lockdowns. These factors are where we identify lost sales. Conversely, markets such as US Farm Animal, pet pain management, and the overall biological pet vaccine market are areas where we are either maintaining or growing our market share based on relative sales. We are analyzing various metrics, and in the EU, sell-out data shows that the declines we observed are consistent with overall industry declines across different countries. This consistency indicates that our performance aligns with our competitors in that category. Similarly, in pet retail, our analysis of both in-store and e-commerce data reveals that the declines are comparable between us and our competitors. The dollar decline highlighted in this guidance is primarily attributed to these categories. Regarding China, we anticipated an easing of lockdowns, but the situation deteriorated in over 60 cities during August and September. The anticipated improvement did not materialize. We will continue to monitor our market share closely, but overall, we see ourselves maintaining share in other markets when compared to our expectations.

Thanks. Mike, did you have a follow-up, or should we go on?

Yes, yes. Sorry. Wanted to go one at a time.

Okay. Thank you.

I appreciate that. For the follow-up regarding the approval timing for the parasiticides, it's great to see that you have made the regulatory submission. However, you have mentioned a timeframe of 12 to 18 months for the approval process, and I would like to hear more about the potential for an early 2024 approval. Several other companies have experienced delays in approvals recently, so I am curious about how confident you are in the 12 to 18-month timeframe. What are the chances that the approval could extend beyond that to 18 to 20 or even 18 to 24 months? Will you be able to provide updates as this progresses? Additionally, I'd like your insights on how these products will be differentiated, especially regarding the JAK and the broad spectrum. Thank you.

Yes. Good. So let's start with Ellen on the timeline and kind of how we think about differentiation.

Thank you for the question. I'm pleased to update you on the progress within our R&D organization. We have a strong team and an impressive pipeline, establishing a solid foundation for our organization. As highlighted in our earlier results, we are indeed making significant strides. One project of particular note is the broad spectrum parasiticides, for which we are enthusiastic about the data we have collected thus far this year. We have submitted our initial application to the FDA today. Generally, it takes 12 to 18 months to receive final approval for these innovations. However, based on our past experiences and the data we have gathered, we are confident that we can secure approval in the first half of 2024 for this project.

And then maybe on differentiation, how we think about that here at Elanco?

Yes. That's not an important question. So, thanks for that. Usually, when we talk about differentiation, we think in three different channels. One is in the efficacy part, the coverage. So, how broad and how well does it actually treat the disease or prevent the disease. Second is the safety part and third is in the area of convenience, so onset of activity, duration of activity, a pill versus injection. So, those are all elements where you can differentiate and bring something new that is not yet available. So, that's exactly how we are focusing our innovation more and more to focus on best-in-class or first-in-class. And we are quite excited that those in the broad sector parasiticides as well as in the JAK inhibitor, we are targeting positive differentiation versus products already in the market.

Thanks, Ellen. We'll take the question from the next caller.

Your next question comes from the line of Erin Wright from Morgan Stanley. Your line is open.

Great. Thanks for taking the question. So, given the varying progress we've seen with certain product launches, what's a reasonable time frame to get to blockbuster status here for your upcoming parasiticide as well as the derm launches? And have you ramped up from a manufacturing perspective? And what are incremental investments that you need to make on that front? And just on the JAK inhibitor, do you anticipate you'll be second or third to market in that space? And then just lastly, on the retail side in US Pet Health, how is the new retail strategy working out relative to your internal expectations? You gave us global numbers for Advantage and Seresto, but presumably the US number fared differently. And how much of that is macro versus supply chain versus the new retail strategy? Thanks.

Good. All right, Jeff, let's start with you here on progress for potential blockbusters and then the JAK timing.

Thank you, Erin. Those are excellent questions. We are very enthusiastic about the upcoming derm launch and the broad-spectrum parasiticide. The dermatology market is growing rapidly, and we believe it will contribute positively to Elanco. We have distinct advantages, and we will be introducing a portfolio that includes both the IL-31 short-acting treatment and the JAK, along with future developments. We are committed to being ready for launch by the end of 2023 and are considering various factors in our preparations. First, on manufacturing. We've got the manufacturing plant in place, and that is working and coming together supply chain, the marketing and selling as you know in the US we really even as we look at launching ZORBIUM right now, we're using digital. We're making sure share of voice is right. We're going to follow that with parvo and now the first SGLT2 inhibitor. So, those same capabilities are really starting to build a muscle. We'll be ramping those capabilities to be ready by the end of the year in 2023, so that we can, we believe, take significant share. And it will be tied to those capabilities. It will be tied to the differentiation and, of course, the investment as we enter the market. So, that's our expectation. On the timing, the FDA process is expected to take 12 to 18 months, while the USDA will take less time. We believe both of these compounds could reach the market in the first half of 2024. Regarding pet retail, it's important to note that we aim to meet pet owners where they prefer to shop. Currently, about one third of our US Pet Health business comes from retail. It’s a balanced approach; we still have a significant percentage of pet owners who do not visit veterinarians, and the convenience factor has increased more than ever post-COVID. So we see what we're doing in pet retail, Aaron, very importantly, and I would say significantly more today than when we bought it from Bayer as we brought in more expertise. We are working our value and our pricing at another level. We are, as Bobby Modi has come in, physical availability, more stores, more shelves, more channels, that's increasing significantly. And now what's introduced on this call is proof points that Ellen has brought another dimension in, and we've developed now an OTC outside the vet innovation engine. We're bringing Advantage XD, an Elanco product with a Bayer brand, and then we're combining it, bringing three additional OTC products this next year between Europe and the US.

All right. Thanks. We'll take the next caller.

Your next question comes from the line of Chris Scott from JPMorgan. Your line is open.

Hi. This is Katrina on for Chris. Thank you so much for taking our questions. So the first is on the macroeconomic environment. Can you elaborate a bit on any notable differences when it comes to pet owner demand across geographies? How different are the dynamics that you're seeing in Europe, which you've highlighted are a little bit difficult comparing to what you're seeing like LatAm, Asia and other regions? And how does that compare to the US? And then my other question is on supply chain. It seems like this is a topic that has come into greater focus this quarter for the industry. Can you just elaborate a little bit of what you're seeing and what are the product lines that are seeing the most impact? And kind of where we are towards the resolution of this, and how quickly some of these issues can be worked through? Thank you so much.

Great. Thanks, Jeff, why don't you take the first one, just kind of on what we're seeing from a pet owner perspective across regions of the world, and then we'll go to Todd?

Yes, I'll start. Thanks, Katrina. There's a lot to cover. I want to emphasize a few key points, starting with the US pet vet market. There's been considerable discussion around this. We've observed that vet visits are normalizing after COVID, but spending continues to increase. This is significant as it suggests that consumers are still willing to invest in their pets, even amid economic difficulties. We're witnessing this trend in the US vet market. Our adjustment in guidance mainly pertains to the pet retail sector. This is in line with our current assumptions regarding the veterinary side. I want to make that clear. A few key points to note are that we are observing increased price sensitivity in both the European and US retail markets, driven by several factors. As economic pressures mount, there is a noticeable shift from prevention to treatment. Consumers are opting for lower-cost alternatives, and we have observed retailers in both regions reducing their inventories, similar to trends in other industries. Additionally, there is increasing competition in the prescription market. So those are the factors that we've seen. We look at the rest of the world outside of the COVID lockdowns in China, and that impact, everything else is really for us, seem pretty resilient overall. Spend continues to be pretty strong, Latin America, Eastern Europe, and the Asia markets, Australian markets. So, again, overall, the robust marketplace. Retail is the area we're highlighting. We see this as cyclical. This will recover as the economy recovers and those are the factors driving it.

Todd, on supply chain?

Certainly. Thanks for the question, Katerina. Overall, our supply chain has stabilized in the last couple of months. As we called out on the last earnings call in August, we did expect some second half headwinds from supply mainly on third-party sourced product. That has continued as expected. But overall, our internal production is doing better than it did in the first half of the year. All the paper and product supply issues we had in the first half have been resolved, and now we have multiple suppliers for those products, which we believe will enhance our ability to effectively provide product next year, but also be in a spot to improve our procurement savings going forward. So, overall, the supply chain has stabilized, as we noted on the slide. We expect that to be a positive next year given the problems we had this year. The one item was some farm animal vaccines in Q3 with a little pressure on that in Q4 as well our US farm business. But overall, as you saw, the US farm business, its portfolio had a great quarter in Q3, especially across swine, poultry, and our cattle business did better than expected. So, again, that team is really delivering right now.

Thanks. We will take the next caller.

Your next question comes from the line of Umer Raffat from Evercore ISI. Your line is open.

Hi everyone. Thank you for taking my questions. I have two today. First, I'm considering the supply challenges at Zoetis and contrasting that with Merck's strong performance in animal health and their success in the parasiticide sector. I would have expected you to see some positive trends in parasiticides as well. Can you discuss those dynamics? Have there been any changes in your distribution model or inventory in Europe, etc.? Secondly, this may be a minor point, but I'm curious about something. You might remember when you presented a pipeline slide at your Investor Day a few years back. For your Trio product, you had a similar legend with dark blue arrows, and there were three arrows indicating several hundred million in potential for Trio, whereas there is only one arrow now. Am I misinterpreting this, or should I assume that your perception of the commercial opportunity remains unchanged, and you still anticipate it being a multi-hundred-million-dollar product? Thank you.

Yes. Go ahead, Jeff.

Let me address the last question first to clarify. There is no change. You may be interpreting it differently. There might be some changes in graphics over three years. We continue to see significant potential and positive differentiation across the market today. We are well positioned. Compared to the time of the investor conference, our capabilities in parasiticides have significantly improved, making us a stronger company in that area. Therefore, we anticipate a very successful launch as well. I'll emphasize that the initial submission has been made. Relative to just the differences, I think there's differences in portfolios. There's differences in geographies. What we would say is we're in line in parasiticides in the vet clinic with our expectations. We guided $70 million to $80 million down from competitive pressures, and we're still aligned with those expectations. No change. We continue to see nice growth from Credelio globally. Credelio Plus is doing well internationally. Credelio and our portfolio are doing well relative to expectations. We saw nice growth with Credelio in the quarter, complemented candidly by extremely nice growth in pain. We're taking share in the pain market here in the US. Got about just shy of 50% of our pain is non-Galliprant. So ZORBIUM, Nocita, Onsior, that's doing well, and our vaccines have held well. So it is about pet retail. We see it cyclical. We see we're declining with the market in the data, very similar to the market, and we are doing what we should be doing, price, channel expansion in pet retail and more importantly, adding innovations that will bring value and convenience, which will fit the trends that we're coming after.

Good. Thanks.

And let me also emphasize that there has been no change in distribution. Inventory remains consistent with other quarters, and there has been no change in that at all. As Todd just mentioned, our supply chain is stable and functioning.

Good. Thanks. We'll take a question from the next caller.

Your next question comes from the line of Nathan Rich from Goldman Sachs. Your line is open.

Hi. Good morning. Thanks for the questions. A couple of numbers ones and then one high level. As we think about 2023, should we think about the $80 million incremental revenue headwind that was put into guidance for the back half of this year related to Europe, China and US pet retailers kind of having to annualize into next year as we think about the right baseline for revenue, obviously, assuming no major changes in the macro environment? And can you quantify the impact from higher R&D investments, FX and interest expense on 2023? And then, at a high level, if I could just follow up on one of Ellen's prior comments. She mentioned the rolling submission process. Could you maybe just elaborate on what's needed for those future submissions? And are any pre-approval inspections required by the FDA for any of these products? Thank you.

Sure. Todd, let's start with some of the numbers in 2023, or context, I should say.

Sure. Yes, Nathan, we appreciate the question. I understand everyone is looking forward to 2023. We will provide our guidance for that in February. Today, we want to give some context on the factors we see moving forward. Regarding your question on retail, I want to remind everyone that we're currently out of season for the OTC products. This period typically accounts for about 75% of Seresto sales in the first half of the year, which is a much smaller base. Therefore, we want to note that, given the economic pressures, it's easier for someone to choose treatment over prevention now than it will be in the springtime when people are out with their dogs and engaging in outdoor activities. So we wouldn't just roll that into the base and assume it. And then, with respect to China, we do expect that to get better. We all know and are following the China situation very closely. We feel very good about our competitive position on parasiticides as well as where we fit with the large swine producers and our team on the ground continues to diligently work through the challenges that come with the current environment. So that end, we’re not going to get into. On FX, again, we’ve given our FX rate assumptions throughout. So those are pretty easy to look at. It is a headwind right now given, in the first half of the year, I would say euro was at about 105 just to provide context versus the 97 parity that we've been seeing over the last couple of months. Interest expense will be higher on the P&L just from floating rate debt going up. And then from an R&D standpoint, we've been running at about $80 million a quarter. Ellen and her team have taken full advantage of the productivity and the reshaping and integrating of three legacy organizations from Bayer, Kindred and Elanco into one, and we don't see a significant increase in that investment in order to drive the pipeline going forward. But I will say, to the extent we see items that will drive greater value from R&D, we'll certainly put money behind that. So, thanks for the question.

Yes. There's a second question regarding submissions and pre-approvals of the site. We probably won't delve too deeply into that, but Ellen may provide some context on your thoughts about it.

Thank you for the question. In order to obtain approval, we need to complete several submissions, which we refer to as rolling submissions since they don't all have to be submitted at the same time. We have begun the initial submissions for both our broad spectrum and parasiticides. We plan to submit one for our JAK inhibitor later this year, and we expect to make the first submission for our IL-31 short-acting product early next year or in the first half of next year. We are truly entering the submission phase for each of these three projects. Additionally, part of the approval process includes an inspection by the regulatory agency of the manufacturing sites to ensure we can produce the product in accordance with the specifications we provided.

Thanks. We will take the next question, please.

Your next question comes from the line of Balaji Prasad from Barclays. Your line is open.

Hi, good morning everyone. Thanks for the questions. Firstly, it's great to see the progress on the pipeline front. But could you call out the opportunity size that you see in the market both on the parasiticides side and the atopic derm side vis-à-vis the broader market size for these indications? Probably a bit more specifically, atopic dermatitis is going to be a function of market share gain, or would you be tapping into the nearly 40%, 50% market, which is still unaddressed. So, what would be the lower-hanging fruit for you? Thanks.

Good. Yes, Jeff?

Yes, Balaji, great question, and we're spending a lot of time analyzing this and looking at some historical market architypes too. And no question, the first thing is when innovation comes into animal health into a market like derm, increased awareness will go up because share of voice will go up, marketing will go up. And so that unaddressable market will expand. We're seeing that right now in pain as an example. Pain in Europe is one of the faster-growing markets as an example. So, we see that happening in atopic dermatitis. There are limited choices in a large market, so we will be able to offer veterinarians and pet owners more options. Additionally, how we stand out in the marketplace will be crucial, as well as ensuring that our product launches are equal to or better than any we have done before. We are focusing on new methods to engage with veterinarians and pet owners as they prepare to launch. These factors, along with the ongoing opportunities in the global market for parasiticides, will play a significant role. Our ability to differentiate and leverage our strengths in various channels will be key in launching this new broad-spectrum parasiticide.

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

Your next question comes from the line of Jonathan Block from Stifel. Your line is open.

Great. Thanks guys. Good morning. Maybe just a couple and I'll ask them all upfront. To begin, I think, Todd, I got the 2022 revenue guidance down about $100 million, EBITDA down $45 million to $50 million. So the decrementals, we're close to 50%. And I think when I go back and I look at when you lowered 2022 guidance last call in the 2Q, the decremental, I think, was closer to 30%. So why the big step-up in the decrementals, maybe you could talk to that bigger hit? Is it just a case of fewer levers to pull? Maybe a follow-up. I think the prior 2022 gross margin was 57.5% for this year. You missed this by a good couple of hundred basis points. Is there a new 2022 gross margin? And then, Jeff, maybe just for you to end with. I know you called out global growth in Galliprant. But a specific question, was it up year-over-year in Europe? Because clearly, that's where you're facing competition, and just I think it's an important data point as we think about competition eventually coming to the US. Thanks, guys.

Jeff, you want to start with Galliprant and then we'll come back on the guide?

Yes. Good question. Overall, Galliprant, nice growth globally in the quarter, driven by the US, without question. And we've seen continued double-digit growth overall on this brand in 2022 in the US, offset by, yes, we saw a slight decline in Europe. I would really emphasize a couple of things. We've got a different organization, and we're preparing a little bit more in the pain market in Europe; and two, there is a different label. We don't have the inflammation claim in Europe that we do in the US. So different labels, different approaches. But again, overall, expanding our pain portfolio and expanding capabilities in Europe over time. We continue to see nice growth ahead, both for Galliprant in the US as well as for the pain sector overall.

Jon, thanks for the questions on the margin profile, the EBITDA flow through. Two items. First, yes, less levers, less predicted savings late in the year. So that is one of the items. And then the other is just the mix of products. With that retail being a big driver of the incremental change, that's one of our highest gross margin areas. And so when that hits, there's a greater flow through to the EBITDA side of things. And then on the gross margin, yes, we'd expect for the full year to be about 100 basis points behind the previous guidance we gave in August as a result of both the Q3 being a little lighter than expected, plus then this incremental sales decline, deleveraging the fixed manufacturing cost base with the product mix.

Thanks. We'll take the next question.

Your next question comes from the line of Brandon Vazquez from William Blair. Your line is open.

Hi, everyone. Thanks for taking the question. I wanted to focus on the macro conditions a little bit and maybe just get a little granular on kind of like the progression of macro headwinds you've seen over the past couple of months and as we go into the fourth quarter. So I guess the question is, kind of, like, are macro conditions worsening? Are they kind of stabilized as we go into the fourth quarter, trying to get a read of how things go into the end of the year? And then, how those macro headwinds progress through 2023?

Brandon, thanks for joining us for the new coverage universe from William Blair. Happy to have you on the side of us. On respect to the conditions, we did call out these items from the global macro slowdown in August. We just under-told the impact. As we look across Europe, it is getting more challenged, and we've seen that come through. As Jeff mentioned, we had a retailer in Europe shut down that's had an impact as a result of their retail space as well as one in China. So, those are certainly, ones that are impacting. As we look at our Q4 guide versus our Q3 guide, we do have Q4 down slightly more than Q3. But overall, again, we've got it focused in the areas we called out in August. We just under-called them then. We feel good about the guidance we provided today. And as we look to 2023, we're excited about a lot of the innovation we're bringing to the retail channels, especially the US Advantage XD for cats being a long-duration spot-on treatment that we launched in October and as the season comes in next year, excited about what that product can do. So a lot yet to play out over the next few months as we get into 2023.

All right. Thanks. We will take the next question.

Your next question comes from the line of Elliot Wilbur from Raymond James. Your line is open.

Hi guys. This is actually Michael Parolari on for Elliot. Thanks for taking the question. Quick one for me, today, just on the debt, see slide 20 that cost of debt was 3.9% in the quarter, and you guys got about 70% of it fixed. Just wondering if you could tell us if you have it on hand, the effective rate between the fixed and the variable portion of the debt? And then how to think about that going forward? Thank you.

I don't have off the top of my head, Michael, the relative fixed rate versus floating. As you know, our fixed-rate coupons are reasonably high given the coupon step-ups we had versus the face of those. And so I believe we did the tender earlier this year, which helped reduce interest expense overall in the year. So, from that aspect, it's lower. I think we've got a LIBOR rate for the end of this year at projected to be about 4.77% and our fixed rate is generally LIBOR plus 1.75 % that gives you a feel for the floating rate debt. But if I step back big picture and look at our overarching debt profile, we've got $400 million due next year, then nothing until 2027 to speak of. We're continuing to generate cash. We're continuing to pay down debt. We expect that will continue next year as well. So, overall, we feel very comfortable servicing the debt we have, and we'll continue to look for ways to optimize our capital market strategy, much like we did by the interest rate swap transactions to accelerate cash inventory to pay down debt versus waiting for that to play out over time. So, again, I appreciate the question and feel good that we can manage through the higher level of debt that we expected when we started this year.

Thanks. I think that's all our questions. I'll turn it back to Jeff to close this out.

Yes. I think the third quarter, without question, a worsening economic situation, China lockdowns and a stronger dollar. But it really provided some significant proof points inside Elanco on where we're going as a company. The pipeline progress, we know will be the biggest value driver. And to say that we have five potential path to five blockbusters from now through the first half of 2024 is one of the most significant things our company has seen, and it's in front of us, and we're in execution mode against that, but as well as market share and price being a focal point and improving supply situation, our overall productivity that came through in OpEx and in the middle of the income statement, which led to cash and paying down debt. And I think I would like to also highlight a lot of the organization focused on standing up our systems to have one system and to be totally all integrated a quarter earlier by early Q2, all of this driving, expanding EBITDA and EPS. So we're controlling the controllables in a challenging environment. Thank you for your interest in Elanco. We look forward to continuing to engage with you in the future.

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