ELAN - Elanco Animal Health: Robust Results Overshadowed By Persisting Challenges

2023-07-14 07:09:42 ET

Summary

• Elanco Animal Health Incorporated reported a 3% increase in first quarter revenue, surpassing initial projections due to a sales shift from the second to the first quarter.
• Despite vaccine supply disruptions and decreased demand for cattle implants, Elanco's farm animal business globally reported a 5% constant currency growth.
• Elanco is raising the lower end of its annual guidance range, forecasting revenue to be in the range of $4.31 billion to $4.4 billion, and an adjusted EBITDA between $940 million to $1 billion.

Thesis

Elanco Animal Health Incorporated (ELAN) recently managed to exceed financial projections in Q1 , largely due to an unprecedented sales shift triggered by their Enterprise Resource Planning system. However, I argue in this article that underlying concerns persist that could hamper their growth opportunities.

Company Overview

Elanco Animal Health is a player in the animal health sector. Having its genesis in 1954, Elanco strategically stands at the crossroads of innovation and production, successfully delivering a plethora of products for both pets and livestock .

With pet wellness at the heart of their operations, Elanco has a robust product portfolio that includes parasiticide and vaccine products - a notable armor against common pet nuisances like worms, fleas, and ticks.

Their impact isn't limited to domestic animals. Elanco also plays a vital role in the commercial farming space, providing critical healthcare products for poultry and aquaculture. Their offerings span across vaccines, antibiotics, and parasiticides, as well as nutritional supplements like enzymes, probiotics, and prebiotics.

Distribution-wise, Elanco primarily targets third-party distributors, veterinarians, and a broad range of farm animal producers including beef, dairy, pork, poultry, and aquaculture operations.

Bucking the Trends and Boosting the Bottom Line

Examining the company's most recent financial update, Elanco Animal Health disclosed a first quarter revenue of $1.257 billion , registering a 3% boost, or 6% when adjusted for constant currency. This performance surpassed initial projections, mainly due to an estimated $90 million to $110 million sales shift from the second to the first quarter, orchestrated by the implementation of their Enterprise Resource Planning (ERP) system. This shift, Elanco speculates, was driven by clients eager to mitigate any anticipated disruptions due to the system changeover.

The U.S. pet health business experienced impressive expansion, with revenue swelling by 12%, a figure that includes a 12 percentage point benefit attributed to the ERP shift. Elanco attributes this favorable outcome to their robust Over-The-Counter (OTC) parasiticide portfolio, which flourished in spite of minor supply hiccups.

On the international front, pet health witnessed a 5% growth in constant currency. Despite being hit by the aftermath of COVID lockdown in China, the company remains bullish on the prospects of an improved end market demand. Elanco's farm animal business globally reported a 5% constant currency growth, though the U.S. segment experienced a 6% dip, which can be traced to vaccine supply disruptions, shift of poultry customers away from Elanco products, and decreased demand for cattle implants.

Elanco's adjusted EBITDA amounted to $379 million, marking a 12% growth. The gross margin escalated 230 basis points to 60.8%. By the end of the quarter, the company was grappling with a net debt of $5.8 billion.

Looking ahead, Elanco is upping the lower end of its annual guidance range, buoyed by the successful integration of the ERP system, positive market indicators in the U.S. pet health and international poultry sectors, as well as innovation momentum. They forecast revenue to be in the range of $4.31 billion to $4.4 billion, an adjusted EBITDA between $940 million to $1 billion, and an adjusted EPS between $0.76 and $0.83. Therefore, based on their quarterly beats since Q1 2022 (see above) they appear to have the momentum to exceed estimates again, which will be revealed on August 3 .

Expectations

Elanco is followed by 12 Wall Street analysts that amount to a " Buy " rating and average price target for the stock projecting a healthy +25% upside.

Performance

Right off the bat, the most glaring number that catches my eye is the drastic decrease in the company's share price (see chart below), which plummeted from USD 31.83 in January 2019 to USD 10.32 in July 2023. The 67.6% decrease represents a compounded annual rate of return (ROR) of a staggering -22.07%. For a company in the animal health sector, this kind of erosion in market value is alarming.

On top of that, Elanco's non-payment of dividends only compounds the issue especially when contrasted with the S&P 500's USD 984.77 dividend return (based on a $10k initial investment for this time-frame), further detracts from the company's appeal as an investment option.

Valuation

The modified growth rate of operating earnings registers at -1.79%, pointing to a slight decline in growth (see chart below). Observing the Blended Price to Earnings (P/E) ratio, it stands at a modest 10.91x, considerably beneath the typical P/E ratio of 27.26x.

This hints that the market currently perceives Elanco's earning prowess to be underperforming its historic norm. Assuming the market is factoring in some form of risk or uncertainty, investors who believe in this company could see this as an opportunity to buy at more reasonable valuation.

Risks & Headwinds

ERP Blackout Fallout: A primary concern from the company's most recent results revolves around the estimated impact of the ERP blackout on sales. Elanco has attributed a notable portion of Q1 sales performance to this 'blackout,' creating an inflated revenue picture that will likely regress in Q2. If we peel back the layers of the reported 3% growth (or 6% in constant currency), we find a significant portion, estimated at between $90 million to $110 million, was a one-time uplift from this systemic shift. While a short-term boom, the aftermath may lead to a significant headwind in Q2 when this one-time benefit is absent. The full implications of this shift are yet to unfold, making it a key area to monitor.

Supply Chain Woes: There were murmurs of supply disruptions from management, particularly concerning certain vaccines. The concern here is twofold. First, the disruptions could hamper revenue if they persist or escalate, and second, it could impact the company's reputation and relationships with customers. Equally concerning is the pressure on legacy parasiticide products - an essential pillar of Elanco's pet health revenue. Together, these supply-side disruptions could translate into significant risks if not managed effectively.

Farm Business Deterioration: Diving deeper into the company's segments, the U.S. farm business witnessed a 6% decline, driven by vaccine supply disruptions, loss of poultry customers, and weaker demand for cattle implants. This is reflected in the Economic Research Service of the USDA 2023 Farm Sector Income Forecast. Specifically:

Farm sector income is forecast to fall in 2023 following two years of strong growth

Such declines in what should be a stable, growth-oriented business are concerning. If these factors persist, they could potentially offset gains in other segments, straining overall performance.

Dispensing Trends and Pricing Strategy: Elanco's anticipation of a softening in dispensing trends is another area of concern. The reimplementation of the MAP policy has led to higher prices, which could have a cooling effect on consumer demand. It's a balancing act - ensuring profitability while maintaining market demand, particularly as competitors may seize the opportunity to undercut prices.

International Expansion Roadblocks: The global growth ambitions of Elanco are not without their challenges. The lingering impact of COVID-19, especially in key growth markets like China, has created an uphill battle. Despite management echoing positive indicators in the first quarter, the legacy of the pandemic could continue to hamper international growth if economic recovery stalls or, what most of us probably don't wish to ever consider again in our lifetime, another significant outbreak occurs.

Financial Health and Liquidity: From a financial health standpoint, Q1 saw $145 million used for operations, representing a year-on-year decrease. Coupled with their $5.8 billion net debt figure and lower cash flows from operations resulting in reduced operating cash flow could put pressure on financial flexibility as well as growth investment opportunities for the company. Management have assured shareholders they have confidence they are capable of servicing this debt obligation; yet reduced cash flows combined with high indebtedness could limit its investment options and hamper investments into new opportunities for expansion.

Final Takeaway

Based on the information provided, I would rate Elanco as a "Hold." While the company has demonstrated strong Q1 performance and increased its guidance range, several risks such as a potential Q2 sales regression due to the ERP 'blackout' effect, ongoing supply chain issues, and weakening U.S. farm business paint a less favorable picture. Additionally, the company's high level of debt coupled with lower cash flows could restrict financial flexibility and growth potential, creating further cause for concern. Although Wall Street analysts project a 25% upside, the steep share price decrease and lack of dividends make the stock less appealing for immediate purchase.

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