ELAN - Elanco Animal Health: Turning More Healthy

2023-12-21 09:34:00 ET

Summary

• Elanco Animal Health has faced revenue declines and suffered from high debt, creating a challenging operating environment.
• The company's performance has been disappointing, with missed synergy targets and declining sales.
• However, recent quarters have shown signs of stabilization and green shoots, aided by lower interest rates.

In early October, I saw some signs of stabilization for shares of Elanco Animal Health ( ELAN ) amidst a still very substantial debt pile. The company has been facing revenue declines and high debt for a while, creating a tough environment to operate within, certainly in a world of higher interest rates.

While the 2023 guidance was disappointing, minimal improvements and green shoots were visible in recent quarters, a trend which continues and is furthermore aided by lower interest rates.

A String Of Disappointments

Elanco long was part of Eli Lilly ( LLY ) until it was spun off from its parent company in 2018. Eli Lilly aimed to pull off a similar move which Pfizer ( PFE ) did, when it spun off Zoetis ( ZTS ) in the years before.

The idea was to create a pure play on animal health, with the business focused on disease prevention, therapeutics, health, and animal food. A $24 stock at the time of the spin-off initially rose to the mid-thirties, driven by investors who were becoming very upbeat, with earnings power stuck around a dollar per share.

After the business operated on its own feet, it relatively soon became involved with industry M&A. This came as it acquired the animal health business from Bayer, which needed to raise cash following its purchase of Monsanto. While Bayer should have been a willing seller in theory, Elanco paid a premium 4.5 times the sales multiple for a $1.7 billion business.

The idea was that both businesses combined would post EBITDA around $1.1 billion, while operating with a steep $7.3 billion net debt load, for leverage ratios in the mid-6s. Elanco believed that it could deliver on $300 million in synergies, which would dramatically reduce leverage, yet with synergies seen equal to 5% of combined sales, those estimates looked quite ambitious.

If delivered, synergies could boost earnings towards $1.50 per share, but these have only turned out to be paper promises. Following the deal closing in 2020, the company guided for 2021 sales at $4.6 billion, with earnings seen between $0.90 and $1.00 per share, as there were adjusted earnings of course.

All Downhill

Still a $30 stock in 2021, shares have gradually come down to levels around the $10 mark in spring of this year. Initially, the company delivered on its promises with 2021 sales and earnings topping the original guidance, with revenues reported at $4.77 billion, while earnings were reported at $1.05 per share.

2022 revenues fell, while adjusted earnings improved slightly to $1.11 per share, although based on a mere $1.02 billion adjusted EBITDA number. This performance meant that while absolute net debt levels fell to $5.5 billion, leverage ratios were still very high.

The problem was that the 2023 performance was expected to come under further pressure, with sales seen between $4.28 and $4.40 billion, with EBITDA seen between $920 million and a billion, and adjusted earnings seen at just $0.74-$0.83 per share.

With the nearly half a billion shares trading at just $11 in March, the market value of the firm of $5 billion and change was equal to the net debt load. Moreover, investors were not convinced about management, as they embarked on a big and expensive headquarters project, worrying given the state of the business. Given the debt and interest overhang, shares have traded around the $10 mark over the summer, as investors feared the impact of stagnation and higher interest rates.

Green Shoots

Elanco has been showing some green shoots, with first-quarter sales up 3% to $1.26 billion, as growth doubled in constant currency terms. This however included an estimated hundred million orders being placed forward in anticipation of a change in the ERP system.

Nonetheless, the company hiked the full-year guidance on both the sales and earnings front, as it hiked the guidance again following the release of the second-quarter results, even as second-quarter sales fell 10% (for the same reason why first-quarter sales rose, with orders reversing). By now, full-year sales were seen between $4.35 and $4.41 billion, with EBITDA now seen at a midpoint of $980 million. Moreover, the company announced some upbeat news on the R&D front and product launches.

A Big Move

Since early October, shares of Elanco have risen from around $11 per share to $14 per share, driven by a massive decline in interest rates across the board.

In November, Elanco posted a 4% increase in third-quarter sales to $1.07 billion, as the company posted a huge + billion GAAP loss on the back of a massive impairment charge, mostly related to higher interest rates.

Adjusted earnings per share rose by a penny to $0.18 per share as growth was seen across both roughly equally large segments: pet health and farm animal, although the first segment has the better growth profile and performance.

The company mostly narrowed its full-year guidance, with the midpoint of the full-year guidance seen around $4.38 billion, EBITDA seen around $982 million and adjusted earnings seen around $0.91 per share. Net debt of $5.59 billion still works down to a leverage ratio around 5.7 times here.

While the near-term outlook shows continued stagnation and baby steps in terms of improvements, the company sounds upbeat for 2024. The company expects several substantial commercial launches of new drugs next year and has high hopes for them. Another potential driver for the business is lower interest rates (over time), which now trend at $280 million per annum, equal to 5% of the debt load. Every percentage improvement on this front could boost pre-tax profits by ten cents from here, but moreover, it is the lower rate environment which lifts all boats, certainly leveraged ones.

And Now?

It is very comforting to see improvements in the underlying business being accompanied by a lower interest rate environment, providing real potential for growth from here onwards, certainly as organic growth could accelerate in 2024 amidst new product introductions.

It seems that not all investors can wait for that, with activist investor Ancora having built a stake in the business, hoping for a change at the top helmet. This might provide another driver, as all these developments mean that I am still upbeat on Elanco here. Right now, the worst leverage concerns are a thing of the past, as we see clear growth drivers for next year, making me upbeat to let the shares ride further in anticipation of some more re-rating here to levels in the high-teens.

For further details see: