January 23, 2020 - 10:56pm EST by
2020 2021
Price: 32.25 EPS 0 0
Shares Out. (in M): 489 P/E 0 0
Market Cap (in $M): 15,754 P/FCF 0 0
Net Debt (in $M): 6,073 EBIT 0 0
TEV ($): 21,827 TEV/EBIT 0 0

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Elanco (ticker: ELAN, or “the Company”) operates an animal health business that develops products to prevent and treat disease in livestock and pets.  It is effectively a pharmaceutical company for animals. At ~$32, it’s a ~$15bn market cap company (~$22bn EV) that generates ~$4.7bn of revenue pro forma for the pending acquisition of Bayer’s animal health business.  The reason why the stock is interesting is that this Bayer deal is a transformative transaction that will accelerate the already in-place margin improvement opportunity that will take EBITDA margins from ~24% in 2020 to north of 30% in 2022 as the Company streamlines operations across the combined enterprise.  While the Company recently guided somewhat disappointing top line growth for 2020 (+LSD on the core Elanco business), EPS is still poised to nearly double from ~$1.12 at the guided 2020 midpoint to ~$1.90+ in 2022 (compounding at ~30%).  Moreover, this EPS acceleration assumes just ~3% revenue growth which is both below the industry and below the MSD growth that the Company believes is realistic, leaving an additional call option for the stock if management delivers on the top line.  Beyond the margin improvement story (~$300mm+ of cost synergies) and yet to be determined revenue synergies, the transaction will also: 1) add scale (allowing it to grow more closely to the MSD of the industry) and make Elanco the #2 player in the space (up from 4th), 2) diversify its revenue base across more products and geographies (further reducing earnings volatility), 3) balance the portfolio by enlarging the more attractive Companion Animal “pet” segment to almost an equal split with the Food Animal ‘livestock’ segment, 4) expand the international presence to attractive geographies such as China, 5) enhance the R&D/innovation pipeline (spend a similar percentage on R&D but can optimize more nominal dollars), and 6) add alternative channel/ecommerce distribution capabilities where revenue is growing at ~3x the industry pace.  At a low/mid 20’s P/E multiple, a discount to both the high 20’s historical multiple for this asset and the low/mid 30’s where rival Zoetis (ticker: ZTS) trades, there’s potential for 50%+ upside to the stock over the next 24 months

Taking a step back, Elanco went public via an IPO in the fall of 2018 and subsequently separated from its prior parent company, Eli Lilly, through a share exchange offer.  The Company operates in two distinct end markets, Companion Animal or “CA” and Food Animal or “FA”, offering products to improve the health of pets and livestock respectively.  The CA business will generate approximately ~$2.2bn in revenue and offers two categories of products: ‘disease prevention’ (a portfolio of parasiticides that protect pets against fleas, ticks, worms, as well as a portfolio of vaccines) that is growing MSD+, and ‘therapeutics’ (a portfolio of products that help address pain and osteoarthritis in pets) which is also growing MSD+.  The FA business will generate ~$2.5bn in revenue and similarly offers two categories of products: ‘future protein & health’ (a portfolio of vaccines, enzymes, and antibiotics to serve the poultry and aquaculture food animal markets) which is growing M/HSD, and ‘ruminants & swine’ (a portfolio of products to improve the health of cattle, sheep, and pork livestock) which is growing LSD.

Away from the idiosyncratic nature of the opportunity for Elanco as a result of the pending Bayer merger, the animal health industry itself has quite attractive characteristics.  At a high level, it offers much of the resiliency and defensiveness of the traditional human healthcare industry, but it comes without the baggage of third-party payors, healthcare reform, significant threats from generics, or drug development inefficiencies.  With regard to generics, there are very few ‘blockbuster’ products that are north of $100mm making it generally uneconomical to launch a generic against the majority of products, and the price/share decline curves are much less pronounced (typically 10-15% of each price and volume annually for a couple of years before stabilizing versus the potential for 80%+ price declines and larger share loss when traditional pharma becomes genericized).  Other benefits to the animal health industry vis-à-vis human pharma include a more direct trial process that allows treatment directly with the species, a lower bar for approvals (beating a placebo versus having to beat a standard of care), private pay versus intermediaries with reimbursement risk, lower development costs (<$100mm versus <$1bn), fewer years to bring a product to market (3-7 versus 9+), and a lower risk of market adoption upon launch.  Further, there are secular drivers that are driving up demand for animal health products. On the pets’ side, pet ownership is increasing, pets are living ~20%+ longer, there’s an increasing willingness among pet owners and younger generations to spend more on their pets, and emerging markets are increasingly becoming pet owners as the middle class grows. On the food animal side, there’s an increasing focus on efficient farming (improve productivity of livestock, cause less environmental strain), there’s similarly rising demand in meat consumption from emerging markets and growing middle classes, and there’s an increasing demand to protect livestock from disease such as the recent African Swine Fever epidemic which decimated millions of pigs across China and Southeast Asia.  The results of these dynamics are a Companion Animal industry that’s ~$12bn growing M/HSD, and a ~23bn Food Animal industry that’s growing L/MSD (collectively growing approximately volume ~2%, price ~2%, and innovation ~1-2%).   

With that said in terms of attractive industry dynamics, there are a handful of risks worth noting.  First, while the African Swine Fever damage has largely been done, the FA business will see some continued weakness in the first half of this year before turning into a tailwind in the 2nd half.  Second, one of Elanco’s largest products Rumensin (~7.5% of PF revenue) will be facing generic competition in the United States (though early data are showing a less pronounced degradation).  Third, Zoetis is launching a ‘trio’ parasiticide (a single product that treats fleas, ticks, and worms) that could impact a range of offerings in the Companion Animal business. However, all of this has been reflected in the 2020 guidance that underwrites a ~$60-90mm headwind that is believed to be offset by ~$90-130mm of new growth opportunities (new product launches, aquaculture capacity expansion, and growth in the specialty vet channel).  Beyond competitive launches, the premium valuation commanded by the stocks across the animal health group is worth debating (~20-30x+ P/E), but Elanco’s embedded EPS acceleration over the next few years coupled with an industry that is defensive, growing, high margin, and offers better dynamics versus traditional pharma make the premium easier to justify. Further, with ~$2.00+ of earnings power in a couple years, permanent capital loss is less likely even if multiples compressed significantly.  Leverage is another significant risk to consider (initially ~6x gross, ~5.5x net). Traditional pharmaceutical investors typically shun leverage, and the ‘accretive acquiror’ stories of the past like Valeant and Endo ended horrifically. However, the Company should be generating ~$1bn in resilient operating cash flow by 2022 and will de-lever to less than ~3.0x through debt pay down and EBITDA growth by then. There is also some debate of the risk posed by protein alternatives produced by companies like Beyond Meat, but it will be years and likely decades (if ever) before the demand characteristics for animal-based proteins are meaningfully impaired (and the pets business is of course not affected).  Finally, perhaps the biggest ‘risk’ for near-term investors is time in the sense that the stock has the potential to be ‘dead money’ for much of 2020. The deal is not expected to close until early 3Q, and 2020 is poised to be a very unexciting year from a growth perspective organically.     

In summary, an attractive outcome for the Elanco stock from here is largely predicated on the self-help story and execution related to merger integration (the fruits of which will be seen largely in 2021-2023) that should produce ~1,000bp+ of EBITDA margin expansion (consolidating staff/salesforce, leveraging scale and combined manufacturing capabilities, closing plants, consolidating R&D, etc.).  And this management team has successfully acquired/integrated ten prior deals with synergies exceeding expectations. With the bar lowered across the street after the 2020 guidance release a couple weeks ago, and the overhang for the equity issuance related to acquisition financing removed this past week, the setup for the back half of 2020 onward looks attractive.  For investors willing to underwrite to 2022+ numbers, EPS has the ability to compound at ~30% from a 2020 base toward ~$2.00+ in 2022 offering ~50%+ upside to the stock at a reasonable mid-20’s multiple over the next 24 months.    


APPENDIX: Pro Forma Company


APPENDIX: Core Elanco


APPENDIX: Industry Trends