In March, I believed that leverage remained the issue in the case of Elanco Animal Health (NYSE:ELAN). The company was supposed to be a secular growth story in animal health, but instead the company has seen revenue declines in an inflationary environment. Such observation was bad enough as it is, but this came amidst a heavy debt load, and that it’s in a higher interest rate environment.
If the business could stabilize and leverage could be controlled, great upside might be seen, but that requires some real execution, which for now still involves quite some question marks.
A Turbulent Story
Elanco used to be part of Eli Lilly (LLY) but it was spun off from its former parent in 2018, after its peer Pfizer (PFE) made a similar (successful) move in the years before with Zoetis (ZTS).
The spin-off created a pure play on animal health, focused on disease prevention, therapeutics, health and animal food. A $24 stock at the time of the spin-off rose to the mid-thirties later that year. This made me cautious as even if the company could post impressive 20% margins, that only would yield earnings power around a dollar, making the valuation hard to justify.
Moreover, the company took part in consolidation as it acquired the animal health business from German-based Bayer which needed to sell assets following its purchase of Monsanto. Despite the poor negotiation position (with Bayer being a willing seller), Elanco paid a premium 4.5 times sales multiple for the $1.7 billion business.
Pro forma EBITDA was set to come in around $1.1 billion which had to support a $7.3 billion net debt load, translating into sky-high leverage ratios in the mid-6s. The company rationalized this by pointing towards $300 million in potential synergies, being equivalent to 5% of pro forma sales, a huge ambition in my view.
At best, after deleveraging and realization of synergies, I pegged earnings potential round $1.50 per share, but these results were not delivered upon. With the deal closing in 2020, the company guided for 2021 sales at $4.6 billion, with adjusted earnings seen at $0.90-$1.00 per share, as quite frankly I was surprised to see shares still trade in the $20-$30 range in 2021 and 2022.
By the fall of last year, shares broke the $15 mark, and they fell to the $10 mark in March of this year. In the end, 2021 sales came in at $4.77 billion, with adjusted earnings posted at $1.05 per share. Guiding for modest growth in 2022, the company cut back on these promises during the year amidst inflationary pressures and a strong dollar. In the end, sales ended up falling to $4.2 billion, with adjusted earnings reported at $1.11 per share.
This was based on a mere $1.02 billion EBITDA number and with net debt down to just $5.55 billion, leverage ratios were still sky-high. Moreover, the 2023 guidance was highly disappointing with 2023 sales seen down to a range between $4.28 and $4.40 billion, with EBITDA seen down to $920 million to a billion. This made that forward-looking leverage ratios might rise towards 6 times, as earnings for 2023 were seen at just $0.74-$0.83 per share.
Trading at $11 in March, the 487 million shares granted the business a $5.3 billion equity valuation, in line with the net debt load. This mere observation shows the importance of leverage, as management has some to prove after an expensive deal and expensive headquarters project. High leverage and operating issues were the causes of concern, although that valuations were low enough to show major appeal if execution could be delivered upon.
Trading Stagnant
Since March shares of Elanco have traded in an $8-$12 range, now trading at $10 and change and that is in a tougher environment in which interest rates keep rising.
In May, Elanco posted first quarter sales of $1.26 billion, up 3% on the year before as growth would have doubled if we look at revenues in constant currency terms. This looks better than it is, as the revenue number includes an estimated $100 million in orders being shifted from the second quarter to the first quarter due to a change in ERP systems which made that customers pre-ordered many products.
Despite the hard-to-read numbers, the company hiked the lower end of the sales guidance to $4.31 billion, while the lower end of the EBITDA guidance was hiked by twenty million, and earnings were raised by two pennies.
In August, Elanco posted second quarter sales of $1.06 billion, down 10% on a reported basis which is due to the estimated $100 million revenue shift into the first quarter. The company hiked the full year guidance to $4.35-$4.41 billion in terms of sales, now seeing EBITDA come in between $950 million to $1.01 billion. With net debt stable at $5.75 billion, the company continues to struggle from a leverage point of view. The stable, or even falling EBITDA comes in the light of higher interest rates, trending around $300 million here.
Other news includes some progress on the R&D front and product launches, as well as some improvements on the governance front, all of which has the aim to boost long term shareholder value.
A Final Word
The truth is that after a dismal 2023 outlook, the company has raised the guidance in a minimal fashion for two quarters in a row, which is a promising sign. That said, the hike in the guidance is quite minimal, and in the meantime interest rates kept rising, although that the second quarter conference call revealed that by now about 75% of debt is fixed.
Amidst all this, I am cautiously upbeat here on the modest guidance hike (which still implies year-over-year sales and EBITDA declines) as hopefully inflationary and product introduction can ignite some growth again in 2024. Delivering on this is key in order to tackle the debt load and leverage ratios, to thereby reveal upside in the shares.
Amidst all this, I continue to hold onto a modest position which I initiated this spring, although it is modest given the debt overhang.
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