FatCamera
Towards the end of last year, I believed that the outlook for Elanco Animal Health (NYSE:ELAN) started to look healthier. Following an expensive deal for Bayer’s animal health unit, Elanco was saddled with debt but moreover faced revenue declines, the cocktail of which cast a real shadow on the business and its shares.
With signs of stabilization seen in 2023, interest rates moving lower towards the end of the year, and new product introductions on the arrival, the outlook for 2024 looks a lot better already, now backed up by what appears to be a solid divestment.
A Disappointment
Long a part of Eli Lilly (LLY), which has been one of the hottest stocks in 2023 on the back of its weight-loss drugs, Elanco was spun off back in 2018. Eli Lilly decided to embrace more focus after Pfizer (PFE) successfully spun off Zoetis (ZTS) in the years before.
As a pure play on animal health, focused on disease prevention, therapeutics, health and animal food, Elanco was a $24 stock at the time of the spin-off, as the thesis quickly changed after the company bought the Bayer animal health business in 2020 at a 4.5 times sales multiple of $1.7 billion. Pro forma EBITDA of $1.1 billion was really never achieved as the business suffered from lack of growth, even declining sales, and pressure on margins.
In fact, the company originally guided for 2023 sales around $4.3 billion (some 10% below the pro forma numbers) while EBITDA was set to fall below the $1 billion mark, despite the promise of synergies at the time of the deal announcement. While debt had come down a bit in dollar terms, it was declining margins which still resulted in sky-high leverage ratios over 5 times, causing a $30 stock in 2020 to fall to the $10 mark early in 2023.
Sentiment Turns
A $9 stock in October saw a massive rally to the $14 mark just days ahead of Christmas, driven by a combination of lower interest rates (providing avail amidst high leverage) as the company had reported a 4% increase in third quarter sales, the first annual increase in sales in a long time.
Following the stronger report, the company now guided for full-year sales of around $4.38 billion, EBITDA of $982 million, and earnings of $0.91 per share, with net debt of $5.59 billion translating into a 5.7 times leverage ratio.
While this revised guidance marked baby steps in terms of improvements, the company sounded upbeat for 2024, expecting several commercial launches for new drugs (for which the company had high hopes). Analysts at Stifel estimate that these new drugs could contribute about $150 million in lucrative sales by 2025, equal to about 4% of sales, as I hope that this is a conservative estimate. On the third quarter call, management anticipated FDA approval of Credelio Quattro, Bovaer, and Zenrelia, all set to happen in the first half of 2024, and being cited as potential blockbusters. More importantly, organic growth was seen, with or without approvals.
Furthermore, activist investor Ancora built a stake in the business, likely keeping management on their toes as well to drive improvements, as I was upbeat and willing to hold onto a position in anticipation of a re-rating to the higher teens.
Recovery Continues – Leverage Addressed
Since December, shares of Elanco have risen to the $16 mark, levels last seen in the summer of 2022. Right now, the 493 million shares of Elanco represent a $7.9 billion equity valuation, for a $13.5 billion enterprise valuation.
Given this backdrop, the company announced the sale of its aqua business early in February. The company reached a deal to sell this business to Merck Animal Health (MRK), one of the few big pharmaceutical names that held onto its animal business.
The $1.3 billion cash deal will go a long way in addressing the worst leverage concerns, but moreover is valued at 7.4 times sales, suggesting that just $175 million in sales will leave the door. In comparison, despite the rally, all of Elanco trades at just around 3 times sales here, with the business becoming more focused on animal health and livestock. Of interest, is that the aqua business actually posted small revenue declines as of the third quarter, making that the divestment is not necessarily dilutive to organic growth here.
While the sales multiple is very rich, the unit was incredibly profitable with $92 million in EBITDA reported, for a margin in excess of 50%. Based on this metric, the unit was valued at 14 times EBITDA, a multiple largely in line with Elanco itself here.
With $1.0-$1.1 billion earmarked for debt reduction, the company will forego $65 million in annual interest expenses, making the deal dilutive to the tune of three cents this year, while reducing leverage a full turn here. All this looks quite fair, also in the eyes of investors who send shares up a dollar on the back of the news announcement, with shares adding about half a billion in value on the back of this deal tag. This confirms that investors like the price, but certainly the reduction in leverage.
And Now?
With pro forma net debt down to less than $4.5 billion, leverage ratios will fall below 5 times overnight, with little impact on earnings power, as the company continues to sound upbeat for 2024 in terms of innovation and new business development.
Given all this, I continue to have a positive undertone here, as I clearly see a roadmap for earnings in excess of a dollar in 2024. Combined with a multiple re-rating (after debt is down further) this could create a roadmap for shares to prolong their rally to the $20 mark. I remain constructive and a patient holder of the shares now after what appears to have been a fair divestment.
