Activist board members and a recession-proof business may push this company to a nice turnaround.
Elanco Animal Health Incorporated (ELAN)
From Cabot Turnaround Letter
Elanco is one of the world’s largest animal health companies, with estimated 2021 revenues of $4.6 billion. It offers a broad range of products, including the Soresto and Advantage flea and tick collars, prescription treatments for various pet diseases and ailments, and farm animal nutritional enzymes, vaccines, antibiotics, and other treatments. About 55% of its sales are produced outside of the United States.
Founded in 1954 within pharmaceutical giant Eli Lilly, the Greenfield, Indiana-based company was spun off in a September 2018 initial public offering. Lilly no longer owns any shares. In August 2020, Elanco acquired the animal health business of German company Bayer AG for $6.9 billion in cash and shares. The deal expanded Elanco’s pet care segment to about 50% of total revenues and boosted its new product pipeline.
Elanco’s shares remain nearly flat since its IPO at $24, even during the strong stock market. Investors have been disappointed in the company’s uninspiring near-zero revenue growth, which has been hobbled by weak new product introductions and its low-productivity research pipeline. Elanco’s stagnation compares unfavorably to the industry’s 3-5% growth rate and competitor Zoetis’ 5-10% growth rate. Further, Elanco’s EBITDA margin of about 22% in 2019 (before a pandemic-weakened 16% margin in 2020) significantly lags Zoetis’ margin (at about 44% in both years) and is not much better than poorly-positioned Phibro (at about 13-14%). In addition to chronic revenue and margin problems, Elanco’s debt is an elevated 5.6x EBITDA. Compounding investor frustration, a recent article in the USA Today highlighted potential safety risks in its Soresto flea and tick collars, sending the shares down nearly 20%. With all of these problems, Elanco shares remain out of favor.
Elanco’s underperformance has not gone unnoticed or unchallenged. Activist investor Sachem Head (with an estimated $3.5 billion in assets) holds a 5.9% ownership stake and recently received a board seat. Sachem Head is not new to the animal health industry – in 2014, it partnered with activist Pershing Square to take a combined 10% stake in Zoetis that led to long-standing performance improvements. Also joining the board is the former Zoetis CFO and a former Zoetis board member who were instrumental in that company’s activist-driven turnaround. Sachem Head recently received support in its Elanco campaign from a new stake by highly-regarded activist Starboard Value. These oversight changes are likely to bring significant improvements in Elanco’s pace of innovation and revenue growth, along with wider profit margins.
Improved profitability would add to the company’s already-healthy free cash flow. Management has committed to directing much of this cash toward reducing its net debt to below 3x EBITDA by the end of 2023.
Supporting the overall Elanco story is the healthy tailwind of secular growth and recession-resistant demand for pet care products. Pet ownership continues to increase as does spending per pet, with these trends likely to continue into the foreseeable future. This growth provides plenty of opportunities for Elanco to participate.
While the Soresto publicity could reduce demand or prompt a recall of the highly-profitable $400 million brand, there appears to be no scientific data supporting the safety claims. We believe the long-term effects on Elanco will be readily manageable.
Like all stocks, ELAN shares carry risks. In addition to the issues discussed above, risks include the possibility of weak integration of Bayer Animal Health, strong competition and higher regulatory costs.
ELAN shares already discount considerable risk. On consensus 2022 estimates, which include only moderate improvements in its profits, ELAN shares trade at a reasonable 15.8x EBITDA. This compares to 22.4x for Zoetis and 12.1x for the weaker Phibro Animal Health company. Our 44 price target for ELAN is based on the shares reaching a modest 19x multiple.
The changes at Elanco look poised to produce a much more valuable company, with considerable opportunity for shareholders.
We recommend the purchase of Elanco Animal Health shares with a 44 price target.
Bruce Kaser, Cabot Turnaround Letter, cabotwealth.com, 978-745-5532, March 31, 2021