Why Animal Health Leader Elanco Crashed 65% & How It Can Be Fixed

Elanco is an intriguing mix of good assets, poor management, high leverage, and multiple activist investors

Summary

• Elanco shares are down 65% since going public in 2018, including a 57% decline in 2022 alone.

• The company is the #2 worldwide player in an attractive and rapidly-growing industry, animal health.

• An activist investor, Scott Ferguson of Sachem Head Capital, has put $1 billion into the company at far higher prices and is now down 60% on that.

• Shares are going for around 10x forward earnings and less than 7x estimated 2023 cash flows.

• I explain what's gone wrong for Elanco, how things can turnaround, and the potential multi-bagger upside once conditions improve.

Happy New Year's everyone! I will be away from internet this weekend, so no Digest on Sunday. Rather, here's the writeup on Elanco, and we'll be back to the normal publishing schedule the following week.

Animal Health's Boom & Bust Cycle

For the past five years or so, animal health was a hot investment theme. And it fit well within the broader category of lab tools, diagnostics, and clinical testing companies. Well-known quality-focused investors, such as Fundsmith out of the UK, have made a fortune owning these sorts of companies, and many hedge funds piled into the space in the late 2010s.

Animal health in particular got a boost during the pandemic as people were stuck at home, bored and lonely.

Pet adoption levels hit record rates and adoption shelters ran out of animals altogether as folks were so eager to pick up companions. With less stuff to spend money on as well, people lavished their animals with better quality foods, more toys, and -- of course -- top-of-the-line medical care to keep their pets going strong well into old age. People no longer put down their pets at the first sign of a chronic illness; now, as a society, we've started to engage in the same elaborate medical treatments for cats and dogs that we do for humans.

All this has led to absolutely sensational returns for many companies involved in the animal and veterinary industries. Zoetis (ZTS), for example, was up as much as 700% over the past decade.

However, the animal health mania came to an abrupt end in 2022. Adoption levels plummeted as people returned to normal lives. In fact, many people have started giving up the pets they adopted in 2020-1 as soaring inflation and other competiting costs and interests have taken up their time and resources instead.

It's not just that the industry tailwinds faded, either. Quality companies, as a category, had their worst year in more than a decade. Your classic 30-40x P/E stocks that grow earnings at a double-digit clip every year just got pummeled in 2022.

A bunch of hedge funds all owned the same stocks, often with a lot of leverage, and thought the party would go on forever. It stopped in 2022, leading to massive selling for a whole bunch of high quality but perpetually expensive stocks across a variety of sectors.

That sets the stage for where we are today, where industry-leader Zoetis was taken to the doghouse, with shares plunging 37%. Meanwhile, its smaller peer, Elanco Animal Health (ELAN), has gone from bad to worse, with shares now down close to 70% since they started trading. Thus the opportunity heading into 2023.

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The animal health industry may not be a particularly well-known one for most investors. That's because the pureplay companies haven't been known by their current names for all that long.

Zoetis came about as the animal health division of Pfizer (PFE). Pfizer eventually spun it off, and Zoetis IPOed in 2013. Zoetis is a made-up name derived from the Latin word zoetic "pertaining to life," which is not probably not a particularly memorable word for most English speakers. 

Elanco, meanwhile, is a spin-off of its own. It was long a division of Eli Lilly & Co (LLY) dedicated to animal health products. If you say Eli Lilly & Co quickly in a certain way, it sounds like Elanco. Thus came the name. While Elanco is now a publicly-traded independent company (since 2018), it retains the old Eli Lilly-derived name.

Elanco quickly showed off its independent streak, however. In 2020, it closed a massive $6.9 billion merger, acquiring Bayer's animal health division. In doing so, Elanco became the world's second-largest animal health company, only trailing Zoetis.

As you can see, the idea of standalone animal health companies is fairly new. Historically, these were all divisions of big pharma companies such as Bayer, Eli Lilly, and Pfizer. Other leading players in animal health, such as Merck's subsidiary in that area, also are controlled by big pharma companies.

However, as animals have taken on more importance in our lives (particularly companion pets), it stopped making sense to have animal health as merely a hidden division within a faceless pharmaceutical giant. Instead, with animal spending soaring, these animal health companies are now taking center stage.

Zoetis certainly helped pave the way for this increased interest in the industry; Zoetis shares are up more than 300% since their IPO. And gains were much larger than that until 2022, when the investor mania around pets finally subsided. Still, it's been an incredible run for Zoetis since it separated from Pfizer:

Data by YCharts

With Zoetis up as much as 600% since 2013, Elanco might have seemed like an obvious slam dunk when Lilly decided to spin it off.

But it hasn't turned out that way. Elanco shares didn't generate much excitement following their launch in 2018. And then, after largely treading water for their first few years, ELAN stock imploded in 2022, losing the majority of its value:

Data by YCharts

Elanco's failure to launch is pretty easy to explain. While it is now the #2 player in animal health, it's not nearly on the same level as #1. Anyone that bought ELAN stock at $32 on the simple thesis that "It's the next Zoetis," was mistaken. Elanco, at least to date, has not shown itself to be of the same caliber.

The Problem: Elanco's Profitability Trails Zoetis

It'd be easy to have the perception that all animal health companies are created equal, at least the large ones. Elanco's business, like peers, is widely diversified across geography and type of animal:

However, while all the companies sell vaccines, antibiotics, antiparasitic products, and so on, that doesn't mean they are all earning the same profits for their endeavors.

In fact, looking at gross margin, Zoetis has a structurally far higher gross margin than Elanco, and this has been a persistent feature between the two businesses:

Data by YCharts

Note that Zoetis' gross margin was consistently in the low 60s and then inflected higher starting in 2016 and has now hit 70%. We'll reflect back on what changed in 2016 in a minute.

Elanco, by contrast, came out of the gate with a gross margin around 50%. It has actually been trending up a little since then, in contrast with its stock price, though there was some benefit from mix due to major M&A along the way.

Regardless, Elanco starts with a significantly lower gross margin than Zoetis, meaning it has less funds available for overhead, R&D, and marketing as a proportion of its revenues. 

The difference in profits trickles down the income statement, with Elanco only earning a roughly 22% EBITDA margin, whereas a 30%+ margin should be achievable in this industry. Elanco made a major corporate move in 2020 to address its competitive position, however, it hasn't yet paid off as hoped...

Bayer Acquisition Arguably Missed The Mark

In 2020, Elanco closed its merger with Bayer's animal health division, spending almost $7 billion to add a massive piece to its business. That acquisition jumped Elanco from #4 to #2 globally in animal health.

It also added a ton of debt to the balance sheet. I'd note that the combined market cap of Elanco + Bayer Animal Health is now just $5.5 billion, highlighting how destructive the merger has been to shareholder value up to this point. 

With that added leverage, however, comes both risk and opportunity. Elanco now has a massive asset and revenue base in comparison to its market capitalization. If the company can get more positive operating momentum, upside would be considerable. Elanco had a market cap exceeding $10 billion prior to buying Bayer and it paid $7 billion for that asset. Simply getting back to the pre-deal valuations of those assets (legacy Elanco at $10 and Bayer at $7) gets a combined market cap of $17 billion, or a share price around $35.

Is the Bayer merger a bust, or simply a victim of bad timing? If I were a newly-independent company, I'd be very frustrated that my first big merger integration happened right during the peak of Covid-19. That was a major unforecastable disruption. Regardless, some critics have said the deal would have struggled even without the pandemic.

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The Bayer merger was supposed to be a big engine for growth at Elanco. However, various experts have cited that deal as a mistake, or at least a poorly-executed operation. Experts noted that Elanco had not engaged in M&A before, and management seemed ill-prepared for the challenge of integrating such a large merger target so soon after becoming an independent public company.

Here's one former Elanco head of engineering who commented on the Bayer deal:

"From Elanco's side, it didn't look like they had any experienced people who had done good acquisitions before. It was chaotic and not much information was shared with us at the company [Bayer] being acquired. Also, there were quite a few promises that were made, and that were not kept. It might be just the corporate gloss or it might be the mistake in messaging from Elanco's side because of their naivety in M&A field. That did resonate badly with the people who were acquired [...]

If you look at the public profiles of people who were in Bayer and who were also in Elanco, you will find that most of the Bayer's executives and senior executives, they left Elanco either within four, six months or within a year or maximum, maybe a year and half."

Source: Stream by AlphaSense

Elanco did see an initial boost in results following the closure of the Bayer deal. But the company ran into major supply chain and pricing issues in 2022, and the company failed to reach the some of profit margin and EBITDA gains that analysts had expected when the deal was announced.

In my view, it's too early to write a final analysis of the merger, since Elanco started to integrate it right during Covid-19, and is now trying to consolidate supply chains and achieve scale benefits during the biggest logistics logjam in decades. The early grade on this merger would be poor, but I'm not sure it's time to write a final judgment of it quite yet.

Activists Arrive To Shake Up Elanco

Following initial concern around the execution of the Bayer deal, activist investors showed up at Elanco. 

Specifically, both Starboard and Sachem Head Capital took sizable positions in ELAN stock and demanded change.

Sachem Head is of particular interest. Its fund manager was previously at Bill Ackman's Pershing Square. 

You'll recall from above that Zoetis dramatically boosted its gross margins (and thus earnings and stock price) in the mid-2010s. This came after Ackman went activist on Zoetis in 2014 with one of his detailed presentations on how to fix the company. Zoetis implemented much of the gameplan and it was dramatically successful.

During that campaign, Sachem Head's principal was at Pershing Square and saw the blueprint play out. He took that knowledge with him and decided to run the same strategy with Elanco. Elanco became a top five position for Sachem Head, with the firm betting more than $1 billion of its own capital on ELAN stock. Notably, Elanco shares were trading around $30 a pop at that time. The activists (Starboard as well) were loading up on shares at prices far above today's levels, seeing an easy path for ELAN stock to rise to $50 or beyond.