Elanco Animal Health Inc (ELAN) 2020 Q3 法說會逐字稿

Hello. Ladies and gentlemen, thank you for standing by, and welcome to today's Elanco Animal Health Q3 Earnings Call. (Operator Instructions)

I would now like to hand the call over to your speaker today, Tiffany Kanaga, Head of Investor Relations. Please go ahead.

Good morning. Thank you for joining us for Elanco Animal Health's Third Quarter 2020 Earnings Call. I'm Tiffany Kanaga, Head of Investor Relations. Joining me on today's call are Jeff Simmons, our President and Chief Executive Officer; Todd Young, our Chief Financial Officer; and Katy Grissom from Investor Relations.

As always, during this conference call, we anticipate making projections and forward-looking statements based on our current expectations. Our actual results could differ materially due to a number of factors, including those listed on Slide 2 and those outlined in our latest forms 10-K and 10-Q filed with the Securities and Exchange Commission. The information we provide about our products and pipeline is for the benefit of the investment community. It is not intended to be promotional and is not sufficient for prescribing decisions.

You can find our press release, the slides referenced on this call and an investor workbook in the Investors section of elanco.com. The slides and the press release also contain further information about the non-GAAP financial measures that we will discuss today during this call. After our prepared remarks, we will be happy to take your questions.

I will now turn the call over to Jeff to provide the highlights.

Thanks, Tiffany. Good morning, everyone. In the third quarter, Elanco continued executing with discipline to deliver on our stated expectations for the quarter, all while closing the industry's largest acquisition to date with Bayer Animal Health and announcing our initial restructuring. Our underlying business continues to perform and is bolstered by our distribution strategy, which is generating important positive progress. Finally, our independent stand up and integration are on track.

Specifically, in the quarter, we achieved legacy Elanco revenue at the high end of our guidance. We completed the Bayer acquisition and moved with speed and decisiveness to announce the initial $100 million of value capture actions. We posted our first term loan repayment and ended the quarter with $660 million in cash on the balance sheet.

We drove commercial competitiveness through our distribution strategy with improved receivables, cash conversion, pricing, margin and market share gains for Credelio and Galliprant in the U.S. Became the retail channel leader in U.S. flea, tick and heartworm and outgrew the market in the quarter. We expanded gross margin, including ongoing benefits from our productivity agenda. And we received 2 new product approvals and now stand with 4 approvals out of at least 5 planned launches expected by the end of 2021. And we're on track to finalize the separation from Lilly, with our ERP stand-up transition expected by the end of Q1. Ultimately, our IPP -- Innovation, Portfolio and Productivity -- strategy is working, and Elanco is competitively positioned to provide shareholder value.

On Slide 3, let me summarize our execution in the quarter. On the top line, legacy Elanco delivered $694 million, at the high end of our guidance, as anticipated pressure from COVID lessened sequentially and was contained to our farm animal business. Overall, revenue increased 16%, driven by the addition of Bayer, which contributed $196 million or 25% growth from the 7 weeks of invoicing reflected in the quarter. Revenue and growth by category and legacy business are detailed on Slide 4.

Gross margin improved by 90 basis points, underpinned by ongoing productivity improvements, price discipline and the addition of the higher-margin Bayer business. Continued mix headwinds represented a partial offset. We're rigorously managing costs across the organization. In the third quarter, it is important to note that the inclusion of Bayer Animal Health costs began on day 1, while cutovers and reregistrations impacted sales. Rounding out the P&L, our adjusted EBITDA of $148 million was down 13% versus the year ago period, and our adjusted EPS was $0.13.

And finally, on the balance sheet and working capital, in the third quarter, we began the debt deleveraging process. We achieved further sequential improvement in days of sales outstanding. All of these highlights and underscores our focus and progress, and I'm pleased with the execution of our global organization during this significant time in our history.

Moving to Slide 5, let's discuss the commercial environment and our performance, beginning with U.S. pet health. We maintained overall dispensing share for legacy Elanco on a year-to-date basis versus last year and built share in key products. This performance comes on top of a favorable industry backdrop as vet clinic traffic continued its V-shaped global recovery.

The business outperformed our expectations in the third quarter and vaccines were particularly strong. Our flea and tick product, Credelio, led our growth, up 85% in the third quarter, with Kynetec dispensing data showing continued market share gains at the vet clinic. We are seeing further traction in the pairing opportunity with Interceptor Plus. Kynetec data shows that for the third quarter, when Interceptor Plus is sold with a flea and tick solution, it's paired with Credelio 49% of the time, improving 6 percentage points from June and up more than 50% year-over-year.

Our offering of the broadest overall parasite coverage is resonating with vets and pet owners. Meanwhile, we're actively managing our core loyal customer base for our legacy product, Trifexis, where share shifts are in line with expectations for this older but profitable part of our portfolio.

In therapeutics, Galliprant is performing well, continuing to outpace the branded market in dollar growth compared to last year according to the Kynetec data. Overall, U.S. pet health, EDI, which represents sales from distributors into vet clinics and alternative channels, was up mid-single digits in the third quarter, in line with our reported U.S. pet health revenue trends after adjusting for last year's benefit from the initial stock-in at a large retailer and this year's divestitures. We continue to closely manage inventory in the distribution channel to stay at target levels. And we exited the third quarter with inventory levels consistent with the second quarter.

Moving to our farm animal business, COVID-19 pressures are lessening in the U.S. while the pandemic was a greater factor in certain international animal health subsectors in the quarter. Globally, we estimate that COVID represented a $35 million headwind to legacy Elanco revenue in the quarter, in line with our guidance. About 1/4 of that impact was felt domestically, primarily in swine. These challenges on the U.S. protein supply chain and on our business eased sequentially through the period. We've been encouraged by the higher cattle on feed numbers and the diminishing pork processing backlog, allowing for improved producer margins in both cattle and swine since the summer slows.

While the momentum is promising, we do expect the time line for industry normalization to still extend into 2021. For Rumensin, we see sustained commercial strength despite generic disruption. Our market share assumptions are tracking better than originally planned after 12 months of competitive entry as our team is successfully demonstrating the product's meaningful therapeutic and quality differences to customers.

In our international business, let me start with pet health, where markets around the world appear to have broadly stabilized in the quarter with some variances by country. Credelio was a growth driver in the quarter outside of the U.S., driven by market expansion and uptake of Credelio for cats in Europe.

On the farm side, our international future protein and health portfolio was negatively affected by unfavorable macroeconomic conditions and reduced consumption trends. As a result, the industry has seen pressured prices and producer profitability across species, most notably poultry and aqua markets.

In the global poultry market, we've seen acute production declines and reduced export opportunity in certain regions, particularly Central America, the Middle East and India, which more than offset growth in markets like China and Vietnam. Poultry prices have dropped to an outsized degree due to relatively high dependence on foodservice sales, including restaurants and wholesale markets. Balancing local supply with volatile demand has proven challenging for global producers. Production growth estimates this year vary widely, from up 15% in China compared to declines of 8% and 10% in Thailand and India, respectively.

We believe these near-term industry headwinds have impacted Elanco more acutely as a result of our unique portfolio composition, which is weighted towards premium-priced feed additives. As poultry producers experience greater economic pressure, we see trade out of performance food safety and premium products while biologics and disease treatment products tend to remain more stable.

Transitioning to aqua, we've seen severe macro-related shocks to the industry with salmon prices down 40% since the start of the year. These adverse economic conditions have impacted producers' use of premium solutions like Clynav. However, we expect aqua to still provide growth for 2020 in total, and we see the potential for a return to robust sales growth and market share gains next year. This volatile international backdrop in future protein and health is likely to persist in 2021, but we continue to view both species as important growth drivers for Elanco over time.

Although our international ruminant and swine portfolio was pressured by macroeconomic conditions and decreased producer profitability, our Asia swine business provided a partial offset. This business experienced healthy growth in the quarter as the recovery continues compared to last year's African swine fever headwinds. Both legacy Elanco and legacy Bayer China swine sales were up robustly year-over-year, and both also saw a more than 30% improvement compared to the third quarter of 2018.

Finally, let's discuss Bayer Animal Health side of our newly combined organization. For July, Bayer reported animal health revenues of EUR 166 million or approximately $191 million. As I mentioned earlier, legacy Bayer contributed $196 million in the remainder of the quarter for Elanco, totaling about $387 million combined for Q3. This represents approximately 3% growth for the quarter, excluding the impact of divestitures.

The Bayer business experienced robust growth in the first 7 months of the year, driven by retailer stock-in to support higher demand as a result of COVID and the blackout period ahead of the deal close. In the third quarter, we observed some unwind of this inventory pull from retailers. But overall, we believe the Bayer business remains in line with the 4% to 5% underlying growth that we estimated in the first half.

The strength reflects Seresto, now our largest single product on a pro forma basis, which added nearly $20 million to Elanco's revenues for the quarter. Advantage family revenue was $55 million and performance for both in the quarter was impacted by seasonality, the unwind of retailer stock-in and system cutovers.

In just our first few short months together, I'm encouraged by how well the integration is progressing. Our team is managing the complexities of an acquisition of this size, while still completing our standup, to be fully independent from Lilly.

As I mentioned earlier, we are moving with speed as evidenced by our initial restructuring announcement. We remain on track for $275 million to $300 million in total synergies, including the first 2/3 in the first 30 months. Our combined team is focused on commercial competitiveness, delivering innovation and realizing synergies, especially as we continue to navigate a challenging macro environment. We have the right plans in place, the right people to execute them, with strong momentum into the balance of the year and beyond.

Moving to Slide 6, we continue to see strong progress against our IPP strategy. Let's look at a few of the key milestones and achievements on the strategy during the quarter. Starting with innovation. We received 2 new approvals since our last earnings call. The first is the European Commission approval for Increxxa, a product for bovine and swine respiratory disease, which will be a valuable complement to our farm animal portfolio. In October, we also received U.S. FDA approval for Elura, a weight loss management treatment for cats with chronic kidney disease. With these 2 products alongside Experior and Cosabody, we remain on track towards at least 5 launches by the end of 2021 and 25 by the end of 2024.

Bigger picture, we're taking a holistic approach to innovation. Many shots on goal, including differentiated efforts in large addressable markets. I'm excited about our pipeline potential, which will fuel a part of our growth algorithm over the long term. We look forward to sharing more at our Investor Day on December 15. On the portfolio front, we have a solid group of focus brands that drive our growth. The 14 legacy Elanco products launched or acquired since 2015 grew 18% in the quarter, excluding divestitures and adjusting for last year's initial stock-in at a new retailer as shown on Slide 17.

Through Bayer, we have an enhanced portfolio and capabilities to serve customers across all channels globally. Bayer tripled the size of our international pet health business where Seresto and Advantage still have a long runway ahead, especially in markets like China. On the U.S. side, the combined Elanco is now a leader in the flea, tick and heartworm retail market and outgrew the industry in these alternative channels in the quarter.

Finally, on productivity, we remain relentless on operating expense and cash management in the quarter and layered on incremental savings from reduced travel and related expenses. We also continue to drive manufacturing efficiencies and are on track to realize the $215 million in savings and cost avoidance as planned from 2018 through the end of the year. We expect to share more on our next phase during our December investor meeting.

Additionally, we maintained price discipline in the quarter, up over 2% for legacy Elanco. Price and productivity contributed to our 54.2% gross margin performance, which Todd will detail in a moment. As I look to next year and beyond, our IPP strategy has uniquely positioned Elanco within the animal health sector. Our strategic actions since the IPO have set the stage for meaningful value creation for all of our stakeholders moving forward.

With that, I'll turn the call over to Todd to provide more color on our results and outlook.

Thanks, Jeff. Slide 7 summarizes our presentation of GAAP results, while Slide 8 describes the items considered in the adjusted financials. Slides 18 to 21 in the appendix provide a summary of the adjustment made to the GAAP results to arrive at our adjusted presentation. I'll focus my comments on our adjusted measures in order to provide insights on the underlying trends in our business, so please refer to today's earnings press release for a detailed description of the year-over-year changes in our third quarter GAAP results. I'll also remind you that our third quarter 2020 results include 2 months with Bayer Animal Health.

Looking at the adjusted measures on Slide 9, you'll see that total Elanco revenue increased 15% in the quarter on a reported basis. Foreign exchange had a 1% negative impact. I'll break down the effect of Bayer on our revenue growth in further detail in a moment.

Gross margin, as a percent of revenue, was 54.2%, an increase of 90 basis points compared to the third quarter of last year. The improvement was driven by the inclusion of Bayer's higher-margin business, positive price on Elanco's legacy portfolio, continued productivity gains and an absorption benefit in advance of our go-live on our new independent Elanco ERP system in the first quarter of 2021, partly offset by legacy Elanco mix headwinds as well as the cost of our fixed manufacturing footprint spread over lower total sales at our legacy business.

Total operating expense increased 40% in the third quarter, including the addition of the Bayer Animal Health business in August and September. As a percent of sales, operating expense increased from 34% in the year ago period to 41% in this period, reflecting the impact of cutovers in August as Bayer's costs hit our P&L on day 1, while sales experienced a blackout period of about 2 weeks.

At legacy Elanco, operating expense continued to reflect cost management as many parts of our business are still operating virtually. Operating income decreased 22%. At the bottom line, Q3 adjusted net income decreased 46% to $60.3 million. The Q3 effective tax rate was 9.7%, reflecting the decrease in international income that was subject to the GILTI tax, which was introduced through U.S. tax reform in 2017. Our adjusted EBITDA margin was 16.6%.

On Slide 10, you can see the effect of price, rate and volume on our revenue performance. The benefit of the Bayer acquisition is reflected in volume. As is typical with acquisitions, we will continue to report the addition of the Bayer business and volume for the next 4 quarters. For the legacy Elanco business, price was up 2% for the quarter, demonstrating the value of our innovation and the ongoing discipline we are applying despite competitive pressures.

Slide 11 provides more detail on our overall performance in the U.S. and internationally, both of which were impacted by COVID, but also benefited from the addition of Bayer. In the U.S., total revenue increased 9%, and international revenues grew 23%.

We expect to file our 10-Q shortly. But moving to Slide 12, let me now provide an update on working capital, cash and our debt leverage, including our recent term loan pay down. As we have discussed, working capital is an area of focus for us. In the U.S., consistent with Q2, we held all distributors at 60-day payment terms. In the third quarter, days sales outstanding continued to improve sequentially, standing at 67 days versus the peak of 103 days in the first quarter of 2020. We ended the third quarter with $660 million in cash and equivalents on our balance sheet.

As announced at the end of the quarter, we repaid $100 million on our term loan that funded the Bayer Animal Health acquisition. We will continue to repay debt from our operating cash flow in 2021, with a focus on our $500 million note, which is due in August of 2021. Our net debt leverage ratio stood at 6.4x at the end of Q3.

During October, we borrowed $250 million on our revolver to fund local country asset purchases as part of the Bayer acquisition. Once the purchases are complete, Bayer AG will pay Elanco the $250 million purchase price back, which we will use to repay the revolver. This circular transaction should be completed this year.

2020 remains a uniquely cash-heavy year, given the stand-up of the independent Elanco ERP system and IT infrastructure, the execution of the acquisition and the build of the requisite ERP infrastructure for the Bayer business. We now estimate total cash costs for the independent company stand-up to be in the range of $280 million to $320 million net of certain offsets. The increase versus the prior range of $240 million to $290 million primarily reflects higher costs to execute local country IT infrastructure deployment and transitions as a result of the COVID-19 pandemic-related travel restrictions and protocols as well as increased site cutover and additional scope costs.

The vast majority of our global team are now operating in the Elanco IT infrastructure environment, and we remain confident in completing the stand-up of the independent Elanco with the Elanco ERP cutover in Q1 of 2021. The completion of the ERP transition will drive the culmination of the remaining Lilly transitional services agreements. Additionally, as we shared in the pro forma financials in the October 15 8-K filing, I want to note that Elanco capitalized approximately $72 million for the ERP infrastructure supporting the Bayer business.

Now I will transition to our outlook on Slide 13. For the fourth quarter of 2020, we expect Elanco total revenue to be between $1.02 billion and $1.06 billion. Our fourth quarter guidance includes an estimate of approximately $20 million to $30 million of COVID-related headwinds, primarily in our farm animal business. We are also monitoring the potential impact of another phase of broad shutdowns, including actions currently being taken in Europe. However, our guidance does not reflect a broad U.S. or international shutdown as we saw earlier this year.

On the Bayer side of our global pet health business, the fourth quarter will reflect an estimated $10 million of continued reversal of revenue pull forward due to COVID and IT cutovers. For the full year, we believe that retailers are holding an additional $25 million of inventory compared to 2019, and that this incremental balance is appropriate to match Bayer's larger sales base and strong underlying trends in recent periods, as well as the larger trend across consumer packaged goods with retailers reacting to the ongoing COVID backdrop and rising case counts.

Additionally, fourth quarter revenue guidance incorporates a number of other discrete headwinds to growth, including divestitures as part of executing the Bayer acquisition, lapping sales of Posilac inventory, awaiting regulatory clearance in India and the impact of deferring the typical January 1 price increases at Bayer to our February time frame.

The treatment of certain trade funds as SG&A under IFRS versus a sales reduction under our U.S. GAAP accounting also reduces legacy Bayer sales compared to all prior periods. Importantly, however, our outlook is grounded in underlying growth trends on both sides of the business that are in line with our fundamentals year-to-date, including continued 4% to 5% underlying growth for Bayer's global portfolio.

We are not introducing EPS guidance at this time, given the volatile macroeconomic backdrop and the unpredictability of potential future effects from COVID-19. We expect to provide more details on the fourth quarter at our Investor Day in addition to 2021 guidance. In the meanwhile, let me offer some commentary on operating metrics.

We anticipate a sequential deceleration in gross margin from the third quarter's result, reflecting our normal seasonality step down as a result of plant maintenance and shutdowns, sales seasonality for Seresto and the Advantage family and the reversal of the absorption benefit in advance of Elanco ERP cutovers in January, as well as ongoing mix headwinds and fixed cost deleverage. We expect to continue to capture productivity efficiencies and remain disciplined on price. Furthermore, the quarter will include 3 months of Bayer's higher-margin business.

With respect to operating expenses, we anticipate year-over-year declines for both legacy Elanco and legacy Bayer relative to the pro forma expenses provided in our October 15 8-K filing. Our outlook reflects benefit from the continued cost management initiatives and ongoing reductions in travel expenses. Value capture actions are on track, but we remain very early on the curve to realizing benefits.

Now I'll hand it back to Jeff for closing comments.

Thanks, Todd. Let me summarize. We closed the third as a stronger enterprise, seeing positive progress from key strategic decisions with the inclusion of Bayer and the distribution model shift. We are executing with discipline and urgency to deliver on our stated expectations for the quarter, achieving results at the high end of our guidance. We are gaining share with key pet health products and entering the balance of the year with momentum.

We are moving quickly on the integration and making the tough decisions necessary to capture value. The final phase of our independent stand-up is underway and on track for completion in early 2021. Our IPP strategy is working, with a combined stronger portfolio, greater access to the world's animals and through a pipeline that is progressing and with a productivity agenda that continues to enhance margin growth.

I want to end today on Slide 14, highlighting the 2030 Elanco Healthy Purpose sustainability commitments we unveiled last week. These decade-long commitments support the United Nations' Sustainable Development Goals and are a first of its kind in the animal health industry. Our protein, planet and pet pledges aim to provide improved access to nutritious protein, reduce the company's and our customers' footprint on the planet and increase the health of the pet to support people's well-being. We outlined these pledges in detail on our website at elanco.com. But it all starts with a healthy and strong enterprise driven by the growth, innovation and margin expansion agenda against which we are executing. Through these efforts, Elanco is focused on creating value for our customers, employees, shareholders and society as a whole.

With that, I'll turn it over to Tiffany to moderate the Q&A.

Thanks, Jeff. (Operator Instructions) Michelle, please provide the instructions for the Q&A session, and then we'll take the first caller.

(Operator Instructions) Your first question comes Michael Ryskin from Bank of America.

I'll just ask one to make sure everyone gets enough time. I want to focus on the livestock business in the quarter. I mean I recognize some of your comments in the prepared remarks, Jeff. But if we just look at what some of the peers were able to accomplish: Merck Animal Health livestock was up 8%, Novartis livestock was up 9%, Phibro livestock was up 5%. And it looks like the legacy Elanco business declined pretty meaningfully in the quarter, if we try to back out Bayer's contribution, I'm getting something like double-digit decline.

So can you go into that in a little bit more detail? What's the discrepancy here? Is it anything by species, by geography, sort of what sticks out? And then how do we think about that in 4Q? Despite COVID headwind, it seems like other businesses very well work through them and benefit from some timing impacts in cattle. When can we expect that to start showing up for Elanco?

Yes. Thanks, Michael. I think, first of all, differences in portfolio in places where the business is. I think, first of all, we feel very good about the fundamentals and the improvement, as I've said, in cattle and swine in the markets. I mean the markets are improving post-COVID, plant capacity, the diminishing backlog, as I mentioned, in pigs. And I see that being a positive. I think overall, and I would stay on some of the positives, again, strong swine recovery from African swine fever.

So these are just some of the key, I would say, pushes, and then I'll share some of the differences that you outlined. I think on the positive side, we see strong swine growth even relative to 2018, as I said, both on the Bayer side and the Elanco side in the Asian area. That is a positive. We continue to see what we would say is strong positive fundamentals in our overall business when you look at the U.S.

What I think are some of the differences is, one, we've got finishing 1 year in relative to generic Rumensin. And that is a -- we're doing well relative to our expectations, but there is a decline there. And then the highlight to me is really poultry and aqua. We continue -- they've been major growth drivers for us as future protein and health. They will continue to be. But what we've seen is, one, salmon industry, which is a big part of our growth and big part of our plans this year, that has been impacted by industry dynamics. Not by market share, not by where our products sit, but just actually by the economics of the industry and its impact on pulling away from use of animal health products.

Second is international poultry, Again, a pretty significant 75% to 80% of our future protein and health is poultry and a big international poultry business. And that's been impacted as well by, again, the impact of kind of the lingering effects of COVID and the pulling back of usage on certain animal health products.

Again, as we look going into '21, there's no question, some of these trends will persist a little bit and the COVID impact. But as I look even into '21: one, introduction of new products; two, the fundamentals of where our share are and poultry and aqua recovery, we continue to see them as key growth drivers in the future protein and health being a key growth contributor starting in 2021. Okay. So I would say as a whole, we feel very good relative to our expectations. There's just been a setback a little bit relative to international poultry and aqua.

And your next question will come from Nathan Rich from Goldman Sachs.

Jeff, I wanted to ask on the pipeline. Obviously, bringing new drugs to market and having that flow of innovation is kind of a key piece of the revenue outlook. This is an industry, obviously, where visibility on the pipeline has been pretty limited. You talked about sharing more details at the Analyst Day. But can you talk about the type of disclosures we're maybe likely to get there? And what you kind of see at a high level as the most attractive market opportunities?

And as just a quick follow-up, you talked about the 4 recent approvals. Any details you can provide on the timing of those launches as well as the potential market opportunity would also be helpful.

Yes. Thank you, Nathan. So real, real quick, I would just say at a very, very high level, we feel very good about where our pipeline is. As I've shared at a high level and we'll get into some of the detail, we had 25 new products, 5 from Bayer, 20 from Elanco. We see that as our starting point. That's what we'll highlight and talk about at the investor conference, at least, as I mentioned, 5 between now and the end of 2021 with 4 approvals. I'll look for pet health to contribute beyond in the remainder of the approvals here for this next year.

And I think what you're seeing this year, you're going to see going forward: one, a mix of bigger, more significant products in bigger, more material markets as well as strong innovations that can play an added contribution in our overall portfolio. So a constant flow of innovation. We see this constant over this next 5-year period a contributing factor. What we're going to do at the investor conference is to highlight the markets and the market spaces we're going into: parasiticides, pain, therapy, aging dog and cat therapy on the pet side, antibiotic replacements and continued therapy on the livestock side.

We're going to talk about what we see in those markets and how our innovations will contribute into those, all while balancing the competitive exposure to this. But what I would say to you is I feel very good about the portfolio we have. I feel very good about Bayer's contribution that they bring relative to pipeline and capability and size and scale and a constant flow of innovation that will be the lead growth driver in our algorithm of growth that we'll talk about at the investor conference.

Your next question comes from Erin Wright from Crédit Suisse.

I wanted to clarify what is the fourth quarter guidance assume in terms of the underlying growth for Bayer and Elanco separately, excluding divestitures. And if there's any -- what sort of major destocking/stocking dynamics we should be aware of in the fourth quarter and even into 2021, if there's some moving pieces we should be aware of there. I think you mentioned the $25 million in inventory in the channel, is that companion animal or production animal?

And then a follow-up question on the Advantage business. Can you give us an update on the long-term assumptions for that business, at least how it's shaping up from a competitive standpoint? How it's playing into that alternative channel as well? That would be helpful.

Erin, it's Todd. Thank you for the question. Overall, for Q4, we've not separated out Bayer versus Elanco as part of the guidance. We have pointed out a number of the year-over-year items that are in play, including -- registration in India hasn't happened yet, so we get the economic benefits, but we don't get the sales. We do think retailers are still holding a little more Bayer product in the U.S. pet health retail chain, and that's about a $10 million unwind in Q4.

With respect to the $25 million you mentioned, we -- that's also U.S. pet retail. We think that's just growth that happened this year because of the underlying growth in the Bayer business in those channels as the demand from the Seresto collar for A family, all have gone very well. That's contributing to what we think is a strong underlying 4% to 5% growth for the total Bayer business, but the double-digit growth they experienced in the first half of the year definitely had those effects. So we're expecting, again, to get there. We think inventory in the channels will be appropriate across our entire portfolio, farm animal and pet health, by the end of this year, and that's all playing out well for us as we're excited to have this higher-growth Bayer business.

With respect to the A family, again, it's been very good. This year, they've had a very nice run, especially in China. And we're pleased as people continue to use those products and they do well in the retail and online channels with it. Originally, when we did the deal, we were expecting a low single-digit decline on A family going forward. And we'll be talking more about it at the investor conference as we refresh our total growth portfolio at that point.

Your next question will come from Chris Schott from JPMorgan.

Just 2 for me. I guess, first, I want to talk about 4Q sales levels. I think these were about $100 million below consensus. So I guess ex the COVID headwinds, ex that Bayer inventory you laid out, do you consider 4Q kind of a normalized sales number? I know you're going to have some first half seasonality with the new mix, but I'm just trying to get a sense if we're trying to kind of build a baseline sales level, how normalized we should think about 4Q being?

And my second question was just an update on the longer-term margin targets you laid out with the deal. I guess what's your confidence in hitting those estimates? And particularly on the time lines, how quickly can we think about those being achieved?

Chris, thanks for the question. With respect to the second question, we're still confident in our ability to get to a 60% plus gross margin and over 30% EBITDA margins. As we've spoken before on calls, those have been pushed out. We are seeing more competitive pressure than we were in August of 2019 on the legacy Elanco portfolio, and we've been seeing that in some of our fundamental organic growth. At the same time, COVID is having these different impacts that are affecting us. That being said, we're confident in the overall portfolio for the long-term and our ability to deliver on 60% gross margin and a 30-plus percent EBITDA margin.

With respect to Q4, there are a number of discrete items that we have tried to call out here today on the call. The price increase on Bayer products being pushed out to February versus happening in January does impact sales in the quarter on a year-over-year comp basis. This adjustment for accounting where trade funds previously had been down in SG&A. Those are moving up under GAAP reporting, and those were in our numbers in Q3 and will be in Q4 and going forward. That is a decline in sales relative to historic times for Bayer, but no change at the EBITDA as it's just a movement amongst the P&L.

The other bit to mention is we think divestiture impact is about $20 million on the legacy Elanco portfolio and just around $10 million on the legacy Bayer portfolio. So those are all items that are affecting the absolute quantity of sales in Q4 relative to what a pro forma without those items would have been a year ago.

I would emphasize, too, Chris, I think the underlying demand, again, for the Bayer business and the Elanco, especially U.S. pet health business, we continue to grow share. We continue to see, as I highlighted, the 14 focus products of Elanco up 18%. We'll be adding 5 more to that going forward. But I would emphasize again, we feel very good about no change in the underlying demand sequentially coming from Q3 into Q4. A lot of this is the adjustments that Todd highlighted.

Your next question comes from David Risinger from Morgan Stanley.

Congrats on the corporate progress. So I have, I guess, a couple questions here. First, clearly, various moving parts are precluding Elanco from providing earnings guidance for the fourth quarter. But given that uncertainty, how is the company going to be able to provide earnings guidance for the full year of 2021 on December 15?

Second, with respect to the launches, so 5 launches by the end of 2021 and 25 by 2024. Could you just please quantify how many of those -- I'm assuming none of the 5 would have blockbuster or greater than $100 million revenue potential in terms of the 5 that are launching by the end of 2021. But for the 25 that are launching by the 2024 period, how many of those would have blockbuster or greater than $100 million revenue potential?

Let me take the first question, Dave, and I'll let Jeff answer the second one. With respect to the earnings, it's a great question, a very fair one. We do expect to provide greater detail in the Investor Day on December 15, with respect to how we project Q4 to come out. Clearly, with 2 weeks to go in the quarter, you'd expect us to be able to do that, and we'll do that to help provide that baseline then to give a 2021 guidance. Jeff?

Yes, real quick, David. On the pipeline, first of all, I think I want to reiterate, nice mix between pet health and farm animal, a constant flow of approvals throughout that entire 5-year period. We will get into more of these specifics in terms of spaces and what areas that we will be launching in. We have been very clear. Areas like broad spectrum parasiticide will be in there, derm will be in there, more pet therapy, antibiotic replacements in farm animal and some additional kind of first-in-class, best-in-class like -- products like Experior, for instance.

So what I would say when you ask about numbers, we're looking through a different lens with a higher bar. With it being a larger company, we need larger, faster kind of adoption rates on new products. So I would say that these products are looking through that lens of an Elanco plus Bayer needing more materiality. And we've got a significant number for those that we believe with the right market creation, launch and competitive commercialness -- commercial ability, that there will be blockbusters.

So I would say that there will be a series of them in there and again, a linear line and a nice blend between pet health and farm animal. So feeling very good about our pipeline, feeling very good about the ability with Bayer plus Elanco capability, size and Bayer's contributions. We're stronger with innovation than we were before the Bayer transaction and looking forward to starting that with these launches. And I keep reiterating, too, a lot of runway with the 14 products that we have that are focused products; we're going to add into that Seresto and Claro as other products with a lot more growth potential. And then you add on 5 this year and then the series of launches beyond. So we like our algorithm of growth. We like our pipeline, and there will be some nice blockbusters within that.

Your next question will come from John Kreger from William Blair.

I just wanted to clarify your comments about stocking unwinding for Bayer in the fourth quarter, that $10 million. Do you think that finishes the necessary unwind? Or should we expect more needed in '21? And then the follow-up, Todd, I think you rattled off a number of puts and takes on gross margin. Can you just kind of expand on that a little bit more? Can we think about gross margin as having kind of a normalized improvement trajectory in '21? Or will that take a little bit longer, given those items?

Sure, John. Yes. We think that the retailer inventory levels for U.S. pet on the historic Bayer business will be at the appropriate level, given the growth we've seen on dispensing data for those products in 2020, and that we won't have that. To the extent there was an inventory growth in 2020, that's something that will be a headwind to growth in 2021 for us, but fundamental underlying growth of U.S. pet products and Bayer, we're really pleased with as dispensing growth continues to track very nicely on those products for the last 15 months.

On the margin side, that's something we just -- as a reminder, we have a step down in legacy Elanco business. It was stepped down more than 500 basis points in Q4 of 2019 versus Q3 of 2019. So that's a part of how our mix plays out and something we wanted to highlight. The higher-margin Bayer business certainly helps our overall gross margin. But as you know, the seasonality of the U.S. parasiticide business makes Q4 a lower level than what it looks like in Q1 and Q2.

So overall, we're very pleased with our initiatives on the gross margin. Aside from a productivity, the team continues to take cost out and take cost out on an absolute basis with respect to reducing compensation and benefit costs, reducing the cost of API through our initiatives on sourcing, and those are on track.

The mix headwinds we've seen, as called out earlier, with the legacy Elanco business in ruminants and swine, does impact that gross margin. So we'll continue to provide greater guidance on it, but we wanted to clarify that we do expect a margin step down in Q4 versus the one we just had here in Q3.

Your next question will come from Balaji Prasad from Barclays.

So I just wanted to call and commend on the sustainability goals introduced. Post that I would like to get your thoughts around the parasiticide market. Your peers spoke of a 6% gain in parasiticide. You're commenting on price growth and volume growth in the market, too. So are there some dynamics which are happening, which we are not properly figuring out? Is the market growing faster than what we are anticipating? And so, if so, what are the factors?

Secondly, is it fair to assume that your share of this market will stay intact or even increase with the new launches which are expected to come out over the next 1 to 2 years?

Yes. So let me start first on the first question, and that is -- yes, we feel very good about the overall, I think, pet health market. I'll start there. I think we know that COVID has increased the attention to the pet, the compliance. We've seen a V-shaped recovery. We've seen both growth nicely in the vet clinic market. We also are seeing very strong growth, as you know, in the retail market as well.

Yes, on parasiticide, as you see, we've seen nice growth across all sectors, price growth in parasiticides. We also -- we believe that there is a continued offering. And when we look at marketing all the way to the pet owner, understanding things more clearly by reaching that direct pet order and pulling them into the vet clinic. And I would note our pairing of Credelio plus Interceptor Plus is an example of that. Pairing is increasing. Growth is significant, and a lot of that can be attributed by a marketing approach that reaches pet owners, taking them into the vet clinic. And there's a knowledge and an awareness of that message. That is a big driver in this. And then, yes, we believe attention and compliance helps drive volume, but it also helps drive price as well.

The one thing to note there, Balaji, we are seeing a decline in Trifexis, our historic product. And so, I think as Jeff mentioned, we're managing that within our expectations, but that is a decline in the parasiticide market.

Just a follow-up on livestock side with Rumensin. So you said that it's faring better than what you've anticipated. So what's the current market share or what is the impact of the generic version? And you called out poultry under pressure. Could you identify the factors, what's driving this in LatAm and India?

Yes, there's no question that there's a lot of moving parts from the earlier question on ruminants with -- we feel good about the increased number of days cattle on feed. There's been a talk about -- yes, there was a cattle run in Q3, a little premature or a little sooner than normal. That puts more cattle on feed as you go into Q4. That's positive. When you look at actually the generic we see and our ability to differentiate and hold, although there was a market size change from COVID from earlier this year. So when we back up and look at our assumptions of holding in year 1, 20% total value loss or less, we're feeling good relative to that in relative terms to a market that has actually changed in size. So again, doing very well competitively, and I attribute a lot of this to portfolio and product differentiation. And then...

Well, the second part of the question about the international bucket, poultry.

The factors driving lower market growth in poultry in Latin America and India.

Yes. I mean, it's very clear that the COVID impact has been a little bit linger -- a little bit later and has lingered a little bit longer relative to this. And a lot of this is attributed to international poultry markets are more dependent on foodservice and restaurants. And we know the impact of that and now we're starting to see that impact. We see it returning quickly and -- but this will persist as we go into 2021.

And your next question will come from Kathy Miner from Cowen.

Just a -- first, one quick follow-up. On your guidance or your expectation for $20 million to $30 million COVID headwind in Q4, is that mostly on the U.S.? Or is that an outside of the U.S. expectation?

Second of all, could you comment on your swine business in China? And if that's returning to growth and how you see that developing going forward? And if you could, just at least a brief comment on the channel trends in the third quarter. That's certainly a big part of the Bayer transition. And just curious how -- whether that was continuing to grow through Q3?

Sure. So with respect to the swine business in China...

I think her first question was...

COVID headwind.

COVID headwind.

Sorry. The COVID headwinds primarily continuing international farm animal markets; the poultry impact, Middle East, Latin America, India, we do see those continuing. It will be some impact in the U.S., but that's not as big a quantity. That's why we're seeing it come down quarter-over-quarter. I'll let Jeff jump in on the swine side.

Yes. So Kathy, we've seen very good growth, both in the Elanco and Bayer, and I'll even go back to using a comparison of 2018, so before the African swine fever effect. So we're seeing stronger prices. We're seeing more industrial farms. Those are 2 really positive trends, and then I think multinational product use. So when you put those things together, we're seeing over a 30% growth in both the Elanco business back to pre-COVID comparisons in 2018, both on the Elanco and Bayer side. And again, I would put those 3 factors as the big drivers, strong economics. We see that tailwind benefiting as we go into 2021, and we'll talk some about that at the investor conference.

Let me just highlight on distribution, very clearly, just to make sure it's real clear, that on our legacy Elanco business, the overall business, our inventory levels are the same in Q3 as they are in Q2. They're at the right levels. We're at 60-day terms. That strategy is working. Our relationships are very strong with the 4 remaining distributors that we have, and it's paid off, as I've shared. Relative to demand creation, we're growing market share. We've got better -- improved receivables and cash conversion and pricing within that. And the distribution strategy, we think, is working extremely well. And I would highlight that that is a heavy focus.

In addition, there's the retail business that Todd has talked about, and we would really highlight what drove that retail Bayer business was much more retailers. Distributors are not involved in that. So there's no inventory issues there at all, and that buy ahead a little bit was driven by both the cutover and the COVID concerns. But again, underlying business remains very strong on both retail and the vet clinic business for our pet business.

Your next question comes from David Westenberg from Guggenheim.

So can you talk about capromorelin in cats? We've seen a lot of off-label usage of Entyce for a number of years now. Do you see the cat market as larger than the dog market, just given the health consequences for weight in cats is much worse? And this is a small market, but it's opportunity to pioneer into maybe a $50 million product. Is that fair to say?

And then secondly, can you talk about retail channel mix? We've seen just in OTC pet a dramatic acceleration in the shift to online from pet specialty and box retailers. Do you think that's to your advantage there in terms of, particularly, around the Bayer Animal Health products?

Yes. Let me just highlight again, Elura, we believe, first and best-in-class relative to what we have here relative to an oral treatment and, again, the mode of action. You're exactly right: we believe this is a market creation archetype for us. It's an opportunity. As you know, chronic kidney disease may affect -- right now, the numbers are 1% to 3%. We think that can be higher, but a much higher instance in older cats, intensified where we're seeing at a cat that can be 12, 15 years old. It can be estimated at 30% to 50% of the cats are affected. So we like this segment.

We like the market creation opportunity, which gets back to a big part of our innovation strategy, bringing first best-in-class, unique mode of action here with a liquid oral solution. And so we see this being an opportunity to create a really nice product. I won't get into exactly how much, but we will say that our intention is to lean in heavily here. And again, we continue to increase our portfolio, and we'll talk some about that in the feline market, which is a really strong market, highlighted even by our success with Credelio in cats in Europe. So we feel very good. And yes, there is some pairing and some opportunity with Entyce that is a similar product in dogs.

And then yes, on retail, look, I would highlight, we are a retail leader. We are the retail leader right now with the combination of Bayer plus Elanco in flea, tick, heartworm. There is no question you need that capability and a portfolio, both a scripted and an unscripted OTC portfolio like Seresto and Advantage to win. And we feel very good about the Bayer capabilities in this space, our leadership position and our innovation and our ability to grow in this space. So yes, we see these trends persisting that came through COVID.

The next question comes from Elliot Wilbur from Raymond James.

Maybe just real quickly for Jeff. Give us perspective or color on sort of the emerging ASF cases that we're seeing in Europe, obviously, negative for some markets and positive for others, but maybe just how that impacts Elanco's business, if at all? And for Todd, with respect to -- obviously, been getting a lot of focus on cash flow and leverage position. Anything you could say at this point that could help us in terms of thinking about a longer-term framework with respect to cash conversion metrics?

Yes. So let me start with ASF. We -- again, there still is spotted cases that have popped up in industrialized operations in Asia. For instance, there's some noted here in South Korea. But again, I want to emphasize no material effect on ASF that we see really anywhere in the world, but especially in Asia. And you're seeing, again, the positive fundamentals of the recovery in China. That, again, will be a tailwind for us as we go into 2021.

On the cases in Europe, again, mostly in Germany and East Europe, we do not see, at this point in time, a risk to any commercial pig production. It's mostly been in the wild boar market. And so we've not seen anything and no material effect that we're assuming at this point in time for our European pig business.

Elliot, with respect to cash conversion, we feel good about the working capital discipline we've instilled over the last few months bringing DSOs down considerably since the Q1 time frame. We are continuing to look at working capital needs across the -- our business. I would say one of the things about operating 2 different systems as we need multiple bank accounts in countries in order to efficiently process the payments on both sides of the business. That does chew up a little bit more of cash on the balance sheet, but something that we're working through and trying to manage.

We're also focused on inventory levels. We did grow inventory on our own balance sheet here in Q3 as a result of the IT cutover we will have to go on to our separate ERP system in Q1. So we do expect to have better inventory numbers in 2021 as we get past a lot of these IT-related items. So again, we'll get into more on EBITDA growth expectations on the Investor Day in December.

Your next question will come from Umer Raffat from Evercore.

I wanted to focus on the distribution strategy ex-U. S. And could you remind us what exactly is the distribution strategy for international livestock? And how many months of product did these international distributors have as of end of June versus end of September? And I'm trying to understand if that had anything to do with the tightening of days sales outstanding, which drove the livestock issues ex-U. S.

Yes. Most of that is directly with large protein producers are mostly our customers internationally. No factor at all. Again, as I shared international and U.S. and globally Elanco inventory and distribution was at the levels we wanted coming out of Q2 remained the same in Q3 and was not a factor at all in our results.

Jeff, do they buy additional ahead of quarter close if there are incentives that exist, these large protein makers?

Very little to none. Once in a while when a price increase program is in place, sometimes there's an allowance of some buy ahead. But again, that is -- we've moved those out, mostly across the globe from Q4 into Q1 to prevent any of that any change. But no, that is not the case. And again, I want to reemphasize inventory levels same in Q3 as they were in Q2. We're at the right levels and feel very good about those changes. Not a factor.

Your next question will come from Navin Jacob from UBS.

Navin Jacob, UBS. I appreciate you putting me in. So I just want to expand on Umer's question around inventory. If you could provide very simply how many days on hand or weeks on hand or months on hand you have for Companion Animal in the U.S. and for livestock as well as for not just your portfolio but for the Bayer portfolio because it seems you had called out the reduction in Bayer inventory. I just want to try and understand so we don't have any more surprises around "inventory" in quarters forward, where exactly your inventory levels stand both on the companion side of things, livestock side of things Elanco stand-alone, Bayer stand-alone, please?

Navin, as we said, the inventory issue we put behind us at the end of Q2. Inventories are consistent in Q3 versus Q2. If there is a material change in inventories that drives an impact on revenue, we will disclose that, and we'll be upfront about it. With respect to the Bayer side, as we talked and tried to be very clear on the retailer side, which is not distribution, right? We're not talking about the Covetrus and MWIs and those that are on our side, but rather the Amazons and Walmarts that given COVID as well as continued uptake in the Seresto and Advantage products, they did hold more inventory. As we said, we think that's about a $25 million increase in 2020 compared to 2019. That's after another $10 million comes out of that here in Q4.

And so going into 2021, we feel very good about inventory levels across our business, across the Bayer business and that they're set up to grow as we keep it. We've changed the strategy in the earlier part of this year and talked about it extensively on the Q2 call and feel very good about both our relationships with our distributors in the U.S., the international business and how it's operating as well as the retailer relationships that got -- we had before, but now it is enhanced with the broader OTC product portfolio that Bayer brings.

With that, we'll wrap it up today. Thank you for joining us for Elanco Animal Health's third quarter conference call.

Thank you, everyone. This will conclude today's conference call. You may now disconnect.