Elanco Animal Health Incorporated (ELAN) Q4 2022 Earnings Report, Transcript and Summary

Good morning, and welcome to Elanco Animal Health's Fourth Quarter and Full Year 2022 Earnings Call. All participants are in a listen-only mode. After the speakers presentation we will conduct the question and answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Katy Grissom, Head of Investor Relations. Thank you. Please go ahead.

Good morning. Thank you for joining us for Elanco Animal Health's fourth quarter and full year 2022 earnings call. I'm Katy Grissom, 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 Scott Purucker from Investor Relations. The slides referenced during this call are available on the Investor Relations section of elanco.com. Today's discussion will include forward-looking statements. These statements are based on our current assumptions, and expectations and are subject to risks and uncertainties that could cause actual results to differ materially from our forecast. For more information, see the risk factors discussed in today's earnings press release, as well as our latest Form 10-K and 10-Q filed with the SEC. We do not undertake any duty to update any forward-looking statements. Our remarks today will focus on our non-GAAP financial measures. Reconciliations of these non-GAAP measures are included in the appendix of today's slides and in the earnings press release. After our prepared remarks, we'll be happy to take your questions. I will now turn the call over to Jeff.

Thanks, Katy. Good morning, everyone. Reflecting on our 4 years since completing our IPO, I am proud of and grateful for the determination and dedication of the Elanco team. We have fully separated and established an independent company. We've integrated the industry's largest acquisition, reset our cost base and built a strong leadership team. In 2022, we continue to execute our IPP strategy, significantly advancing our innovation pipeline while driving productivity gains across all areas of the company and positioning the business for acceleration in 2024 and beyond. In 2022, our financial results were negatively impacted beyond our expectations due to significant challenging macro factors and competitive innovation. However, we are encouraged as we look forward, as shown on Slide 4. First, while macro pressures remain in 2023, we see strengthening Elanco tailwinds and with early proof points giving us confidence in our guidance for the year. Also, our late-stage innovation is on track, and we continue to see a path towards U.S. approval of 5 potential blockbuster products by the first half of 2024. And today, very importantly, after close collaboration with the FDA, we are pleased to announce we now anticipate a first half 2024 U.S. approval and launch of Bovaer, a methane reducing product for cattle. This adds another potential blockbuster to our suite of late-stage innovation and adds to our confidence in 2024 and beyond. In addition, this year, we're executing on our plans to reduce operational complexity. Our final step in the Bayer integration, the systems transition is on track for an early Q2 go live. We are well prepared and this will be a key step to improve efficiencies, offer a better customer experience and reducing integration cash needs. Finally, with a historic launch window in front of us, we're enhancing our focus on commercial and launch excellence. Along with our experienced commercial lead team, we are pleased to welcome Tim Beddington, as our new Head of Strategy and Market Development, a seasoned animal health leader, Tim will help us shape, enhance and execute on this opportunity. Moving to Slide 5. In 2022, Elanco delivered just over $4.4 billion in revenue, a 3% decline in constant currency with Farm Animal flat and Pet Health declining 5%. Despite the revenue decline, we delivered more than $1 billion in adjusted EBITDA. The 10% reduction in operating expenses contributed to adjusted EBITDA margin of 23.2%, an improvement of 90 basis points. This operating cost discipline and better-than-expected tax rate enabled adjusted EPS growth for the full year of 4% to $1.11. Over the last 4 years, Elanco has maintained a consistent strategy of innovation, portfolio and productivity, or IPP. In 2022, this flywheel continue to strengthen, and I'll provide a few key proof points of this momentum on Slide 6. First, with innovation. We had a productive year with 8 product approvals in major markets. This included differentiated fee line innovations like Zorbium, Advantage XD and Bexacat as well as important geographic expansions like Credelio for dogs in China. Additionally, the organization delivered valuable life cycle management, regional innovation and geographic expansions across the portfolio. We continue to grow adoption for Experior and integrate value beyond product offerings like Uplook and Pinpoint. Overall, our combined portfolio of innovation products contributed $133 million in revenue this year or an incremental $61 million year-over-year. ZoaShield, Experior and Credelio Plus led the growth with our fee line innovations demonstrating momentum in the fourth quarter. Most importantly, we made the initial U.S. submission of two differentiated pet health potential blockbusters: our broad-spectrum parasiticide and our JAK1 inhibitor in dermatology. The solid progress of each of our key late-stage innovation projects continues to increase our confidence in Elanco's next era of growth. Moving to portfolio. Globally, price contributed two percentage points of growth for the year. Despite known competitive dynamics in the U.S. vet parasiticide market, Elanco remains an established market leader across many areas of our diverse portfolio. In Pet Health, Galliprant and our global pain portfolio grew double digits last year. And while our retail OTC parasiticide sales declined in 2022, our analysis shows our continued global market leadership in this space despite pressure on the category overall. In Farm Animal, we're the number two player in the U.S. and gained market share over the course of 2022. Outside the U.S., we remained very competitive in the medicated feed additive space, including leading in poultry and swine and are a top two player in Aqua. Finally, on productivity. We delivered savings in cost avoidance despite significant inflation and product mix pressure, allowing for a slight expansion of gross margin in 2022. To date, we have delivered approximately $360 million in cumulative adjusted EBITDA synergies from the Bayer acquisition, exceeding our expectations. Finally, we reduced gross debt by approximately $500 million last year from $6.4 billion to $5.9 billion. Debt paydown remains our key capital allocation priority. In summary, our IPP strategy is delivering foundational value with multiple proof points that we believe set up our next era of innovation, growth and improved cash conversion. Now pivoting to 2023. We expect the Animal Health industry to remain resilient. The global Pet Health market is poised to continue growing this year, albeit at a slower pace as we expect the post-COVID normalization to continue and a weaker economic environment to persist for at least a portion of the year. While that labor and capacity constraints are expected to stabilize this year, we expect innovation, increased product compliance enabled by e-commerce and geographic expansion to drive market growth. In Farm Animal, we expect lower industry growth rates than Pet Health. Long-term tailwinds from the continued increase in global animal protein demand are expected to be balanced by higher input costs a cyclical decline in the U.S. cattle herd and continued generic competition. Moving to Slide 7. In 2023, our overall business will continue to be impacted by many of the same trends we faced in 2022, economic slowdown, competitive innovation, and rising interest rates. While these factors will contribute to a challenging year for Elanco, we expect strengthening Elanco's specific drivers to partially offset macro headwinds. We expect top line trends to modestly improve from a 3% constant currency decline last year to an expected 1.5% constant currency decline at the midpoint of our guidance in 2023. Outside of FX, we expect aggregate headwinds from environmental factors to be similar in magnitude to what we experienced in 2022 in the range of $120 million to $130 million. While we are seeing improving external supply chain dynamics and promising signs of recovery in China, the impact of economic-driven pressure on retail OTC products is expected to continue. For China, our business grew 9% in constant currency in the fourth quarter, a reversal from 4 previous consecutive quarters of decline. We expect improved performance this year in China, but continue to watch pork prices and consumer confidence levels as key leading indicators. Regarding retail OTC, encouraging early data points in the U.S. and Europe suggest improving demand trends compared to the second half of 2022, but we expect continued economic-driven pressure on the category. Given the larger notional size of the business in the first half of the year, driven by the Northern Hemisphere parasiticide season, we anticipate a headwind to Elanco's performance in the first half despite sequentially improving trends. Although some U.S. retail partners reduced inventory levels in the fourth quarter, we do not anticipate a meaningful step down in 2023 and from 2022 ending levels. Importantly, we believe our strategy to bring innovation expand physical availability and strategically price our products will help us maintain leadership in the category and position us well for the long term. With regard to more Elanco-specific drivers, we expect strengthening tailwinds will partially offset the environmental headwinds I just described by approximately $60 million at the midpoint of our guidance. The Elanco specific drivers of price and accelerating innovation sales are expected to be partially offset by continued pressure from competitive innovation, internal supply constraints and continued planned reduction in our contract manufacturing business. We expect price to deliver more than 2 percentage points of growth as we annualize our 2022 increases and implement incremental increases in certain markets, with the majority of pricing actions already taken. Innovation revenue contribution is expected to be $210 million to $250 million or approximately $80 million to $120 million incremental, representing 2 to nearly 3 percentage points of growth from innovation. This includes $20 million to $30 million of contribution from a small bolt-on acquisition we closed in early January to enhance our farm animal medicated feed additive portfolio with nutritional products. We expect these antibiotic alternatives will enhance our Farm Animal mix, be accretive to growth and help us grow share in the U.S. and globally. We continue to expect $600 million to $700 million of innovation revenue contribution by 2025 from price commercialise by Elanco in 2021 and beyond. On Slide 8, we highlight the key milestones and expected timing for several late-stage assets. Before getting into updates on our Pet Health portfolio, I'll provide an update on Bovaer. As you recall, last spring, we announced the in-licensing of the methane reducing product for cattle from DSM for the U.S. market, and we continue to believe it has blockbuster revenue potential in excess of $200 million. Our development team has been working swiftly on Bovaer since finalizing our licensing agreement. Through close collaboration with the FDA, we have made great strides in meeting their requirements to commercialize the product. Given these positive developments with the FDA and our parallel work to finalize contract manufacturing capacity, we anticipate a first half 2024 approval and launch. We look forward to integrating this product into our portfolio of strategic sustainability offerings for our beef and dairy customers. Shifting to our more near-term Pet Health drivers. Bexacat, the first-in-class SGLT2 inhibitor for cats gained FDA approval in December. We are taking preorders and expect to ship product in the coming months. For our parvovirus innovation, we continue to await USDA approval of our monoclonal antibody manufacturing facility, an important milestone for our broader monoclonal antibody platform. The expected conditional approval for the product will be followed by state approvals. We expect strong interest for this first-in-class treatment and expect to ramp supply over time as we expand capacity. In addition to advancing our vet clinic innovation, we expect 2023 to benefit from pet health OTC retail innovations and refreshes. In the coming months, we are preparing to launch 2 of the 3 new OTC parasiticides in the U.S. and Europe that we expect this year. In the U.S., we're relaunching the original formulation of Advantage, a flea preventative for cats; and K9 Advantix, a flea and tick preventative for dogs. These products will be positioned as value offerings that capture the cost-conscious consumer. We expect these products to be on the shelves of a small subset of retailers over the next few months. It's important to note, our Advantage family of products has the highest brand recognition of our pet retail products. And as we move into this critical Northern Hemisphere flea and tick season, we're excited to now have Advantage and K9 Advantix, alongside Advantage to K9 Advantix 2 and Advantage XD for cats on the shelves to meet our customers' needs, refreshing our OTC product offerings and driving physical availability of the Advantage family and Seresto are key initiatives that our pet health teams are driving globally. Now I'll pass it to Todd to provide more on our fourth quarter results and 2023 guidance.

Thank you, Jeff, and good morning, everyone. Before I go over our results, I want to provide some additional information about the revisions we made to our 2020 and 2021 financials that were described in today's earnings release. In connection with finalizing our 2022 financial statements, a cumulative error was identified relating to the valuation allowance for taxes for a Southeast Asia affiliate that affected our GAAP financial statements for 2020 and 2021. While immaterial to prior years, the air could not be addressed by a cumulative correction in the fourth quarter of 2022 without creating a material error to the 2022 results. Once we determine that a revision to prior periods was necessary, we then made additional revisions that would have otherwise been immaterial for 2020, 2021 and 2022 in each affected quarter. None of the revisions had an impact on revenue and they had immaterial impact on our adjusted results. If these revisions had been recorded in the correct reporting period originally, the impact to the first 9 months of 2022 would have been an increase of $2.9 million of net income and an increase of $4.1 million of adjusted EBITDA. We are finalizing our consolidated financial statements, including our income tax items and expect to file our Form 10-K timely. Accordingly, the amounts presented in today's press release and on this call are unaudited and subject to change pending such finalization. However, we believe that the numbers presented today will not change materially. We are also evaluating the effectiveness of our controls relating to income taxes. I will now focus my comments on our fourth quarter and full year adjusted measures, so please refer to today's earnings press release for a detailed description of the year-over-year changes in our reported results. Starting on Slide 10. In the fourth quarter, we delivered near the midpoint of our guidance range for our key metrics. Revenue was $988 million, an 11% decline or a 6% decline in constant currency with price growing 3%. Foreign exchange rates represented an approximate $53 million headwind in the quarter or 5%. The Slides 11 and 12 break down our revenue performance in the quarter by price, rate and volume as well as species and region. For Pet Health, we declined 10% in constant currency in the quarter, with volume declines in our parasiticides portfolio, partially offset by growth in our pain portfolio. Our U.S. business declined 13% compared to last year, primarily due to retail channel pressure, competition and parasiticides and supply challenges for certain vaccines. Our international business declined 6% in constant currency, primarily driven by the economic slowdown in Europe. As anticipated in our November guidance, Seresto and Advantage family products were impacted by pressure felt across the broader retail channel. We estimate approximately $10 million to $15 million of impact on our business year-over-year from a reduction in U.S. retailer inventories. We believe the remaining decline for these brands was a result of decreasing consumer discretionary spending as well as competitive innovation in the vet channel. In the fourth quarter, our farm animal business declined 3% in constant currency. Increased demand for aqua products and strength in international cattle was more than offset by declines in swine outside the U.S. and in U.S. cattle. Our U.S. cattle business was negatively impacted by supply challenges for certain vaccines and a reduction in distributor purchases. Poultry declined 4% in constant currency, primarily driven by rotation timing in the U.S. Continuing down the income statement, gross margin increased 70 basis points to 54.7% despite the decline in reported sales. The improvement was driven by our 3% top line price performance and productivity, partially offset by higher inflation and unfavorable product mix. Operating expenses declined 9% year-over-year in the quarter. Adjusted EBITDA margin was 17.6%, a decline of 160 basis points year-over-year. Adjusted earnings per share was $0.19 in the quarter, including a $0.07 benefit from a favorable fourth quarter tax rate. Referring back to the 2-year revenue bridge on Slide 7, I'll provide a few comments on our 2022 full year performance. We delivered just over $4.4 billion in sales, a 7% decline or 3% decline at constant currency, accounting for the approximate $200 million of impact from foreign exchange rates. Environmental factors, including COVID lockdown implications in China, external supply chain disruptions and economic pressure on pet health retail represented an estimated $120 million or 2.5 percentage point drag on our business. Outside of our planned reductions in contract manufacturing sales, which drove 0.5 percentage point of decline Elanco-specific factors were effectively balanced with price and innovation delivering tailwinds, offset by competitive innovation and other factors primarily impacting the core, including internal supply challenges. On Slides 24 to 28, we provided additional revenue breakdowns, including by top affiliates. Continuing down the P&L on Slide 13. Gross margin was 56.7%, an expansion of 10 basis points compared to last year. This was enabled by full year top line price growth of 2% and continued productivity improvements, partially offset by inflation and unfavorable product mix. These factors, combined with reducing operating expenses by 10%, contributed to the 90 basis point expansion in adjusted EBITDA margin for the full year. Adjusted earnings per share was $1.11, growth of 4% for the year as both adjusted interest expense and tax expense declined compared to 2021. Our non-GAAP tax rate dropped from 22% in 2021 to 17.9% in 2022. This year-over-year decline was primarily driven by a favorable tax ruling in the fourth quarter of 2022 in Brazil, and the jurisdictional location of Elanco profits. Related to our productivity savings in 2022, on Slide 14, we have updated our adjusted EBITDA synergy progress. We delivered approximately $140 million in incremental synergies, bringing the cumulative total to $363 million through 2022 and exceeding previous expectations as we efficiently executed our fourth quarter 2021 restructuring and accelerated expected savings from 2023 into 2022. We have increased our adjusted EBITDA synergy expectations in 2023 to approximately $380 million. We remain committed to deliver more than $400 million of synergy capture by 2024 and as the final tranche associated with our Bayer ERP and business process integration annualizes. Before moving to our 2023 guidance, let me offer a few words on our cash debt and working capital on Slide 15. While we are still finalizing our operating cash flow results for 2022, we expect full year to be between $450 million to $460 million for the year, and between $10 million to $20 million for the fourth quarter. The year-over-year decrease in the fourth quarter reflects an increase in net working capital, driven by an increase in inventories. We also had higher cash interest cost year-over-year in the fourth quarter as a result of the swap restructuring we executed in the second and third quarters of 2022 and rising interest costs on our floating rate debt. We ended the year with net debt of $5.6 billion as we reduced gross debt approximately $500 million for the full year and net debt, $208 million. Our net leverage ratio was 5.4 times, slightly above our previous expectations as a result of lower cash balances than expected at year-end. We continue to see durable cash flows from this business. And in a moment, I'll touch on our expectations for debt paydown in 2023 and the factors improving our outlook for free cash flow going forward. Now let's move to our 2023 financial guidance, starting on Slide 17. We expect revenue to be between $4.28 billion and $4.4 billion or approximately flat to a 3% decline in constant currency. For adjusted EBITDA, we expect $920 million to $1 billion. Finally, we anticipate adjusted EPS of $0.74 to $0.83. Slide 35 in the appendix provides a number of additional assumptions to help support your modeling efforts. On Slide 18, we'll review some of the underlying factors in our 2023 revenue expectations. We expect the impact of foreign exchange rates to be a $10 million to $15 million headwind for the full year. However, this will not be consistent across quarters. Utilizing spot rates from early February, we expect headwinds in the first half with tailwinds in the second half. In Pet Health, we expect improved performance. First, we expect continued global growth for the Credelio franchise and accelerated growth from innovation. We expect a return to growth in our China Pet Health business as the market is expected to normalize by midyear. Finally, we expect improving supply dynamics to benefit the Advanced family products and vaccines in the U.S. year-over-year. On the other hand, we expect ongoing pressure from competitive innovation and have incorporated assumptions for new entries in U.S. parasiticides, pain and otitis. Collectively, we expect the magnitude of competitive pressures on volumes to be largely in line with 2022. On retail, the European economic outlook appears better overall, but remains pressured along with the U.S. consumer. That said, as we enter the heart of the flea and tick season starting next month, we expect consumers in both the U.S. and Western Europe to once again focus on prevention and to be less likely to trade down to lower cost and less efficacious post infestation treatment options given the heavier risk of fleas and ticks during this time of year. We also believe the launch of our new Advantage family products and increased physical availability will enhance our competitive position in 2023. Moving to Farm Animal, we expect growth to be driven by the continued uptake and conversion of Experior as well as the addition of several portfolio enhancing bolt-on products. Additionally, we expect improvement in China throughout the year. Pork prices have been depressed over the last several months, but industry analysts believe this will be temporary. Finally, we expect to see continued strength in aqua markets globally. At the same time, we expect continued generic pressure and expect internal supply challenges on a few products globally. Finally, favorable weather conditions in 2022 led to a strong cheap season in the U.K. and Australia, which we don't expect to repeat in 2023. Moving to adjusted EBITDA on Slide 19. Price increases are expected to offset reduced volumes and the impact of inflation on our manufacturing base. We expect a flat to modest increase in operating expenses primarily driven by global wage increases and strategic investments in key Pet Health brands. With the acceleration of synergies into 2022, we expect less incremental savings contribution in 2023. After our reprioritization of the R&D portfolio and reduction in 2022, we expect our R&D investments to be approximately $80 million per quarter were generally flat year-over-year as Ellen and her team continue to drive our innovation forward. Finally, adjusted EPS on Slide 20. The reduction in adjusted EBITDA translates to $0.03 to $0.15 of the year-over-year decline, with increased interest expense from our floating rate debt and the expectation of higher tax rate in 2023, primarily driving an additional $0.21 to $0.24 of decline. As we think about the shape of the year, let me offer a few words on phasing in the first half. With our ERP system go live in April, we expect a meaningful impact on the split of our financial results between the first and second quarters. We will have certain sales blackout periods for most affiliates in late March and early April that we expect will cause some customers to accelerate their orders of legacy bar products into the first quarter from the second quarter. As a result of this ordering uncertainty, we are providing financial guidance for the first half of 2023 versus first quarter guidance. We expect to return to quarterly guidance for the second quarter in May. On Slide 21, we share our first half 2023 guidance. We expect revenue of $2.23 billion to $2.31 billion, adjusted EBITDA of $490 million to $540 million and adjusted EPS of $0.43 to $0.50. We expect foreign exchange rates to be a headwind of approximately $40 million or about 2% in the first half. While the cadence of the top line will be impacted by the Bovaer system integration across the first half, interest and tax expense will not be. Finally, on our balance sheet expectations for the year. We expect to end the year with a net leverage ratio between 5.3 times and 5.9 times. The sensitivity to adjusted EBITDA is reflected in this wide range. While we aren't guiding to a specific change in gross debt, we expect to refinance a portion of our senior notes due in August of 2023. We remain confident in our ability to service our future debt obligations and generate cash as we bring meaningful differentiated innovation in the market while relentlessly managing our costs. In 2024 and beyond, we expect increasing EBITDA and minimal onetime cash costs to drive improved operating cash flow. Over the last four years, Elanco has had significant uses of cash as we have stood up, integrated and transformed our company. On Slide 22, we have laid out the estimated cash cost for the three primary projects the standup of Elanco's own independent ERP infrastructure, business processes and shared service center network, the Bayer business integration and restructurings and the Bayer systems integration. The independent company standup was completed in 2021. Most of the cash for the Bayer their business integration was completed in 2022, and we will complete the Bayer system integration in 2023. While we expect $140 million to $160 million in 2023, there's a substantial step down starting in 2024 as cash expenses associated with these projects moves to less than $20 million. Moving past the approximately $1 billion necessary to stand up and integrate this company will substantially improve our free cash flow generation. Now I'll hand it back to Jeff for closing comments.

Thanks, Todd. Before we take your questions, I'd like to provide our view on why the Elanco Board and team have deep belief and confidence in our future. First, pipeline delivery. Dr. Ellen De Brabander, and her team are consistently delivering milestones across the portfolio from research to late-stage development. We are refreshing our pet health OTC portfolio with advantage and K9 Advantix as well as Advantage XD for cats. We are launching first-in-class innovation in the vet clinic with Zorbium, Bexacat, soon parvovirus and Experior ramping. In the U.S., we have a path to approval by the first half of 2024 for our broad spectrum parasiticide, our K9 dermatology products, the JAK1 inhibitor and the IL-31 monoclonal antibody and now also Bovaer, as I discussed earlier. Our excitement about Bovaer enhanced by tangible progress on farmers' ability to monetize environmental sustainability efforts. In 2023, we expect the first carbon credits will be minted for beef producers, which will be proof that farm animal sustainability can transition from strategy to tangible action that can create value for farmers, investors and society as a whole. The next reason for confidence is our focus on reducing operational complexity. With the Bayer system integration going live in April, we're fast approaching one operating environment for our complete portfolio, creating more stability, a better customer experience and opportunity for more efficiencies. Importantly, it allows us to move past the distraction and the significant associated cash cost pivoting the organization towards driving the portfolio and improving free cash flow generation, as Todd laid out. And finally, we are building a commercial leadership team that will drive our commercial execution and launch excellence as we enter the next era for Elanco. In this first year leading the U.S. pet health business, Bobby Modi has built a data-driven organization, improving capabilities across sales force excellence, pricing, digital engagement, retail marketing and vet clinic targeting. Jose Simas a nutritionist and our U.S. farm animal leader is growing Elanco's share across the business while helping to shape the industry's future with antibiotic alternatives and game-changing sustainability offerings. Ramiro Cabral, a veterinarian and seasoned international animal health leader has demonstrated his ability to lead across our diverse business outside the U.S. across many geographies, species and products. And finally, we're pleased to announce we are further enhancing the strength of our commercial leadership team with the addition of Tim Bennington. With his 25 years of industry experience across both farm animal and pet health, Tim will be a great complement to our commercial leaders and our organization broadly. He has led some of the most successful blockbuster launches in our industry. and run some of the largest P&Ls in Animal Health. We are confident he will enhance our overall competitiveness as our team prepares for this historic launch window and sustainable growth. With that, I'll turn it over to Katy to moderate the Q&A.

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

[Operator Instructions] Our first question comes from Michael Ryskin from Bank of America. Please go ahead. Your line is open.

Jeff, maybe one for you to start, and then I have a follow-up for Todd. So first, you continue to emphasize a focus on OTC parasiticides. How do you see the OTC market there playing out longer term? It seems like we're seeing an increasing shift in recent years, so some of the more prescription oral products in the market, including the combination products. So but you're continuing to sort of double down at least this year on the OTC. That seems to be a that's lost market share in 2022 and is expected to do again in '23. So can you just talk about the OTC versus prescription. In particular, maybe you can comment on Seresto expectations going forward, given pretty disappointing 2022?

Yes, absolutely, Michael. Thank you for the question. So we believe this is an and not an or. You can see the pipeline that's coming. We believe that the vet clinic in the vet is critical -- we've got game-changing technology that's coming, some of the biggest blockbusters in some of the biggest spaces -- so the vet clinic will be critical. And then really, this is about the omnichannel, right, in terms of meeting more pet owners where they want to shop. We still have a large segment of the pet owner population that does not go to the vet and even the economic challenges may even drive some of that. So we believe this is a combination of both -- and what we've done since picking up the Bayer portfolio is do what we said we were going to do, more physical availability. We're in more retailers today than ever on more end caps and more shelves. Two is innovate. We're bringing three advantaged products here with the 2 that we announced today and XD that we've announced before. And that really puts us targeting more different consumer segments from the cost conscious to those that are more loyal and want to products that are maybe more convenient like a Seresto. So we see the medium and long term as this is a growth segment. It's global. The key initiatives we said we were going to put in place are now coming to life, and we see this as something in the medium and long term as strong. Seresto, loyalty continues to remain high. it was impacted heavily by the economic pressures that we mentioned in the U.S. and EU the step down in retailer inventory as well as trade down and some, yes, movement over across maybe new innovations in the vet clinic. But as a whole, again, improvements in '23, we see with Seresto continuing to be a product that's going to have we think a strong profile that will help this company going forward, not just in margin, but in growth with more physical availability, we'll see that in '23, more price more geographic presence. So again, an improving year for Seresto in '23.

Follow up, Mike? Your follow-up for Todd.

Yes, I appreciate that. Todd, a quick follow-up on cash balance sort of debt pay-up plans. Can you provide a lot more color on sort of the cash projects going on, Slide 22 really helpful. But any you could say on operating cash flow, debt leverage targets for end of year '23, just sort of as we think through where we should be exiting this year?

Mike, looking at year-end leverage, right, we've just provided the net debt numbers relative to EBITDA. So that's 5.3 times to 5.9 times. Projected. If you do look at all the assumptions we've provided in the appendix for modeling purposes, there's a lot of cash that still goes out the door on the project expense as we said. We've got cash taxes, CapEx as well as the cash interest. So if you look at all of that, while we're not guiding to a gross debt paydown, that gets you to about $100 million of paydown depending on net working capital performance. That was a very disappointing area for us in 2022, and we've got new initiatives with a lot of focus on that across the company in 2023 as that needs to improve to help us drive better performance on the cash line. So those are the key things we're looking at. But at the end of the day, right now, it would be about $100 million of net pay down.

Next question comes from Erin Wright from Morgan Stanley. Please go ahead. Your line is open.

So one on innovation and one on the parasiticide. So can you break down what you are baking in, in terms of the guidance for 2023 in terms of innovation contribution? And how we should be thinking about that ramping in 2024? And what's that growth as well as net contribution from innovation in '24. Does your long-term innovation target now embed the small acquisition as well as the expedited launch of Bovaer. And then just my second question is on the broad spectrum parasiticide, -- how are you thinking now in terms of the competitive positioning -- do you you'll think be still third to market? Or is it for to market? And will you be able to take share more so from the existing combination products out there? Or will it be mostly legacy OTC and oral parasiticides?

Sure. Todd, do you want to start on innovation?

Sure. Erin, we've got $220 million to $250 million in innovation sales in 2023 after doing $133 million in 2022. So that's ramping in the $90 million to $115 million range. Overall, we have not changed the $600 million to $700 million, but we are excited about these innovative antibiotic alternatives we're adding as well as Bovaer coming earlier, just gives us more confidence in the ability to deliver on that $600 million to $700 million amount. And again, we look forward to ramping in '24, but we're not giving guidance on that today.

Erin, regarding the broad spectrum parasiticide, -- so submission made last year, continued path. I want to emphasize on really the whole pipeline that really nothing has slipped we have increased confidence in the overall pipeline and the progress, the quality of the submissions that are being made, I will highlight really the differentiation. We're not going to highlight all the details of what that is. But what we would say is differentiation matters most, and we believe we have a differentiated leading product that can come in that's already passed the heartworm threshold coming into this product. The other news here in this earnings call is our pivot as we finish the system standup, we're pivoting now to commercial excellence. Bringing Tim on, Tim Bennington, with his experience leading some of the largest launches in the business, our energy is now channelled around launch readiness, commercial excellence globally, how we can ramp products more segment them even better and take more share earlier. That is the focus and Tim's charge as he comes in, complementing the existing team that's focusing on the existing business.

Our next question comes from Nathan Rich from Goldman Sachs. Please go ahead. Your line is open.

I'll ask both upfront. One, I kind of just wanted to build on Erin's question. Jeff, when you're thinking about the launches next year and that kind of historic launch window that you referenced, how should we think about the contribution of new products ramping up in 2024? And what are the biggest kind of swing factors and things we should keep in mind as you think about kind of go-to-market strategy. And then secondly, I wanted to ask just on cadence of earnings this year. It seems like the first half numbers were maybe a little bit than we would have expected, especially on the EBITDA line. Could you maybe just talk about kind of first half versus second half cadence and what you kind of expect for kind of underlying growth as we think -- as we move through the year.

Yes. Great question, Nathan. So I think, first of all, it is to us, taking the existing capabilities that we're actually building and building on. And I think Zorbium is a good example of this is we're looking at adding enhanced back to our Investor Day marketing enablers from the right pricing to digital, to globally, making sure we've got the right share of voice in the right markets, that will be absolutely critical. We feel like we're in a really strong place now. We don't need to add a significant number of sales reps we believe, but it will be targeting and enhancing the appropriate insurance of having the right share of voice the right capabilities to drive demand. And we're seeing that, and we're able to test that with the Zorbiums, the Bexacats, the parvovirus is coming the vet clinic. And actually, these are first-in-class products that are drawn a lot of interest in bringing us into a lot more clinics. That's number one. Two then is all around the segmentation of the differentiation in the products and what segments that we'll go after. And that will be all building around this launch readiness. So we've had a lot of good progress on our launch plans for these products. what Tim is going to be able to do is bring his experience and take our existing teams and actually enhance those launch plans and ensure that we're efficiently but putting the resources in the right place to capture those areas. And then look, we're going to look at the timing of these launches with numerous coming is where do we leverage them together and where do we lean in individually. And as Todd said, there will be pushes and pulls. There will be some that will come sooner than we expect and maybe some of that will be a little bit delayed. But as a whole, we'll be timing those resources and looking at how we can complement them together as well.

And Nathan, let me provide you how we're seeing the first half, second half dynamics first half, Northern Hemisphere, parasiticide season, and the contribution from the retail product is the big driver of both gross margin and EBITDA. We do have that declining year-over-year in the first half as we've got this recessionary pressure the Q4 ending and taking those things into account. So that does make it a tougher EBITDA situation. The other part, I would say, Bobby Modi came on at the end of the first quarter last year, his team has really ramped up their execution is seen by bringing the new advantage relaunches to play and making sure we're investing appropriately behind our biggest brands at the right time and doing that. So I think that's probably the mix element and that expectation of what those sales in the first half contribute being the biggest item on the cadence. And then on the second half, Again, it's just -- it was a really tough compare in the -- or an easy compare for the second half versus the first half for us, and that again gives us confidence in the EBITDA split between the two halves of the year.

Our question comes from Chris Schott from JPMorgan. Please go ahead. Your line is open.

Just two questions for me. Maybe first on price. It seems like some of your peers are seeing a larger contribution from price this year. So can you just elaborate on I think it was kind of a 2%-plus contribution and just some of the dynamics you're seeing across the portfolio? And then my second was on interest expense. I guess with interest kind of expense ramping in the second half, and I think some of your interest rate swaps rolling off -- can you help us just understand what a reasonable run rate for interest expense would look like if we're just kind of looking out to 2024, assuming rates stay where they are today, I guess, can we just kind of take that second half kind of run rate on interest expense and annualize that as a reasonable target? Or could it step up further from there?

Yes, I'll take the first one on price. We saw, Chris, price increased throughout the year with 3% in Q4, 2% for the full year. we are saying more than 2%. I will put some kind of support points behind that. One, we will have some lapping of price increases taken last year, and we'll have that effect in the first half of this year. We see some good leading indicators as we start the year as well. We've also taken most of the significant price increases here at the end of last year, beginning of this year. So the price increases are in place and we're doing the things necessary to sustain and build price, which is adding innovation, targeting customers better, building out value beyond product and both on the farm animal and on the pet side. I mean adding nutritional health products, sustainability is going to help our bundle and our portfolio on the farm animal side, bringing more innovation in pet do the same. So -- and we've added some price experts and capabilities coming in. So again, we're going to hold here saying more than 2% price, but we will say that pricing will be a key growth driver for us in '23 and beyond.

And Chris, on your question on interest, on our Q3 call in November, we provided the debt stacks as well as the facts regarding our interest rate swap portfolio. And as you rightly pointed out, we do have another $1 billion of swaps rolling off at the start of Q4. That would give us roughly we're at about $1.8 billion of floating rate debt today, that would get you up to $2.8 billion so as we get into higher interest rate environments with the Fed, these are all at SOFR plus 185. So for the back half of the year, we're expecting to be in about the 7% range on our debt -- so that's the big driver. I want to make that clear back in Q3 on the impact of floating rate debt and the amount of leverage we have. As we look to 2024, I'd focus you on the cash project slide, those dropping off dramatically as we finish up the integration of the Bar systems and our systems will allow for more cash -- free cash to pay down debt. And then the forward curves would suggest interest rates are going to drop with the Fed starting to cut rates in '23 or '24. I'm not going to comment on that. That's why I really can't comment on is the second half a good run rate into '24 because a lot of it is floating rate debt that will be driven by Fed policy and how the economies play out over time.

Our next question comes from Umer Raffat from Evercore ISI. Please go ahead. Your line is open.

I have two here, if I may. First, Jeff, as you reflect back over the course of last year, so and all the negative guidance revisions, -- why do you think the Elanco team was overestimating numbers in such a consistent way? And can we reasonably assume that the $0.74 to $0.83 is truly a trough first? And then secondly, on the base business EPS, which is no longer that $1 that it used to be, I think an important question for a lot of new investors looking at Elanco is, what's the incremental operating margin on the new launches? Will they come in at 65% or so? Or would it be much less than that.

Yes. Thank you, Mark. We stand here today with confidence in our '23 guidance, as Todd has highlighted. As we look back at last year and we came into our May call and went to the second half, we had put together 6 consistent quarters of holding and staying to our guidance. And we had an environment that that hit us in a multitude of ways, and predicting war, coved lockdowns in China, the inflation and the recession and the impact on really us where we were over-indexed into China in a pet retail situation in the Northern Europe. Those were things that I'm not sure that we could have predicted. I would say that we've taken a very measured approach this year and looking at overall, our confidence in this guidance is looking at saying, yes, we've got a competitive portfolio and a team -- but looking at this macro environment, as Todd highlighted, we've taken assumptions. We've assumed that we're going to carry a lot of these same headwinds and challenges out of '22 into the first half -- and we will -- we have seen a lot of sequential improvements, but we're seeing this as a lower step-up throughout the year. And so again, I stand here with confidence in the assumptions, the approach we've taken in our guidance. We start to return to growth in the second half of the year. We're going to do it in a balanced way and also prepare this next era of growth in '24 and '25, that's so critical to our investors and long-term value of this company.

Over on the launches, certainly, over time, these launches will be incrementally higher margins and will provide really good EBITDA flow-through given our installed base at the vet clinic where these big launches will go is appropriate for the coverage needed. And so it will really be about incremental margin or marketing expenses to drive the launches versus needing to double the sales force or something that in. So over time, certainly, we expect these to be incrementally higher margins. But as you know, scale helps. And as we drive them higher over time, margins is to continue to improve.

Our next question comes from Jon Block from Stifel. Please go ahead. Your line is open.

Todd, just the $5.3 million to $5 million leverage for year-end '23, and there's a lot of reasons in the slides, why the cash requirements stepped down in '24. I think I get that, but -- is there anything from a covenant perspective to be aware of? Any step downs in 24 or 25 on the leverage ratios to call out? And then the second question, I'll ask about the front. Just Seresto down Q-over-Q, Jeff, I don't think it's been down 3Q to 4Q for the past 4 to 5 years, at least since I've got the breakout. So can you talk about the product share. And then anything new with the EPA on the horizon, do you expect resolution with the EPA in 2023?

Jon, the leverage covenants are over 7 times. We don't think there's any issue on that going forward. We continue to feel confident in this guide and EBITDA expanding in future years.

Yes, Jon, on Q4, as you know, the seasonality, this is a much smaller quarter for Seresto. It's off season. We think the economic dynamics and the recessionary pullback on the retail segment where people went more for treatment and prevention. That was definitely a big driver. Retailers stepped down in inventory. It was a little trade down and maybe a move over to the vet clinic, but not substantial. So we've done a lot of study into this. I think the key lead indicators that give us a lot of confidence as we come into the season and the early indicators in the year are positive as we look at sequential change is 1 as we move into the season, Seresto's brand loyalty, the retailer and e-com loyalty to this product, we've got as many as much physical availability, as I mentioned, and more retailers, probably more end caps going into this season as ever. And so I think it was a lot of economic-driven off-season, smaller quarter that caused the bigger percentages. Now we're going to have some of these same pressures across the bigger notion of our total business. So we're going to see some step down, but as a whole, again, a lot of confidence in Seresto. I would highlight that as we look at the EPA, yes, we're having a very constructive positive dialogue -- we do expect to report as we look at the overall working arrangement with the EPA on how we can improve brand stewardship and oversight of this product is something that we're endorsing and looking at as FDA products like the EPA. So look for us to have an outcome with EPA, yes, I would see it in '23. And again, the dialogue has been very collaborative and constructive and something that we're encouraging. And again, we see Seresto medium, long term being a key product that will help drive the strength and profile of this company.

Thanks. We'll take the next caller. And I realize we have a few in the queue. We'll continue to answer questions. We might go a little bit over the hour.

Our next question comes from Elliot Wilbur from Raymond James. Please go ahead. Your line is open.

First question for Jeff and or Todd. I heard the number you called out specifically for competitive pressures in the fourth quarter. But if you mentioned the full year impact, I did not catch those. So I was wondering if you could detail what the full year impact was of the competitive pressures that you have cited on a couple of occasions over the last couple of calls. And then specifically, Jeff, how are you thinking about the forthcoming launch of mab for osteoarthritis in the U.S., given what you've seen to date in Europe. And I understand the product labeling is slightly more favorable in the U.S. than Europe, but just trying to sort of balance that versus what seems to be a growing desire on the part of vets to reduce or control disintermediation within the U.S. vet channel? And then for Todd, can you just talk specifically about gross margin trends the guide for next year, I guess, at the low end of the range is down about 100 basis points. But trying to tease out all the different effects in terms of inflation, or just reduce expectations for some of the performance products or higher-margin products in 2024. Just trying to think about what in a more normal environment may allow those margins to improve a little bit more than just sort of modestly. And how should we be thinking about your previous longer-term targets in light of today's update.

Okay. A lot in there. Well.

Let me do the first and the third, and I'll turn it back to Jeff on -- so first, we think competitive pressure was roughly $100 million full year. We called out $80 million previously. The vet clinic traffic continues to be reasonably similar to there was a generic launch of a product that competes against Claro that hit us in Q4 plus some of the trade from retail channel into the vet channel. When we think about gross margin, a lot of this is mix. We don't expect our pet health business to grow in '23 in constant currency. That is our highest margin business. So that is a negative impact. The other part is we still have about $80 million of inflation, adding into our top space. A lot of productivity and work across our manufacturing network to offset that in the face of both declines in pet health and inflation in '22, we were able to increase gross margin. So the team continues to find ways, but that mix element is certainly impacting it. And then we did take off the longer-term targets a year ago, right now, we're looking to stabilize on a lot of different areas before we think about reiterating any of those things. Do we expect margins to improve Absolutely. The new products will drive it. The new retail innovations will continue, but we're not putting any commitments out there at this time. And I'll turn it over to Jeff for the Galliprant.

Yes. We -- just at a high level, Galliprant, again, had a very strong year. And our overall pain segment continues to expand with on Sierra Nocita, Zorbium, as we know, and Galliprant and that whole segment is pain is growing and really one of the fastest-growing markets in pet overall, and we're well positioned with a large portfolio. When you look specifically, Elliott, at Galliprant, first of all, in the U.S. and relative to the new competitive entry coming in. It's been here longer. It has a wider label. It has more brand awareness and vets are using in an increasing way. And I would say pain for OA is multimodal. Most of that will recommend multimodal treatments with a focus on inflammation. I think that's important. And we expect the treatment guidelines will recommend typically an inset like a Galliprant. We're becoming more of a first-line treatment of an NSA segment. in addition to maybe an overall treatment regimen that would include maybe innovation. So again, we believe we're well positioned overall in pain. Galliprant in a much stronger position than we even were in Europe. And we believe that, again, this segment, even with our pipeline, pain will become increasingly more and more important to Elanco as we go forward.

Next question comes from Balaji Prasad from Barclays. Please go ahead. Your line is open.

Just getting back to the guidance part of the question on Slide 17. As I look at the Elanco-specific factors and the guidance bridge. What I understand from this is you're likely to get around $90 million of pricing benefit this year, assuming 2% and another $100 million to $110 million of innovation driven incremental revenue. So that gives me around of positive on positive contribution. And on the other side, balancing it seems to be competitive innovation and supply. So is there a case where both competitive innovation and supply can fully offset this $20 million benefit going with the range you provided. That's one. And secondly, on the OpEx side, I was surprised to see FX not impacting the EBITDA bridge. Can you help us understand that and also call out the investments this year as that needs to go into supporting new launches.

Sure. Todd, do you want to start on the -- just the bridge for '23?

Sure. You've got a very good handle on how you think about the bridge. We have spent more than 2% price Yes, the innovation revenues, competitive and supply provide an offset. But again, this is all built into constant currency guidance for sales being flat to down 3%. Certainly, if certain things play out our way as we continue to execute through the year, we'll do better than that. And that certainly what our commercial leadership is focused on as they continue to drive demand for products. And again, as Jeff mentioned, China off to the start demand getting better there, demand is getting better at retail. So again, we're confident in the guidance. With respect to the EBITDA, as we mentioned, it's about a $10 million to $15 million headwind on top line. It's just a little bit off in that -- it's a big headwind in the first half. It becomes a tailwind in the second half and that out, it's $3 million to $5 million headwind from an EBITDA standpoint at this point. But again, that's always some timing. So we just didn't make a big deal of it in the walk.

Our next question comes from Brandon Vazquez from William Blair. Please go ahead. Your line is open.

I'll ask Tom as well. The first is just -- there's been a couple of mentions of inventory levels. I think it was in the U.S. in Q4. Curious if kind of like reduced inventory levels are expected to continue in '23, and if that's already baked into the guidance? And the second is just on the relaunch of Advantage and Advantix, maybe these more value plays. Can you talk about, are those kind of margin accretive at launch? Does that need to sale as well as you were talking about before? And can that help through the year?

Sure. Thanks, Brandon. So on inventory levels and how we're seeing those again, there was a step down in Q4 from the farm animal side. We've not assumed a rebuild there or rather just that they would continue at that point. So it's not a headwind in '23 in theory from a growth perspective, to be a tailwind if we don't have that headwind again in the back half, that's part of back half acceleration. Similarly, on retail inventories, for the OTC pet products, again, retailers did take that down at the end of the year, $10 million to $15 million Overall, it will be volatile over the course of the year. We've not assumed an increase of that. So again, assuming it stays at this level, and we think it's about at a level they need in order to serve the customers well. then again, that would be part of the growth in the back half as we wouldn't have that headwind making through an easier comp. With respect to the relaunch products, again, very efficient scale at our keel manufacturing facility. And so yes, even at the lower price point for the consumer, they're accretive to overall gross margins of Elanco.

We have no further questions in queue. I would like to turn the call back over to Jeff Simmons for closing remarks.

Okay. Very briefly. Thank you for your time today. Coming off from a challenging environment in 2022, maybe 3 points to close as this next area of innovation and growth is really in front of us here in Elanco. We do see this challenging environment persisting into the first half of this year that came from '22 into '23, but I really leave it with one. We do have confidence in this '23 guide that was shared our guidance. We do see our business returning to growth in the second half. But when we back up and look at the overall macro environment, our assumptions, it gives us confidence, we believe, that this guidance is the right guidance. And then second is really the 23 proof points. As highlighted, just in summary, sequential improvements in sell-out data, China returning to growth, OTC, early signals as well as FX. And then the big drivers that will offset this environment is innovation, 2 to 3 percentage points of growth, price more than 2 and supply being better. And then I really end with the third point, which is just really the next area of innovation growth. Over the next 2 months we finish up the system, stand up, which really takes the complexity out of Elanco and really allows us to lean into this pipeline. 6 blockbusters as we add Bovaer now with a path to the first half of 2024, and that will again open the door for the next era of innovation and growth. So thank you for your time today. We look forward to engaging with you as we go through the quarter. Thank you.

This concludes today's conference call. Thank you for your participation. You may now disconnect.