ELAN - NYSE

Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Elanco Animal Health Second Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Katy Grissom, Head of Investor Relations, you may begin your conference.

Good morning. Thank you for joining us for Elanco Animal Health's second quarter 2023 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 statement. 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'll now turn the call over to Jeff.

Thanks, Katy. Good morning, everyone. Elanco delivered a strong second quarter with meaningful progress in our late-stage pipeline, the successful completion of our ERP integration and exceeded the top end of our guidance range on revenue by $4 million, adjusted EBITDA by $61 million and adjusted EPS by $0.13. We continue to expect this sequential improvement in the first half to continue with an anticipated return to revenue growth in the second half of 2023. We are updating our expectations for the year, raising guidance for revenue, adjusted EBITDA, and adjusted EPS. Starting on Slide 4. Since our last call, we delivered improved operational performance and achieved key milestones advancing our strategy. First, in Q2, we delivered the second consecutive quarter of sequential improvement and year-over-year revenue performance, excluding the ERP blackout impact, driven by strong performance from the U.S. Pet Health business, International Farm Animal and contributions from new products. Additionally, we completed our ERP integration and announced resolution of the EPA Seresto review, confirming the product's continued registration. On debt, we are completing the refinancing of our August 2023 notes today. Next, in the quarter, we saw strong adoption in several EU markets for Adtab, our newly launched oral OTC flea and tick solution; and in July, we launched our Canine Parvovirus Monoclonal Antibody in the U.S. We made significant progress on our late-stage blockbuster pipeline advancing key programs and gaining additional confidence on the differentiation and launch plans. Finally, we issued our 2022 ESG report demonstrating progress on our Healthy Purpose sustainability efforts in our internal operations, customer collaborations and beyond. Focusing now on financial performance, on Slide 5, we provide a view of year-over-year revenue for the first half of the year, excluding the impact of the ERP integration between the first two quarters. Elanco reported a 1% decline in constant currency, demonstrating a marked improvement from the 5% decline in the second half of 2022 and surpassing our guidance expectations of a 2% to 4% decline. Looking now to the key drivers in our four business areas that drove this overachievement. First, U.S. Pet Health. U.S. Pet Health returned to growth in the first half of the year, delivering 1% growth year-over-year. Our strategy to increase share of voice, improve physical availability, leverage innovation, and grow price contributed to the improved performance. The strong parasiticides season contributed to the OTC retail market dispensing growth in both units and total sales, while Elanco execution led to share gain in this market through the first six months of the year. Both Seresto and the Advantage Family grew revenue high-single digits, exceeding expectations, as our new creative campaigns and increase in total distribution points began to payoff. On the vet clinic side, our investment in digital and enhanced sales force effectiveness drove a 36% increase in total touch points in the first half of the year. This deeper engagement with veterinarians and clinics contributed to penetration growth for Credelio and Interceptor Plus and Galliprant. While competition remains impactful in the U.S. vet market, these increased touch points and penetration contributed to the stabilization of our business in this channel. Bobby Modi's team's strategic execution is improving outcomes, and we expect continued positive momentum from this business in the second half as we prepare for an exciting innovation launch window in 2024 and beyond. Next in our International Pet Health business. This business declined 7% in constant currency in the first half. 6 percentage points of the decline was driven by the impact of ongoing demand pressure in the Spain retail parasiticide market. More broadly, we saw continued growth in our Credelio franchise, balanced by slower markets, primarily impacting retail and other key geographies like Italy, China and Japan. The European launch of Adtab surpassed expectations, increasing its expected full year contribution. Our market penetration strategy and quick action has positioned us well in the emerging OTC oral parasiticide market in Europe. We expect improvement in our International Pet Health business in the second half as we leverage innovation and anticipate a better economic environment in Europe compared to the second half of 2022. Now moving to Farm Animal. Our International Farm Animal business, the largest of the four quadrants, grew 4% in constant currency in the first half, driven by strength in poultry, aqua and price. We expect these drivers to remain strong in the second half of the year. The U.S. Farm Animal business declined 5% in the first half, with 4 percentage points driven by supply disruption for cattle vaccines and the remaining driven by implant regulation changes and timing of poultry rotations. These were partially offset by increased adoption of Experior and contribution from NutriQuest. In the second half, we expect stronger performance from our U.S. Farm Animal business, driven by improved vaccine supply, the continued ramp of new products and increased demand for our poultry portfolio. A few comments on Experior. Experior remains an important innovation sales growth driver for this year. Beginning in March, we saw a positive trajectory change in the use of the product, which continued to accelerate through July, resulting in second quarter sales at three times those of the first quarter. Adoption in Canada is tracking on a similar trajectory as the U.S. We continue to focus on expanding use with existing customers and expect to exit the year at an annualized run rate of approximately 60 million to 70 million. Finally, we're encouraged by the recent announcement from Tyson Foods to reintroduce animal-only antibiotics or ionophore into their poultry supply chain. Elanco leads the in-feed poultry solutions area with a variety of tools from nutritionals to our differentiated narasin, an ionophore, products, Maxiban and Monteban, which we expect will be key products in these new programs. As the processor of about one-fifth of all the U.S. chickens, we believe Tyson shift will result in a more sustainable production, improved animal welfare and a positive net impact on Elanco's business. Moving now to Slide 6. Let's look at the strategic drivers of our innovation, portfolio and productivity framework over the past few months. First, with productivity. In April, we successfully completed our ERP integration, simplifying our internal and customer-facing business processes and enabling synergies. Among other things, the simplification offered the ability to engage in a commonly used accounts receivable asset securitization program. This program will provide the majority of the funds to retire our 2023 notes, which we are completing today. Next, onto the portfolio. For Seresto, we're very pleased with the outcome of the EPA's comprehensive review and the confirmed continued registration of the product. We never wavered in our data-driven confidence in the safety profile of Seresto, and we are encouraged by the robust science-based approach taken by the agency. We view the stewardship plan as an opportunity to raise the bar across the collar category. We see the EPA outcome as a positive for the Seresto brand, pet retail, veterinarians and, most importantly, pet owners. We now shift our focus to maximizing the commercial opportunity for Seresto globally, with a product returning to high single-digit growth in the U.S. in the first half of this year. Next, price continues to be strong, driven by the improved capabilities over the last year with 4% growth on a year-to-date basis. We now expect price growth of at least 3% for the full year. With the encouraging pipeline progression and our expectations regarding differentiation, we're increasing our investment in the U.S. Pet Health business. The commercial organization, led by Bobby Modi, in partnership with Tim Beddington, leading our market strategy efforts, are focused on building on our digital progress, adding experienced animal health marketing talent and accelerating our efforts to expand our field force. This investment is focused on maximizing the potential of our total pet health portfolio, including our launches this year and the innovation we expect to launch in 2024 as we globalize the portfolio over time. Finally, moving to Slide 7, I'll provide an update on our late-stage pipeline. Overall, the pipeline is strengthening with important progress in key late-stage programs and portfolio-enhancing approvals in major markets across species. Ellen de Brabander and her team are driving early-stage advancements, moving exciting projects from research into clinical development as we continue to build the components needed to deliver consistent, high-impact innovation. In the U.S., we launched our canine parvovirus monoclonal antibody, a highly anticipated treatment for one of the most contagious and deadly dog viruses. The supply chain is enabling responsiveness and the product is already saving dogs' lives, driving reorders. As expected, in 2023, demand is outpacing supply due to the anticipated capacity limitations in our facility at launch. We are on track to ramp up our capacity to 10x today's volume to support the expected increase in demand in the coming years. This year, we expect revenue contribution of $5 million to $7 million. However, we see this product as an important growth driver to both the top- and bottom-line starting in 2024 and expect blockbuster contribution as we expand outside the U.S. over time. As we've shared previously, we took a phased approach to filing our late-stage potential blockbusters. With three products in late-stage review, we appreciate the predictable nature of the FDA process, driven by ADUFA, the Animal Drug User Fee Act. Our views about our products are based on the data we've generated and, of course, are subject to the approval process. Today, we are proud to share that we believe the FDA has all the data necessary to approve our differentiated JAK inhibitor for canine dermatology. We are encouraged by this product's progress and believe it will be highly valued by veterinarians and pet owners. Additionally, by the end of August, we expect the FDA will have all the data necessary to approve our broad spectrum parasiticide for dogs, and for Bovaer, our methane-reducing product for cattle. Based on this, we continue to see a path towards FDA approval in the first half of 2024 for all three of these potential blockbuster products. With the developments in the parasiticide space, over the last month, our confidence regarding the expected differentiation for our canine broad spectrum parasiticide has increased. Our product, upon approval, will be known as Credelio Quattro. A combination of lotilaner and three other active ingredients, it will focus on fleas and ticks as well as broad coverage of internal parasites, including heartworm, round warm and tapeworm. The product is seeking to demonstrate 100% heartworm prevention after one month. We expect that differentiated coverage of Credelio Quattro and the differentiation of our JAK inhibitor for dermatology, this will allow Elanco to provide a more comprehensive and valuable portfolio of canine products to veterinary clinics in 2024. Shifting to Bovaer, our first-in-class innovation to enable methane reduction in cattle where we will focus our initial efforts first on dairy. Based on the wide body of research supporting the product's approval in many countries around the world and our discussions with the FDA, we're highly confident in the path to approval for this product in the first half of 2024. Importantly, we believe we have secured necessary launch supply with a contract manufacturer, a key component of the 2024 growth contribution. As we pioneer new ground with products to reduce environmental impact, we are working across the value chain to validate, aggregate and create value for reducing livestocks' environmental impact and we are encouraged by the interest from the food chain. Regarding our IL-31 short-acting monoclonal antibody for canine dermatology, we now expect a differentiated product profile relative to the current technology. However, our expectation for U.S. approval has shifted to 2025 as a result of the USDA's increased data requirements across monoclonal antibody platforms. We remain confident in the product and its value in our overall portfolio. Our innovation sales for 2023 continue to track to our guidance of $210 million to $250 million, and we still expect to have incremental innovation revenue of $600 million to $700 million by 2025. The shift of IL-31 is balanced by increased expectations for our other late-stage potential blockbuster products as well as confidence in our views on Experior, Parvo and Adtap. Over the last several months, our launch revenue expectations for our late-stage potential blockbusters have increased as a result of higher confidence in our differentiation, enhanced launch plans and the evolving competitive landscape. We understand delivering on our opportunities and our pipeline go well beyond getting the product over the regulatory finish line, and we are investing in talent and capabilities to fully capture the value of our portfolio in 2023 and beyond. Now I'll pass it to Todd to provide more on the second quarter results and financial guidance.

Thank you, Jeff, and good morning, everyone. Today, I'll focus my comments on our second quarter 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 9. In the second quarter, we delivered $1.057 billion of revenue, a decline of 10% or 9% in constant currency. Price contributed 4% in the quarter. In April, we completed our global systems integration, bringing the legacy Bayer Animal Health business into the Elanco ERP environment. We remain confident in our May estimate, which includes a revenue shift between quarters from the ERP blackout estimated in the range of $90 million to $110 million, representing an 8 percentage point to 9 percentage point detriment to growth in the second quarter. Outside of this, the base business performed above our expectations in the second quarter with an estimated flat to 1% revenue decline in constant currency compared to prior year, as shown on Slide 10. This represents a trajectory change from mid-single-digit constant currency decline we reported in the last few quarters. Consistent with last quarter, on Slide 11, we provide our revenue results by business area on a reported and constant currency basis. For Pet Health, constant currency decline was 14%, with an estimated headwind of 11 percentage points to 13 percentage points from the ERP blackout. In the U.S., Pet Health revenue declined 9%, including an estimated 11 percentage point headwind from the ERP blackout. The estimated 2% growth in the underlying business was driven by OTC retail, as our strategic efforts drove improved dispensing while also benefiting from price, innovation and supply disruption in the second quarter of 2022. This year, we increased our participation in retailer promotion events with key e-commerce partners, resulting in increased purchasing in the second quarter. Relative to our guidance in May, we estimate approximately $10 million of OTC products were sold to retailers in the second quarter versus our expectation for the third quarter. Additionally, we saw growth in our pain portfolio in vaccines despite supply disruptions on certain vaccines. Growth was partially offset by continued pressure on our legacy prescription parasiticide portfolio; however, share loss has slowed over the last several quarters. International Pet Health declined 23% in constant currency, with an estimated headwind of 14 percentage points from the ERP blackout. Excluding the blackout impact, the underlying business decline was driven primarily by our Spain retail business. Exceptionally strong demand expectations and purchasing from distributors and retailers in the first half of 2022 was followed by [pressured] (ph) economic conditions. As a result, demand did not materialize in the second half of 2022 and remain below expectations in the first half of 2023, resulting in a year-over-year decline in both periods for our business. In 2023, this impacted our business in the first quarter, but was more significant in the second quarter. We believe continued improvement in consumer demand will drive sales improvements in the second half of 2023 and the first half of 2024. Moving to Farm Animal. Our global business declined 3% with an estimated 5% headwind from the ERP blackout. Excluding that, the underlying business growth was driven by strength across international poultry and aqua, partially offset by expected declines in U.S. cattle related to vaccine supply disruption and regulatory changes for implant. Supply disruption for cattle vaccines is expected to be remediated in the third quarter, providing a tailwind in the second half, but to a lesser extent than we expected in our call in May. Continuing down the income statement on Slide 12. Gross margin increased 10 basis points to 58.9%. Gross margin included 150 basis points to 180 basis points of unfavorability from the ERP blackout. The underlying improvement was driven by price growth, productivity and the favorable impact of FX on cost of sales, offset by higher inflation. Operating expense increased 2% year-over-year in the quarter, with R&D expenses down 1% to $81 million and SG&A expenses up 3%, driven by increased marketing investment and employee-related expenses, partially offset by the favorable impact of foreign exchange rates. Interest expense was $74 million compared to $50 million last year, slightly better than our expectations. Adjusted EBITDA was $222 million in the quarter or a decline of 27% with an estimated $70 million to $90 million headwind from the ERP blackout. Adjusted EBITDA margin was 21%, a decline of 490 basis points with an estimated 450 basis point to 540 basis point reduction from the blackout. Adjusted EPS was $0.18 in the quarter, with an estimated $0.11 to $0.14 headwind from the ERP blackout, assuming a corporate consolidated tax rate in line with the first quarter of 21.9%. On Slide 13, we provide a walk from our second quarter guidance to actuals. The over performance compared to guidance for adjusted EBITDA and adjusted EPS in the quarter was driven by higher-than-expected sales and our higher margin U.S. Pet Health business. Additionally, the adjusted EBITDA benefit of $61 million compared to the top end of the guidance range, included favorable impacts on COGS and lower operating expense. The adjusted EPS benefit of $0.13 was also impacted by $0.03 of favorability from interest and tax. Before moving to guidance, let me offer a few words on our cash, working capital and debt on Slide 14. Cash provided by operations was $61 million in the quarter. The year-over-year decline in the second quarter operating cash flow reflects the impact of last year's interest rate swap settlement, higher cash interest and an increase in net working capital, specifically from inventory. Inventory was the use of cash again this quarter, driven primarily by increased Farm Animal inventory, largely as a result of pressure on sales volumes over the last several quarters. We are very focused on actions to improve working capital. The system integration enables opportunities to streamline collections across our entire business, improving accounts receivable, and we are improving inventory management by reducing distribution centers. We are taking further actions to manage our inventory, including renegotiating the timing of delivery on API and raw material contracts, assessing safety stock levels by product and ongoing reduction of throughput at certain manufacturing facilities. These efforts are expected to deliver benefits to the balance sheet gradually over time as we implement changes while also prioritizing new product launch supply needs. We ended the quarter with net debt of $5.75 billion, with $250 million drawn on our $750 million revolver. Today, we will retire the $344 million of notes due in 2023 as we reported on our Form 8-K from early July. We will fund the retirement with a $250 million asset securitization facility on accounts receivable and approximately $100 million from the revolving credit facility. As Jeff mentioned, the consolidation of our ERP system provided us the flexibility to enter into the securitization agreement. At the end of June, our net leverage ratio was 5.9x, up from 5.4x at the end of the first quarter, but below our expectations due to our adjusted EBITDA outperformance in the second quarter. Given the increased use of cash for inventory above our expectations in the second quarter, we now expect to pay down $50 million of debt in 2023. We anticipate our year-end net leverage ratio will be between 5.5x and 5.8x. Importantly, we continue to expect durable cash flows from our business over time with debt paydown as the primary capital allocation priority. The next significant debt obligation is due in 2027. We have updated Slide 23 to reflect our key debt information after the retirement of the 2023 notes. In May, we fixed an additional $750 million of variable rate debt with interest rate swaps that mature in 2028. As a result of these two financing transactions, our fixed rate debt will remain approximately 75% of total debt through the end of this year. After including the late July rate hike by the Federal Reserve, if we assume flat interest rates throughout 2024, no more Fed rate adjustments, we expect next year to have income statement interest expense of approximately $305 million to $315 million and cash interest between $340 million and $355 million or a $40 million to $55 million improvement compared to this year on cash interest. Finally, we have also included Slide 24 in the appendix which points to our expected meaningful reduction in project cash costs beginning in 2024. Now let's move to our financial guidance, starting on Slide 16. As Jeff said, we are raising our full year guidance for revenue, adjusted EBITDA and adjusted EPS. For the full year, we now expect revenue to be between $4.35 billion and $4.41 billion or approximately 1% growth to a 1% decline in constant currency. For adjusted EBITDA, we now expect $950 million to $1.01 billion. Adjusted EBITDA reflects the improved sales outlook and the second quarter overperformance. It also factors in gross margin headwinds we expect from reducing manufacturing throughput to reduce inventory and improve cash and the investment in our pet health business that Jeff described. For adjusted EPS, we are raising our guidance to $0.80 to $0.89, reflecting the adjusted EBITDA impacts and improved assumptions for interest expense and tax. On Slide 17, we are introducing financial guidance for the third quarter. We expect revenue of $1.025 billion to $1.06 billion, representing a constant currency growth range of 1% decline to 2% growth. We expect adjusted EBITDA between $170 million and $200 million, and adjusted EPS of $0.08 to $0.13. Finally, moving to Slide 18. Our implied second half revenue guidance represents flat to 3% constant currency growth. We remain confident in the second half return to growth, led by contributions from price, new product ramps, improved supply for vaccines and continued growth in poultry and aqua, offsetting continued pockets of competition. Now I'll hand it back to Jeff for closing comments.

Thanks, Todd. As we close, I want to thank the global Elanco team. This team around the world is laser-focused on delivering value for our customers and shareholders, and our results this quarter reflect significant progress. We delivered a strong second quarter, demonstrating operational improvement, exceeding our expectations and contributing to our raised full year guidance. The continued sequential improvement in year-over-year underlying revenue performance was driven by a return to growth in the U.S. Pet Health business, strong International Farm Animal performance and contribution from the new products. We expect this momentum to continue with an anticipated return to revenue growth for the company in the second half of 2023. Importantly, we've reached the pivot point with our standup and integration now behind us and an optimized infrastructure to build our next era of innovation and growth. Our team is making strong progress on our efforts to transform animal care, bringing new solutions to some of our customers' greatest challenges from diabetes and cats to deadly parvovirus and puppies to environmental solutions in cattle. This quarter, we made significant pipeline progress on our late-stage pipeline, enhancing our confidence in our differentiation and launch revenue expectations. We are very encouraged by this advancement and are investing to maximize the potential of our full portfolio and the expected launches. Our focus is on consistent delivery and sustained innovation with a balanced outlook for future growth, improved cash flow and long-term value generation. With that, I'll turn it over to Katy to moderate the Q&A.

Thanks, Jeff. We'd like to take questions from as many callers as possible. So we ask that you limit yourself to one question and one follow-up. Operator, please provide the instructions for the Q&A session, and then we'll take the first caller.

[Operator Instructions] Your first question comes from the line of Mike Ryskin from Bank of America. Your line is open.

Great. Thanks for taking the question, guys. My first one is going to focus on the innovation side of things. There were a number of times you flagged that you have all necessary data for approval with the FDA. So that's the case for the JAK inhibitor now, and then you expect that to be the case for Credelio Quattro and Bovaer by the end of August. Could you just walk us through what comes after that? What are the additional steps? Obviously, that's in the hands of the FDA at that point, but it is a four- to four-month window from all data with the FDA to approval, assuming things go correctly, and there's no secondary data request. Does four or six months the right way to think about that timeframe?

Yes, Mike, thank you. Thanks for the question. That is correct. So what we were doing here is to just be very clear is whether it's dialogue with the FDA or the submission itself, we're confident that they have the information they need. As you know, when the ADUFA process, these products are subject to approval, but that is correct. And I think we disclosed some additional information today that really reiterates and builds our confidence more than even a quarter ago, relative to that $600 million to $700 million commitment that we have. And I just really want to emphasize that, the $210 million to $250 million of innovation led by Adtab, the Experior success, the parvo success, that will be our base, and then the additional information that we shared on Credelio Quattro, our broad spectrum parasiticide, the Bovaer as well as -- those two submissions as well as the JAK1 inhibitor. So that is correct. When you follow the ADUFA process, which is predictable, you are going to see that, that's in that window of four to six months, which put us on the path for the first half of 2024.

Great. Thanks. And kind of related to that, one for Todd. As you called out, you beat the 2Q EBITDA by a little over $60 million, but you're raising the full year by only about $10 million. So, you talked about the moving pieces in the second half, a little bit on gross margin, but you also flagged additional investments in Pet Health. Could you talk through what that -- what those investments are? And is that the biggest part of the incremental spend in the second half? Just clarify that second half EBITDA bridge for us a little bit. Thanks.

Sure, Mike. Thank you for the question. Yes, we're very pleased with how the team executed across the second quarter. We always take a balanced approach in looking at our business and have a lot of things breaking our way this past quarter to deliver that significant EBITDA beat. As we then look to the second half, we're focused on continuing to build and create value for the long term. As Jeff just mentioned, the innovation that's coming is critical to that long-term success and continued increased EBITDA growth we expect to have. To that end, we're investing about $10 million incrementally on sales force expansion for our U.S. Pet Health team to drive both the complete portfolio, but also the new innovation. Embedded in that is also increasing global marketing expertise with Tim Beddington and his team that we're building underneath Tim to be ready to globalize these products to build them out in international markets over time as well. So that's one part of the EBITDA bridge for the second quarter. The other element is about $20 million relates to slowing down our manufacturing plants. Q2 was a really good quarter across the board, except for one thing, and that was increasing inventory, more than we expected on our own balance sheet. A lot of that relates to API purchases for products especially on the Farm Animal business that we have to make decisions on kind of 18 to 24 months in advance given the disruption to the supply chain from COVID. So, a lot of that product is still coming in the door, but we're addressing it. We're slowing down plant output. That's putting pressure on gross margin as well to about $20 million. And then there's some other timing elements and mix shifts that are always going on in our business that are also impacting that bridge. But net-net, strong quarter, really strong quarter by U.S. OTC business. And as a reminder, the seasonality of our business makes that predominantly a first half business, and so that also affects where our beat could come from. So again, very pleased with the execution by the team across the year, which is allowing us to raise full year guidance on sales, adjusted EBITDA and adjusted EPS.

Thanks, Mike. We'll take the next caller.

Your next question comes from the line of Chris Schott from JPMorgan. Your line is open.

Great. Thanks so much for the questions and color on the pipeline updates here. I guess the first question for me is maybe just extending that discussion on SG&A and not looking for formal guidance here, but just as we think about next year, how much incremental investment do we need to think about now that you have additional clarity on some of these assets and the profiles in the market? I guess on one hand, it's, I guess, the balance between investing properly behind these and then similarly kind of managing kind of earnings progression. Could you just help a little bit about how do we think about those? And then the second question I had was just on the pipeline. I think you talked about Credelio Quattro and the profile of there. Is there anything you can provide on the JAK inhibitor? I see in the slides that mentions differentiation, but just any color on what that profile could look like and how that fits in the market? Thanks so much.

Sure, Chris. With respect to next year's investments, certainly, we're starting to ramp that up this year as we expand the sales force and add to the marketing. Overall, we're continuing to make sure that we launch these products really well. They will be the growth driver for Elanco in the years to come. And so, we're going to make sure to not short those. We've got a broad business. We've got a lot of things in motion. As we've talked the ERP completion does provide incremental synergies next year across our portfolio that we continue to capture in about $20 million range, in addition then to investments we'll need to make for these products to launch them well. So not giving guidance today, but certainly understand the importance of driving a launch as these products come to market. And then, Jeff, on the...

Yes, Chris, thank you for the question. I'd just say and emphasize, I think Ellen and her team this quarter represents just the level of discipline, I think the level of quality, the quality of the submissions, the engagement with the regulatory bodies. And I would say the engagement, the capacity has probably never been higher any time I've seen in the Elanco R&D. As you look specifically to JAK, again, going into this $1 billion plus term market, we've not put any more light on the differentiation. As I've said in the past, safety, efficacy, convenience will be important. I think the noted significant differentiation we see on the para side having this differentiated coverage it really allows us, as we start to think about approaching vet clinics, being able to have a very broad pain portfolio, a differentiated para and very broad para and now coming with this JAK, that will be another factor to Todd's point, on our level of confidence, the increasing of that confidence in the last quarter, the level of differentiation, candidly, the level of current innovation with even parvo has led us to say we're going to lean in and make some of these investments. So -- but no more additional color at this time on the JAK other than to say it is differentiated. We believe the FDA already has what they need and we're tracking nicely for a first half -- a path to a first half approval for '24.

Thank you.

Great. Thanks. We'll take the next caller please.

Your next question comes from the line of Umer Raffat from Evercore ISI. Your line is open.

Hi, guys. Thanks for taking my questions. Maybe a couple, if I may. First, I saw you raised the overall guidance, but the low end of your net leverage expectation is now 5.5x versus 5.3x previously. And I was trying to understand why that would be. And I'm talking about the year-end net leverage expectation. Secondly, on the securitization facility, I noticed your collateral for that includes cash and investments and inventory, and it also proceeds to say all other personal fixture property or assets of the borrower. And I'm trying to understand, is that typical?

Yes, Umer, with respect to the leverage, we did increase, but as we called out, we're expecting to pay down less gross net debt this year than we had previously had. But again, I feel confident that the management of the inventory that we're getting into as well as the continued underlying growth in the business as we return to revenue growth in the second half will make that improve over time. And then, A/R facility is a very standard secured facility. This was really enabled by our ERP integration with having all of the receivables in one system, that allows us to execute this typical facility that's got the lowest cost of variable rate financing for us at SOFR plus 125 basis points inside our credit revolver. So, something we've been looking at for years but just couldn't execute until we had the implementation done, but very standard facility.

Thank you.

Thanks. We'll take the next caller please.

Your next question comes from the line of Jon Block from Stifel. Your line is open.

Thanks, guys. Good morning. I'll ask both at the front. Todd, the 1H to 2H '23 EBITDA cadence seems largely in line with the '22 cadence, but I believe the revenue seems a little bit more back-end weighted in '23 relative to '22. So, maybe if you could just explain the confidence in that slightly greater percent of sales for 2H '23 relative to what you experienced last year? A quick sidebar question to that is the $21 million add back in EBITDA this quarter, do I have that right that, that aided EBITDA? It seems like $15 million of that might have been unwinding an accrual on Seresto. And that there was a natural segue there. The second part of the question would just be, Jeff, Seresto resolution is finally there. That's great. Just would love you taking a step back and getting your thoughts about the long-term growth rate of that product going forward. Thanks, guys.

Thanks, John, for your question. No, I would say there's nothing different on the revenue cadence other than second half of last year was not a strong second half for Elanco and that factors in. With respect to the Seresto settlement on the multi-district litigation we had, we're in the process of finalizing that, but enough there to do the accrual. That is not in our adjusted EBITDA results, that's in the OID part of the adjustments that you can see in the back of our press release as we walk from GAAP to our adjusted results. Jeff?

Yes. Thanks, John, for the question. We had a really great first quarter and second quarter, first half on pet retail, and I think it links to the Seresto question. We're very happy with the outcome. We, as I mentioned, believe that it's a science-based decision. It reaffirms the long-term registration of the product and raising the bar on the overall category of collars. As we look at retail, we -- you saw the return to growth, high-single digits for Seresto in the quarter. I think as you look forward, here are some of the things that we mentioned on the last quarter that really played out: the increased physical availability; the bringing in innovation with it, so the Advantage brands that we've launched inside of those; price; and share of voice. Just call out a couple of things, and I think just because our retail capability grows, our share has grown. It's been a very strong market, with really less trade down and actually a strong market. A couple of things. We put a very aggressive and probably most comprehensive campaign we've ever done with Seresto. We've seen a 50% increase in a kind of click rate on that campaign. And then the total distribution points back to physical availability were up 14% for the first half. So these are the factors. I believe our team is kind of as experienced as anyone in the industry. Our share is growing. So, when I look at Seresto long term, we're well positioned, but it's going to be these four factors that matter: price, innovation, physical availability and share of voice. We're not giving guidance today, but we see the stability and return to growth is a positive thing long term, not just in the U.S., but globally.

Great. We'll take the next question, please.

Your next question comes from the line of Nathan Rich from Goldman Sachs. Your line is open.

Great. Good morning. Thanks for the questions. Todd, I guess, first, I wanted to go back to the commentary on gross margin and the $20 million impact from reduced throughput in the manufacturing facilities. Can you talk about how that plays through to 2024? And do you see kind of that normalizing next year so that there wouldn't be the type of gross margin drag? And does it have any implications for your free cash flow expectations next year? And then, I wanted to, as a second question, ask on the IL-31. I think you added the commentary around it's now kind of a differentiated product versus what's on the market. Are there any details that you can give us there? And in terms of the timing of approval, can you maybe talk about what additional data requirements you got from the USDA that led to the shift in approval?

Yes, Todd?

Thanks, Nate. With respect to your first question, the way the team sees it today, we've got a number of different items across our manufacturing footprint that we continue to work on to improve gross margins. You would have seen it here in the second quarter that we had a very strong gross margin quarter, well north of 60% once you add back the impact from the ERP integration. So you get into improved price. That continues to be a big driver of gross margin improvement. We've got productivity continuing. Inflation in certain areas is starting to stabilize, especially on the shipping side. Then, with respect to plants, yes, it does have an impact on the second half of this year. It will have an impact into next year. But overall, we continue to feel good about the momentum, especially with U.S. Pet Health doing better as that is our highest margin area of the company.

Nate, relative to the IL-31, yes, we're excited to announce that research has confirmed differentiation of the product. So this now confirms that all of our late-stage pet assets are differentiated and that leads to the investment and our belief that we have an opportunity to take more share as we go into the market, which leads to the investments. Relative to the change in -- and I'm not going to get into the differentiation at this time, but it would fall in the categories that I've mentioned before. I think the shift in expectations, again, I won't get into the great detail, but again, this is a USDA, not an FDA product. I think that's important. So, it doesn't fall under an ADUFA, which is maybe a process that's very well defined on the FDA side. But this is a shift of expectation that was really driven by the USDA's increased data requirements across the monoclonal antibody platforms here in the U.S. And again, I won't get into great detail. Those increased requirements, I will say, though, are related to more of the magnitude of the data. And it doesn't really, we believe, oppose any technical risk, only a time line shift.

Great. We'll take the next question.

Your next question comes from the line of Brandon Vazquez from William Blair. Your line is open.

Hi, everyone. Thanks for taking the question. I wanted to kind of focus a little bit on the progression of margins and sales, especially as we're kind of updating our models for '24 and maybe ask a slightly different question. But maybe you can talk a little bit about when you have some of these new product launches in the first half of '24, what are your expectations maybe around controlled launch periods? Is that -- should we be factoring in a little bit of a period where you ramp sales more so than normal? And then, on the other side of that, how does the manufacturing side look? When can they start to be kind of margin accretive?

Thanks, Brandon. As you well aware, we're not going to give guidance today. But we'll again, talk about same information we've provided last quarter, with respect to approval to launch, usually, it's about two to four months, post approval, before we get the launch, as labels get finalized, in those sorts of elements. With respect to margin, again, we feel very good about the margin prospects in all of these products over time. But clearly, as you ramp sales and get to higher levels, we get better economies of scale on those. With the Credelio Quattro as well as the JAK inhibitor, we expect those to be higher margins at the start. With respect to Bovaer, given that significant pull forward of approval versus when we acquired it, it means we're going to have third-party contract manufacturing supply that will be at a higher margin and thus less accretive to our overall portfolio than the Pet Health products. But overall, we're looking forward to getting these approved, getting them launched and they'll be the big drivers over the next few years to increase margins, increase free cash flow and drive EBITDA higher.

Great. Thank you. And then one other question just on the international side. I think you mentioned some pockets of international weakness in some countries. Can you just give an update on the macro backdrop internationally? And where there might be any pockets of weakness or strength? Thanks.

Yes. I think on the strength side, our global poultry and aqua franchises continue to do well. China, as we've said, is meeting our expectation, but more of a U-shaped recovery, not a V. So, we're keeping our eyes on consumer confidence on the pet side. And swine prices still remain just a little below breakeven. We're seeing mid-single-digit growth in China tracking to our expectations. I think there's a little bit of a slower pet market in Japan and Australia. I mean, those would be a little bit of a few pockets of softness. But again, I've traveled to Asia, Latin America this year or this past quarter, and I would say, again, the resiliency of the pet market continues to hold. The strength of global poultry and aqua continue to hold very well. So, our portfolio is faring very well, which has driven the 4% growth in Farm Animal International.

Great. We'll take the next question.

Your next question comes from the line of Balaji Prasad from Barclays. Your line is open.

Good morning, everyone. This is [Mikaela] (ph) on for Balaji. Thanks for taking our questions. Jeff, could you provide a bit more detail around how you're thinking about Credelio Quattro [when compared to] (ph) Experior and NexGard Plus? And just really any further details on how it is going to be a differentiator? Thanks.

Yes. Thank you for the question. Yes, very much so. So look, I think a lot has happened over the last few months in the parasiticide business. Again, the largest market globally, over $5 billion. And I would just say, look at Credelio Quattro, it's the next evolution in our Credelio franchise, with building off from Credelio Dog, Credelio Cat, Credelio Plus, which is really our broad spectrum outside of the U.S. doing very well and very competitive. This will be, I believe, the first product in canine with four active ingredients and the differentiated coverage I just would want to emphasize is fleas and ticks, but also heartworm, round warm and tape warm. Additionally, that would be new information here on this call. And then I think if approved, we are focused on 100% heartworm prevention after one month. I think that's important, and active during that first month, and I think that would be additional. Again, all of these, this is relative to products. It's still under subject to approval. But again, we believe differentiated coverage will be key. It will play with a broad parasiticide portfolio that we have, and it will be also kind of in sequence with a derm portfolio that will be coming as well, which we believe will be a factor in our adoption rates and our competitiveness as we enter into the market in 2024.

Great. Thanks. We'll take the next caller.

And your next question comes from the line of David Westenberg from Piper Sandler. Your line is open.

Hi. Thank you for taking the question and great job executing this quarter. Can you talk about some of the assumptions on the -- pretty fast growth assumptions for parvo, whether it be maybe a prophylactic indication, maybe what outside the U.S. might look like in that indication? Just any kind of color on what you -- why you think that could be a blockbuster or the assumptions needed? And then, just I'll ask the second question upfront. I think you highlighted, if I [misunderheard] (ph) some new marketing strategies with Seresto and Advantage, just give a little bit more color on to what those are? Thank you very much.

Yes, thank you for the questions. On parvo, we're off to a great start, as we mentioned, launching the product in July, early reports and some amazing stories. Again, the product is working extremely well. The supply chain is solidified, being able to move a frozen product, and that's going well. So again, our first monoclonal antibody, I would focus first and foremost on our U.S. market. So, 330,000 cases we are seeing on an annual basis, that doesn't include shelters. We're building a market here while we're doing this. And early efficacy is really important, and we're seeing that. We're seeing quicker treatments. So, if you think about the value proposition of this product, what you're seeing is a quicker response rate to recovery and a higher rate. At this point in time, every dog that's been treated, to our knowledge, the puppies have survived. But what may take four to five days in a vet clinic and a very burdensome treatment regime, this can be 24 to 48 hours and a much higher success rate. I think the other thing for us is we're seeing a carryover with parvo, more access to more clinics, because all clinics want to talk about and have the ability to have this product. So that's also fared well. So, our focus right now is on the U.S. Our focus is on increasing manufacturing capacity 10x. We're expecting $5 million to $7 million of sales this year, but a very big step-up in manufacturing capacity as we go into 2024, and that will help us as we head forward. And then, yes, global approvals give us a path to a blockbuster product. Back on the retail side, again, I come back to just these four pillars we're focused on, led by fiscal availability is just we're in more stores on more shelves both Seresto, Advantage, leveraging those brands and also at more price points. So when we introduced the new Advantage brands at more price points. So price is another factor. Increasing share of voice, more campaigns, more targeted digital with those campaigns as another factor. And then bringing innovation. We've got Ellen and Bobby, they've got a whole arm of innovation and links to that. So as a whole, we've increased our share this quarter on retail, and we continue to see this as a significant driver. And as we launch Adtab over in Europe, the same thing applies as well to the international markets. So, excited about that.

Great. I believe that was our last caller question. So Jeff, would you like to close this?

Yes. So thank you for your interest. Again, another quarter, we believe, of proof and progress on our strategy, delivering above our expectations, raising the guidance for the full year. We see our company returning to growth in the second half of this year and heading into the next era of significant innovation and growth, starting with the innovation that's approved, that is ramping as we move forward today. Again, we are more capable today than we've ever been with our ERP stand-up complete, Seresto behind us, and now our focus is on delivering today while preparing also for these historical innovations that are coming in as we head into 2024. Thanks for your interest. We look forward to engaging with you throughout the quarter.