Elanco Animal Health (ELAN) 10-Q2023 Q2 Quarterly report

PART I

Note 1. Basis of Presentation and Summary of Significant Accounting Policies

In our opinion, the financial statements reflect all adjustments (including those that are normal and recurring) that are necessary for fair presentation of the results of operations for the periods shown. In preparing financial statements in conformity with GAAP, we must make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures at the date of the financial statements and during the reporting period. Actual results could differ from those estimates. Certain reclassifications of prior year information have been made to conform to the current year's presentation.

The following table provides a brief description of an accounting standard that was recently adopted:

Note 3. Revenue

We recognize revenue primarily from product sales to customers. Revenue from sales of products is recognized at the point where the customer obtains control of the goods and we satisfy our performance obligations, which is generally once the goods have been shipped and the customer has assumed title. For contract manufacturing organization (CMO) arrangements, we recognize revenue over time or at a point in time depending on our evaluation of when the customer obtains control of the promised goods or services.

We have a single customer that accounted for approximately 9% and 10% of revenue for the six months ended June 30, 2023 and 2022, respectively. Product sales with this customer resulted in accounts receivable of $84 million and $73 million as of June 30, 2023 and December 31, 2022, respectively.

Provisions for sales rebates and discounts are established in the same period the related sales are recognized and are based on specific agreements. Sales rebates and discounts are recorded as a reduction to revenue. In determining the appropriate accrual amount, we consider our historical experience with similar incentive programs, current sales data and estimates of inventory levels at our channel distributors. The following table summarizes the activity in our global sales rebates and discounts liability:

The following table summarizes our revenue disaggregated by product category:

Note 4. Acquisitions, Divestitures and Other Arrangements

On January 3, 2023, we acquired certain U.S. marketed products, pipeline products, inventory and an assembled workforce from NutriQuest, LLC (NutriQuest). NutriQuest is a provider of swine, poultry and cattle nutritional health products to animal producers. The acquisition allows us to expand our existing nutritional health offerings and furthers our efforts to explore innovative antibiotic alternatives.

The composition of the purchase price was as follows:

The NutriQuest acquisition was accounted for as a business combination under the acquisition method of accounting. The acquisition method requires, among other things, that assets acquired and liabilities assumed in a business combination be recognized at their fair values as of the acquisition date. The determination of estimated fair value requires management to make significant estimates and assumptions. The excess of the purchase price over the fair value of the acquired assets has been recorded as goodwill. Contingent consideration includes up to $85 million of cash consideration payable if specific development, sales and geographic expansion milestones are achieved, as outlined in the asset purchase agreement. The initial fair value assessment of this contingent consideration liability of $37 million was estimated as of the acquisition date using a Monte Carlo simulation model, which represented a Level 3 measurement under the fair value measurement hierarchy (see Note 10. Fair Value for further information).

The following table summarizes the preliminary amounts recognized for assets acquired as of the acquisition date:

Other intangible assets consist of customer relationships and trade names. The acquired definite-lived intangible assets are being amortized over a weighted-average estimated useful life of approximately 12 years on a straight-line basis. The estimated fair values of identifiable intangible assets were determined using the income approach, which is a valuation technique that provides an estimate of the fair value of an asset based on market participant expectations of the cash flows an asset would generate over its remaining useful life. Some of the significant assumptions inherent in the development of these asset valuations include the estimated net cash flows for each year for each asset or product (including revenues, cost of sales, R&D expenses, marketing, selling and administrative expenses and contributory asset charges), the appropriate discount rate necessary to measure the risk inherent in each future cash flow stream, the life cycle of each asset, the potential regulatory and commercial success risk and competitive trends impacting the asset and each cash flow stream, as well as other factors.

The accounting for this acquisition has not been finalized as of June 30, 2023. The purchase price allocation is preliminary and subject to change, including the valuation of the contingent consideration and intangible assets. The final determination of these amounts will be completed as soon as possible but no later than one year from the acquisition date. Revenue attributable to the NutriQuest acquisition for the six months ended June 30, 2023, was approximately $9 million.

On August 1, 2023, we acquired certain assets including inventory and distribution rights for certain marketed products from NutriQuest Nutricao Animal Ltda (NutriQuest Brazil). As of the closing date, we paid cash consideration of approximately $3 million, with future payments required through 2026 of up to $19 million, pursuant to the terms and conditions set forth in the asset purchase agreement. The accounting for this acquisition was incomplete at the time the condensed consolidated financial statements were issued; however, we anticipate this transaction will be accounted for as a business combination under the acquisition method of accounting.

In April 2022, we signed an agreement to transfer assets associated with our microbiome R&D platform to a newly created, independent biopharmaceutical company, BiomEdit, focused on developing solutions for animal and human health. As part of the agreement, we retained a non-voting, minority stake in the company. In addition, we entered into transitional services agreements with the company for certain services. Assets transferred included

intellectual property and laboratory equipment. The book values of those assets were not material. We recorded a gain on disposal of the assets of approximately $3 million during the year ended December 31, 2022.

During 2021, as part of our strategy to optimize our manufacturing footprint, we announced an agreement with TriRx Pharmaceuticals (TriRx) to sell our manufacturing sites in Shawnee, Kansas (Shawnee) and Speke, U.K. (Speke), including the transfer of approximately 600 employees. In connection with these arrangements, we also entered into long-term manufacturing and supply agreements, under which TriRx began manufacturing existing Elanco products at both sites upon the closing of the transactions. On August 1, 2021 and February 1, 2022, we completed the sales of our Shawnee and Speke sites, respectively. Upon closing the sale of the Speke site, we recorded a contract asset of $55 million for the favorable supply agreement, which was included in prepaid expenses and other and other noncurrent assets on our condensed consolidated balance sheets.

Based on the terms of the agreements and cash proceeds received to date, as of June 30, 2023, we had a net receivable balance from TriRx of $71 million from the sales of Shawnee and Speke, of which $65 million was included within other receivables on the condensed consolidated balance sheets, with the remainder included in other noncurrent assets. In May 2023, we entered into amendments to the agreements which effectively restructured the payment schedule related to the remaining amount owed. Under the terms of the amendments, we expect to receive the $65 million current portion of this receivable balance upon the earlier of the date on which certain conditions are met or in equal installments over a twelve-month period beginning January 31, 2024. At this time, we believe amounts owed by TriRx are collectible and we will continue to assess collectibility. Further, we have rights to certain collateral in the event of a default and we continue to monitor the value of this collateral.

Note 5. Asset Impairment, Restructuring and Other Special Charges

Components of asset impairment, restructuring and other special charges were as follows:

These reserves were included within other current liabilities and other noncurrent liabilities on our condensed consolidated balance sheets based on the timing of when the obligations are expected to be paid, which can vary due to certain country-specific negotiations and regulations.

Note 6. Inventories

Inventories are stated at the lower of cost and net realizable value. We use the last-in, first-out (LIFO) method for a portion of our inventories located in the continental U.S. Other inventories are valued by the first-in, first-out (FIFO) method or the weighted average cost method.

Inventories consisted of the following:

Note 7. Equity

In January 2020, we issued 11 million in TEUs at the stated amount of $50 per unit. Total proceeds, net of issuance costs, were $528 million. The gross proceeds and deferred finance costs from the issuance of the TEUs were allocated 86% to equity (prepaid stock purchase contracts) and 14% to debt (TEU amortizing notes) based on the relative fair value of the respective components of each TEU. The TEU prepaid stock purchase contracts were converted into shares of our common stock on February 1, 2023. Holders of our TEUs received 1.5625 shares of our common stock based on the maximum settlement rate for the applicable market value being below $32.00. In total, we issued approximately 17 million shares to holders in connection with the settlement.

Note 8. Debt

On August 3, 2023, we entered into a new $300 million secured term facility (the "Securitization Facility") that is secured and collateralized by our U.S. Net Eligible Receivables Balance (as defined within the applicable agreement). Of the maximum borrowing capacity under the Securitization Facility of $300 million, $250 million was drawn on August 3, 2023. The Securitization Facility will require monthly interest payments over its three-year term at a variable rate based on Term SOFR plus 125 basis points, and our borrowing capacity under the Securitization Facility will be subject to fluctuation over time based on the level of our borrowing base, which is correlated to our U.S. Net Eligible Receivables Balances. The full, outstanding balance of the Securitization Facility will be due on July 31, 2026. On August 7, 2023, we utilized the proceeds from the Securitization Facility, in addition to a $100 million draw on our Revolving Credit Facility on August 4, 2023, to redeem in full the 4.272% Senior Notes due 2023. As the 4.272% Senior Notes due 2023 have been refinanced with long-term financing, they are reflected within long-term debt on our condensed consolidated balance sheet as of June 30, 2023. The early redemption of the 4.272% Senior Notes due 2023 has satisfied all obligations and commitments thereunder.

Subsequent to the issuance of the Securitization Facility and the redemption of the 4.272% Senior Notes due 2023, as of the date of this filing, approximately 75% of our long-term indebtedness now bears interest at a fixed-rate (including variable-rate converted to fixed-rate through the use of interest rate swaps - see Note 9. Financial Instruments for further information).

We were in compliance with all of our debt covenants as of June 30, 2023, and remain in compliance subsequent to entering into the new Securitization Facility.

Note 9. Financial Instruments

To manage our exposure to market risks, such as changes in foreign currency exchange rates and interest rates, we have entered into various derivative transactions. We formally assess, designate and document, as a hedge of an underlying exposure, each qualifying derivative instrument that will be accounted for as an accounting hedge at inception. We also assess at least quarterly thereafter whether the financial instruments used in the hedging transaction are effective at offsetting changes in either the fair values or cash flows of the underlying exposures. Derivative cash flows, with the exception of net investment hedges, are principally classified in the operating activities section of the condensed consolidated statements of cash flows, consistent with the underlying hedged item. Cash flows related to net investment hedges are classified in the investing activities section of the condensed consolidated statements of cash flows. Further, we do not offset derivative assets and liabilities on the condensed consolidated balance sheets. Our outstanding positions are discussed below.

We may enter into foreign exchange forward or option contracts to reduce the effect of fluctuating currency exchange rates. Foreign currency derivatives used for hedging are put in place using the same or like currencies and duration as the underlying exposures and are recorded at fair value with the gain or loss recognized in other expense (income), net in the condensed consolidated statements of operations. Forward contracts generally have maturities not exceeding 12 months. As of June 30, 2023 and December 31, 2022, we had outstanding foreign exchange contracts with aggregate notional amounts of $988 million and $784 million, respectively.

The amount of net (losses) gains on derivative instruments not designated as hedging instruments, recorded in other expense (income), net were as follows:

To manage our exposure to variable interest rate risk, we utilize interest rate swap contracts to effectively convert our variable-rate debt into fixed-rate debt. We recognize any differences between the variable interest rate payments and the fixed interest rate settlements with the swap counterparties as an adjustment to interest expense, net of capitalized interest over the life of the swaps. We have designated our interest rate swaps as cash flow hedges and record them at fair value on the condensed consolidated balance sheets. Changes in the fair value of the hedges are recognized in other comprehensive income (loss). Fair value is estimated based on quoted market values of similar hedges and is classified as Level 2 in the fair value hierarchy (see Note 10. Fair Value for further information). Our outstanding forward-starting interest rate swaps had maturities ranging between 2023 and 2028, with aggregate notional amounts of $3,800 million and $3,050 million as of June 30, 2023 and December 31, 2022, respectively.

In March 2023, we entered into new interest rate swap agreements with a combined notional amount of $1,000 million, which will become effective on October 1, 2023, following the maturity of certain current swaps with the same combined notional amount. Additionally, on May 1, 2023, we entered into new interest rate swap agreements with a combined notional amount of $750 million, which became effective on June 1, 2023, and mature in August 2028. As of June 30, 2023, when factoring in the $3,800 million of variable rate debt converted to fixed-rate through the use of interest rate swaps, our weighted-average effective interest rate on our outstanding indebtedness was 6.28%.

The amounts of net gains (losses) on cash flow hedges recorded, net of tax in other comprehensive income (loss) were as follows:

During the three months ended June 30, 2023 and 2022, activity on cash flow hedges recorded in other comprehensive income (loss) included gains of $55 million and $33 million, net of tax, respectively, related to mark-to-market adjustments. During the six months ended June 30, 2023 and 2022, activity on cash flow hedges recorded in other comprehensive income (loss) included gains of $33 million and $142 million, net of tax, respectively, related to mark-to-market adjustments.

In April 2022 and September 2022, we settled certain existing interest rate swaps and simultaneously entered into new agreements with the same notional amount and covering the same tenor. As a result, we received cash settlements of $132 million and $75 million, respectively, the former of which was reflected in net cash from operating activities in the condensed consolidated statement of cash flows for the six months ended June 30, 2022.

During the three months ended June 30, 2023 and 2022, we reclassified $29 million and $1 million of net gains, respectively, into interest expense, net of capitalized interest. During the six months ended June 30, 2023 and 2022, we reclassified $59 million of net gains and $2 million of net losses, respectively, into interest expense, net of capitalized interest. Over the next 12 months, we expect to reclassify a gain of $108 million to interest expense, net of capitalized interest.

Note 10. Fair Value

We also had investments without readily determinable fair values and equity method investments, which were classified as other noncurrent assets on our condensed consolidated balance sheets totaling $27 million as of June 30, 2023 and December 31, 2022. These investments are not recorded at fair value on a recurring basis, and as such, are not included in the fair value table above.

Contingent consideration liabilities totaling $38 million as of June 30, 2023 related to our acquisition of certain assets of NutriQuest during the first quarter of 2023 (see Note 4. Acquisitions, Divestitures and Other Arrangements for further information). We may pay up to $85 million in cash consideration, which is contingent upon the achievement of specific development, sales and geographic expansion milestones as outlined in the asset purchase agreement. The fair values of the contingent consideration liabilities were estimated using the Monte Carlo

simulation model, consisting of Level 3 inputs not observable in the market, including estimates relating to revenue forecasts, discount rates and volatility.

Note 11. Income Taxes

For the three and six months ended June 30, 2023, we recognized income tax expense of $18 million and $23 million, respectively. Our effective tax rates of (23.0)% and 79.9%, respectively, differ from the statutory income tax rates due to the earnings mix of income in jurisdictions with statutory tax rates higher than the U.S. and losses in the U.S. and various foreign affiliates for which there was no tax benefit, as valuation allowances have been established in those jurisdictions.

For the three and six months ended June 30, 2022, we recognized an income tax benefit of $4 million and income tax expense of $20 million, respectively. Our effective tax rates of 28.6% and 32.3%, respectively, differ from the statutory income tax rate largely due to changes in the earnings mix between periods resulting in projected losses in the U.S. The U.S. federal and state losses were subject to valuation allowances. The income tax (benefit) expense was partially offset by a $17 million income tax benefit reclassified from accumulated other comprehensive loss due to the termination of interest rates swaps during the three months ended June 30, 2022.

We were included in Eli Lilly and Company's (Lilly) U.S. tax examinations by the Internal Revenue Service through the full separation date of March 11, 2019. Pursuant to the tax matters agreement we executed with Lilly in connection with our initial public offering (IPO), the potential liabilities or potential refunds attributable to pre-IPO periods in which Elanco was included in a Lilly consolidated or combined tax return remain with Lilly. The U.S. examination of tax years 2016 to 2018 began in 2019 and remains ongoing.

Note 12. Commitments and Contingencies

We are party to various legal actions that arise in the normal course of business. The most significant matters are described below. Loss contingency provisions are recorded when it is deemed probable that we will incur a loss and we can formulate a reasonable estimate of that loss.

For the litigation matters discussed below we either believe loss is not probable or are unable to estimate the possible loss or range of loss, if any. The process of resolving these matters is inherently uncertain and may develop over an extended period of time; therefore, at this time, the ultimate resolutions cannot be predicted. As of June 30, 2023 and December 31, 2022, we had no material liabilities established related to the litigation matters mentioned below.

On July 1, 2021, we received a subpoena from the SEC relating to our channel inventory and sales practices prior to mid-2020. We have cooperated in providing documents and information to the SEC and will continue to do so.

Management believes that its actions were appropriate. At this stage, we are unable to estimate the range of any potential loss associated with this matter.

As of June 30, 2023, we had a lease commitment that has not yet commenced for our new corporate headquarters in Indianapolis, Indiana. Total minimum lease payments are estimated to be approximately $378 million over a term of 25 years, excluding extensions. Final lease payments may vary depending on the actual cost of certain construction activities. Lease commencement is expected in 2025.

The land for our new corporate headquarters is located in a Tax Increment Finance District, and the project is, in part, funded through Tax Incremental Financing (TIF) through an incentive agreement between us and the City of Indianapolis. The agreement provides for an estimated total incentive of $64 million to be funded by the City of Indianapolis in connection with the future tax increment revenue generated from the developed property. In December 2021, as part of a funding and development agreement entered into between us and the developer, we made a commitment to use the expected TIF proceeds towards the cost of developing and constructing the headquarters. In exchange, the developer reimbursed us up to the $64 million commitment in 2021. During 2022, we refunded approximately $15 million of the TIF proceeds to the developer. As a result, it is our expectation that our future lease payments will be reduced. The remaining accrued incentive was included in other noncurrent liabilities on our condensed consolidated balance sheets and will be amortized over the lease term beginning on the commencement date and offset future rent expense.

Note 13. Earnings Per Share

We compute basic earnings (loss) per share by dividing net income (loss) available to common shareholders by the actual weighted average number of common shares outstanding for the reporting period. Elanco has variable common stock equivalents relating to certain equity awards in stock-based compensation arrangements. We also had variable common stock equivalents related to the TEU prepaid stock purchase contracts during the three and six months ended June 30, 2022, and in the first quarter of 2023 through the settlement date of February 1, 2023 (see Note 7. Equity for further discussion). Diluted earnings per share reflects the potential dilution that could occur if holders of the unvested equity awards converted their holdings into common stock and that could have occurred if holders of unsettled TEUs had converted their holdings into common stock prior to the February 1, 2023 settlement date. The weighted average number of potentially dilutive shares outstanding was calculated using the treasury stock method. Potential common shares that would have the effect of increasing diluted earnings per share (or reducing loss per share) are considered to be anti-dilutive and as such, these shares were not included in the calculation of diluted earnings (loss) per share.

Basic and diluted weighted-average shares outstanding were as follows:

Introduction

Elanco is a global animal health company that develops products for pets and farm animals in more than 90 countries. With a heritage dating back to 1954, we rigorously innovate to improve the health of animals and to benefit our customers while fostering an inclusive, cause-driven culture for our employees. We operate our business in a single segment directed at fulfilling our vision of enriching the lives of people through food, making protein more accessible and affordable, and through pet companionship, helping pets live longer, healthier lives. We advance our vision by offering products in the Pet Health and Farm Animal product categories.

We offer a diverse portfolio of approximately 200 brands that make us a trusted partner to pet owners, veterinarians and farm animal producers. Our products are generally sold worldwide to third-party distributors and independent retailers and directly to farm animal producers and veterinarians. With the acquisition of Bayer Animal Health in 2020, we expanded our presence in retail and e-commerce channels, allowing our customers to shop where and how they want.

During the six months ended June 30, 2023, we continued to incur costs related to integration activities, including the build out of processes and systems to support our global organization. Integration costs totaled $75 million for the six months ended June 30, 2023. We anticipate some additional costs through 2023 as we finalize these integration activities.

While there has been an overall improvement in the conditions related to the COVID-19 pandemic in 2023 as compared to 2022, we may continue to experience geographical variations. The extent to which the COVID-19 pandemic may continue to impact our financial condition and results of operations remains uncertain.

The following discussion and analysis of our results of operations should be read along with our condensed consolidated financial statements and the notes thereto.

In connection with the preparation of our financial statements as of and for the year ended December 31, 2022, a cumulative error was identified relating to the valuation allowance for taxes for a Southeast Asia affiliate. While immaterial to prior years, correcting this cumulative error in 2022 would have caused the 2022 financial statements to be materially misstated. As a result of having to make the revisions related to this error, we made other immaterial revisions to our 2022 unaudited interim consolidated financial statements. All of the revisions have been reflected throughout this Form 10-Q.